HCSB FINANCIAL CORP - FORM 10-Q

Attached files

file	filename
EX-32 - HCSB FINANCIAL CORP	e00560_ex32.htm
EX-31.2 - HCSB FINANCIAL CORP	e00560_ex31-2.htm
EX-31.1 - HCSB FINANCIAL CORP	e00560_ex31-1.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)
x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
	OF THE SECURITIES EXCHANGE ACT OF 1934

	For the Quarterly Period Ended September 30, 2016

	OR

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

For the Transition Period from _________to_________

Commission File Number 000-26995

HCSB FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

South Carolina	57-1079444
(State or other jurisdiction of incorporation)	(I.R.S. Employer Identification No.)

5201 Broad Street

Loris, South Carolina 29569

(Address of principal executive offices, including zip code)

(843) 756-6333

(Registrant’s telephone number, including area code)

________________________________________________

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 o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o

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 definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

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

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o No x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

	Voting Common Stock, par value $0.01 per share	405,232,383 shares outstanding as of November 1, 2016
	Non-Voting Common Stock, par value $0.01 per share	90,531,557 shares outstanding as of November 1, 2016

Index

PART I. FINANCIAL INFORMATION	Page No.

Item 1. Financial Statements (Unaudited)

Condensed Consolidated Balance Sheets – September 30, 2016 and December 31, 2015	3

Condensed Consolidated Statements of Operations – Nine and three months
ended September 30, 2016 and 2015	4

Condensed Consolidated Statements of Comprehensive Income (Loss) – Nine and three months
ended September 30, 2016 and 2015	5

Condensed Consolidated Statements of Changes in Shareholders’ Equity -
Nine months ended September 30, 2016 and 2015	6

Condensed Consolidated Statements of Cash Flows –
Nine months ended September 30, 2016 and 2015	7

Notes to Unaudited Condensed Consolidated Financial Statements	8

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	51

Item 3. Quantitative and Qualitative Disclosures about Market Risk	64

Item 4. Controls and Procedures	64

PART II. OTHER INFORMATION

Item 1. Legal Proceedings	65

Item 1A. Risk Factors	66

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	66

Item 3. Defaults Upon Senior Securities	66

Item 4. Mine Safety Disclosures	66

Item 5. Other Information	66

Item 6. Exhibits	66

SIGNATURES

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Item 1. Financial Statements

CONDENSED CONSOLIDATED BALANCE SHEETS

	September 30,			December 31,
(Dollars in thousands except share amounts)	2016			2015
Assets:	(unaudited)			(audited)
Cash and cash equivalents	$	31,174		$	22,137

Securities available-for-sale		111,581			89,701
Nonmarketable equity securities		1,090			1,330
Total investment securities		112,671			91,031

Loans receivable		209,176			209,367
Less allowance for loan losses		(4,676	)		(4,601	)
Loans, net		204,500			204,766

Premises and equipment, net		14,456			15,917
Accrued interest receivable		1,350			1,745
Cash value of life insurance		11,562			11,319
Other real estate owned		4,032			13,624
Other assets		1,362			884
Total assets	$	381,107		$	361,423

Liabilities and Shareholders’ Equity
Liabilities:
Deposits:
Noninterest-bearing transaction accounts	$	47,060		$	40,182
Interest-bearing transaction accounts		43,718			40,478
Money market savings accounts		69,948			65,806
Other savings accounts		12,119			10,394
Time deposits $250 and over		4,002			3,735
Other time deposits		146,503			170,236
Total deposits		323,350			330,831

Repurchase agreements		1,662			1,716
Advances from the Federal Home Loan Bank		17,000			17,000
Subordinated debentures		—			11,021
Junior subordinated debentures		—			6,117
Accrued interest payable		104			5,958
Other liabilities		2,398			1,030
Total liabilities		344,514			373,673

Commitments and contingencies

Shareholders’ Equity
Preferred stock, $0.01 par value; 5,000,000 shares authorized;
Series A, no shares issued and outstanding at September 30, 2016 and December 31, 2015		—			—
Series T, no shares issued and outstanding at September 30, 2016 and 12,895 shares issued and outstanding at December 31, 2015		—			12,895
Common stock, Voting, $0.01 par value, 500,000,000 shares authorized; 405,232,383 and 3,846,340 shares issued and outstanding at September 30, 2016 and December 31, 2015, respectively		4,053			38
Common stock, Non-voting, $0.01 par value, 150,000,000 shares authorized; 90,531,557 and no shares issued and outstanding at September 30, 2016 and December 31, 2015, respectively		905			—
Capital surplus		82,051			30,220
Common stock warrant		—			1,012
Retained deficit		(49,961	)		(54,807	)
Accumulated other comprehensive loss		(455	)		(1,608	)
Total shareholders’ equity (deficit)		36,593			(12,250	)
Total liabilities and shareholders’ equity (deficit)	$	381,107		$	361,423

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

-3-

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited)

	Nine months ended September 30,						Three months ended September 30,
(Dollars in thousands except share amounts)	2016			2015			2016			2015
Interest income:
Loans, including fees	$	7,731		$	8,875		$	2,667		$	3,088
Investment securities:
Taxable		1,273			1,501			426			506
Nonmarketable equity securities		39			37			11			8
Other interest income		172			53			68			16
Total		9,215			10,466			3,172			3,618
Interest expense:
Deposits		1,553			1,884			518			595
Borrowings		770			1,504			150			510
Total		2,323			3,388			668			1,105
Net interest income		6,892			7,078			2,504			2,513
Provision for loan losses		4,984			—			—			—

Net interest income after provision for loan losses		1,908			7,078			2,504			2,513

Noninterest income:
Service charges on deposit accounts		538			581			188			197
Gains on sales of securities available-for-sale		68			232			153			20
Gains on sales of mortgage loans		—			175			—			50
Other fees and commissions		239			325			70			93
Brokerage commissions		13			73			—			42
Income from cash value of life insurance		330			322			110			109
Net (loss) gain on sales of assets		(222	)		721			(222	)		736
Gain from early extinguishment of debt		19,115			—			—			—
Other operating income		122			283			35			96
Total		20,203			2,712			334			1,343

Noninterest expenses:
Salaries and employee benefits		4,602			4,155			1,648			1,330
Net occupancy expense		815			876			275			292
Furniture and equipment expense		663			764			218			266
FDIC insurance premiums		719			1,071			204			346
Net cost of operations of other real estate owned		6,229			465			1,392			382
Other operating expenses		3,317			2,229			885			837
Total		16,345			9,560			4,622			3,453

Income (loss) before income taxes		5,766			230			(1,784	)		403
Income tax expense		920			67			—			35
Net income (loss)	$	4,846		$	163		$	(1,784	)	$	368
Preferred dividends		—			(1,107	)		—			(514	)
Net income (loss) available to common shareholders	$	4,846		$	(944	)	$	(1,784	)	$	(146	)
Net income (loss) per common share
Basic	$	0.02		$	(0.25	)	$	(0.00	)	$	(0.04	)
Diluted	$	0.02		$	(0.25	)	$	(0.00	)	$	(0.04	)
Weighted average common shares outstanding
Basic and diluted		245,538,014			3,816,340			411,085,981			3,816,340

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

-4-

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(unaudited)

	Nine months ended September 30,
(Dollars in thousands)	2016			2015

Net income	$	4,846		$	163
Other comprehensive income (loss):
Unrealized gains (losses) on securities available-for-sale:
Net unrealized holding gains (losses) arising during the period, net of tax		1,221			141
Reclassification to realized gains		(68	)		(232	)
Other comprehensive income (loss), net of tax		1,153			(91	)
Comprehensive income	$	5,999		$	72

	Three months ended September 30,
(Dollars in thousands)	2016			2015

Net income (loss)	$	(1,784	)	$	368
Other comprehensive income (loss):
Unrealized gains (losses) on securities available-for-sale:
Net unrealized holding gains (losses) arising during the period, net of tax		(201	)		595
Reclassification to realized gains		(153	)		(20	)
Other comprehensive income (loss), net of tax		(354	)		575
Comprehensive income (loss)	$	(2,138	)	$	943

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

-5-

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

Nine months ended September 30, 2016 and 2015

(unaudited)

																				Accumulated
					Common															Other
	Common Stock				Stock			Preferred Stock						Capital			Retained			Comprehensive
	Shares		Amount		Warrant			Shares			Amount			Surplus			Deficit			Loss			Total
(Dollars in thousands except share data)

Balance, December 31, 2014		3,816,340	$	38	$	1,012			12,895		$	12,895		$	30,214		$	(54,561	)	$	(845	)	$	(11,247	)
Net income		—		—		—			—			—			—			163			—			163
Other comprehensive loss		—		—		—			—			—			—			—			(91	)		(91	)
Balance, September 30, 2015		3,816,340	$	38	$	1,012			12,895		$	12,895		$	30,214		$	(54,398	)	$	(936	)	$	(11,175	)

Balance, December 31, 2015		3,846,340	$	38	$	1,012			12,895		$	12,895		$	30,220		$	(54,807	)	$	(1,608	)	$	(12,250	)
Net income		—		—		—			—			—			—			4,846			—			4,846
Redemption of Series T preferred stock and CPP Warrant		—		—		(1,012	)		(12,895	)		(12,895	)		13,778			—			—			(129	)
Issuance of Series A preferred stock		—		—		—			905,316			9			9,044			—			—			9,053
Issuance of common stock		373,636,043		3,737		—			—			—			33,628			—			—			37,365
Stock issuance costs		—		—		—			—			—			(3,491	)		—			—			(3,491	)
Issuance of restricted stock		27,750,000		278		—			—			—			(278	)		—			—			—
Stock conversion		90,531,557		905		—			(905,316	)		(9	)		(896	)		—			—			—
Stock-based compensation expense		—		—		—			—			—			46			—			—			46
Other comprehensive income		—		—		—			—			—			—			—			1,153			1,153
Balance, September 30, 2016		495,763,940	$	4,958	$	—			—		$	—		$	82,051		$	(49,961	)	$	(455	)	$	36,593

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

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

(Dollars in thousands)	Nine months ended September 30,
	2016			2015
Cash flows from operating activities:
Net income	$	4,846		$	163
Adjustments to reconcile net income to net cash (used by) provided by operating activities:
Depreciation and amortization		497			570
Amortization of debt issuance costs		2			—
Provision for loan losses		4,984			—
Amortization less accretion on investments		178			130
Net gains on sales of securities available-for-sale		(68	)		(232	)
Net gains on sales of other real estate owned		(52	)		(530	)
Write-downs of other real estate owned		5,582			184
Gain from early extinguishment of debt		(19,115	)		—
Net gain on sale of branches		—			(736	)
Net loss on sale of assets		222			—
Stock based compensation expense		46			—
Decrease in accrued interest receivable		395			41
Increase in accrued interest payable		378			1,059
Income (net of mortality cost) on cash value of life insurance		(243	)		(237	)
(Increase) decrease in other assets		(618	)		1,474
Increase in other liabilities		1,368			99
Net cash (used by) provided by operating activities		(1,598	)		1,985

Cash flows from investing activities:
(Increase) decrease in loans to customers, net		(5,514	)		5,009
Purchases of securities available-for-sale		(80,655	)		(14,054	)
Maturities, calls and principal paydowns of securities available-for-sale		34,450			13,122
Proceeds from sales of securities available-for-sale		25,100			23,326
Redemptions of nonmarketable equity securities		240			12
Proceeds from sales of other real estate owned		4,858			5,395
Purchases of premises and equipment, net		964			(224	)
Net cash paid in branch sale		—			(23,933	)
Net cash (used by) provided by investing activities		(20,557	)		8,653

Cash flows from financing activities:
Net increase in demand deposits and savings		15,985			17,428
Net decrease in time deposits		(23,466	)		(26,915	)
Net decrease in repurchase agreements		(54	)		(493	)
Redemption of subordinated debentures		(3,454	)		—
Redemption of junior subordinated debentures		(617	)		—
Redemption of Series T preferred stock and CPP Warrant		(129	)		—
Issuance of Series A preferred stock		9,053			—
Issuance of common stock		37,364			—
Stock issuance costs		(3,490	)		—
Net cash provided by (used by) financing activities		31,192			(9,980	)

Net increase in cash and cash equivalents		9,037			658
Cash and cash equivalents, beginning of period		22,137			28,527
Cash and cash equivalents, end of period	$	31,174		$	29,185

Cash paid during the period for:
Income taxes	$	—		$	—
Interest	$	1,945		$	2,337

Noncash investing and financing activities:
Transfers of loans to other real estate owned	$	796		$	4,058
Change in unrealized gains (losses) on securities available-for-sale	$	885		$	(91	)

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

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 – ORGANIZATION, SIGNIFICANT ACCOUNTING POLICIES AND RECENT DEVELOPMENTS

Organization and Significant Accounting Policies

Basis of Presentation and Consolidation - The accompanying consolidated financial statements include the accounts of HCSB Financial Corporation (the “Company”) which was incorporated on June 10, 1999 to serve as a bank holding company for its wholly owned subsidiary, Horry County State Bank (the “Bank”). The Bank was incorporated on December 18, 1987, and opened for operations on January 4, 1988. The principal business activity of the Company is to provide commercial banking services in Horry County, South Carolina, and in Columbus and Brunswick Counties, North Carolina. The Bank is a state-chartered bank, and its deposits are insured by the Federal Deposit Insurance Corporation (the “FDIC”). HCSB Financial Trust I (the “Trust”) is a special purpose subsidiary organized for the sole purpose of issuing trust preferred securities. The trust preferred securities were redeemed in the second quarter of 2016. The operations of the Trust were not consolidated in the financial statements prior to the dissolution.

The accompanying consolidated financial statements have been prepared in accordance with the requirements for interim financial statements and, accordingly, they are condensed and omit disclosures, which would substantially duplicate those contained in the most recent annual report to shareholders. The financial statements as of September 30, 2016 and for the interim periods ended September 30, 2016 and 2015 are unaudited and, in our opinion, include all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation. Operating results for the nine and three month periods ended September 30, 2016 are not necessarily indicative of the results that may be expected for the year ending December 31, 2016. The financial information as of December 31, 2015 has been derived from the audited financial statements as of that date. For further information, refer to the financial statements and the notes included in HCSB Financial Corporation’s 2015 Annual Report on Form 10-K which was filed with the Securities and Exchange Commission (the “SEC”) on March 30, 2016, as amended on Form 10-K/A which was filed with the SEC on April 1, 2016.

Management’s Estimates - In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the balance sheet date and income and expenses for the period. Actual results could differ significantly from those estimates.

Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan losses, including valuation allowances for impaired loans, and the carrying amount of real estate acquired in connection with foreclosures or in satisfaction of loans. Management must also make estimates in determining the estimated useful lives and methods for depreciating premises and equipment.

While management uses available information to recognize losses on loans and foreclosed real estate, future additions to the allowance may be necessary based on changes in local economic conditions. In addition, regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowances for losses on loans and foreclosed real estate. Such agencies may require the Company to recognize additions to the allowances based on their judgments about information available to them at the time of their examination. Because of these factors, it is reasonably possible that the allowances for losses on loans and foreclosed real estate may change materially in the near term.

Investment Securities - Investment securities available-for-sale owned by the Company are carried at amortized cost and adjusted to their estimated fair value for reporting purposes. The unrealized gain or loss is recorded in shareholders’ equity net of any deferred tax effects. Management does not actively trade securities classified as available-for-sale, but intends to hold these securities for an indefinite period of time and may sell them prior to maturity to achieve certain objectives. Reductions in fair value considered by management to be other than temporary are reported as a realized loss and a reduction in the cost basis in the security. The adjusted cost basis of securities available-for-sale is determined by specific identification and is used in computing the realized gain or loss from a sales transaction.

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to Unaudited CONDENSED Consolidated Financial Statements

NOTE 1 – ORGANIZATION, SIGNIFICANT ACCOUNTING POLICIES AND RECENT DEVELOPMENTS - continued

Nonmarketable Equity Securities - Nonmarketable equity securities include the Company’s investment in the stock of the Federal Home Loan Bank (the “FHLB”). The FHLB stock is carried at cost because the stock has no quoted market value and no ready market exists. Investment in FHLB stock is a condition of borrowing from the FHLB, and the stock is pledged to collateralize the borrowings. Dividends received on FHLB stock are included as a separate component in interest income.

Loans Receivable - Loans receivable are stated at their unpaid principal balance, less any charge-offs. Interest income on loans is computed based upon the unpaid principal balance. Interest income is recorded in the period earned.

The accrual of interest income is generally discontinued when a loan becomes contractually 90 days past due as to principal or interest. Management may elect to continue the accrual of interest when the estimated net realizable value of collateral exceeds the principal balance and accrued interest.

Loan origination and commitment fees and certain direct loan origination costs (principally salaries and employee benefits) are deferred and amortized to income over the contractual life of the related loans or commitments, adjusted for prepayments, using the straight-line method.

Loans are impaired when it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. All loans are subject to these criteria except for smaller balance homogeneous loans that are collectively evaluated for impairment and loans measured at fair value or at the lower of cost or fair value. The Company considers its consumer installment portfolio and home equity lines as such exceptions. Therefore, loans within the real estate and commercial loan portfolios are reviewed individually.

Impairment of a loan is measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the collateral, if the loan is collateral dependent. When management determines that a loan is impaired, the difference between the Company’s investment in the related loan and the present value of the expected future cash flows, or the fair value of the collateral, is charged off with a corresponding entry to the allowance for loan losses or a specific reserve is set aside within the allowance for loan losses. The accrual of interest is discontinued on an impaired loan when management determines the borrower may be unable to meet payments as they become due.

Concentrations of Credit Risk - Financial instruments, which potentially subject the Company to concentrations of credit risk, consist principally of loans receivable, investment securities, federal funds sold and amounts due from banks.

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to Unaudited CONDENSED Consolidated Financial Statements

NOTE 1 – ORGANIZATION, SIGNIFICANT ACCOUNTING POLICIES AND RECENT DEVELOPMENTS - continued

The Company makes loans to individuals and small businesses for various personal and commercial purposes primarily throughout Horry County in South Carolina and Columbus and Brunswick counties of North Carolina. The Company’s loan portfolio is not concentrated in loans to any single borrower or a relatively small number of borrowers. However, the loan portfolio does include a concentration in loans secured by residential and commercial real estate and commercial and industrial non-real estate loans. These loans are especially susceptible to being adversely effected by unfavorable economic conditions. The commercial real estate collateral in each case provides an alternate source of repayment in the event of default by the borrower and may deteriorate in value during the time the credit is extended. If real estate values in our market areas decline, it is also more likely that we would be required to increase our allowance for loan losses.

In addition to monitoring potential concentrations of loans to particular borrowers or groups of borrowers, industries and geographic regions, management monitors exposure to credit risk from concentrations of lending products and practices such as loans that subject borrowers to substantial payment increases (e.g. principal deferral periods, loans with initial interest-only periods, etc.), and loans with high loan-to-value ratios. Management has determined that there is no concentration of credit risk associated with its lending policies or practices. Additionally, there are industry practices that could subject the Company to increased credit risk should economic conditions change over the course of a loan’s life. For example, the Company makes variable rate loans and fixed rate principal-amortizing loans with maturities prior to the loan being fully paid (i.e. balloon payment loans). These loans are underwritten and monitored to manage the associated risks. Therefore, management believes that these particular practices do not subject the Company to unusual credit risk.

The Company’s investment portfolio consists principally of obligations of the United States, its agencies or its corporations and general obligation municipal securities. In the opinion of management, there is no concentration of credit risk in its investment portfolio. The Company places its deposits and correspondent accounts with and sells its federal funds to high quality institutions. Management believes credit risk associated with correspondent accounts is not significant.

Allowance for Loan Losses – The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectability of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectability of the loans in light of historical experiences, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available. Management’s judgments about the adequacy of the allowance are based on numerous assumptions about current events, which management believes to be reasonable, but which may or may not prove to be accurate. Thus, there can be no assurance that loan losses in future periods will not exceed the current allowance amount or that future increases in the allowance will not be required. No assurance can be given that management’s ongoing evaluation of the loan portfolio in light of changing economic conditions and other relevant circumstances will not require significant future additions to the allowance, thus adversely affecting the operating results of the Company.

The allowance is subject to examination by regulatory agencies, which may consider such factors as the methodology used to determine adequacy and the size of the allowance relative to that of peer institutions, and other adequacy tests. In addition, such regulatory agencies could require the Company to adjust its allowance based on information available to them at the time of their examination.

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to Unaudited CONDENSED Consolidated Financial Statements

NOTE 1 – ORGANIZATION, SIGNIFICANT ACCOUNTING POLICIES AND RECENT DEVELOPMENTS - continued

The methodology used to determine the reserve for unfunded lending commitments, which is included in other liabilities, is inherently similar to that used to determine the allowance for loan losses adjusted for factors specific to binding commitments, including the probability of funding and historical loss ratio.

Premises, Furniture and Equipment - Premises, furniture and equipment are stated at cost less accumulated depreciation. The provision for depreciation is computed by the straight-line method. Rates of depreciation are generally based on the following estimated useful lives: buildings - 40 years; furniture and equipment - three to ten years. The cost of assets sold or otherwise disposed of and the related accumulated depreciation is eliminated from the accounts, and the resulting gains or losses are reflected in the income statement.

Maintenance and repairs are charged to current expense as incurred, and the costs of major renewals and improvements are capitalized.

Other Real Estate Owned - Other real estate owned (“OREO”) includes real estate acquired through foreclosure. OREO is initially recorded at appraised value, less estimated costs to sell.

Any write-downs at the dates of acquisition are charged to the allowance for loan losses. Expenses to maintain such assets, subsequent write-downs, and gains and losses on disposal are included in net cost (profit) of operations of other real estate owned on the statement of operations.

Income and Expense Recognition - The accrual method of accounting is used for all significant categories of income and expense. Immaterial amounts of insurance commissions and other miscellaneous fees are reported when received.

Income Taxes – The Company files a consolidated federal income tax return and separate company state income tax returns. Federal income tax expense or benefit has been allocated to subsidiaries on a separate return basis. The Company accounts for income taxes based on two components of income tax expense: current and deferred. Current income tax expense approximates taxes to be paid or refunded for the current period and includes income tax expense related to uncertain tax positions, if any.

Deferred income taxes are determined using the balance sheet method. Under this method, the net deferred tax asset or liability is based on the tax impacts of the differences between the book and tax bases of assets and liabilities and recognizes enacted changes in tax rates and laws in the period in which they occur. Deferred income tax expense results from changes in deferred tax assets and liabilities between periods. Deferred tax assets are recognized subject to the Company’s judgment that realization is more likely than not. A tax position that meets the more likely than not recognition threshold is measured to determine the amount of benefit to recognize. The tax position is measured at the largest amount of benefit that is greater than 50% likely of being realized upon settlement. Interest and penalties, if any, are recognized as a component of income tax expense.

The Company reviews the deferred tax assets for recoverability based on history of earnings, expectations for future earnings and expected timing of reversals of temporary differences. Realization of a deferred tax asset ultimately depends on the existence of sufficient taxable income available under tax law, including future reversals of existing temporary differences, future taxable income exclusive of reversing differences, taxable income in prior carryback years, projections of future operating results, cumulative tax losses over the past three years, tax loss deductibility limitations, and available tax planning strategies. If, based on available information, it is more likely than not that the deferred income tax asset will not be realized, a valuation allowance against the deferred tax asset must be established with a corresponding charge to income tax expense. The deferred tax assets and valuation allowance are evaluated each quarter, and a portion of the valuation allowance may be reversed in future periods. The determination of how much of the valuation allowance that may be reversed and the timing is based on future results of operation and the amount and timing of actual loan charge-offs and asset write-downs. Due to the private placement in April 2016 that removed the going concern considerations, the Company recorded a deferred tax asset of $267 thousand related to unrealized losses in the securities available-for-sale portfolio. The remaining deferred tax asset was offset by a valuation allowance. At December 31, 2015, the Company’s deferred tax asset was offset in its entirety by a valuation allowance.

-11-

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to Unaudited CONDENSED Consolidated Financial Statements

NOTE 1 – ORGANIZATION, SIGNIFICANT ACCOUNTING POLICIES AND RECENT DEVELOPMENTS - continued

The Company believes that its income tax filing positions taken or expected to be taken in its tax returns will more likely than not be sustained upon audit by the taxing authorities and does not anticipate any adjustments that will result in a material adverse impact on the Company’s financial condition, results of operations, or cash flow. Therefore no reserves for uncertain income tax positions have been recorded.

Net Income (Loss) Per Common Share - Basic income (loss) per common share is calculated by dividing net income (loss) by the weighted-average number of common shares outstanding during the period. Diluted net income per common share is computed based on net income divided by the weighted average number of common and potential common shares. The computation of diluted net loss per share does not include potential common shares as their effect would be anti-dilutive. There were no common share equivalents at September 30, 2016.

Comprehensive Income - Accounting principles generally require recognized income, expenses, gains, and losses to be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and losses on available-for-sale securities, are reported as a separate component of the equity section of the balance sheet, such items, along with net income, are components of comprehensive income and are also presented in a separate statement of comprehensive income. Accumulated other comprehensive income for the Company consists entirely of unrealized holding gains and losses on available-for-sale securities.

Statements of Cash Flows - For purposes of reporting cash flows, the Company considers certain highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents. Cash equivalents include amounts due from banks, federal funds sold, and interest-bearing deposits with other banks.

Off-Balance Sheet Financial Instruments - In the ordinary course of business, the Company enters into off-balance sheet financial instruments consisting of commitments to extend credit and letters of credit. These financial instruments are recorded in the financial statements when they become payable by the customer.

Recently Issued Accounting Pronouncements – The following is a summary of recent authoritative pronouncements.

In May 2014, the Financial Accounting Standards Board (“FASB”) issued guidance to change the recognition of revenue from contracts with customers. The core principle of the new guidance is that an entity should recognize revenue to reflect the transfer of goods and services to customers in an amount equal to the consideration the entity receives or expects to receive. The guidance will be effective for the Company for reporting periods beginning after December 15, 2017. The Company does not expect these amendments to have a material effect on its financial statements.

In January 2015, the FASB issued guidance to eliminate from U.S. GAAP the concept of an extraordinary item, which is an event or transaction that is both (1) unusual in nature and (2) infrequently occurring. Under the new guidance, an entity will no longer (1) segregate an extraordinary item from the results of ordinary operations; (2) separately present an extraordinary item on its income statement, net of tax, after income from continuing operations; or (3) disclose income taxes and earnings-per-share data applicable to an extraordinary item. The amendments were effective for the Company on January 1, 2016. The Company is applying the guidance prospectively. The amendments had no effect on the financial statements.

-12-

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to Unaudited CONDENSED Consolidated Financial Statements

NOTE 1 – ORGANIZATION, SIGNIFICANT ACCOUNTING POLICIES AND RECENT DEVELOPMENTS - continued

In February 2015, the FASB issued guidance which amends the consolidation requirements and significantly changes the consolidation analysis required under U.S. GAAP. The amendments were effective for the Company on January 1, 2016 and did not have a material effect on the financial statements.

In April 2015, the FASB issued guidance which changes the presentation of debt issuance costs. The amendments were effective for the Company on January 1, 2016. As a result, all debt issuance costs were reclassified to offset related debt.

In August 2015, the FASB deferred the effective date of Accounting Standards Update (“ASU”) 2014-09, Revenue from Contracts with Customers. As a result of the deferral, the guidance in ASU 2014-09 will be effective for the Company for reporting periods beginning after December 15, 2017. The Company does not expect these amendments to have a material effect on its financial statements.

In August 2015, the FASB issued amendments to the Interest topic of the ASC to clarify the SEC staff’s position on presenting and measuring debt issuance costs incurred in connection with line-of-credit arrangements. The amendments were effective upon issuance. The amendments did not have a material effect on the Company’s financial statements.

In January 2016, the FASB amended the Financial Instruments topic of the ASC to address certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. The amendments will be effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The Company will apply the guidance by means of a cumulative-effect adjustment to the balance sheet as of the beginning of the fiscal year of adoption. The amendments related to equity securities without readily determinable fair values will be applied prospectively to equity investments that exist as of the date of adoption of the amendments. The Company does not expect these amendments to have a material effect on its financial statements.

In February 2016, the FASB amended the Leases topic of the ASC to revise certain aspects of recognition, measurement, presentation, and disclosure of leasing transactions. The amendments will be effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. The Company is currently evaluating the effect that implementation of the new standard will have on its financial position, results of operations, and cash flows.

In March 2016, the FASB amended the Revenue from Contracts with Customers topic of the ASC to clarify the implementation guidance on principal versus agent considerations and address how an entity should assess whether it is the principal or the agent in contracts that include three or more parties. The amendments will be effective for the Company for reporting periods beginning after December 15, 2017. The Company does not expect these amendments to have a material effect on its financial statements.

In March 2016, the FASB issued guidance to simplify several aspects of the accounting for share-based payment award transactions including the income tax consequences, the classification of awards as either equity or liabilities, and the classification on the statement of cash flows. Additionally, the guidance simplifies two areas specific to entities other than public business entities allowing them to apply a practical expedient to estimate the expected term for all awards with performance or service conditions that have certain characteristics and also allowing them to make a one-time election to switch from measuring all liability-classified awards at fair value to measuring them at intrinsic value. The amendments will be effective for the Company for annual periods beginning after December 15, 2016 and interim periods within those annual periods. The Company does not expect these amendments to have a material effect on its financial statements.

-13-

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to Unaudited CONDENSED Consolidated Financial Statements

NOTE 1 – ORGANIZATION, SIGNIFICANT ACCOUNTING POLICIES AND RECENT DEVELOPMENTS - continued

In June 2016, the FASB issued guidance to change the accounting for credit losses and modify the impairment model for certain debt securities. The amendments will be effective for the Company for reporting periods beginning after December 15, 2019. The Company is currently evaluating the effect that implementation of the new standard will have on its financial position, results of operations, and cash flows.

In August 2016, the FASB amended the Statement of Cash Flows topic of the ASC to clarify how certain cash receipts and cash payments are presented and classified in the statement of cash flows. The amendments will be effective for the Company for fiscal years beginning after December 15, 2017 including interim periods within those fiscal years. The Company does not expect these amendments to have a material effect on its financial statements.

Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies are not expected to have a material impact on the Company’s financial position, results of operations or cash flows.

Risks and Uncertainties - In the normal course of its business, the Company encounters two significant types of risks: economic and regulatory. There are three main components of economic risk: interest rate risk, credit risk and market risk. The Company is subject to interest rate risk to the degree that its interest-bearing liabilities mature or reprice at different speeds, or on a different basis, than its interest-earning assets. Credit risk is the risk of default on the Company’s loan portfolio that results from a borrower’s inability or unwillingness to make contractually required payments. Market risk reflects changes in the value of collateral underlying loans receivable and the valuation of real estate held by the Company.

The Company is subject to the regulations of various governmental agencies. These regulations can and do change significantly from period to period. The Company also undergoes periodic examinations by the regulatory agencies, which may subject it to further changes with respect to asset valuations, amounts of required loss allowances and operating restrictions from the regulators’ judgments based on information available to them at the time of their examination.

Reclassifications - Certain captions and amounts for prior periods have been reclassified to conform to the current presentation. These reclassifications had no effect on net income (loss) or shareholders’ equity (deficit) as previously reported.

-14-

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to Unaudited CONDENSED Consolidated Financial Statements

NOTE 1 – ORGANIZATION, SIGNIFICANT ACCOUNTING POLICIES AND RECENT DEVELOPMENTS - continued

Recent Developments

On February 10, 2011, the Bank entered into a Consent Order (the “Consent Order”) with the FDIC and the South Carolina Board of Financial Institutions (the “State Board”). The Consent Order conveyed specific actions needed to address the Bank’s current financial condition, primarily related to capital planning, liquidity/funds management, policy and planning issues, management oversight, loan concentrations and classifications, and non-performing loans. On October 26, 2016, the Bank received notification that the Consent Order was terminated by the FDIC and the State Board and was replaced with certain regulatory requirements and restrictions, including a requirement to continue to improve credit quality and earnings, a restriction prohibiting dividend payments without prior approval from the supervisory authorities, and a requirement to maintain Tier 1 capital at least equal to 8% and total risk-based capital at least equal to 10%. As of September 30, 2016, we believe the Bank is in substantial compliance with the new requirements and restrictions set forth by the supervisory authorities.

On April 11, 2016, the Company completed a private placement of 359,468,443 shares of common stock at $0.10 per share and 905,316 shares of a new series of convertible perpetual preferred stock, Series A (the “Series A preferred stock”), at $10.00 per share for aggregate cash proceeds of approximately $45.0 million (the “2016 private placement”). Net proceeds from the 2016 private placement, after deducting commissions and expenses, were approximately $41.5 million, of which $38.0 million was contributed to the Bank as a capital contribution to support its operations and increase its capital ratios to meet the then higher minimum capital ratios required under the terms of the recently terminated Consent Order. Net proceeds from the 2016 private placement were also used to repurchase the Company’s outstanding Series T preferred stock (as defined below), trust preferred securities, and subordinated promissory notes, as described below.

On June 30, 2016, the Company completed a public offering of 14,167,600 shares of common stock at $0.10 per share for aggregate cash proceeds of approximately $1.4 million (the “2016 follow-on offering”). The 2016 follow-on offering was conducted primarily to provide the Company’s legacy shareholders, employees and others in its community with an opportunity to invest in the Company at the same offering price of $0.10 per share that the Company offered to the investors in the 2016 private placement. The offering period ended at 5:00 p.m., Eastern Standard time, on June 30, 2016. The proceeds were used for general corporate and operational purposes.

On July 7, 2016, the Company sold $4.3 million of nonaccrual loans and $270 thousand of other real estate owned (“OREO”). The loans and OREO were recorded at fair value as of June 30, 2016.

On August 23, 2016, the Company filed Articles of Amendment to its Articles of Incorporation to authorize a class of 150,000,000 shares of non-voting common stock. Also on August 23, 2016, the Company converted 905,316 shares of issued and outstanding Series A preferred stock into 90,531,557 shares of non-voting common stock. The 905,316 shares of Series A preferred stock converted into 90,531,557 shares of non-voting common stock represented all of the issued and outstanding shares of Series A preferred stock on such date and, as a result, all shares of the Series A preferred stock are no longer outstanding and resumed the status of authorized and unissued shares of the Company’s preferred stock.

On July 31, 2010, the Company completed a private placement of subordinated promissory notes that totaled $12.1 million. The notes bore interest at a rate equal to the current Prime Rate in effect, as published by the Wall Street Journal, plus 3%; provided, that the interest rate would not be less than 8% per annum or more than 12% per annum. Beginning in October 2011, the Federal Reserve Bank of Richmond prohibited the Company from paying interest due on the subordinated promissory notes. Effective as of September 16, 2015, the Company, the Bank, and certain other defendants entered into a class action settlement agreement in potential settlement of the putative class action lawsuit initiated by three holders of the Company’s subordinated promissory notes, on behalf of themselves and as representatives of a class of similarly situated purchasers of the Company’s subordinated promissory notes, with respect to alleged wrongful conduct associated with purchases of the subordinated promissory notes, including fraud, violation of state securities statutes, and negligence. On March 2, 2016, the Court of Common Pleas for the Fifteenth Judicial District, State of South Carolina, County of Horry entered a final order of approval approving the class action settlement agreement. Immediately following the closing of the 2016 private placement on April 11, 2016, pursuant to the terms of the class action settlement agreement, the Company established a settlement fund of approximately $2.4 million, which represented 20% of the principal of subordinated promissory notes issued by the Company. The settlement fund was used to redeem the subordinated promissory notes held by class members. Also on April 11, 2016, the Company settled, pursuant to previously executed binding settlement agreements, with all subordinated promissory note holders who opted out of the class action settlement. These settlements, including the class action settlement, constituted the full satisfaction of the principal and interest owed on, and required the immediate dismissal of all pending litigation related to, the respective subordinated promissory notes. In each case, the Company and the Bank also obtained a full and complete release of all claims asserted or that could have been asserted with respect to the subordinated promissory notes. Refer to Note 8 to our Financial Statements for additional information on the subordinated promissory notes.

-15-

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to Unaudited CONDENSED Consolidated Financial Statements

NOTE 1 – ORGANIZATION, SIGNIFICANT ACCOUNTING POLICIES AND RECENT DEVELOPMENTS - continued

On March 6, 2009, as part of the Troubled Asset Relief Program (the “TARP”) Capital Purchase Program (the “CPP”) established by the U.S. Department of the Treasury (the “U.S. Treasury”) under the Emergency Economic Stabilization Act of 2009, the Company issued and sold to the U.S. Treasury (i) 12,895 shares of fixed rate cumulative perpetual preferred stock, Series T, having a liquidation preference of $1,000 per share (the “Series T preferred stock”), and (ii) a ten-year warrant to purchase up to 91,714 shares of its common stock at an initial exercise price of $21.09 per share (the “CPP Warrant”), for an aggregate purchase price of $12.9 million in cash. Beginning in February 2011, the Federal Reserve Bank of Richmond required the Company to defer dividend payments on the Series T preferred stock. On February 29, 2016, the Company entered into a securities purchase agreement with the U.S. Treasury, pursuant to which the Company agreed to repurchase all 12,895 shares of the Series T preferred stock for $129 thousand, plus reimbursement of attorneys’ fees and other expenses incurred by the U.S Treasury not to exceed $25 thousand. Under the terms of the securities purchase agreement, the U.S. Treasury also agreed to waive any and all unpaid dividends on the Series T preferred stock and to cancel the CPP Warrant.

Immediately following the closing of the 2016 private placement on April 11, 2016, pursuant to the terms of the securities purchase agreement, the Company repurchased all 12,895 shares of the Series T preferred stock from the U.S. Treasury for $129 thousand and the U.S. Treasury canceled the CPP Warrant. Refer to Note 9 to our Financial Statements for additional information on the Series T preferred stock.

On December 21, 2004, the Trust issued and sold a total of 6,000 trust preferred securities, with $1,000 liquidation amount per capital security and a maturity of December 31, 2034, to institutional buyers in a pooled trust preferred issue. The Company received from the Trust the $6.0 million proceeds from the issuance of the securities and the $186 thousand initial proceeds from the capital investment in the Trust and, accordingly, has shown the funds due to the trust as a $6.2 million junior subordinated debenture. Beginning in February 2011, the Federal Reserve Bank of Richmond prohibited the Company from paying interest due on the trust preferred securities. The Company was permitted to defer these interest payments for up to 20 consecutive quarterly periods, or until March 15, 2016, at which point all of the deferred interest, including interest accrued on such deferred interest, would become due and payable. On February 29, 2016, the Company entered into a securities purchase agreement with Alesco Preferred Funding VI LTD (“Alesco”), pursuant to which the Company agreed to repurchase the trust preferred securities for $600 thousand, plus reimbursement of attorneys’ fees and other expenses incurred by Alesco not to exceed $25 thousand. Alesco also agreed to forgive any and all unpaid interest on the trust preferred securities. On March 16, 2016, the Company received a notice of default from The Bank of New York Mellon Trust Company, N.A., in its capacity as trustee, relating to the trust preferred securities. Immediately following the closing of the 2016 private placement on April 11, 2016, pursuant to the terms of the securities purchase agreement, the Company repurchased all of the trust preferred securities from Alesco for $600 thousand plus $17 thousand in direct legal expenses. Refer to Note 7 to our Financial Statements for additional information on the trust preferred securities.

After taking into account the discounted repurchase or redemption prices for the Series T preferred stock, the trust preferred securities and the subordinated promissory notes, each as described above, as well as the forgiveness of accrued and deferred interest, legal fees, amounts paid in settlement of litigation, income taxes, and other expenses incurred in connection with these transactions, the Company recognized a gain, net of income taxes, of approximately $13.8 million on the repurchase of the Series T preferred stock, which is included in capital surplus and an aggregate gain of $19.1 million from the extinguishment of debt which is included in noninterest income. See the respective notes referred to above for additional information.

-16-

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to Unaudited CONDENSED Consolidated Financial Statements

NOTE 2 – REGULATORY MATTERS AND OTHER CONSIDERATIONS

Removal of Consent Order with the Federal Deposit Insurance Corporation and South Carolina Board of Financial Institutions

As noted above, on February 10, 2011, the Bank entered into the Consent Order with the FDIC and the State Board. The Consent Order conveyed specific actions needed to address the Bank’s current financial condition, primarily related to capital planning, liquidity/funds management, policy and planning issues, management oversight, loan concentrations and classifications, and non-performing loans. On October 26, 2016 the Consent Order was terminated by the FDIC and the State Board and was replaced with certain regulatory requirements and restrictions, including a requirement to continue to improve credit quality and earnings, a restriction prohibiting dividend payments without prior approval from the supervisory authorities, and a requirement to maintain Tier 1 capital at least equal to 8% and total risk-based capital at least equal to 10%. We believe that we are currently in substantial compliance with the new regulatory requirements and restrictions.

Written Agreement

On May 9, 2011, the Company entered into a Written Agreement with the Federal Reserve Bank of Richmond. The Written Agreement is designed to enhance the Company’s ability to act as a source of strength to the Bank.

The Written Agreement contains provisions similar to those in the recently terminated Consent Order. Specifically, pursuant to the Written Agreement, the Company agreed, among other things, to seek the prior written approval of the Federal Reserve Bank of Richmond before undertaking any of the following activities:

declaring or paying any dividends,

directly or indirectly taking dividends or any other form of payment representing a reduction in capital from the Bank,

making any distributions of interest, principal or other sums on subordinated debentures or trust preferred securities,

directly or indirectly, incurring, increasing or guarantying any debt, and

directly or indirectly, purchasing or redeeming any shares of its stock.

-17-

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to Unaudited CONDENSED Consolidated Financial Statements

NOTE 2 – REGULATORY MATTERS AND OTHER CONSIDERATIONS - continued

The Company also agreed to comply with certain notice provisions set forth in the Federal Deposit Insurance Act and regulations of the Board of Governors of the Federal Reserve System (the “Federal Reserve”) in appointing any new director or senior executive officer, or changing the responsibilities of any senior executive officer so that the officer would assume a different senior executive officer position. The Company is also required to comply with certain restrictions on indemnification and severance payments pursuant to the Federal Deposit Insurance Act and FDIC regulations.

We believe we are currently in substantial compliance with the Written Agreement.

On August 18, 2014, the Federal Reserve Bank of Richmond informed the Company that it was required to repay two notes in the amount of $1.8 million to the Bank as soon as the Company has the funds available to do so for repayment of loans deemed made from the Bank to the Company. The Bank was a general unsecured creditor of the Company with respect to these loans. The Company made these payments to the Bank shortly following the closing of the private placement on April 11, 2016.

Other Considerations

The effects of the Great Recession continue to be felt across many industries, with financial services and residential real estate being particularly hard hit. The Bank, with a loan portfolio consisting of a concentration in commercial real estate loans, experienced a decline in the value of the collateral securing its loan portfolio as well as a rapid deterioration in its borrowers’ cash flow and ability to repay their outstanding loans to the Bank. As a result, the Bank’s level of nonperforming assets increased substantially during 2010 and 2011. However, since 2012, the Bank’s nonperforming assets have begun to stabilize. In addition to increasing write-downs on OREO to expedite sales during the first nine months of 2016, the Bank sold $4.3 million of nonperforming loans and $270 thousand of OREO which had been reduced to fair value prior to the sale. The Bank’s nonperforming assets at September 30, 2016 were $5.0 million compared to $22.4 million at December 31, 2015. As a percentage of total assets, nonperforming assets were 1.30% and 6.19% as of September 30, 2016 and December 31, 2015, respectively. As a percentage of total loans, nonperforming loans were 0.45% and 4.18% as of September 30, 2016 and December 31, 2015, respectively.

The Company and the Bank operate in a highly regulated industry and must plan for the liquidity needs of each entity separately. A variety of sources of liquidity have historically been available to the Bank to meet its short-term and long-term funding needs. Although a number of these sources have been limited following execution of the Consent Order (which was terminated on October 26, 2016), management has prepared forecasts of these sources of funds and the Bank’s projected uses of funds during 2016 in an effort to ensure that the sources available are sufficient to meet the Bank’s projected liquidity needs for this period.

Prior to the most recent economic downturn, the Company, if needed, would have relied on dividends from the Bank as its primary source of liquidity. The Company is a legal entity separate and distinct from the Bank. However, various legal limitations restrict the Bank from lending or otherwise supplying funds to the Company to meet its obligations, including paying dividends. In addition, regulatory restrictions remaining following the termination of the Consent Order further limit the Bank’s ability to pay dividends to the Company to satisfy its funding needs.

Management believes the Bank’s liquidity sources are adequate to meet its needs for at least the next 12 months.

-18-

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to Unaudited Condensed Consolidated Financial Statements

NOTE 3 - INVESTMENT SECURITIES

Securities available-for-sale consisted of the following:

	Amortized		Gross Unrealized					Estimated
(Dollars in thousands)	Cost		Gains		Losses			Fair Value
September 30, 2016
Government-sponsored enterprises	$	8,870	$	71	$	(59	)	$	8,882
Mortgage-backed securities		88,518		236		(987	)		87,767
State and political subdivisions		14,916		85		(69	)		14,932
Total	$	112,304	$	392	$	(1,115	)	$	111,581

December 31, 2015
Government-sponsored enterprises	$	36,720	$	—	$	(688	)	$	36,032
Mortgage-backed securities		53,368		54		(977	)		52,445
State and political subdivisions		1,221		5		(2	)		1,224
Total	$	91,309	$	59	$	(1,667	)	$	89,701

The following is a summary of maturities of securities available-for-sale as of September 30, 2016. The amortized cost and estimated fair values are based on the contractual maturity dates. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without penalty.

September 30, 2016 (in thousands)	Amortized Cost Due
	Due		After One		After Five
	Within		Through		Through		After Ten				Market
	One Year		Five Years		Ten Years		Years		Total		Value

Government-sponsored enterprises	$	—	$	285	$	2,000	$	6,585	$	8,870	$	8,882
Mortgage backed securities		—		—		19,846		68,672		88,518		87,767
State and political subdivisions		—		—		9,634		5,282		14,916		14,932
Total	$	—	$	285	$	31,480	$	80,539	$	112,304	$	111,581

The following table shows gross unrealized losses and fair value, aggregated by investment category, and length of time that individual securities have been in a continuous unrealized loss position, at:

	September 30, 2016
	Less than twelve months					Twelve months or more					Total
	Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
(Dollars in thousands)	Value		Losses			Value		Losses			Value		Losses

Government-sponsored enterprises	$	6,527	$	(58	)	$	284	$	(1	)	$	6,811	$	(59	)
Mortgage-backed securities		38,331		(348	)		19,500		(639	)		57,831		(987	)
State and political subdivisions		11,042		(69	)		—		—			11,042		(69	)
Total	$	55,900	$	(475	)	$	19,784	$	(640	)	$	75,684	$	(1,115	)

	December 31, 2015
	Less than twelve months					Twelve months or more					Total
	Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
(Dollars in thousands)	Value		Losses			Value		Losses			Value		Losses

Government-sponsored enterprises	$	31,489	$	(558	)	$	4,543	$	(130	)	$	36,032	$	(688	)
Mortgage-backed securities		28,024		(354	)		17,008		(623	)		45,032		(977	)
State and political subdivisions		617		(2	)		—		—			617		(2	)
Total	$	60,130	$	(914	)	$	21,551	$	(753	)	$	81,681	$	(1,667	)

-19-

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to Unaudited Condensed Consolidated Financial Statements

NOTE 3 - INVESTMENT SECURITIES - continued

Management evaluates its investment portfolio periodically to identify any impairment that is other than temporary. At September 30, 2016, the Company had one government-sponsored enterprise security and 20 mortgage-backed securities that have been in an unrealized loss position for more than twelve months. Management believes these losses are temporary and are a result of the current interest rate environment. The Company does not intend to sell these securities and it is more likely than not that the Company will not be required to sell these securities before recovery of their amortized cost.

At September 30, 2016 and December 31, 2015, investment securities with a book value of $45.0 million and $36.7 million, respectively, and a market value of $44.7 million and $36.1 million, respectively, were pledged to secure deposits.

Proceeds from sales of available-for-sale securities were $25.1 million and $23.3 million for the nine-month periods ended September 30, 2016 and 2015, respectively and $16.9 million and $5.4 million for the three-month periods ended September 30, 2016 and 2015, respectively. Gross realized gains and losses on sales of available-for-sale securities for the periods ended were as follows:

(Dollars in thousands)	Three months ended September 30,					Nine months ended September 30,
	2016			2015		2016			2015
Gross realized gains	$	180		$	20	$	217		$	232
Gross realized losses		(27	)		—		(149	)		—
Net gain	$	153		$	20	$	68		$	232

NOTE 4 – LOAN PORTFOLIO

Loans consisted of the following:

	September 30,		December 31,
(Dollars in thousands)	2016		2015

Residential	$	72,417	$	75,081
Commercial Real Estate		97,573		101,291
Commercial		34,304		27,881
Consumer		4,882		5,114
Total gross loans	$	209,176	$	209,367

At June 30, 2016, $4.3 million of loans receivable were transferred to loans held for sale at fair value which also represented the contract value at that time, and the loans were subsequently sold on July 7, 2016. The charge-offs related to these loans accounted for a significant portion of total loan charge-offs of $6.5 million in the first nine months of 2016.

-20-

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to Unaudited Condensed Consolidated Financial Statements

NOTE 4 - LOAN PORTFOLIO – continued

Provision and Allowance for Loan Losses

An allowance for loan losses is maintained at a level deemed appropriate by management to adequately provide for known and inherent losses in the loan portfolio. The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectability of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.

In evaluating the adequacy of the Company’s loan loss reserves, management identifies loans believed to be impaired. Impaired loans are those not likely to be repaid as to principal and interest in accordance with the terms of the loan agreement. The fair value of impaired loans is estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, or liquidation value and discounted cash flows. Reserves are maintained for each loan in which the principal balance of the loan exceeds the net present value of cash flows. In addition to the specific allowance for individually reviewed loans, a general allowance for potential loan losses is established based on management’s review of the composition of the loan portfolio with the purpose of identifying any concentrations of risk, and an analysis of historical loan charge-offs and recoveries. The final component of the allowance for loan losses incorporates management’s evaluation of current economic conditions and other risk factors which may impact the inherent losses in the loan portfolio. These evaluations are highly subjective and require that a great degree of judgmental assumptions be made by management. This component of the allowance for loan losses includes additional estimated reserves for internal factors such as changes in lending staff, loan policy and underwriting guidelines, and loan seasoning and quality, and external factors such as national and local economic trends and conditions.

Based on management observation, judgment, and experience, environmental factors used in the allowance for loan loss model were reassessed during the second quarter of 2016 for all loan classes. Management also determined that a look back period of twelve quarters would be more appropriate in light of recent changes to the economy. The allowance was previously based on a six quarter look back period. The impact of the change to the model resulted in a $2.1 million increase to the loan loss reserves as of the time of the change.

-21-

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to Unaudited Condensed Consolidated Financial Statements

NOTE 4 - LOAN PORTFOLIO - continued

The following table details the activity within our allowance for loan losses as of and for the nine months ended September 30, 2016 and 2015 and as of and for the year ended December 31, 2015, by portfolio segment:

September 30, 2016
(Dollars in thousands)				Commercial
	Commercial			Real Estate			Consumer			Residential			Total

Allowance for loan losses:
Beginning balance	$	952		$	2,543		$	80		$	1,026		$	4,601
Charge-offs		(1,132	)		(4,591	)		(45	)		(778	)		(6,546	)
Recoveries		1,372			188			13			64			1,637
Provision		(492	)		4,445			84			947			4,984
Ending balance	$	700		$	2,585		$	132		$	1,259		$	4,676

Ending balances:
Individually evaluated for impairment	$	41		$	367		$	7		$	372		$	787
Collectively evaluated for impairment	$	659		$	2,218		$	125		$	887		$	3,889

Loans receivable:

Ending balance, total	$	34,304		$	97,573		$	4,882		$	72,417		$	209,176

Ending balances:
Individually evaluated for impairment	$	1,513		$	13,905		$	91		$	7,815		$	23,324
Collectively evaluated for impairment	$	32,791		$	83,668		$	4,791		$	64,602		$	185,852

September 30, 2015
(Dollars in thousands)
				Commercial
	Commercial			Real Estate			Consumer			Residential			Total

Allowance for loan losses:
Beginning balance	$	597		$	3,591		$	185		$	1,414		$	5,787
Charge-offs		(458	)		(948	)		(57	)		(410	)		(1,873	)
Recoveries		189			713			27			178			1,107
Provision		547			(247	)		(47	)		(253	)		—
Ending balance	$	875		$	3,109		$	108		$	929		$	5,021

Ending balances:
Individually evaluated for impairment	$	145		$	742		$	11		$	560		$	1,458
Collectively evaluated for impairment	$	730		$	2,367		$	97		$	369		$	3,563

Loans receivable:

Ending balance, total	$	34,070		$	102,834		$	5,264		$	77,814		$	219,982

Ending balances:
Individually evaluated for impairment	$	2,710		$	21,453		$	138		$	10,103		$	34,404
Collectively evaluated for impairment	$	31,360		$	81,381		$	5,126		$	67,711		$	185,578

-22-

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to Unaudited Condensed Consolidated Financial Statements

NOTE 4 - LOAN PORTFOLIO - continued

December 31, 2015
(Dollars in thousands)
				Commercial
	Commercial			Real Estate			Consumer			Residential			Total

Allowance for loan losses:
Beginning balance	$	597		$	3,591		$	185		$	1,414		$	5,787
Charge-offs		(539	)		(1,212	)		(81	)		(501	)		(2,333	)
Recoveries		200			727			37			183			1,147
Provision		694			(563	)		(61	)		(70	)		—
Ending balance	$	952		$	2,543		$	80		$	1,026		$	4,601

Ending balances:
Individually evaluated for impairment	$	137		$	396		$	10		$	560		$	1,103
Collectively evaluated for impairment	$	815		$	2,147		$	70		$	466		$	3,498

Loans receivable:

Ending balance, total	$	27,881		$	101,291		$	5,114		$	75,081		$	209,367

Ending balances:
Individually evaluated for impairment	$	2,727		$	21,582		$	134		$	9,418		$	33,861
Collectively evaluated for impairment	$	25,154		$	79,709		$	4,980		$	65,663		$	175,506

Loan Performance and Asset Quality

Generally, a loan will be placed on nonaccrual status when it becomes 90 days past due as to principal or interest, or when management believes, after considering economic and business conditions and collection efforts, that the borrower’s financial condition is such that collection of the loan is doubtful. When a loan is placed in nonaccrual status, interest accruals are discontinued and income earned but not collected is reversed. Cash receipts on nonaccrual loans are not recorded as interest income, but are used to reduce principal.

The following chart summarizes delinquencies and nonaccruals, by portfolio class, as of September 30, 2016 and December 31, 2015.

September 30, 2016
(Dollars in thousands)
	30-59 Days		60-89 Days		90+ Days		Total				Total Loans		Non-
	Past Due		Past Due		Past Due		Past Due		Current		Receivable		accrual

Commercial	$	133	$	1	$	—	$	134	$	34,170	$	34,304	$	18
Commercial real estate:
Construction		34		—		12		46		21,089		21,135		12
Other		—		—		326		326		76,112		76,438		524
Real Estate:
Residential		366		100		310		776		71,641		72,417		376
Consumer:
Other		2		10		—		12		4,319		4,331		1
Revolving credit		—		1		—		1		550		551		—
Total	$	535	$	112	$	648	$	1,295	$	207,881	$	209,176	$	931

-23-

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to Unaudited Condensed Consolidated Financial Statements

NOTE 4 - LOAN PORTFOLIO - continued

December 31, 2015
(Dollars in thousands)
	30-59 Days		60-89 Days		90+ Days		Total				Total Loans		Non-
	Past Due		Past Due		Past Due		Past Due		Current		Receivable		accrual
Commercial	$	321	$	110	$	1	$	432	$	27,449	$	27,881	$	139
Commercial real estate:
Construction		25		—		3,186		3,211		27,321		30,532		3,384
Other		973		—		3,046		4,019		66,740		70,759		3,895
Real Estate:
Residential		2,887		142		948		3,977		71,104		75,081		1,314
Consumer:
Other		108		18		10		136		4,395		4,531		10
Revolving credit		4		—		—		4		579		583		—
Total	$	4,318	$	270	$	7,191	$	11,779	$	197,588	$	209,367	$	8,742

There were no loans outstanding 90 days or more and still accruing interest at September 30, 2016 or December 31, 2015.

-24-

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to Unaudited Condensed Consolidated Financial Statements

NOTE 4 - LOAN PORTFOLIO – continued

The following table summarizes management’s internal credit risk grades, by portfolio class, as of September 30, 2016 and December 31, 2015.

September 30, 2016
(Dollars in thousands)
			Commercial
	Commercial		Real Estate		Consumer		Residential		Total

Grade 1 - Minimal	$	2,158	$	—	$	421	$	85	$	2,664
Grade 2 – Modest		691		129		52		671		1,543
Grade 3 – Average		2,779		10,673		90		6,496		20,038
Grade 4 – Satisfactory		16,534		56,087		3,843		46,275		122,739
Grade 5 – Watch		11,308		18,633		280		10,675		40,896
Grade 6 – Special Mention		466		702		119		1,309		2,596
Grade 7 – Substandard		368		11,349		77		6,906		18,700
Grade 8 – Doubtful		—		—		—		—		—
Grade 9 – Loss		—		—		—		—		—
Total loans receivable	$	34,304	$	97,573	$	4,882	$	72,417	$	209,176

December 31, 2015
(Dollars in thousands)
			Commercial
	Commercial		Real Estate		Consumer		Residential		Total

Grade 1 - Minimal	$	975	$	—	$	434	$	—	$	1,409
Grade 2 – Modest		561		1,024		37		277		1,899
Grade 3 – Average		4,934		5,620		218		4,716		15,488
Grade 4 – Satisfactory		14,693		58,549		4,031		53,187		130,460
Grade 5 – Watch		2,445		9,654		152		2,988		15,239
Grade 6 – Special Mention		992		6,321		98		3,544		10,955
Grade 7 – Substandard		3,281		20,123		144		10,369		33,917
Grade 8 – Doubtful		—		—		—		—		—
Grade 9 – Loss		—		—		—		—		—
Total loans receivable	$	27,881	$	101,291	$	5,114	$	75,081	$	209,367

-25-

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to Unaudited Condensed Consolidated Financial Statements

NOTE 4 - LOAN PORTFOLIO - continued

Loans graded one through four are considered “pass” credits. As of September 30, 2016, $147.0 million, or 70.3% of the loan portfolio, had a credit grade of “minimal,” “modest,” “average” or “satisfactory.” For loans to qualify for these grades, they must be performing relatively close to expectations, with no significant departures from the intended source and timing of repayment.

Loans with a credit grade of “watch” and “special mention” are not considered classified; however, they are categorized as a watch list credit and are considered potential problem loans. This classification is utilized when there is an initial concern about the financial health of a borrower. These loans are designated as such in order to be monitored more closely than other credits in the portfolio. Loans on the watch list are not considered problem loans until they are determined by management to be classified as substandard. As of September 30, 2016, loans with a credit grade of “watch” and “special mention” totaled $43.5 million. Watch list loans are considered potential problem loans and are monitored as they may develop into problem loans in the future.

Loans graded “substandard” or greater are considered classified credits. At September 30, 2016, classified loans totaled $18.7 million, with $18.3 million being collateralized by real estate. This includes $11.7 million in troubled debt restructurings (“TDRs”), of which $11.6 million were performing as expected under the new terms and $109 thousand were considered to be nonperforming. Classified credits are evaluated for impairment on a quarterly basis. Loans showing improvement may be upgraded to “watch”.

The Bank identifies impaired loans through its normal internal loan review process. A loan is considered impaired when, based on current information and events, it is probable that we will be unable to collect the scheduled payments of principal or interest when due, according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Impairment is measured on a loan-by-loan basis by calculating either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent. Any resultant shortfall is charged to provision for loan losses and is classified as a specific reserve. When an impaired loan is ultimately charged-off, the charge-off is taken against the specific reserve.

Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Impaired consumer and residential loans are identified for impairment disclosures, however, it is policy to individually evaluate for impairment all loans with a credit grade of “substandard” or greater that have an outstanding balance of $50 thousand or greater, and all loans with a credit grade of “special mention” that have outstanding principal balance of $100 thousand or greater.

Impaired loans are valued on a nonrecurring basis at the lower of cost or market value of the underlying collateral or based on the net present value of cash flows. For loans valued based on collateral, market values were obtained using independent appraisals, updated every 18 to 24 months, in accordance with our reappraisal policy, or other market data such as recent offers to the borrower. At September 30, 2016, the recorded investment in impaired loans was $23.3 million, compared to $33.9 million at December 31, 2015.

-26-

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to UNAUDITED Condensed Consolidated Financial Statements

NOTE 4 - LOAN PORTFOLIO - continued

The following chart details our impaired loans, which includes TDRs totaling $20.9 million and $29.1 million, by category, as of September 30, 2016 and December 31, 2015, respectively:

September 30, 2016
(Dollars in thousands)							Nine months ended				Three months ended
			Unpaid				Average		Interest		Average		Interest
	Recorded		Principal		Related		Recorded		Income		Recorded		Income
	Investment		Balance		Allowance		Investment		Recognized		Investment		Recognized
With no related allowance recorded:
Commercial	$	560	$	560	$	—	$	811	$	29	$	711	$	7
Commercial real estate		9,794		12,912		—		11,305		356		11,093		261
Residential		4,591		4,751		—		4,848		192		4,824		65
Consumer		40		40		—		45		3		43		1
Total:	$	14,985	$	18,263	$	—	$	17,009	$	580	$	16,671	$	334
With an allowance recorded:
Commercial		953		953		41		1,003		32		975		11
Commercial real estate		4,111		4,111		367		4,169		159		4,140		61
Residential		3,224		3,224		372		3,249		100		3,236		34
Consumer		51		51		7		173		2		171		1
Total:	$	8,339	$	8,339	$	787	$	8,594	$	293	$	8,522	$	107
Total:
Commercial		1,513		1,513		41		1,814		61		1,686		18
Commercial real estate		13,905		17,023		367		15,474		515		15,233		322
Residential		7,815		7,975		372		8,097		292		8,060		99
Consumer		91		91		7		218		5		214		2
Total:	$	23,324	$	26,602	$	787	$	25,603	$	873	$	25,193	$	441

December 31, 2015
(Dollars in thousands)			Unpaid				Average		Interest
	Recorded		Principal		Related		Recorded		Income
	Investment		Balance		Allowance		Investment		Recognized
With no related allowance recorded:
Commercial	$	1,070	$	1,339	$	—	$	1,319	$	72
Commercial real estate		17,180		22,037		—		18,989		722
Residential		4,016		4,338		—		4,936		137
Consumer		68		68		—		84		7
Total:	$	22,334	$	27,782	$	—	$	25,328	$	938
With an allowance recorded:
Commercial		1,657		1,657		137		1,729		79
Commercial real estate		4,402		4,402		396		4,461		207
Residential		5,402		5,443		560		5,445		215
Consumer		66		66		10		66		3
Total:	$	11,527	$	11,568	$	1,103	$	11,701	$	504
Total:
Commercial		2,727		2,996		137		3,048		151
Commercial real estate		21,582		26,439		396		23,450		929
Residential		9,418		9,781		560		10,381		352
Consumer		134		134		10		150		10
Total:	$	33,861	$	39,350	$	1,103	$	37,029	$	1,442

-27-

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to unaudited Condensed Consolidated Financial Statements

NOTE 4 - LOAN PORTFOLIO - continued

TDRs are loans which have been restructured from their original contractual terms and include concessions that would not otherwise have been granted outside of the financial difficulty of the borrower. We only restructure loans for borrowers in financial difficulty that have designed a viable business plan to fully pay off all obligations, including outstanding debt, interest and fees, either by generating additional income from the business or through liquidation of assets. Generally, these loans are restructured to provide the borrower additional time to execute upon their plans.

With respect to restructured loans, we grant concessions by (1) reduction of the stated interest rate for the remaining original life of the debt, or (2) extension of the maturity date at a stated interest rate lower than the current market rate for new debt with similar risk. We do not generally grant concessions through forgiveness of principal or accrued interest. Restructured loans where a concession has been granted through extension of the maturity date generally include extension of payments in an interest only period, extension of payments with capitalized interest and extension of payments through a forbearance agreement. These extended payment terms are also combined with a reduction of the stated interest rate in certain cases.

Success in restructuring loans has been mixed but it has proven to be a useful tool in certain situations to protect collateral values and allow certain borrowers additional time to execute upon defined business plans. In situations where a TDR is unsuccessful and the borrower is unable to follow through with terms of the restructured agreement, the loan is placed on nonaccrual status and continues to be written down to the underlying collateral value.

Our policy with respect to accrual of interest on loans restructured in a TDR follows relevant supervisory guidance. That is, if a borrower has demonstrated performance under the previous loan terms and shows capacity to perform under the restructured loan terms, continued accrual of interest at the restructured interest rate is likely. If a borrower was materially delinquent on payments prior to the restructuring but shows capacity to meet the restructured loan terms, the loan will likely continue as nonaccrual going forward. Lastly, if the borrower does not perform under the restructured terms, the loan is placed on nonaccrual status.

We will continue to closely monitor these loans and will cease accruing interest on them if management believes that the borrowers may not continue performing based on the restructured note terms. If, after previously being classified as a TDR, a loan is restructured a second time, then that loan is automatically placed on nonaccrual status. Our policy with respect to nonperforming loans requires the borrower to make a minimum of six consecutive payments in accordance with the loan terms before that loan can be placed back on accrual status. Further, the borrower must show capacity to continue performing into the future prior to restoration of accrual status. We believe that all of our modified loans meet the definition of a TDR.

-28-

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to unaudited Condensed Consolidated Financial Statements

NOTE 4 - LOAN PORTFOLIO – continued

The following is a summary of information pertaining to our TDRs at September 30, 2016 and December 31, 2015:

	September 30,		December 31,
(Dollars in thousands)	2016		2015
Nonperforming TDRs	$	109	$	5,449
Performing TDRs:
Commercial		1,497		2,565
Commercial real estate		12,734		13,883
Residential		6,491		7,059
Consumer		89		106
Total performing TDRs		20,811		23,613
Total TDRs	$	20,920	$	29,062

The following tables summarize how loans that were considered TDRs were modified during the periods indicated:

For the Nine Months ended September 30, 2016

(Dollars in thousands)							TDRs identified in the last twelve
	TDRs identified during the period						months that subsequently defaulted⁽¹⁾
			Pre-		Post-				Pre-		Post-
			modification		modification				modification		modification
	Number		outstanding		outstanding		Number		outstanding		outstanding
	of		recorded		recorded		of		recorded		recorded
	contracts		investment		investment		contracts		investment		investment
Commercial real estate		4	$	475	$	311		—	$	—	$	—
Residential		6		634		534		3		169		169
Commercial		4		179		155		3		242		161
Consumer		—		—		—		1		2		2
Total		14	$	1,288	$	1,000		7	$	413	$	332

During the nine months ended September 30, 2016, fourteen loans were modified that were considered to be TDRs. Term concessions only were granted for seven loans; term and interest concessions were granted for two loans; term and payment deferrals were granted for one loan; term, payment deferrals and interest concessions were granted for one loan; principal was forgiven on two loans; and other concessions were extended for one loan.

Nine modified loans that were considered to be TDRs during the first nine months of 2016 were sold during the third quarter of 2016, two of which subsequently defaulted and are included in the above table.

⁽¹⁾ Loans past due 90 days or more are considered to be in default.

For the Three Months ended September 30, 2016

(Dollars in thousands)							TDRs identified in the last twelve
	TDRs identified during the period						months that subsequently defaulted⁽¹⁾
			Pre-		Post				Pre-		Post-
			modification		modification				modification		modification
	Number		outstanding		outstanding		Number		outstanding		outstanding
	of		recorded		recorded		of		recorded		recorded
	contracts		investment		investment		contracts		investment		investment
Commercial real estate		1	$	167	$	167		—	$	—	$	—
Residential		—		—		—		1		59		59
Commercial		—		—		—		1		30		30
Consumer		—		—		—		—		—		—
Total		1	$	167	$	167		2	$	89	$	89

During the quarter ended September 30, 2016, one loan was modified that was considered to be a TDR. Term and interest concessions were granted for the loan.

⁽¹⁾ Loans past due 90 days or more are considered to be in default.

-29-

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to unaudited Condensed Consolidated Financial Statements

NOTE 4 - LOAN PORTFOLIO – continued

For the Nine Months ended September 30, 2015

(Dollars in thousands)							TDRs identified in the last twelve
	TDRs identified during the period						months that subsequently defaulted⁽¹⁾
			Pre-		Post-				Pre-		Post-
			modification		modification				modification		modification
	Number		outstanding		outstanding		Number		outstanding		outstanding
	of		recorded		recorded		of		recorded		recorded
	contracts		investment		investment		contracts		investment		investment

Commercial real estate		4	$	448	$	448		1	$	243	$	128
Residential		7		851		811		2		268		268
Commercial		1		60		60		—		—		—
Consumer		3		14		14		—		—		—
Total		15	$	1,373	$	1,333		3	$	511	$	396

During the nine months ended September 30, 2015, 15 loans were modified that were considered to be TDRs. Term concessions only were granted for four loans; payment deferrals only were granted for four loans; interest concessions only were granted for one loan; term and payment deferrals were granted for four loans; and term, payment deferrals and interest concessions were granted for two loans.

⁽¹⁾ Loans past due 90 days or more are considered to be in default.

For the Three Months ended September 30, 2015

(Dollars in thousands)							TDRs identified in the last twelve
	TDRs identified during the period						months that subsequently defaulted⁽¹⁾
			Pre-		Post				Pre-		Post-
			modification		modification				modification		modification
	Number		outstanding		outstanding		Number		outstanding		outstanding
	of		recorded		recorded		of		recorded		recorded
	contracts		investment		investment		contracts		investment		investment

Commercial real estate		2	$	202	$	202		—	$	—	$	—
Residential		2		223		223		1		116		116
Commercial		—		—		—		—		—		—
Consumer		2		4		4		—		—		—
Total		6	$	429	$	429		1	$	116	$	116

During the quarter ended September 30, 2015, six loans were modified that were considered to be TDRs. Term concessions only were granted for two loans; payment deferrals only were granted for three loans; and interest concessions only were granted for one loan.

⁽¹⁾ Loans past due 90 days or more are considered to be in default.

-30-

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to unaudited CONDENSED Consolidated Financial Statements

NOTE 4 - LOAN PORTFOLIO - continued

Portions of the allowance for loan losses may be allocated for specific loans or portfolio segments. However, the entire allowance for loan losses is available for any loan that, in management’s judgment, should be charged-off. While management utilizes the best judgment and information available to it, the ultimate adequacy of the allowance for loan losses depends on a variety of factors beyond our control, including the performance of our loan portfolio, the economy, changes in interest rates, and the view of the regulatory authorities toward loan classifications. If delinquencies and defaults increase, we may be required to increase our provision for loan losses, which would adversely affect our results of operations and financial condition. There can be no assurance that charge-offs of loans in future periods will not exceed the allowance for loan losses as estimated at any point in time or that provisions for loan losses will not be significant to a particular accounting period.

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

The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual or notional amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.

Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to customers. The fair value of standby letters of credit is insignificant.

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since some of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation of the counter-party.

Collateral held for commitments to extend credit and standby letters of credit varies but may include accounts receivable, inventory, property, plant, equipment, and income-producing commercial properties. The following table summarizes the Company’s off-balance sheet financial instruments whose contract amounts represent credit risk:

	September 30,		December 31,
(Dollars in thousands)	2016		2015
Commitments to extend credit	$	31,485	$	21,318
Standby letters of credit		459		257

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to unaudited CONDENSED Consolidated Financial Statements

NOTE 5 – OTHER REAL ESTATE OWNED

The following table shows transactions in OREO for the nine-month period ended September 30, 2016 and the year ended December 31, 2015:

	September 30,			December 31,
(Dollars in thousands)	2016			2015
Balance, beginning of period	$	13,624		$	19,501
Additions		796			4,058
Sales		(4,806	)		(9,709	)
Write-downs		(5,582	)		(226	)

Balance, end of period	$	4,032		$	13,624

Increased write-downs were taken during the first nine months of 2016 in an effort to expedite sales to reduce nonperforming assets.

NOTE 6 - ADVANCES FROM THE FEDERAL HOME LOAN BANK

Advances from the FHLB consisted of the following at September 30, 2016:

(Dollars in thousands)	Advance	Advance		Advance			Maturing
	Type	Amount		Rate			On

	Convertible Advance	$	2,000		3.60	%		9/4/18
	Convertible Advance		5,000		3.45	%		9/10/18
	Convertible Advance		5,000		2.95	%		9/18/18
	Fixed Rate		5,000		3.86	%		8/20/19
		$	17,000

As of September 30, 2016, we had advances totaling $17.0 million with various interest rates and maturity dates. Interest on all advances is at a fixed rate and payable quarterly. Convertible advances are callable by the FHLB on their respective call dates. The Company has the option to either repay any advance that has been called or to refinance the advance as a convertible advance.

At September 30, 2016, the Company had pledged as collateral for FHLB advances approximately $2.9 million of one-to-four family first mortgage loans, $1.3 million of commercial real estate loans, $4.0 million in home equity lines of credit, and $19.2 million of agency and private issue mortgage-backed securities. The Company has an investment in FHLB stock of $1.1 million. The Company has $8.9 million in excess borrowing capacity with the FHLB that is available if liquidity needs should arise. As a result of negative financial performance indicators, there is also a risk that the Bank’s ability to borrow from the FHLB could be curtailed or eliminated, although to date the Bank has not been denied advances from the FHLB or had to pledge additional collateral for its borrowings.

As of September 30, 2016, scheduled principal reductions include $12.0 million in 2018 and $5.0 million in 2019.

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to unaudited CONDENSED Consolidated Financial Statements

NOTE 7 – JUNIOR SUBORDINATED DEBENTURES

On December 21, 2004, the Trust issued $6.0 million floating rate trust preferred securities with a maturity of December 31, 2034. In accordance with current accounting standards, the Trust has not been consolidated in these financial statements. The Company received from the Trust the $6.0 million proceeds from the issuance of the securities and the $186 thousand initial proceeds from the capital investment in the Trust and, accordingly, has shown the funds due to the Trust as a $6.2 million junior subordinated debenture offset by debt issuance costs. The current regulatory rules allow certain amounts of junior subordinated debentures to be included in the calculation of regulatory capital.

The Federal Reserve Bank of Richmond prohibited the Company from paying interest due on the trust preferred securities beginning February 2011 and as a result, the Company had deferred interest payments in the amount of approximately $958 thousand due and payable at the time of redemption on April 11, 2016, as described below.

As described in Note 1 to our financial statements, on February 29, 2016, the Company entered into a securities purchase agreement with Alesco for the repurchase of all the trust preferred securities for an aggregate cash payment of $600 thousand plus reimbursement of attorneys’ fees and other expenses incurred by Alesco not to exceed $25 thousand. Alesco also agreed to forgive any and all unpaid interest on the trust preferred securities.

On March 16, 2016, the Company received a notice of default from The Bank of New York Mellon Trust Company, N.A., in its capacity as trustee, relating to the trust preferred securities. The notice of default related specifically to the Indenture dated December 21, 2004, by and among the Company and The Bank of New York Mellon Trust Company, N.A., successor-in-interest to JP Morgan Chase Bank, National Association, under which the Company issued the trust preferred securities. As permitted by the Indenture, the Company previously exercised its right to defer interest payments on the trust preferred securities for 20 consecutive quarterly payment periods. The Company’s right to defer such interest payments expired on March 15, 2016, at which time all deferred payments of interest became due and payable. The Company did not pay such deferred interest at the end of the permitted deferral period, constituting an event of default under the Indenture, and therefore pursuant to the Indenture, the trustee provided this notice of default. However, under the Indenture, the principal amount of the trust preferred securities, together with any premium and unpaid accrued interest, would only become due upon such an event of default if the trustee or Alesco declared such amounts due and payable by written notice to the Company.

On April 11, 2016, immediately following the closing of the 2016 private placement, the Company repurchased all of the outstanding trust preferred securities for $600 thousand, plus reimbursement of approximately $17 thousand in third party legal expenses. The redemption gain realized on this settlement was approximately $6.3 million.

The redemption consisted of the following (in thousands):

Assets
Other assets	$	186
Reduction to assets		186
Liabilities
Junior subordinated debentures		6,117
Accrued interest payable		958
Reduction to liabilities		7,075

Cash paid		(617	)
Gain on extinguishment of debt	$	6,272

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to unaudited CONDENSED Consolidated Financial Statements

NOTE 8 - SUBORDINATED DEBENTURES

The Federal Reserve Bank of Richmond prohibited the Company from paying interest due on the subordinated notes beginning October 2011 and, as a result, the Company had deferred interest payments in the amount of approximately $5.3 million at the time of redemption on April 11, 2016, as described below.

During 2013, $1.0 million of the subordinated notes were canceled by the holder as part of a settlement of litigation between the holder, the Bank, and the Company. The Company was obligated to contribute capital in this amount to the Bank when it was able and did so immediately following the closing of the 2016 private placement. The forgiveness of this debt was recognized in 2013 as noninterest income in the consolidated statements of operations.

Effective as of September 16, 2015, the Company, the Bank, and certain other defendants entered into a class action settlement agreement in potential settlement of the putative class action lawsuit initiated by three holders of the Company’s subordinated promissory notes, on behalf of themselves and as representatives of a class of similarly situated purchasers of the Company’s subordinated promissory notes, with respect to alleged wrongful conduct associated with purchases of the subordinated promissory notes, including fraud, violation of state securities statutes, and negligence. On March 2, 2016, the Court of Common Pleas for the Fifteenth Judicial District, State of South Carolina, County of Horry entered a final order of approval approving the class action settlement agreement.

On April 11, 2016, immediately following the closing of the 2016 private placement, the Company established a settlement fund of approximately $2.4 million, which represented 20% of the principal of subordinated promissory notes issued by the Company. The proceeds of the fund were used to redeem the subordinated promissory notes held by class members. Also on April 11, 2016, the Company settled, pursuant to previously executed binding settlement agreements, with the subordinated promissory note holders who opted out of the class action settlement. These settlements, including the class action settlement, constituted the full satisfaction of the principal and interest owed on, and required the immediate dismissal of all pending litigation related to, the respective subordinated promissory notes. In each case, the Company and the Bank also obtained a full and complete release of all claims asserted or that could have been asserted with respect to the subordinated promissory notes. The redemption gain realized on this settlement was approximately $12.8 million.

The redemption consisted of the following (in thousands):

Assets
Reduction to assets	$	—
Liabilities
Subordinated debentures		11,023
Accrued interest payable		5,274
Reduction to liabilities		16,297

Cash paid		(3,454	)
Gain on extinguishment of debt	$	12,843

-34-

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to unaudited CONDENSED Consolidated Financial Statements

NOTE 9 - SHAREHOLDERS’ EQUITY AND CAPITAL REQUIREMENTS

Preferred Stock

Series T - In March 2009, in connection with the CPP, the Company issued to the U.S. Treasury 12,895 shares of the Company’s Series T preferred stock. The Series T preferred stock had a dividend rate of 5% for the first five years and 9% thereafter, and had a call feature after three years.

In connection with the sale of the Series T preferred stock, the Company also issued to the U.S. Treasury the CPP Warrant to purchase up to 91,714 shares of the Company’s common stock at an initial exercise price of $21.09 per share.

The Series T preferred stock and the CPP Warrant were sold to the U.S. Treasury for an aggregate purchase price of $12.9 million in cash. The purchase price was allocated between the Series T preferred stock and the CPP Warrant based upon the relative fair values of each to arrive at the amounts recorded by the Company. This resulted in the Series T preferred stock being issued at a discount which was amortized on a level yield basis as a charge to retained earnings over an assumed life of five years.

As required under the CPP, dividend payments on and repurchases of the Company’s common stock were subject to certain restrictions. For as long as the Series T preferred stock was outstanding, no dividends could be declared or paid on the Company’s common stock until all accrued and unpaid dividends on the Series T preferred stock were fully paid. In addition, the U.S. Treasury’s consent was required for any increase in dividends on common stock before the third anniversary of issuance of the Series T preferred stock and for any repurchase of any common stock except for repurchases of common shares in connection with benefit plans.

Beginning in February 2011, the Federal Reserve Bank of Richmond required the Company to defer dividend payments on the 12,895 shares of the Series T preferred stock. Therefore, for each quarterly period beginning in February 2011, the Company notified the U.S. Treasury of its deferral of quarterly dividend payments on the Series T preferred stock. The amount of each of the Company’s quarterly interest payments was approximately $161 thousand through March 2014 and then increased to $290 thousand. At the time the shares were repurchased on April 12, 2016, as described below, the Company had $5.1 million of deferred dividend payments due on the Series T preferred stock, $398 thousand of which had previously been shown as accrued preferred dividends on the Company’s statement of operations for 2016.

On April 12, 2016, the Company repurchased all 12,895 shares of the outstanding Series T preferred stock from the U.S. Treasury for $129 thousand. The U.S. Treasury also canceled the CPP Warrant. The redemption gain realized on this settlement was approximately $13.8 million and was recorded as capital surplus.

Series A – As previously disclosed, on April 1, 2016, the Company designated 905,316 shares of the Company’s authorized but unissued preferred stock as shares of the Company’s Series A preferred stock. As discussed in Note 1, the Company issued 905,316 shares of its Series A stock at $10.00 per share in the 2016 private placement.

Non-Voting Common Stock

On August 23, 2016, the Company filed Articles of Amendment to the Company’s Articles of Incorporation to authorize a class of 150,000,000 shares of non-voting common stock. Also on August 23, 2016, the Company converted 905,316 shares of issued and outstanding Series A preferred stock into 90,531,557 shares of non-voting common stock. The 905,316 shares of Series A preferred stock converted into 90,531,557 shares of non-voting common stock represented all of the issued and outstanding shares of Series A preferred stock on such date and, as a result, all shares of the Series A preferred stock are no longer outstanding and resumed the status of authorized and unissued shares of the Company’s preferred stock.

-35-

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to unaudited CONDENSED Consolidated Financial Statements

NOTE 9 - SHAREHOLDERS’ EQUITY AND CAPITAL REQUIREMENTS - continued

Restrictions on Dividends

Under the terms of the Written Agreement, the Company is currently prohibited from declaring or paying any dividends without the prior written approval of the Federal Reserve Bank of Richmond. In addition, because the Company is a legal entity separate and distinct from the Bank and has little direct income itself, the Company relies on dividends paid to it by the Bank in order to pay dividends on its common stock. As a South Carolina state bank, the Bank may only pay dividends out of its net profits, after deducting expenses, including losses and bad debts. Under the Federal Deposit Insurance Corporation Act (“FDICIA”), the Bank may not pay a dividend if, after paying the dividend, the Bank would be undercapitalized. In addition, regulatory restrictions remain following the termination of the Consent Order that prohibit the Bank from paying dividends without the prior approval of the FDIC and State Board.

Regulatory Capital

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

Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum ratios of Tier 1 and total capital as a percentage of assets and off-balance sheet exposures, adjusted for risk weights ranging from 0% to 1250%. Tier 1 capital consists of common shareholders’ equity, excluding the unrealized gain or loss on securities available-for-sale, minus certain intangible assets. Tier 2 capital consists of the allowance for loan losses subject to certain limitations. Total capital for purposes of computing the capital ratios consists of the sum of Tier 1 and Tier 2 capital. The Company and the Bank are also required to maintain capital at a minimum level based on quarterly average assets, which is known as the leverage ratio.

In July 2013, the federal bank regulatory agencies issued a final rule that has revised their risk-based capital requirements and the method for calculating risk-weighted assets to make them consistent with certain standards that were developed by the Basel Committee on Banking Supervision (“Basel III”) and certain provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). The final rule applies to all depository institutions, such as the Bank, top-tier bank holding companies with total consolidated assets of $1 billion or more, and top-tier savings and loan holding companies, which we refer to below as “covered” banking organizations. Bank holding companies with less than $1 billion in total consolidated assets, such as the Company, are not subject to the final rule. Effective March 31, 2015, the Bank was required to implement the new Basel III capital standards (subject to the phase in for certain parts of the new rules).

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to unaudited CONDENSED Consolidated Financial Statements

NOTE 9 - SHAREHOLDERS’ EQUITY AND CAPITAL REQUIREMENTS - continued

The approved rule includes a new minimum ratio of common equity Tier 1 capital to risk-weighted assets (“CET1”) of 4.5% and a capital conservation buffer of 2.5% of risk-weighted assets, which when fully phased-in, effectively results in a minimum CET1 ratio of 7.0%. Basel III also raises the minimum ratio of Tier 1 capital to risk-weighted assets from 4.0% to 6.0% (which, with the capital conservation buffer, effectively results in a minimum Tier 1 capital ratio of 8.5% when fully phased-in), effectively results in a minimum total capital to risk-weighted assets ratio of 10.5% (with the capital conservation buffer fully phased-in), and requires a minimum leverage ratio of 4.0%. Basel III also makes changes to the risk weights for certain assets and off-balance sheet exposures. Finally, CET1 includes accumulated other comprehensive income (which includes all unrealized gains and losses on available-for-sale debt and equity securities), subject to a transition period and a one-time opt-out election. The Bank elected to opt-out of this provision. As such, accumulated comprehensive income is not included in the Bank’s Tier 1 capital.

The new capital conservation buffer began its phase-in period on January 1, 2016 at 0.625% of risk-weighted assets and will increase each subsequent year by an additional 0.625% until reaching its final level of 2.5% on January 1, 2019, as discussed above. The Bank had sufficient capital to meet the new conservation buffer requirements at September 30, 2016.

To be considered “well-capitalized,” a bank must maintain total risk-based capital of at least 10%, Tier 1 capital of at least 6%, and a leverage ratio of at least 5%. To be considered “adequately capitalized” under these capital guidelines, a bank must maintain a minimum total risk-based capital of 8%, with at least 4% being Tier 1 capital. Although the Bank is no longer subject to the Consent Order as of its termination on October 26, 2016, the Bank must continue to maintain a Tier 1 capital at least equal to 8% and total risk-based capital at least equal to 10%.

At September 30, 2016, the Company exceeded its minimum regulatory capital requirements. While the Bank could not be considered “well capitalized” at September 30, 2016 due to the Consent Order (which was subsequently terminated on October 26, 2016), as a result of the 2016 private placement, the Bank met all of the capital requirements set forth under the Consent Order as of September 30, 2016.

-37-

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to unaudited CONDENSED Consolidated Financial Statements

NOTE 9 - SHAREHOLDERS’ EQUITY AND CAPITAL REQUIREMENTS - continued

The following table summarizes the capital ratios and the regulatory minimum requirements for the Company and the Bank as of the dates indicated.

												Minimum
												To Be Well
							Minimum					Capitalized Under
							Capital					Prompt Corrective
	Actual						Requirement					Action Provisions
(Dollars in thousands)	Amount			Ratio			Amount		Ratio			Amount			Ratio

September 30, 2016
The Company
Total Capital
(to Risk-Weighted Assets)	$	40,085			16.61	%	$	19,305		8.00	%		N/A			N/A
Tier 1 Capital
(to Risk-Weighted Assets)	$	37,048			15.35	%	$	9,652		4.00	%		N/A			N/A
Tier 1 Capital
(to Average Assets)	$	37,048			9.51	%	$	15,587		4.00	%		N/A			N/A
The Bank
Total Capital
(to Risk-Weighted Assets)	$	39,441			16.34	%	$	19,305		8.00	%	$	24,131			10.00	%
Tier 1 Capital
(to Risk-Weighted Assets)	$	36,404			15.09	%	$	14,478		6.00	%		(1	)		(1	)
Tier 1 Capital
(to Average Assets)	$	36,404			9.38	%	$	15,525		4.00	%	$	31,051			8.00	%
Common Equity Tier 1 Capital
(to Risk-Weighted Assets)	$	36,404			15.09	%	$	10,859		4.50	%		N/A			N/A

December 31, 2015
The Company
Total Capital
(to Risk-Weighted Assets)	$	(10,642	)		(4.15	)%	$	20,537		8.00	%		N/A			N/A
Tier 1 Capital
(to Risk-Weighted Assets)	$	(10,642	)		(4.15	)%	$	10,269		4.00	%		N/A			N/A
Tier 1 Capital
(to Average Assets)	$	(10,642	)		(2.87	)%	$	14,831		4.00	%		N/A			N/A
The Bank
Total Capital
(to Risk-Weighted Assets)	$	15,402			5.92	%	$	20,802		8.00	%	$	26,002			10.00	%
Tier 1 Capital
(to Risk-Weighted Assets)	$	12,135			4.67	%	$	15,601		6.00	%		(1	)		(1	)
Tier 1 Capital
(to Average Assets)	$	12,135			3.28	%	$	14,819		4.00	%	$	29,639			8.00	%
Common Equity Tier 1 Capital
(to Risk-Weighted Assets)	$	12,135			4.67	%	$	11,701		4.50	%		N/A			N/A

⁽¹⁾ Minimum capital amounts and ratios presented as of September 30, 2016 and December 31, 2015, are amounts to be well-capitalized under the various regulatory capital requirements administered by the FDIC. On February 10, 2011, the Bank became subject to a regulatory Consent Order with the FDIC and the State Board. Minimum capital amounts and ratios presented for the Bank as of September 30, 2016 and December 31, 2015, are the minimum levels set forth in the Consent Order. No minimum Tier 1 capital to risk-weighted assets ratio was specified in the Consent Order. Although the Bank is no longer subject to the Consent Order as of its termination on October 26, 2016, the Bank must continue to maintain Tier 1 capital at least equal to 8% and total risk-based capital at least equal to 10%.

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to unaudited CONDENSED Consolidated Financial Statements

NOTE 10 – INCOME (LOSS) PER SHARE

(Dollars in thousands, except	Nine Months ended September 30,
per share amounts)	2016		2015

Basic income (loss) per common share:

Net income (loss) available to common shareholders	$	4,846	$	(944	)

Weighted average common shares outstanding - basic		245,538,014		3,816,340

Basic income (loss) per common share	$	0.02	$	(0.25	)

Diluted income (loss) per common share:

Net income (loss) available to common shareholders	$	4,846	$	(944	)

Weighted average common shares outstanding - basic		245,538,014		3,816,340

Incremental shares		—		—

Weighted average common shares outstanding - diluted		245,538,014		3,816,340

Diluted income (loss) per common share	$	0.02	$	(0.25	)

(Dollars in thousands, except	Three Months ended September 30,
per share amounts)	2016			2015

Basic loss per common share:

Net loss available to common shareholders	$	(1,784	)	$	(146	)

Weighted average common shares outstanding - basic		411,085,981			3,816,340

Basic loss per common share	$	(0.00	)	$	(0.04	)

Diluted loss per common share:

Net loss available to common shareholders	$	(1,784	)	$	(146	)

Weighted average common shares outstanding - basic		411,085,981			3,816,340

Incremental shares		—			—

Weighted average common shares outstanding - diluted		411,085,981			3,816,340

Diluted loss per common share	$	(0.00	)	$	(0.04	)

Weighted average shares outstanding for the nine and three month periods ended September 30, 2016 excludes 27,750,000 shares of unvested restricted stock. There were no unvested shares of restricted stock outstanding for the nine and three month periods ended September 30, 2015. For the nine and three month periods ended September 30, 2015, there were 91,714 common stock equivalents outstanding. These common stock equivalents were not included in the computation of diluted loss per share because their effect would have been anti-dilutive.

-39-

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to unaudited CONDENSED Consolidated Financial Statements

NOTE 11 – STOCK COMPENSATION

Summary

On July 28, 2016, the shareholders of the Company approved the HCSB Financial Corporation 2016 Equity Incentive Plan (the “Plan”) that provides for the grant of stock options, restricted stock awards, restricted stock unit awards and other equity awards to the Company’s officers, employees, directors, advisors and consultants. A total of 30,000,000 shares of voting common stock have been reserved for the issuance of awards under the Plan, all of which may be issued as stock options (including incentive stock options), restricted stock or restricted stock units, subject to the anti-dilution provisions of the Plan. The Board of Directors has appointed the Compensation Committee as the administrator of the Plan.

Stock Options

The Plan requires that stock options can only be issued at or above the fair market value per share on the date of grant. Stock options granted to participants under the Plan may be either incentive stock options or Nonqualified Options. Stock options entitle the recipient to purchase shares of common stock at the exercise price specified in the award agreement. The administrator at its discretion determines the number of option shares, the term of the option, the exercise price (subject to the minimum price described above), the vesting schedule and performance conditions (if any), and any other terms and conditions. In the case of 10% shareholders who receive incentive stock options, the exercise price may not be less than 110% of the fair market value of the common stock on the date of grant. An exception to each of these requirements may be made for options that the Company may grant in substitution for options held by employees of companies that the Company acquires. In such a case, the exercise price is adjusted to preserve the economic value of the employee’s stock option from his or her former employer.

The Compensation Committee will determine the periods during which the options will be exercisable. However, no option will be exercisable more than 10 years after the date of grant. Payment of the exercise price of any option may be made in cash or cash equivalent, as determined by the Compensation Committee, to the extent permitted by law (i) by means of any cashless exercise procedure approved by the Compensation Committee, (ii) by delivering shares of common stock already owned by the option holder, (iii) by such other method as the Compensation Committee may determine, or (iv) any combination of the foregoing.

Restricted Stock

Restricted stock consists of shares of common stock which are granted to the participant, subject to certain restrictions against disposition and certain obligations to forfeit such shares to the Company under certain circumstances. The restrictions, which may be different for each award, will be determined by the Compensation Committee in its sole discretion. Restricted stock awarded under the Plan will be represented by a book entry registered in the name of the participant. Unless otherwise provided in an agreement, the participant will have the right to receive dividends, if any, with respect to such shares of restricted stock, to vote such shares and to enjoy all other shareholder rights, except that the participant may not sell, transfer, pledge or otherwise dispose of the restricted stock until the restrictions have expired. A breach of the terms and conditions established by the Compensation Committee pursuant to an award will cause a forfeiture of the award. The Compensation Committee expects that participants generally will not be required to make any payment for common stock received pursuant to an award, except to the extent otherwise determined by the Compensation Committee or required by law.

Restricted Stock Units

Restricted stock units are similar to restricted stock awards in that the value of a restricted stock unit is denominated in shares of stock. However, unlike a restricted stock award, restricted stock units are a mere promise by the Company to grant stock at a specified point in the future, and no shares of stock are transferred to the participant until certain requirements or conditions associated with the award are satisfied.

-40-

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to unaudited CONDENSED Consolidated Financial Statements

NOTE 11 – STOCK COMPENSATION - continued

Stock Compensation Activity

On August 18, 2016, the Compensation Committee awarded 27,750,000 shares of restricted stock. Subject to earlier forfeiture or accelerated vesting under circumstances described in the applicable Restricted Stock Award Agreements, the restricted shares vest ratably over a five year period, subject to the Company’s achievement of certain performance-based and time-based vesting conditions prior to the applicable vesting date. The performance-based conditions are (i) the removal of the Consent Order, and (ii) the reporting of two consecutive quarters of consolidated net income.

The following summarizes non-vested restricted stock activity for the period (dollars in thousands except per share amounts):

	Nine months Ended September 30,
	2016

Balance, beginning of period		—
Granted		27,750,000
Vested		—
Balance, end of period		27,750,000

Weighted average grant date value per share	$	0.10
Stock compensation expense for the period	$	46
Unrecognized compensation expense	$	2,729
Period over which unrecognized compensation expense will be recognized (years)		4.9

The fair value of the restricted stock awards is amortized to compensation expense over their respective vesting periods and is based on the market price of the Company’s common stock at the date of grant multiplied by the number of shares granted that are expected to vest. Total shares of restricted stock granted under the Plan is 27,750,000.

-41-

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to unaudited CONDENSED Consolidated Financial Statements

NOTE 12 - FAIR VALUE

Fair Value Hierarchy

Fair value is the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date.

Fair value estimates are made at a specific point in time based on relevant market and other information about the financial instruments. Because no market exists for a significant portion of the Company’s financial instruments, fair value estimates are based on current economic conditions, risk characteristics of various financial instruments, and such other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates. Accounting principles establish a fair value hierarchy, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. There are three levels of inputs that may be used to measure fair value:

Level 1	Quoted prices in active markets for identical assets or liabilities. Level 1 assets and liabilities include debt and equity securities and derivative contracts that are traded in an active exchange market, as well as U.S. Treasuries and money market funds.

Level 2	Observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Level 2 assets and liabilities include debt securities with quoted prices that are traded less frequently than exchange-traded instruments, mortgage-backed securities, municipal bonds, corporate debt securities, and derivative contracts whose value is determined using a pricing model with inputs that are observable in the market or can be derived principally from or corroborated by observable market data. This category generally includes certain derivative contracts and impaired loans.

Level 3	Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation. For example, this category generally includes certain private equity investments, retained residual interests in securitizations, residential mortgage servicing rights, and highly-structured or long-term derivative contracts.

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to unaudited CONDENSED Consolidated Financial Statements

NOTE 12 - FAIR VALUE - continued

Financial Instruments

The following methods and assumptions were used to estimate the fair value of significant financial instruments:

Cash and Cash Equivalents - The carrying amount is a reasonable estimate of fair value.

Nonmarketable Equity Securities - The carrying amount is a reasonable estimate of fair value since no ready market exists for these securities.

Loans Receivable - For certain categories of loans, such as variable rate loans which are repriced frequently and have no significant change in credit risk, fair values are based on the carrying amounts. The fair value of other types of loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to the borrowers with similar credit ratings and for the same remaining maturities.

Deposits - The fair value of demand deposits, savings, and money market accounts is the amount payable on demand at the reporting date. The fair values of certificates of deposit are estimated using a discounted cash flow calculation that applies current interest rates to a schedule of aggregated expected maturities.

Repurchase Agreements – The carrying value of these instruments is a reasonable estimate of fair value.

Advances from the Federal Home Loan Bank - For the portion of borrowings immediately callable, fair value is based on the carrying amount. The fair value of the portion maturing at a later date is estimated using a discounted cash flow calculation that applies the interest rate of the immediately callable portion to the portion maturing at the future date.

Subordinated Debentures - The Company is unable to determine the fair value of these debentures.

Junior Subordinated Debentures - The Company is unable to determine the fair value of these debentures.

Off-Balance Sheet Financial Instruments - The contractual amount is a reasonable estimate of fair value for the instruments because commitments to extend credit and standby letters of credit are issued on a short-term or floating rate basis and include no unusual credit risks.

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to unaudited CONDENSED Consolidated Financial Statements

NOTE 12 - FAIR VALUE - continued

The carrying values and estimated fair values of the Company’s financial instruments were as follows:

September 30, 2016					Fair Value Measurements
(Dollars in thousands)					Quoted		Significant
					market		other		Significant
					price in		observable		unobservable
	Carrying		Estimated		active markets		inputs		inputs
	Amount		Fair Value		(Level 1)		(Level 2)		(Level 3)
Financial Assets:
Cash and cash equivalents	$	31,174	$	31,174	$	31,174	$	—	$	—
Securities available-for-sale		111,581		111,581		—		111,581		—
Nonmarketable equity securities		1,090		1,090		—		—		1,090
Loans, net		204,500		204,855		—		—		204,855

Financial Liabilities:
Demand deposit, interest-bearing transaction, and savings accounts		172,845		172,845		172,845		—		—
Certificates of deposit		150,505		150,708		—		150,708		—
Repurchase agreements		1,662		1,662		—		1,662		—
Advances from the Federal Home Loan Bank		17,000		17,821		—		17,821		—

	Notional		Estimated
	Amount		Fair Value
Off-Balance Sheet Financial
Instruments:
Commitments to extend credit	$	31,485		n/a
Standby letters of credit		459		n/a

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to unaudited CONDENSED Consolidated Financial Statements

NOTE 12 - FAIR VALUE - continued

December 31, 2015					Fair Value Measurements
(Dollars in thousands)					Quoted		Significant
					market		other		Significant
					price in		observable		unobservable
	Carrying		Estimated		active markets		inputs		inputs
	Amount		Fair Value		(Level 1)		(Level 2)		(Level 3)
Financial Assets:
Cash and cash equivalents	$	22,137	$	22,137	$	22,137	$	—	$	—
Securities available-for-sale		89,701		89,701		—		89,701		—
Nonmarketable equity securities		1,330		1,330		—		—		1,330
Loans, net		204,766		204,975		—		—		204,975

Financial Liabilities:
Demand deposit, interest-bearing transaction, and savings accounts		156,860		156,860		156,860		—		—
Certificates of deposit		173,971		174,964		—		174,964		—
Repurchase agreements		1,716		1,716		—		1,716		—
Advances from the Federal Home Loan Bank		17,000		17,108		—		17,108		—
Subordinated debentures		11,021		*		—		—		—
Junior subordinated debentures		6,117		*		—		—		—

	Notional		Estimated
	Amount		Fair Value
Off-Balance Sheet Financial
Instruments:
Commitments to extend credit	$	21,318		n/a
Standby letters of credit		257		n/a

* The Company is unable to determine this value.

Fair Value Measurements

Following is a description of valuation methodologies used for assets and liabilities recorded at fair value.

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

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to unaudited CONDENSED Consolidated Financial Statements

NOTE 12 - FAIR VALUE - continued

Loans - The Company does not record loans at fair value on a recurring basis, however, from time to time, a loan is considered impaired and an allowance for loan loss is established. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan are considered impaired. Once a loan is identified as individually impaired, management measures impairment. The fair value of impaired loans is estimated using one of several methods, including the collateral value, market value of similar debt and discounted cash flows. Those impaired loans not requiring a specific allowance represents loans for which the fair value of expected repayments or collateral exceed the recorded investment in such loans. The fair value of Impaired Loans is generally based on judgment and therefore classified as nonrecurring Level 3.

Other Real Estate Owned - OREO is adjusted to fair value upon transfer of the loans to OREO. Real estate acquired in settlement of loans is recorded initially at estimated fair value of the property less estimated selling costs at the date of foreclosure. The initial recorded value may be subsequently reduced by additional allowances, which are charges to earnings if the estimated fair value of the property less estimated selling costs declines below the initial recorded value. Fair value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral. The fair value of OREO is generally based on judgment and therefore is classified as nonrecurring Level 3.

Assets and Liabilities Measured at Fair Value on a Recurring Basis

The tables below present the balances of assets and liabilities measured at fair value on a recurring basis as of and for the periods ended September 30, 2016 and December 31, 2015, by level within the fair value hierarchy.

			Quoted prices in		Significant
			active markets		Other		Significant
			for identical		Observable		Unobservable
(Dollars in thousands)			assets		Inputs		Inputs
	Total		(Level 1)		(Level 2)		(Level 3)
September 30, 2016
Assets:
Government sponsored enterprises	$	8,882	$	—	$	8,882	$	—
Mortgage-backed securities		87,767		—		87,767		—
Obligations of state and local governments		14,932		—		14,932		—
Total	$	111,581	$	—	$	111,581	$	—

December 31, 2015
Assets:
Government sponsored enterprises	$	36,032	$	—	$	36,032	$	—
Mortgage-backed securities		52,445		—		52,445		—
Obligations of state and local governments		1,224		—		1,224		—
Total	$	89,701	$	—	$	89,701	$	—

The Company has no liabilities measured at fair value on a recurring basis.

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to unaudited CONDENSED Consolidated Financial Statements

NOTE 12 - FAIR VALUE - continued

Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

Certain assets and liabilities are measured at fair value on a nonrecurring basis; that is, the instruments are not measured at fair value on an ongoing basis but are subject to fair value adjustments in certain circumstances (for example, when there is evidence of impairment). The following tables present the assets and liabilities carried on the balance sheet by caption and by level within the valuation hierarchy described above for which a nonrecurring change in fair value has been recorded during the periods ended September 30, 2016 and December 31, 2015.

			Quoted prices in		Significant
			active markets		Other		Significant
(Dollars in thousands)			for identical		Observable		Unobservable
			assets		Inputs		Inputs
	Total		(Level 1)		(Level 2)		(Level 3)
September 30, 2016
Assets:
Impaired loans, net of related allowance	$	22,537	$	—	$	—	$	22,537
Other real estate owned		4,032		—		—		4,032
Total	$	26,569	$	—	$	—	$	26,569

December 31, 2015
Assets:
Impaired loans, net of related allowance	$	32,758	$	—	$	—	$	32,758
Other real estate owned		13,624		—		—		13,624
Total	$	46,382	$	—	$	—	$	46,382

The Company has no liabilities measured at fair value on a nonrecurring basis.

Level 3 Valuation Methodologies

The fair value of impaired loans is estimated using one of several methods, including collateral value and discounted cash flows and, in rare cases, the market value of the note. Those impaired loans not requiring an allowance represent loans for which the net present value of the expected cash flows or fair value of the collateral less costs to sell exceed the recorded investments in such loans. When the fair value of the collateral is based on an executed sales contract with an independent third party, the Company records the impaired loans as nonrecurring Level 1. If the collateral is based on another observable market price or a current appraised value, the Company records the impaired loans as nonrecurring Level 2. When an appraised value is not available or the Company determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the impaired loan as nonrecurring Level 3. Impaired loans can be evaluated for impairment using the present value of expected future cash flows discounted at the loan’s effective interest rate. Impaired loans are reviewed and evaluated on at least a quarterly basis for additional impairment and adjusted accordingly.

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to unaudited CONDENSED Consolidated Financial Statements

NOTE 12 - FAIR VALUE - continued

Foreclosed real estate is carried at fair value less estimated selling costs. Fair value is generally based upon current appraisals, comparable sales, and other estimates of value obtained principally from independent sources, adjusted for selling costs. When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the asset as nonrecurring Level 2. However, the Company also considers other factors or recent developments which could result in adjustments to the collateral value estimates indicated in the appraisals such as changes in absorption rates or market conditions from the time of valuation. In situations where management adjustments are significant to the fair value measurements in its entirety, such measurements are classified as Level 3 within the valuation hierarchy.

The following table presents quantitative information about level 3 fair value measurements for financial instruments measured at fair value on a non-recurring basis at September 30, 2016. Management believes the weighted average range of adjustments to be appropriate. As discussed previously, depressed real estate values in the areas we serve may cause larger adjustments from time to time.

(Dollars in thousands)
	September 30,		Valuation	Unobservable	Range
	2016		Techniques	Inputs	(Weighted Avg)
Impaired loans:
Commercial	$	1,472	Appraised Value/	Appraisals and/or sales
			Discounted Cash	of comparable properties/	0.00% - 23.50%
			Flows	Independent quotes	(0.76%)

Commercial real estate		13,538	Appraised Value/	Appraisals and/or sales
			Discounted Cash	of comparable properties/	0.00% - 32.33%
			Flows	Independent quotes	(7.43%)

Residential		7,443	Appraised Value/	Appraisals and/or sales
			Discounted Cash	of comparable properties/	0.00% - 46.60%
			Flows	Independent quotes	(11.57%)

Consumer		84	Appraised Value/	Appraisals and/or sales
			Discounted Cash	of comparable properties/	0.00% - 10.00%
			Flows	Independent quotes	(2.22%)

Other real estate owned		4,032	Appraised Value/	Appraisals and/or sales
			Discounted Cash	of comparable properties/	0.00% - 10.00%
			Flows	Independent quotes	(10.00%)

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to unaudited CONDENSED Consolidated Financial Statements

NOTE 12 - FAIR VALUE - continued

The following table presents quantitative information about level 3 fair value measurements for financial instruments measured at fair value on a non-recurring basis at December 31, 2015. Management believes the weighted average range of adjustments to be appropriate. As discussed previously, depressed real estate values in the areas we serve may cause larger adjustments from time to time.

(Dollars in thousands)
	December 31,		Valuation	Unobservable	Range
	2015		Techniques	Inputs	(Weighted Avg)
Impaired loans:
Commercial	$	2,590	Appraised Value/	Appraisals and/or sales
			Discounted Cash	of comparable properties/	0.00%-10.00%
			Flows	Independent quotes	(8.77%)

Commercial real estate		21,186	Appraised Value/	Appraisals and/or sales
			Discounted Cash	of comparable properties/	0.00%-32.33%
			Flows	Independent quotes	(10.23%)

Residential		8,858	Appraised Value/	Appraisals and/or sales
			Discounted Cash	of comparable properties/	0.00%-10.00%
			Flows	Independent quotes	(9.90%)

Consumer		124	Appraised Value/	Appraisals and/or sales
			Discounted Cash	of comparable properties/	0.00%-10.00%
			Flows	Independent quotes	(10.00%)

Other real estate owned		13,624	Appraised Value/	Appraisals and/or sales
			Discounted Cash	of comparable properties/	0.00%-10.00%
			Flows	Independent quotes	(10.00%)

NOTE 13 - COMMITMENTS AND CONTINGENCIES

In the ordinary course of business, the Company may, from time to time, become a party to legal claims and disputes. At September 30, 2016, the Company is party to several court actions and investigations as discussed in detail in “Legal Proceedings” under Part II, Item 1 of this Form 10-Q.

The Company and the Bank have engaged legal counsel and intend to vigorously defend themselves in all actions. The ultimate outcomes of all referenced actions are unknown at this time and reasonably possible losses cannot be estimated.

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to unaudited CONDENSED Consolidated Financial Statements

NOTE 14 – SUBSEQUENT EVENTS

Subsequent events are events or transactions that occur after the balance sheet date but before financial statements are issued. Recognized subsequent events are events or transactions that provide additional evidence about conditions that existed at the date of the balance sheet, including the estimates inherent in the process of preparing financial statements. Nonrecognized subsequent events are events that provide evidence about conditions that did not exist at the date of the balance sheet but arose after that date. Management has reviewed events occurring through the date the financial statements were issued and no subsequent events occurred requiring accrual or disclosure that are not otherwise disclosed herein.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION

AND RESULTS OF OPERATIONS

INTRODUCTION

The following discussion describes our results of operations for the three and nine month periods ended September 30, 2016, as compared to the three and nine month periods ended September 30, 2015, and also analyzes our financial condition as of September 30, 2016 as compared to December 31, 2015. The following discussion and analysis also identifies significant factors that have affected our financial position and operating results during the periods included in the accompanying financial statements. We encourage you to read this discussion and analysis in conjunction with our financial statements and the other statistical information included in our filings with the SEC.

OVERVIEW

For the nine months ended September 30, 2016, the Company had net income of $4.8 million compared to $163 thousand for the nine months ended September 30, 2015. After closing the 2016 private placement of its common stock and Series A preferred stock in the second quarter of 2016, the Company redeemed its subordinated promissory notes and its junior subordinated debentures and recognized a net gain on the redemption of $19.1 million. This gain was partially offset by a provision for loan losses of $5.0 million, write-downs of OREO of $5.6 million and an income tax expense of $920 thousand.

Total assets at September 30, 2016 were $381.1 million, an increase of $19.7 million from $361.4 million at December 31, 2015. Cash and cash equivalents increased by $9.0 million and securities available-for-sale increased $21.9 million primarily from the investment of proceeds from the 2016 private placement. Net loans receivable decreased by $266 thousand. The sale of $4.3 million of nonperforming loans was offset by increased loan growth in the third quarter of 2016. OREO decreased by $9.6 million from year-end as a result of write-downs and sales. Increased write-downs were taken during the first nine months of 2016 in an effort to expedite sales to reduce nonperforming assets. Total liabilities decreased $29.2 million as proceeds from the 2016 private placement were used to redeem the subordinated promissory notes and the junior subordinated debentures including related accrued interest payable. Time deposits decreased $23.5 million while other deposit accounts aggregately increased $16.0 million.

The closing of the 2016 private placement along with the gain realized on the redemption of subordinated promissory notes and the junior subordinated debentures provided a shareholders’ equity of $36.6 million as of September 30, 2016 compared to a shareholders’ deficit of $12.3 million at December 31, 2015.

RESULTS OF OPERATIONS

Results of Operations for the Nine Months ended September 30, 2016 and 2015

The Company experienced a decrease of $1.3 million in total interest income for the nine months ended September 30, 2016. A decrease in interest, including fees, on our loan portfolio of $1.1 million, or 12.9%, for the nine months ended September 30, 2016 compared to the nine months ended September 30, 2015 combined with a decrease in interest income on our securities available-for-sale of $228 thousand contributed to the decrease. The redemption of the subordinated promissory notes and the junior subordinated debentures along with declines in rates and volume in time deposits resulted in a decrease to total interest expense of $1.1 million, or 31.4%, for the nine month period in 2016 compared to the nine month period in 2015. Net interest income decreased $186 thousand for the nine months ended September 30, 2016 compared to the nine months ended September 30, 2015.

The provision for loan losses is charged to earnings based upon management’s evaluation of specific loans in its portfolio and general economic conditions and trends in the marketplace. Please refer to the section “Loan Portfolio” for a discussion of management’s evaluation of the adequacy of the allowance for loan losses. During the second quarter of 2016, management reevaluated the allowance model, as discussed in Provision and Allowance for Loan Losses, which resulted in an increase of $2.1 million at the time of the change.

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The Bank sold $4.3 million of nonaccrual loans on July 7, 2016. The charge-offs related to these loans accounted for a significant portion of total loan charge-offs of $6.5 million in the first nine months of 2016. A provision of $5.0 million was recorded for the first nine months of 2016. No provision was considered necessary for the nine-month period ended September 30, 2015. Loan charge-offs for the first nine months of 2015 were $1.9 million.

Noninterest income increased $17.5 million for the nine months ended September 30, 2016 compared to September 30, 2015. The Company recognized a gain of $19.1 million related to the redemption of its subordinated promissory notes and its junior subordinated debentures which is discussed in Notes 7 and 8. This gain was partially offset by a loss on sale of loans of $224 thousand and lower gains on the sales of securities available for sale compared to the prior period. During the third quarter of 2015, the Company recognized a gain of $736 thousand on the sale of three branches. Most of the other components of noninterest income also decreased.

Noninterest expense increased from $9.6 million for the nine months ended September 30, 2015 to $16.3 million for the nine months ended September 30, 2016. Net cost of operations of OREO increased $5.8 million. The Company recognized significant write-downs on its OREO properties in an effort to expedite sales to reduce nonperforming assets.

The Company also recognized an income tax expense of $920 thousand for the nine months ended September 30, 2016 compared to $67 thousand for the prior year period.

Results of Operations for the Three Months ended September 30, 2016 and 2015

Net loss for the three months ended September 30, 2016 was $1.8 million compared to a net income of $403 thousand for the three months ended September 30, 2015. The Company recorded write-downs on OREO properties of $1.3 million during the third quarter of 2016 and recognized a loss on sale of loans of $224 thousand compared to a gain of $736 thousand recognized from the branch sale in 2015.

Interest income decreased $446 thousand for the quarter ended September 30, 2016 when compared with the same period in 2015. Lower rates and lower average volume contributed to the reduction. Interest expense also decreased by $437 thousand, or 39.6%, for the quarter ended September 30, 2016 when compared to the same period in 2015 primarily due to the redemption of the subordinated promissory notes and the junior subordinated debentures. Net interest income decreased by $9 thousand for the three months ended September 30, 2016 compared to the three months ended September 30, 2015.

No provision for loan losses was recognized during either quarter.

Noninterest income for the three months ended September 30, 2016 was $334 thousand compared to $1.3 million for the three months ended September 30, 2015. Net gains realized on sales of available-for-sale securities were $153 thousand for the three months ended September 30, 2016 compared to $20 thousand for the three months ended September 30, 2015. The Company recognized a loss on sale of assets of $222 thousand during the third quarter of 2016 compared to a gain of $736 thousand recognized on the sale of three branches during the third quarter of 2015. Most of the other components of noninterest income also declined.

For the three months ended September 30, 2016, noninterest expense was $4.6 million compared to $3.5 million for the three months ended September 30, 2015. The increase was substantially related to the OREO write-downs discussed above.

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FINANCIAL CONDITION

Investment Portfolio

Management classifies investment securities as either held-to-maturity or available-for-sale based on our intentions and the Company’s ability to hold them until maturity. In determining such classifications, securities that management has the positive intent and the Company has the ability to hold until maturity are classified as held-to-maturity and carried at amortized cost. All other securities are designated as available-for-sale and carried at estimated fair value with unrealized gains and losses included in shareholders’ equity on an after-tax basis. As of September 30, 2016 and December 31, 2015, all securities were classified as available-for-sale.

The portfolio of available-for-sale securities increased $21.9 million, or 24.4%, from $89.7 million at December 31, 2015 to $111.6 million at September 30, 2016 as management invested excess cash in higher-yielding securities. Our securities portfolio consisted primarily of high quality mortgage securities, government agency bonds, and high quality municipal bonds.

The following tables summarize the carrying value of investment securities as of the indicated dates and the weighted-average yields of those securities at September 30, 2016.

September 30, 2016 (in thousands)	Amortized Cost Due
	Due			After One			After Five
	Within			Through			Through			After Ten						Market
	One Year			Five Years			Ten Years			Years			Total			Value

Government sponsored enterprises	$	—		$	285		$	2,000		$	6,585		$	8,870		$	8,882
Mortgage backed securities		—			—			19,846			68,672			88,518			87,767
State and political subdivisions		—			—			9,634			5,282			14,916			14,932
Total	$	—		$	285		$	31,480		$	80,539		$	112,304		$	111,581

Weighted average yields
Government sponsored enterprises					2.29	%		2.13	%		1.31	%
Mortgage backed securities		—	%		—	%		2.09	%		1.65	%
State and political subdivisions		—	%		—	%		2.33	%		2.68	%
Total		—	%		2.29	%		2.17	%		1.69	%		1.83	%

	Book		Market
December 31, 2015 (in thousands)	Value		Value

Government-sponsored enterprises	$	36,720	$	36,032
Mortgage-backed securities		53,368		52,445
States and political subdivisions		1,221		1,224
Total	$	91,309	$	89,701

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Loan Portfolio

The Company experienced a decline in its loan portfolio of $191 thousand during the nine months ended September 30, 2016 as a result of selling $4.3 million in nonperforming loans although the Company experienced increased loan growth during the third quarter of 2016. The following table sets forth the composition of the loan portfolio by category as of September 30, 2016 and December 31, 2015.

	September 30,		December 31,
	2016		2015
(Dollars in thousands)
Real estate:
Commercial construction and land development	$	21,135	$	30,532
Other commercial real estate		76,438		70,759
Residential construction		921		2,342
Other residential		71,496		72,739
Commercial and industrial		34,304		27,881
Consumer		4,882		5,114
	$	209,176	$	209,367

The primary component of our loan portfolio is loans collateralized by real estate, which made up approximately 81.3% of our loan portfolio at September 30, 2016. These loans are secured generally by first or second mortgages on residential, agricultural or commercial property. Commercial loans and consumer loans account for 16.4% and 2.3% of the loan portfolio, respectively.

Risk Elements

The downturn in general economic conditions that occurred beginning in 2008 resulted in increased loan delinquencies, defaults and foreclosures within our loan portfolio. This downturn in our local real estate markets resulted, in some cases, in a significant impairment to the value of our collateral and our ability to sell the collateral upon foreclosure. Although the real estate collateral provides an alternate source of repayment in the event of default by the borrower, during an economic downturn like the one we experienced beginning in 2008, the value of the collateral may deteriorate during the time the credit is extended. Another econcomic downturn could result in additional losses of earnings and increases in our provision for loan losses and loans charged-off.

Past due payments are often one of the first indicators of a problem loan. We perform a continuous review of our past due report in order to identify trends that can be resolved quickly before a loan becomes significantly past due. We determine past due and delinquency status based on the contractual terms of the note. When a borrower fails to make a scheduled loan payment, we attempt to cure the default through several methods including, but not limited to, collection contact and assessment of late fees.

For loans to be in excess of 90 days delinquent and still accruing interest, the borrowers must be either remitting payments although not able to get current, liquidation on loans deemed to be well secured must be near completion, or the Company must have a reason to believe that correction of the delinquency status by the borrower is near. The amount of both nonaccrual loans and loans past due 90 days or more were considered in computing the allowance for loan losses as of September 30, 2016.

Nonperforming loans include nonaccrual loans and loans past due 90 days or more. Nonperforming assets include nonperforming loans and other real estate that we own as a result of loan foreclosures.

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Loan Portfolio - continued

In addition to increasing write-downs on OREO to expedite sales during the first nine months of 2016, the Bank sold $4.3 million of nonperforming loans and $270 thousand of OREO which had been reduced to fair value prior to the sale. Nonperforming loans were $931 thousand or 0.45% of total loans at September 30, 2016 compared to nonperforming loans at December 31, 2015 of $8.7 million or 4.18% of total loans. At September 30, 2016, nonperforming assets were $5.0 million compared to $22.4 million at December 31, 2015. As a percentage of total assets, nonperforming assets were 1.30% and 6.19% as of September 30, 2016 and December 31, 2015, respectively.

The following table summarizes nonperforming assets:

	September 30,			December 31,
Nonperforming Assets	2016			2015
(Dollars in thousands)
Nonaccrual loans	$	931		$	8,742
Loans past due 90 days or more and still accruing interest		—			—
Total nonperforming loans		931			8,742
Nonperforming loans held for sale		—
Other real estate owned		4,032			13,624
Total nonperforming assets	$	4,963		$	22,366

Nonperforming assets to total assets		1.30	%		6.19	%
Nonperforming loans to total loans		0.45	%		4.18	%

We identify impaired loans through our normal internal loan review process. A loan is considered impaired when, based on current information and events, it is probable that we will be unable to collect the scheduled payments of principal or interest when due, according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Impairment is measured on a loan-by-loan basis by calculating either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent. Any resultant shortfall is charged to provision for loan losses and is classified as a specific reserve. When an impaired loan is ultimately charged-off, the charge-off is taken against the specific reserve.

Impaired loans are valued based on the net present value of expected cash flows or based on the lower of cost or market value of the underlying collateral. Market values were obtained using independent appraisals, updated every 18 to 24 months, in accordance with our reappraisal policy, or other market data such as recent offers to the borrower. At September 30, 2016, the recorded investment in impaired loans was $23.3 million compared to $33.9 million at December 31, 2015.

TDRs are loans which have been restructured from their original contractual terms and include concessions that would not otherwise have been granted outside of the financial difficulty of the borrower. Concessions can relate to the contractual interest rate, maturity date, or payment structure of the note. As part of our workout plan for individual loan relationships, we may restructure loan terms to assist borrowers facing challenges in the current economic environment. The purpose of a TDR is to facilitate ultimate repayment of the loan.

At September 30, 2016, the principal balance of TDRs totaled $20.9 million. Of these restructured loans, $20.8 million were performing as expected under the new terms and $109 thousand were considered to be nonperforming. TDRs are evaluated for reserves on the basis of the fair value of the collateral or expected cash flows. A TDR can be removed from nonperforming status once there is sufficient history of demonstrating the borrower can service the credit under market terms. We currently consider sufficient history to be approximately six months.

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Loan Portfolio - continued

A rollforward of TDRs for the nine months ended September 30, 2016 and for the year ended December 31, 2015 is presented below:

	September 30,			December 31,
TDRs	2016			2015
(Dollars in thousands)
Balance, beginning of period	$	29,062		$	33,166
New TDRs and advances		1,000			1,393
Repayments		(2,351	)		(2,688	)
Charged-off TDRs		(3,505	)		(2,809	)
Sold		(3,286	)		—
Balance, end of period	$	20,920		$	29,062

Provision and Allowance for Loan Losses

We have established an allowance for loan losses through a provision for loan losses charged to expense on our statements of operations. The allowance represents an amount which management believes will be adequate to absorb probable losses on existing loans that may become uncollectible. We do not allocate specific percentages of our allowance for loan losses to the various categories of loans but evaluate the adequacy on an overall portfolio basis utilizing several factors. The primary factor considered is the credit risk grading system, which is applied to each loan. The amount of both nonaccrual loans and loans past due 90 days or more is also considered. The historical loan loss experience, the size of our lending portfolio, changes in the lending policies and procedures, changes in volume or type of credits, changes in volume/severity of problem loans, quality of loan review and board of director oversight, concentrations of credit, and peer group comparisons, and current and anticipated economic conditions are also considered in determining the provision for loan losses. The amount of the allowance is adjusted periodically based on changing circumstances. Recognized losses are charged to the allowance for loan losses, while subsequent recoveries are added to the allowance.

We regularly monitor past due and classified loans. However, it should be noted that no assurances can be made that future charges to the allowance for loan losses or provisions for loan losses may not be significant to a particular accounting period. Our judgment as to the adequacy of the allowance is based upon a number of assumptions about future events which we believe to be reasonable, but which may or may not prove to be accurate. Because of the inherent uncertainty of assumptions made during the evaluation process, there can be no assurance that loan losses in future periods will not exceed the allowance for loan losses or that additional allocations will not be required. Our losses will undoubtedly vary from our estimates, and there is a possibility that charge-offs in future periods will exceed the allowance for loan losses as estimated at any point in time.

Based on management observation, judgment, and experience, environmental factors used in the allowance for loan loss model were increased during the second quarter of 2016 for all loan classes. Management also determined that a look back period of twelve quarters would be more appropriate. The allowance was previously based on a six quarter look back period. The impact of the change to the model resulted in a $2.1 million increase to the loan loss reserves as of the time of the change.

At September 30, 2016, the allowance for loan losses was $4.7 million or 2.24% of total loans compared to $4.6 million or 2.20% of total loans as of December 31, 2015. Reserves specifically set aside for impaired loans of $787 thousand and $1.1 million were included in the allowance as of September 30, 2016 and December 31, 2015, respectively. The Company sold $4.3 million of loans receivable in the third quarter. The loans were recorded at fair value which also represented the contract value. Differences between the carrying values and contract values were charged off through the allowance for loan losses when the loans were transferred to held for sale and represent a significant portion of charge-offs in the first nine months of 2016. Management believes the allowance is adequate.

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Provision and Allowance for Loan Losses - continued

The following table summarizes the activity related to our allowance for loan losses.

Summary of Loan Loss Experience	Nine			Nine
	months			months			Year
	ended			ended			ended
(Dollars in thousands)	September 30,			September 30,			December 31,
	2016			2015			2015

Total loans outstanding at end of period	$	209,176		$	219,982		$	209,367

Allowance for loan losses, beginning of period	$	4,601		$	5,787		$	5,787

Charge offs:
Real estate		(5,369	)		(1,358	)		(1,713	)
Commercial		(1,132	)		(458	)		(539	)
Consumer		(45	)		(57	)		(81	)
Total charge-offs		(6,546	)		(1,873	)		(2,333	)

Recoveries of loans previously charged off		1,637			1,107			1,147
Net charge-offs		(4,909	)		(766	)		(1,186	)

Provision charged to operations		4,984			—			—
Allowance for loan losses at end of period	$	4,676		$	5,021		$	4,601

Ratios:
Allowance for loan losses to loans at end of period		2.24	%		2.28	%		2.20	%
Net charge-offs to allowance for loan losses		104.98	%		15.26	%		25.78	%
Net charge-offs to provisions for loan losses		98.50	%		n/a			n/a

Advances from the Federal Home Loan Bank

The following table summarizes the Company’s FHLB borrowings for the nine months ended September 30, 2016 and for the year ended December 31, 2015.

	Maximum		Weighted
	Outstanding		Average		Period
	at any		Average		Interest			End
(Dollars in thousands)	Month End		Balance		Rate			Balance
September 30, 2016
Advances from Federal Home Loan Bank	$	17,000	$	17,000		3.44	%	$	17,000
December 31, 2015
Advances from Federal Home Loan Bank	$	17,000	$	17,000		3.44	%	$	17,000

Advances from the FHLB are collateralized by one-to-four family residential mortgage loans, certain commercial real estate loans, certain securities in the Bank’s investment portfolio and the Company’s investment in FHLB stock. Although we expect to continue using FHLB advances as a secondary funding source, core deposits will continue to be our primary funding source. As a result of negative financial performance indicators, there is a risk that the Bank’s ability to borrow from the FHLB could be curtailed or eliminated. Although to date the Bank has not been denied advances from the FHLB, the Bank has had its collateral maintenance requirements altered to reflect the increase in our credit risk. Thus, we can make no assurances that this funding source will continue to be available to us.

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Capital Resources

Shareholders’ equity improved from a deficit of $12.3 million at December 31, 2015 to an equity of $36.6 million at September 30, 2016. On April 11, 2016, the Company completed the 2016 private placement of 359,468,443 shares of common stock and 905,316 shares of Series A preferred stock for net proceeds of $41.5 million. The shares of Series A preferred stock were converted to shares of non-voting common stock during the third quarter. The Series T preferred stock and the CPP warrant were repurchased for $129 thousand. The Company also sold 14,167,600 shares of common stock at $0.10 per share in a public offering for aggregate cash proceeds of approximately $1.4 million which primarily provided the Company’s legacy shareholders, employees and others in its community with an opportunity to invest in the Company at the same offering price of $0.10 per share that the Company offered to the investors in the 2016 private placement. Net income of $4.8 million was recognized during the first nine months of 2016 as a result of the gain on extinguishment of subordinated promissory notes and junior subordinated debentures partially offset by the recorded provision for loan losses and OREO write-downs. Unrealized losses attributable to the available-for-sale securities portfolio also decreased. These unrealized losses, net of tax, are included in accumulated other comprehensive loss. Changes in the deferred tax asset related to unrealized losses in the securities portfolio have no effect on income.

In July 2013, the federal bank regulatory agencies issued a final rule that has revised their risk-based capital requirements and the method for calculating risk-weighted assets to make them consistent with certain standards that were developed by Basel III and certain provisions of the Dodd-Frank Act. The final rule applies to all depository institutions, such as the Bank, top-tier bank holding companies with total consolidated assets of $1 billion or more, and top-tier savings and loan holding companies, which we refer to below as “covered” banking organizations. Bank holding companies with less than $1 billion in total consolidated assets, such as the Company, are not subject to the final rule. Effective March 31, 2015, the Bank was required to implement the new Basel III capital standards (subject to the phase-in for certain parts of the new rules).

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Capital Resources – continued

The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. To be considered “well-capitalized” under these requirements, a bank must maintain total risk-based capital of at least 10%, Tier 1 capital of at least 8%, and a leverage ratio of at least 5%. To be considered “adequately capitalized” under these capital guidelines, a bank must maintain a minimum total risk-based capital of 8%, with at least 6% being Tier 1 capital. In addition, a bank must maintain a minimum Tier 1 leverage ratio of at least 4%.

The recently terminated Consent Order required the Bank to achieve and maintain Tier 1 capital at least equal to 8% and total risk-based capital at least equal to 10%. Although the Bank is no longer subject to the Consent Order as of its termination on October 26, 2016, the Bank must continue to maintain Tier 1 capital at least equal to 8% and total risk-based capital at least equal to 10%.

If a bank is not well capitalized, it cannot accept brokered deposits without prior FDIC approval. In addition, a bank that is not well capitalized cannot offer an effective yield in excess of 75 basis points over interest paid on deposits of comparable size and maturity in such institution’s normal market area for deposits accepted from within its normal market area, or national rate paid on deposits of comparable size and maturity for deposits accepted outside the Bank’s normal market area. Moreover, the FDIC generally prohibits a depository institution from making any capital distributions (including payment of a dividend) or paying any management fee to its parent holding company if the depository institution would thereafter be categorized as undercapitalized. Undercapitalized institutions are subject to growth limitations (an undercapitalized institution may not acquire another institution, establish additional branch offices or engage in any new line of business unless determined by the appropriate federal banking agency to be consistent with an accepted capital restoration plan, or unless the FDIC determines that the proposed action will further the purpose of prompt corrective action) and are required to submit a capital restoration plan. The agencies may not accept a capital restoration plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the depository institution’s capital. In addition, for a capital restoration plan to be acceptable, the depository institution’s parent holding company must guarantee that the institution will comply with the capital restoration plan. The aggregate liability of the parent holding company is limited to the lesser of an amount equal to 5.0% of the depository institution’s total assets at the time it became categorized as undercapitalized or the amount that is necessary (or would have been necessary) to bring the institution into compliance with all capital standards applicable with respect to such institution as of the time it fails to comply with the plan. If a depository institution fails to submit an acceptable plan, it is categorized as significantly undercapitalized.

Significantly undercapitalized categorized depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become categorized as adequately capitalized, requirements to reduce total assets, and cessation of receipt of deposits from correspondent banks. The appropriate federal banking agency may take any action authorized for a significantly undercapitalized institution if an undercapitalized institution fails to submit an acceptable capital restoration plan or fails in any material respect to implement a plan accepted by the agency. A critically undercapitalized institution is subject to having a receiver or conservator appointed to manage its affairs and for loss of its charter to conduct banking activities.

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Capital Resources – continued

An insured depository institution may not pay a management fee to a bank holding company controlling that institution or any other person having control of the institution if, after making the payment, the institution would be undercapitalized. In addition, an institution cannot make a capital distribution, such as a dividend or other distribution that is in substance a distribution of capital to the owners of the institution if following such a distribution the institution would be undercapitalized. Thus, if payment of such a management fee or the making of such would cause a bank to become undercapitalized, it could not pay a management fee or dividend to the bank holding company.

The following table summarizes the capital amounts and ratios of the Company and the Bank at September 30, 2016 and December 31, 2015.

	September 30,			December 31,
	2016			2015
	(Dollars in thousands)
The Company
Tier 1 capital	$	37,048		$	(10,642	)
Tier 2 capital		3,037			—
Total qualifying capital	$	40,085		$	(10,642	)

Risk-adjusted total assets
(including off-balance sheet exposures)	$	241,307		$	256,713

Tier 1 risk-based capital ratio		15.35	%		(4.15	)%
Total risk-based capital ratio		16.61	%		(4.15	)%
Tier 1 leverage ratio		9.51	%		(2.87	)%

The Bank
Common equity Tier 1 capital	$	36,404		$	12,135

Tier 1 capital	$	36,404		$	12,135
Tier 2 capital		3,037			3,267
Total qualifying capital	$	39,441		$	15,402

Risk-adjusted total assets
(including off-balance sheet exposures)	$	241,307		$	260,024

Common equity Tier 1 capital ratio		15.09	%		4.67	%
Tier 1 risk-based capital ratio		15.09	%		4.67	%
Total risk-based capital ratio		16.34	%		5.92	%
Tier 1 leverage ratio		9.38	%		3.28	%

At September 30, 2016, the Company exceeded its minimum regulatory capital requirements. While the Bank could not be considered “well capitalized” at September 30, 2016 due to the Consent Order (which was subsequently terminated on October 26, 2016), as a result of the 2016 private placement the Bank met all of the capital requirements set forth under the Consent Order as of September 30, 2016.

The Company does not anticipate paying dividends for the foreseeable future, and all future dividends will be dependent on the Company’s financial condition, results of operations, and cash flows, as well as capital regulations and dividend restrictions from the Federal Reserve Bank of Richmond, the FDIC, and the State Board.

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ACCOUNTING AND FINANCIAL REPORTING ISSUES

We have adopted various accounting policies which govern the application of accounting principles generally accepted in the United States in the preparation of our financial statements. Our significant accounting policies are described in the footnotes to the consolidated financial statements for the year ended December 31, 2015, as filed in our Annual Report on Form 10-K. Certain accounting policies involve significant judgments and assumptions by us which have a material impact on the carrying value of certain assets and liabilities. We consider these accounting policies to be critical accounting policies. The judgments and assumptions we use are based on historical experience and other factors, which we believe to be reasonable under the circumstances. Because of the nature of the judgments and assumptions we make, actual results could differ from these judgments and estimates which could have a material impact on our carrying values of assets and liabilities and our results of operations.

We believe the allowance for loan losses is a critical accounting policy that requires significant judgment and estimates used in preparation of our consolidated financial statements. Refer to the portion of this discussion that addresses our allowance for loan losses for a description of our processes and methodology for determining our allowance for loan losses.

The determination of the value of OREO is also considered a critical accounting policy as management must use significant judgment and estimates when considering the reasonableness of the value.

The income tax provision is also an accounting policy that requires judgment as the Company seeks strategies to minimize the tax effect of implementing their business strategies. The Company’s tax returns are subject to examination by both federal and state authorities. Such examinations may result in assessment of additional taxes, interest and penalties. As a result, the ultimate outcome, and the corresponding financial statement impact, can be difficult to predict with accuracy.

Fair value determination and other-than-temporary impairment is subject to management’s evaluation to determine if it is probable that all amounts due according to contractual terms will be collected to determine if any other-than-temporary impairment exists. The process of evaluating other-than-temporary impairment is inherently judgmental, involving the weighing of positive and negative factors and evidence that may be objective or subjective.

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LIQUIDITY

Liquidity is the ability to meet current and future obligations through liquidation or maturity of existing assets or the acquisition of additional liabilities. The Company manages both assets and liabilities to achieve appropriate levels of liquidity. Cash and federal funds sold are the Company’s primary sources of asset liquidity. These funds provide a cushion against short-term fluctuations in cash flow from both deposits and loans. The investment securities portfolio is the Company’s principal source of secondary asset liquidity. However, the availability of this source of funds is influenced by market conditions. Individual and commercial deposits are the Company’s primary source of funds for credit activities. Although not historically used as principal sources of liquidity, federal funds purchased from correspondent banks and advances from the FHLB are other options available to management. Management believes that the Company’s liquidity sources will enable it to successfully meet its long-term operating needs.

As of September 30, 2016, the Company had no available lines of credit. The Bank’s greatest source of liquidity resides in its unpledged securities portfolio. The book and market values of unpledged securities available-for-sale totaled $67.3 million and $66.9 million, respectively, at September 30, 2016. This source of liquidity may be adversely impacted by changing market conditions, reduced access to borrowing lines, or increased collateral pledge requirements imposed by lenders. The Bank has implemented a plan to address these risks and strengthen its liquidity position. To accomplish the goals of this liquidity plan, the Bank will maintain cash liquidity at a minimum of 4% of total outstanding deposits and borrowings. In addition to cash liquidity, the Bank will also maintain a minimum of 15% off balance sheet liquidity. These objectives have been established by extensive contingency funding stress testing and analytics that indicate these target minimum levels of liquidity to be appropriate and prudent.

Comprehensive weekly and quarterly liquidity analyses serve management as vital decision-making tools by providing summaries of anticipated changes in loans, investments, core deposits, and wholesale funds. These internal funding reports provide management with the details critical to anticipate immediate and long-term cash requirements, such as expected deposit runoff, loan and securities paydowns and maturities. These liquidity analyses act as a cash forecasting tool and are subject to certain assumptions based on past market and customer trends. Through consideration of the information provided in these reports, management is better able to effectively monitor the Bank’s liquidity position.

To better manage our liquidity position, management also stress tests our liquidity position on a semi-annual basis under two scenarios: short-term crisis and a longer-term crisis. In the short term crisis, we would be cut off from our normal funding along with the market in general. In this scenario, the Bank would replenish our funding through the most likely sources of funding that would exist in the order of price efficiency. In the longer term crisis, we may be cut off from several of our normal sources of funding as our Bank’s financial situation deteriorated. In such a case, we would utilize our unpledged securities to raise funds in the reverse repurchase market or borrow from the FHLB. On a quarterly basis, management monitors the market value of our securities portfolio to ensure its ability to be pledged if liquidity needs should arise.

We believe our liquidity sources are adequate to meet our needs for at least the next 12 months.

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IMPACT OF OFF-BALANCE SHEET INSTRUMENTS

The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments consist of commitments to extend credit and standby letters of credit. Commitments to extend credit are legally binding agreements to lend to a customer at predetermined interest rates as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. A commitment involves, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheets. The Company’s exposure to credit loss in the event of nonperformance by the other party to the instrument is represented by the contractual notional amount of the instrument. Since certain commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Letters of credit are conditional commitments issued to guarantee a customer’s performance to a third party and have essentially the same credit risk as other lending facilities. Standby letters of credit often expire without being used. Management believes that through various sources of liquidity, the Company has the necessary resources to meet obligations arising from these financial instruments.

The Company uses the same credit underwriting procedures for commitments to extend credit and standby letters of credit as for on-balance-sheet instruments. The credit worthiness of each borrower is evaluated and the amount of collateral, if deemed necessary, is based on the credit evaluation. Collateral held for commitments to extend credit and standby letters of credit varies but may include accounts receivable, inventory, property, plant, equipment, and income-producing commercial properties, as well as liquid assets such as time deposit accounts, brokerage accounts, and cash value of life insurance.

The Company is not involved in off-balance sheet contractual relationships, other than those disclosed in this report, which it believes could result in liquidity needs or other commitments or that could significantly impact earnings.

As of September 30, 2016, commitments to extend credit totaled $31.5 million and standby letters of credit totaled $459 thousand.

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Item 3. Quantitative and Qualitative Disclosures About Market Risk

Not applicable.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

Management, including our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by this report. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective to ensure that information required to be disclosed in the reports we file and submit under the Exchange Act is (i) recorded, processed, summarized and reported as and when required and (ii) accumulated and communicated to our management, including our Chief Executive Officer and the Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.

Changes in Internal Control over Financial Reporting

There has been no change in the Company’s internal control over financial reporting during the quarter ended September 30, 2016, that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

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PART II - OTHER INFORMATION

Item 1. Legal Proceedings

In the ordinary course of operations, we may be a party to various legal proceedings from time to time. As of the date of this report, except as noted below we do not believe that there is any pending or threatened proceeding against us, which, if determined adversely, would have a material effect on our business, results of operations, or financial condition.

For the below matters, the Company and the Bank have engaged legal counsel and intend to vigorously defend themselves. Given the Company’s current troubled financial condition, any costs incurred by the Company associated with legal defense, government sanctions, or settlement or other litigation awards could have a material adverse effect on its financial condition due to the Company’s lack of consistent earnings.

	•	On July 19, 2012, Robert Shelley, in his individual capacity and on behalf of a proposed class of other similarly situated persons, filed a lawsuit against the Company and the Bank in the Court of Common Pleas for the Fifteenth Judicial Circuit, State of South Carolina, County of Horry, Case No. 2012-CP-26-5546. The complaint alleges that the plaintiff and other similarly situated persons were contacted by employees of the Bank, that those employees solicited a sale of Bank stock, and that the Bank employees did not disclose material information about the Bank’s financial condition prior to their respective purchases of stock. The complaint seeks the certification of a class action to include all purchasers of Bank stock solicited between July 1, 2009 and December 31, 2011. The plaintiff has asserted violations of the South Carolina Uniform Securities Act, negligence and civil conspiracy, and seeks actual, punitive and treble damages and attorneys’ fees and costs. The Company and the Bank made a motion for summary judgment in March 2014, which the court granted on April 8, 2014. Robert Shelley subsequently filed a motion to reconsider, which was denied. Mr. Shelly subsequently filed a notice of appeal with the South Carolina Court of Appeals. Both parties completed their respective briefing and oral arguments were scheduled for October 6, 2016. However, opposing counsel initiated settlement discussions a few days before the appeal was to be heard and a compromise was reached by the parties. A settlement agreement was executed and an order of dismissal filed, thereby ending this matter.

	•	On or about October 4, 2012, the United States Attorney for the District of South Carolina served the Company and the Bank with a subpoena requesting the production of documents related to the Company’s offering and sale of subordinated debt notes. The Company and the Bank have provided all documents and information requested by the government to date. By letter dated December 28, 2015, the office of the United States Attorney advised the Company and Bank that it was declining to prosecute and was closing its file. After this investigation was concluded, the office of SIGTARP, which had been working with the United States Attorney for South Carolina, notified the Company and the Bank that it would be requesting some additional documents needed for review. On March 1, 2016, the office of SIGTARP issued a subpoena for certain documents to the Company and Bank. The Company and Bank fully and timely responded to this subpoena and are continuing to work with SIGTARP on its follow-up questions and requests.

	•	Plaintiff Mozingo + Wallace Architects, LLC, was a depositor with the Bank. An employee named Debor Guear was charged with being responsible for Mozingo + Wallace’s finances, including the receipt and review of account statements, payment of invoices, and reconciling all financial accounts. In 2013, another bank advised Mozingo + Wallace that it had been receiving an unusually high number of checks issued by Mozingo + Wallace to Ms. Guear’s account. Mozingo + Wallace obtained records of its account at the Bank and alleges that Ms. Guear had been making unauthorized transactions from its account. On September 25, 2013, Mozingo + Wallace sued the Company and the Bank in the Court of Common Pleas for the Fifteenth Judicial District, State of South Carolina, County of Horry, Case No. 2013-CP-26-6494, alleging that the Bank improperly allowed Ms. Guear to control and access account statements and seeking damages in an unspecified amount. The plaintiff dismissed the case without prejudice and re-filed a new action on or about March 27, 2015, naming the Bank and Company, as well as the plaintiff’s former outside bookkeeper. The parties attended mandatory mediation on September 9, 2016, and a settlement of all claims was reached at that time. A release and dismissal were subsequently executed, thereby ending this matter.

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Item 1A. Risk Factors

Under the filer category of “smaller reporting company”, as defined in Rule 12b-2 of the Exchange Act, the Company is not required to provide information requested by Part II, Item 1A of its Form 10-Q.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

None

Item 3. Defaults Upon Senior Securities

None

Item 4. Mine Safety Disclosures

Not applicable

Item 5. Other Information

None

Item 6. Exhibits

The exhibits required to be filed as part of this Quarterly Report on Form 10-Q are listed in the Index to Exhibits attached hereto and are incorporated herein by reference.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

Date: November 4, 2016	By:	/s/ JAN H. HOLLAR
		Jan H. Hollar
		Chief Executive Officer
		(Principal Executive Officer)



Date: November 4, 2016	By:	/s/ JENNIFER W. HARRIS
		Jennifer W. Harris
		Chief Financial Officer
		(Principal Financial and Accounting Officer)

EXHIBIT INDEX

Exhibit Number	Description

3.1	Articles of Amendment to the Articles of Incorporation of HCSB Financial Corporation to authorize the Non-Voting Common Stock, effective August 23, 2016 (incorporated by reference to Exhibit 3.1 of the Company’s Form 8-K filed on August 24, 2016).

10.1	Employment Agreement between the Company, the Bank and Jennifer W. Harris, dated as of July 1, 2016 (incorporated by reference to Exhibit 10.1 of the Company’s Form 8-K filed on July 1, 2016).

10.2	Form of Restricted Stock Award Agreement (incorporated by reference to Exhibit 10.1 of the Company’s Form 8-K filed on August 19, 2016).

31.1	Rule 13a-14(a) Certification of Principal Executive Officer.

31.2	Rule 13a-14(a) Certification of the Principal Financial Officer.

32	Section 1350 Certifications.

101	The following materials from the Quarterly Report on Form 10-Q of HCSB Financial Corporation for the quarter ended September 30, 2016, formatted in eXtensible Business Reporting Language (XBRL): (i) Condensed Consolidated Balance Sheets, (ii) Condensed Consolidated Statements of Operations, (iii) Condensed Consolidated Statements of Comprehensive Income (Loss), (iv) Condensed Consolidated Statements of Changes in Shareholders’ Equity, (v) Condensed Consolidated Statements of Cash Flows and (vi) Notes to Unaudited Condensed Consolidated Financial Statements.

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