This report contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 relating to, without limitation, our future economic performance, plans and objectives for future operations, and projections of revenues and other financial items that are based on our beliefs, as well as assumptions made by and information currently available to us.  The words “may,” “will,” “anticipate,” “should,” “would,” “believe,” “contemplate,” “could,” “project,” “predict,” “expect,” “estimate,” “continue,” and “intend,” as well as other similar words and expressions of the future, are intended to identify forward-looking statements.  Our actual results, performance, or achievements may differ materially from the results expressed or implied by our forward-looking statements.

          The cautionary statements in the “Risk Factors” section and elsewhere in this report also identify important factors and possible events that involve risks and uncertainties that could cause actual results to differ materially from those contained in the forward-looking statements.  All forward-looking statements in this report are based on information available to us on the date of this report.  We do not intend to, and assume no responsibility for, updating any forward-looking statements that may be made by us or on our behalf in this report or otherwise.

General

          We are a South Carolina corporation organized in 1999 and serve as the holding company for First National Bank of the South, a national banking association.  We operate under a traditional community banking model, with a particular focus on commercial real estate and s lending.  We commenced banking operations in March 2000 in Spartanburg, South Carolina, where we operate three full-service branches under the name First National Bank of Spartanburg.  In August 2002, we began to offer trust and investment management services through Colonial Trust Company, a South Carolina private trust company established in 1913.  We also operate a loan production office in Greenville County, which also houses our s lending division that operates under the name First National Business Capital.  

          In October 2005, we successfully converted our Mount Pleasant loan production office, opened in October 2004, to our fourth full-service branch, our first in the Charleston area.  In January of 2006, we expanded into our state’s capital with the opening of our loan production office in Columbia, South Carolina.  In February of 2006, we opened our loan production office on Daniel Island to expand our presence in the Charleston area.  In March of 2006, we received regulatory approval to convert our Greenville loan production office to our fifth full-service branch, our first in the Greenville market, and market headquarters. 

Banking Services

          We are primarily engaged in the business of accepting demand deposits and savings deposits insured by the FDIC and providing commercial, consumer, and mortgage loans to the general public.  We also originate s loans under the SBA’s various loan programs.

Our Market Areas

          Our primary market is Spartanburg County, which is located in the upstate region of South Carolina between Atlanta and Charlotte on the I-85 business corridor.  According to the South Carolina Budget and Control Board, as of July 1, 2004, Spartanburg County’s estimated population totaled 264,230 residents.  The South Carolina Department of Commerce notes that Spartanburg County attracted over $118.8 million in capital investment in 2004.  The Spartanburg Area Chamber of Commerce reports that since 2001 downtown Spartanburg has attracted more than $170 million in investments and 1,200 new jobs. As of 2005, estimated median family income for the Spartanburg metropolitan statistical area was $53,650, as compared to $52,250 for South Carolina, according to the U.S. Department of Housing and Urban Development.  Spartanburg was named the top U.S. market for European business expansion by Expansion Management magazine in 2003.  According to the Spartanburg Area Chamber of Commerce, more than 90 international firms, representing 15 nations, do business in the Spartanburg County business community, including Michelin, BMW, and Invista.  BMW’s North American assembly plant in Spartanburg began production in September 1995 and is now the sole producer of both the Z4 and the X5 Sports Activity Vehicle.  Spartanburg is also home to many domestic corporations, including Milliken, Cryovac, Denny’s, QS/1, and Advance America.  We believe that this dynamic economic environment will continue to support the community and our business in the future.

          We advertise heavily in the Spartanburg market and, through our three full-service offices in Spartanburg, have positioned ourselves as the leading local community bank in that market.  As of June 30, 2005, we were the fourth largest bank in Spartanburg County, with $244.6 million in total deposits, or 8.66% of the approximately $2.82 billion of deposits in the market.  The following table includes information from the FDIC website regarding our market share in Spartanburg County relative to top competitor banks as of June 30, 2005:

Rank

 

 

Bank

 

 

Branches

 

 

Total Deposits

 

 

Market Share

 

 

 

 

 

 

 

1

 

 

Wachovia

 

 

7

 

$

484.9 million

 

 

17.17

%

2

 

 

Bank of America

 

 

8

 

 

409.8 million

 

 

14.51

%

3

 

 

BB&T

 

 

9

 

 

389.6 million

 

 

13.80

%

4

 

 

First National Bank

 

 

3

 

 

244.6 million

 

 

8.66

%

5

 

 

Suntrust Bank

 

 

11

 

 

236.9 million

 

 

8.39

%

6

 

 

First Citizens B&T

 

 

10

 

 

228.9 million

 

 

8.11

%

7

 

 

Arthur State Bank

 

 

7

 

 

178.7 million

 

 

6.33

%

8

 

 

National Bank of South Carolina

 

 

4

 

 

169.7 million

 

 

6.01

%


          Our full-service branch in Mount Pleasant and our loan production office on Daniel Island serve the fast-growing Charleston market.  As of July 1, 2004, Charleston County’s estimated population totaled 326,762 residents, according to the South Carolina Budget and Control Board.  As of 2003, the population of Charleston’s metropolitan statistical area was 571,631 per the U.S. Census Bureau.  The Charleston area achieved an employment growth rate of 13.5% from 1999 through 2004, outpacing national employment growth of 4.3% during that same period, according to the Charleston Regional Development Alliance.  In addition, the South Carolina Department of Commerce reports that Charleston County attracted over $593.0 million in announced capital investment in 2004.  For 2005, the estimated median family income for the Charleston/North Charleston metropolitan statistical area was $55,550, as compared to $52,250 for South Carolina, according to the U.S. Department of Housing and Urban Development.  The Charleston Regional Development Alliance reports that since 1995, new and expanding companies invested more than $5 billion in the region.  In its May 2005 issue, Inc. magazine ranked Charleston as one of “The Top U.S. Cities for Doing Business.”  The Charleston regional economy has attracted approximately 70 firms with internationally-owned operations, according to the Charleston Regional Development Alliance.  These firms include Bosch, Berchtold, Maersk Sealand, Rhodia, and Holset Engineering.  Domestic firms also maintain significant operations in the Charleston area, including MeadWestvaco, Nucor Steel, Alcoa, Arborgen, Blackbaud, and Piggly Wiggly.  In addition, as of 2004, the U.S. Navy and the Charleston Air Force Base collectively employed over 21,000 full-time employees, according to the Charleston Metro Chamber of Commerce.

          Conde Nast Traveler magazine has ranked Charleston as one of the country’s top 10 domestic travel destinations for the past 12 years.  According to the Charleston Metro Chamber of Commerce, in 2004, there were over 4.7 million visitors to the Charleston region with an aggregate regional economic impact of $5.7 billion.  In addition, the total direct and indirect jobs in the Charleston region related to tourism was approximately 105,000 in 2004, resulting in aggregate earnings for local residents exceeding $1.45 billion. 

          As of June 30, 2005, FDIC-insured institutions in Charleston County had approximately $5.82 billion in deposits in the Charleston market, an increase of 17.1% over the $4.97 billion as of June 30, 2004.

Our Expansion Strategy

          While we continue to build our franchise in the Spartanburg and Charleston markets, we plan to expand into other fast-growing, larger metropolitan markets throughout South Carolina, such as Greenville and Columbia and, potentially, other contiguous markets.  In considering the markets in which to expand, we intend to analyze the population, growth rate, deposit growth rate, and other factors related to the target market.  We also plan to identify experienced executives in our target markets with local expertise who share our philosophies regarding community banking, strong credit policies, and customer service.  After retaining these key executives, we would expect to open a loan production office in the new market.  Once we have built a sufficient loan and customer base at the loan production office, we would convert the loan production office to a full-service branch to further serve the market.  We are following this approach with our expansion into the Greenville market through our Greenville loan production office, which we have received regulatory approval to convert to a full-service branch office and market headquarters.  We believe our expansion philosophy enables us to test our markets and operate more efficiently upon the opening of a full-service branch.

In addition to opening new offices in target markets, we may also expand through selective acquisitions.

Our Operating Philosophy and Culture

          We operate under a traditional community banking model, offering both personalized customer service and a broad array of financial products.  We seek to be the premier community bank in each of the markets we serve.  We have created a full-service community bank with a robust product and service offering available for our customers.  To meet our customers’ needs, we also offer trust and investment management services through a strategic alliance with Colonial Trust Company, a South Carolina private trust company established in 1913.  We also operate a s lending division based in Greenville County under the name First National Business Capital that provides s lending services under the SBA’s loan programs to customers primarily in the Carolinas and Georgia.

          We have developed an operations infrastructure designed to support our growth and expansion plans without sacrificing credit quality.  In addition to our use of traditional credit measures, we rely upon our professional and personal relationships and experience in our markets to evaluate subjective aspects of the market that we believe are more difficult to quantify. Our continued focus on asset quality has resulted in our achieving a ratio of nonperforming assets to total assets as of December 31, 2005 of 0.11%.

Lending Activities

          General .  We offer a variety of lending services, including real estate, commercial, and consumer loans, including home equity lines of credit, primarily to individuals and small- to mid-size businesses that are located, or conduct a substantial portion of their business in the Spartanburg or Charleston markets.  As of December 31, 2005, we had total loans of $251.4 million, representing 76.5% of our total assets.  We emphasize a strong credit culture based on traditional credit measures and our knowledge of our markets through experienced relationship managers.  We have designed our credit grading system to reduce the risk in our loan portfolio and to assist us in setting performance benchmarks in the areas of nonperforming assets, charge-offs, past dues, and loan documentation.  In addition to having developed a strong in-house credit review function, we engage outside firms to evaluate our loan portfolio.  As of December 31, 2005, there were no loans accruing interest that were 90 days or more past due, we had no restructured loans, and our ratio of nonperforming assets to total assets was 0.11%.

          Our underwriting standards vary for each type of loan. While we generally underwrite the loans in our portfolio in accordance with our internal underwriting guidelines and regulatory supervisory guidelines, in certain circumstances we have made loans that exceed either our internal underwriting guidelines, supervisory guidelines, or both.  We are permitted to hold loans that exceed supervisory guidelines up to 100% of our capital.  We have made loans that exceed our internal guidelines to a limited number of our customers who have significant liquid assets, net worth, and amounts on deposit with the bank.  As of December 31, 2005, $13.6 million, or approximately 5.4% of our loans and 61.9% of our capital, had loan-to-value ratios that exceeded regulatory supervisory guidelines.

          We have focused our lending activities primarily on s owners, commercial real estate developers, and the professional market.  We also strive to maintain a diversified loan portfolio and limit the amount of our loans to any single customer.  As of December 31, 2005, our 10 largest customer loan relationships represented approximately $42.1 million, or 16.7% of the loan portfolio.

          Real Estate Mortgage Loans .  Loans secured by real estate mortgages are the principal component of our loan portfolio.  To increase the likelihood of the ultimate repayment of the loan, we obtain a security interest in real estate whenever possible, in addition to other available collateral.  As of December 31, 2005 loans secured by first or second mortgages on real estate made up approximately $224.6 million, or 89.3% of our loan portfolio.

          Within the broader category of real estate mortgage loans, the following table describes the loan categories of one-to-four family residential real estate loans, multi-family residential real estate loans, home equity loans, commercial real estate loans, and land loans as of December 31, 2005 (dollars in thousands):

Type of Real Estate Loan

 

Amount

 

 

 

One-to-four residential

 

$

56,966

 

Multi-family residential

 

 

4,823

 

HELOC

 

 

14,934

 

Commercial real estate

 

 

109,686

(1) 

Land

 

 

37,821

 

 

 

 

Total

 

$

224,230

 

 

 

 

(1)          Includes SBA loans.


          Most of our real estate loans are secured by residential or commercial property.  Real estate loans are subject to the same general risks as other loans and are particularly sensitive to fluctuations in the value of real estate.  Fluctuations in the value of real estate, as well as other factors arising after a loan has been made, could negatively affect a borrower’s cash flow, creditworthiness, and ability to repay the loan.

          As of December 31, 2005, our individual commercial real estate loans ranged in size from $9,000 to $3.2 million.  The average commercial real estate loan size was approximately $314,000.  Other than the SBA loans discussed below, these loans generally have terms of five years or less, although payments may be structured on a longer amortization basis.  We evaluate each borrower on an individual basis and attempt to determine the business risks and credit profile of each borrower.  We attempt to reduce credit risk in the commercial real estate portfolio by emphasizing loans on owner-occupied properties where the loan-to-value ratio, established by independent appraisals, does not exceed 80%.  We prepare a credit analysis in addition to a cash flow analysis to support the loan.  In order to ensure secondary sources of payment and liquidity to support a loan request, we typically review all of the personal financial statements of the principal owners and require their personal guarantees.  These commercial real estate loans include various types of business purpose loans secured by commercial real estate.

          As of December 31, 2005, our individual residential real estate loans ranged in size from $2,000 to $1.4 million, with an average loan size of approximately $112,000.  Generally, we limit the loan-to-value ratio on our residential real estate loans to 80%.  We offer fixed and adjustable rate residential real estate loans with amortizations up to 20 years.  To limit our risk, we offer fixed rate and variable rate loans for terms greater than 20 years through a third party, rather than originating and retaining these loans ourselves.  Generally, we do not originate traditional long term residential mortgages for our portfolio, but we do issue traditional first and second mortgage residential real estate loans and home equity lines of credit.  

          As of December 31, 2005, our individual home equity lines of credit ranged in size from $1,000 to $380,000, with an average balance of approximately $50,000.  Our underwriting criteria for, and the risks associated with, home equity loans and lines of credit are generally the same as those for first mortgage loans.  Home equity lines of credit typically have terms of 15 years or less.  We generally limit the extension of credit to 90% of the available equity of each property, although we may extend up to 100% of the available equity.  Included in the residential real estate loans was $21.6 million, or 59.2% of our residential loan portfolio, in first and second mortgages on individuals’ homes, and $14.9 million, or 40.8% of our residential loan portfolio, in home equity loans.

          S Loans.  We offer s loans through our s lending division, First National Business Capital, that typically have terms of 25 years and are made with floating rates.    These loans utilize government enhancements such as the SBA’s 7(a) program and 504 programs and are partially guaranteed, which helps to reduce their risk.    These loans are generally secured by first or second mortgages on commercial real estate.  Government guarantees of SBA loans are generally 75% of the loan.  We usually sell the portion of loans that are secured by the SBA guarantee in the secondary market to provide additional liquidity and to provide a source of nonninterest income. We typically retain servicing for these loans as at an agreed upon servicing rate for the life of the loan.  In order to secure secondary sources of payment and liquidity, we typically require the personal guarantees of the principal owners. 

          Real Estate Construction and Land Development Loans.  We offer adjustable and fixed rate residential and commercial construction loans to builders and developers.  As of December 31, 2005, our commercial construction and development real estate loans ranged in size from approximately $22,000 to $1.9 million, with an average loan size of approximately $382,000.  As of December 31, 2005, our individual residential construction and development real estate loans ranged in size from approximately $46,000 to $164,000, with an average loan size of approximately $97,000.  The duration of our construction and development loans generally is limited to 12 months, although payments may be structured on a longer amortization basis.  We attempt to reduce the risk associated with construction and development loans by obtaining personal guarantees and by keeping the loan-to-value ratio of the completed project at or below 80%.  Construction and development loans generally carry a higher degree of risk than long-term financing of existing properties because repayment depends on the ultimate completion of the project or home and usually on the sale of the property or permanent financing.  Specific risks include:

 

•

cost overruns;

 

•

mismanaged construction;

 

•

inferior or improper construction techniques;

 

•

economic changes or downturns during construction;

 

•

rising interest rates that may prevent sale of the property; and

 

•

failure to sell completed projects in a timely manner.


          As of December 31, 2005, total construction and development loans amounted to $51.2 million, or 20.4% of our total loan portfolio.  Included in the $51.2 million was $9.1 million in construction loans, or 17.8% of our construction and development loan portfolio, that were made to commercial construction developers. 

          Commercial Business Loans.  Most of our commercial business loans are secured by first or second mortgages on real estate, as described above.  We also make some commercial business loans that are not secured by real estate.  We make loans for commercial purposes in various lines of business, including retail, service industry, and professional services.  As of December 31, 2005, our individual commercial business loans ranged in size from approximately $3,000 to $3.0 million, with an average loan size of approximately $110,000.  As with other categories of loans, the principal economic risk associated with commercial loans is the creditworthiness of the borrower.  The risks associated with commercial loans vary with many economic factors, including the economy in our market areas.  Commercial loans are generally considered to have greater risk than first or second mortgages on real estate because commercial loans may be unsecured, or if they are secured, the value of the collateral may be difficult to assess and more likely to decrease than real estate.  As of December 31, 2005, commercial business loans amounted to $20.9 million, or 8.3% of our total loan portfolio.

          Consumer Loans.  We make a variety of loans to individuals for personal and household purposes, including secured and unsecured installment loans and revolving lines of credit.  Consumer loans are underwritten based on the borrower’s income, current debt level, past credit history, and the availability and value of collateral.  Consumer rates are both fixed and variable, with negotiable terms.  Our installment loans typically amortize over periods up to 60 months.  However, we will offer consumer loans with a single maturity date when a specific source of repayment is available.  We typically require monthly payments of interest and a portion of the principal on our revolving loan products.  Consumer loans are generally considered to have greater risk than first or second mortgages on real estate because consumer loans may be unsecured, or if they are secured, the value of the collateral may be difficult to assess and more likely to decrease in value than real estate.  As of December 31, 2005, consumer loans amounted to $6.3 million, or 2.5% of our loan portfolio.

          Loan Approval.  Certain credit risks are inherent in making loans.  These include prepayment risks, risks resulting from uncertainties in the future value of collateral, risks resulting from changes in economic and industry conditions, and risks inherent in dealing with individual borrowers.  We attempt to mitigate repayment risks by adhering to internal credit policies and procedures.  These policies and procedures include officer and customer lending limits, a multi-layered approval process for larger loans, documentation examination, and follow-up procedures for any exceptions to credit policies.  Our loan approval policies provide for various levels of officer lending authority.  When the amount of aggregate loans to a single borrower exceeds an individual officer’s lending authority, the loan request will be reviewed by the internal management loan committee comprised of voting members Mr. Calvert, Mr. Zabriskie, Mr. Murdoch, and Ms. Payne.  Individual loan authorities for secured loans range from $25,000 for our retail lenders, to $500,000 for our senior lenders, and up to $750,000 for our chief executive officer.  Any three concurring members of our management loan committee can approve loans up to $2.0 million.  If the loans exceed $2.0 million, then a board of directors’ loan committee comprised of Mr. Calvert and seven other directors may approve loans up $3.5 million.  The Board of Directors, with any seven concurring members, can approve loans up to 15% of the bank’s capital and unimpaired surplus or our legal lending limit of $4.0 million as of December 31, 2005.

          Credit Administration and Loan Review.  We emphasize a strong credit culture based on traditional credit measures and our knowledge of our markets through experienced relationship managers.  We maintain a continuous internal loan review system and engage an independent consultant on an annual basis to review loan files on a test basis to confirm our loan grading.  Each loan officer is responsible for every loan he or she makes, regardless of whether other individuals or committees joined in the approval.  This responsibility continues until the loan is repaid or until the loan is officially assigned to another officer.  The compensation of our lending officers is dependent in part on the asset quality of their loan portfolios.  We have adopted an incentive plan under which our loan officers are eligible to receive cash bonuses for achieving monthly and annual goals relating to, among other things, loan production and maintenance of minimum quality levels for the officer’s loan portfolio. 

          Our dedication to strong credit quality is reinforced by our internal credit review process and performance benchmarks in the areas of nonperforming assets, charge-offs, past dues, and loan documentation.  As we continue to grow, we intend to add additional employees to assist with credit administration and loan review.  In addition to our strong in-house credit review function, we currently engage an outside firm to evaluate our loan portfolio on a quarterly basis for credit quality, a second outside firm for compliance issues on an annual basis, and a third outside firm to provide advice and recommendations and respond to specific inquiries at any time.

          Lending Limits.  Our lending activities are subject to a variety of lending limits imposed by federal law.  In general, the bank is subject to a legal limit on loans to a single borrower equal to 15% of the bank’s capital and unimpaired surplus.  This limit will increase or decrease as the bank’s capital increases or decreases.  Based upon the capitalization of the bank as of December 31, 2005, our legal lending limit was approximately $4.0 million.  We sell participations in our larger loans to other financial institutions, which allows us to manage the risk involved in these loans and to meet the lending needs of our customers requiring extensions of credit in excess of this limit.

Deposit Services

          One of our principal sources of funds is core deposits (deposits other than time deposits of $100,000 or more).  As of December 31, 2005, approximately 85.1% of our total deposits were obtained from within the Spartanburg market.  We also rely on time deposits of $100,000 or more to support our growth, and we derive most of these deposits from outside our primary market areas.  We generally obtain out-of-market time deposits of $100,000 or more through brokers with whom we maintain ongoing relationships.  We do not obtain time deposits of $100,000 or more through the internet.  As of December 31, 2005, 44.0% of our total time deposits were deposits of $100,000 or more.

          We offer a full range of deposit services, including checking accounts, commercial accounts, savings accounts, and other time deposits of various types, ranging from daily money market accounts to long-term certificates of deposit.  We regularly review our deposit rates to ensure that we remain competitive in our markets.  We have also recently hired a new officer to focus on deposit production for our bank.

          We received regulatory approval to convert our loan production office in Greenville, South Carolina to a full-service branch and market headquarters that will enable us to generate deposits in the Greenville market.  We expect capital expenditures over the next twelve months associated with this conversion to be approximately $1.6 million.

Trust and Investment Management Services

          Since August 15, 2002, we have offered trust and investment management services through an alliance with Colonial Trust Company, a South Carolina private trust company established in 1913 with offices in Greenville and Spartanburg.  This arrangement allows our consumer and commercial customers access to a wide variety of services provided by Colonial Trust Company, including trust services, professional portfolio management, estate administration, individual financial and retirement planning, and corporate retirement planning services.  We receive a residual fee from Colonial Trust Company based on a percentage of the aggregate assets under management generated by referrals from the bank.

Other Banking Services

          We offer other bank services including safe deposit boxes, traveler’s checks, direct deposit, United States savings bonds, and banking by mail.  We earn fees for most of these services, including debit and credit card transactions, sales of checks, and wire transfers.  We provide ATM transactions to our customers at no charge; however, we receive ATM transaction fees from transactions performed at our branches by persons who are not customers of the bank.  We are associated with the Cirrus and Pulse ATM networks, which are available to our customers throughout the country.  Since we outsource our ATM services, we are charged related transaction fees from our ATM service provider.  We have contracted with an outside vendor to provide our core data processing services and our ATM processing.  Given our current size, we believe that outsourcing these services reduces our overhead by matching the expense in each period to the transaction volume that occurs during the period, as a significant portion of the fee charged is directly related to the number of loan and deposit accounts and the related number of transactions we have during the period. 

          First National Online, our internet website www.firstnational-online.com, provides our customers access to internet banking services, including electronic bill payment services and cash management services including account-to-account transfers. The internet banking services are provided through a contractual arrangement with an outside vendor. 

          We offer our customers insurance services, including life, long term care, and annuities through vendors associated with the South Carolina Bankers Association. Additionally, we provide equipment leasing arrangements through an outside vendor.

SUPERVISION AND REGULATION

          Both the company and the bank are subject to extensive state and federal banking laws and regulations that impose specific requirements or restrictions on and provide for general regulatory oversight of virtually all aspects of our operations.  These laws and regulations are generally intended to protect depositors, not shareholders.  The following summary is qualified by reference to the statutory and regulatory provisions discussed.  Changes in applicable laws or regulations may have a material effect on our business and prospects. 

          Beginning with the enactment of the Financial Institutions Reform Recovery and Enforcement Act in 1989 and followed by the FDIC Improvement Act in 1991 and the Gramm-Leach-Bliley Act in 1999, numerous additional regulatory requirements have been placed on the banking industry in the past several years and additional changes have been proposed.  Our operations may be affected by legislative changes and the policies of various regulatory authorities.  We cannot predict the effect that fiscal or monetary policies, economic control or new federal or state legislation may have on our business and earnings in the future.

          The following discussion is not intended to be a complete list of all the activities regulated by the banking laws or of the impact of such laws and regulations on our operations.  It is intended only to briefly summarize some material provisions.

USA PATRIOT Act of 2002

          In October 2002, the USA PATRIOT Act of 2002 was enacted in response to the terrorist attacks in New York, Pennsylvania, and Washington D.C. that occurred on September 11, 2001.  The PATRIOT Act is intended to strengthen U.S. law enforcement’s and the intelligence communities’ abilities to work cohesively to combat terrorism on a variety of fronts.  The potential impact of the PATRIOT Act on financial institutions is significant and wide ranging.  The PATRIOT Act contains sweeping anti-money laundering and financial transparency laws and imposes various regulations, including standards for verifying client identification at account opening and rules to promote cooperation among financial institutions, regulators and law enforcement entities in identifying parties who may be involved in terrorism or money laundering.

Check 21

          On October 28, 2003, President Bush signed into law the Check Clearing for the 21st Century Act, also known as Check 21.  The new law, which became effective October 28, 2004, gives a “substitute check,” such as a digital image of a check and copies made from that image, the same legal standing as the original paper check.  Some of the major provisions include:

 

•

allowing check truncation without making it mandatory;

 

•

demanding that every financial institution communicate to accountholders in writing a description of its substitute check processing program and their rights under the law;

 

•

legalizing substitutions for and replacements of paper checks without agreement from consumers;

 

•

retaining in place the previously mandated electronic collection and return of checks between financial institutions only when individual agreements are in place;

 

•

requiring that when accountholders request verification, financial institutions produce the original check (or a copy that accurately represents the original) and demonstrate that the account debit was accurate and valid; and

 

•

requiring recrediting of funds to an individual’s account on the next business day after a consumer proves that the financial institution has erred.


          This new legislation has affected bank capital spending as many financial institutions are implementing technological or operational changes are necessary to stay competitive and take advantage of the new opportunities presented by Check 21.

First National Bancshares, Inc.

          We own 100% of the outstanding capital stock of the bank and, therefore, we are considered to be a bank holding company under the Federal Bank Holding Company Act of 1956 and the South Carolina Banking and Branching Efficiency Act. 

          The Bank Holding Company Act.   Under the Bank Holding Company Act, we are subject to periodic examination by the Federal Reserve and are required to file periodic reports of our operations and any additional information that the Federal Reserve may require.  Our activities at the bank and holding company levels are limited to:

 

•

banking and managing or controlling banks;

 

•

furnishing services to or performing services for our subsidiaries; and

 

•

engaging in other activities that the Federal Reserve determines to be so closely related to banking and managing or controlling banks as to be a proper incident thereto.


          Investments, Control, and Activities.   With certain limited exceptions, the Bank Holding Company Act requires every bank holding company to obtain the prior approval of the Federal Reserve before:

 

•

acquiring substantially all the assets of any bank;

 

•

acquiring direct or indirect ownership or control of any voting shares of any bank if after the acquisition it would own or control more than 5% of the voting shares of such bank (unless it already owns or controls the majority of such shares); or

 

•

merging or consolidating with another bank holding company.


          In addition, and subject to certain exceptions, the Bank Holding Company Act and the Change in Bank Control Act, together with regulations promulgated thereunder, require Federal Reserve approval prior to any person or company acquiring “control” of a bank holding company.  Control is conclusively presumed to exist if an individual or company acquires 25% or more of any class of voting securities of a bank holding company.  Control is rebuttably presumed to exist if a person acquires 10% or more, but less than 25%, of any class of voting securities and either the company has registered securities under Section 12 of the Securities Exchange Act of 1934 or no other person owns a greater percentage of that class of voting securities immediately after the transaction.  Our common stock is registered under the Securities Exchange Act of 1934.  The regulations provide a procedure for rebutting control when ownership of any class of voting securities is below 25%.

          Under the Bank Holding Company Act, a bank holding company is generally prohibited from engaging in or acquiring direct or indirect control of more than 5% of the voting shares of any company engaged in nonbanking activities unless the Federal Reserve Board, by order or regulation, has found those activities to be so closely related to banking or managing or controlling banks as to be a proper incident thereto.  Some of the activities that the Federal Reserve Board has determined by regulation to be proper incidents to the business of a bank holding company include:

 

•

making or servicing loans and certain types of leases;

 

•

engaging in certain insurance and discount brokerage activities;

 

•

performing certain data processing services;

 

•

acting in certain circumstances as a fiduciary, investment or financial adviser;

 

•

owning savings associations; and

 

•

making investments in certain corporations or projects designed primarily to promote community welfare.


          The Federal Reserve Board imposes certain capital requirements on the company under the Bank Holding Company Act, including a minimum leverage ratio and a minimum ratio of “qualifying” capital to risk-weighted assets.  These requirements are described below under “First National Bank of the South - Capital Regulations.”  Subject to our capital requirements and certain other restrictions, we are able to borrow money to make a capital contribution to the bank, and these loans may be repaid from dividends paid from the bank to the company.  Our ability to pay dividends will be subject to regulatory restrictions as described below in “First National Bank of the South – Dividends.”  We are also able to raise capital for contribution to the bank by issuing securities without having to receive regulatory approval, subject to compliance with federal and state securities laws.

          Source of Strength; Cross-Guarantee.   In accordance with Federal Reserve Board policy, we are expected to act as a source of financial strength to the bank and to commit resources to support the bank in circumstances in which we might not otherwise do so.  Under the Bank Holding Company Act, the Federal Reserve Board may require a bank holding company to terminate any activity or relinquish control of a nonbank subsidiary, other than a nonbank subsidiary of a bank, upon the Federal Reserve Board’s determination that such activity or control constitutes a serious risk to the financial soundness or stability of any depository institution subsidiary of the bank holding company.  Further, federal bank regulatory authorities have additional discretion to require a bank holding company to divest itself of any bank or nonbank subsidiaries if the agency determines that divestiture may aid the depository institution’s financial condition.

          The Gramm-Leach-Bliley Act.   The Gramm-Leach-Bliley Act was signed into law on November 12, 1999.  Among other things, the Act repealed the restrictions on banks affiliating with securities firms contained in sections 20 and 32 of the Glass-Steagall Act.  The Act also permits bank holding companies that become financial holding companies to engage in a statutorily provided list of financial activities, including insurance and securities underwriting and agency activities, merchant banking and insurance company portfolio investment activities.  The Act also authorizes activities that are “complementary” to financial activities.  We have not elected to become a financial holding company.

         The Act is intended, in part, to grant to community banks certain powers as a matter of right that larger institutions have accumulated on an ad hoc basis.  Nevertheless, the Act may have the result of increasing the amount of competition that we face from larger institutions and other types of companies.  In fact, it is not possible to predict the full effect that the Act will have on us.

South Carolina State Regulation. As a South Carolina bank holding company under the South Carolina Banking and Branching Efficiency Act, we are subject to limitations on sale or merger and to regulation by the South Carolina Board of Financial Institutions.  We are not required to obtain the approval of the Board prior to acquiring the capital stock of a national bank, but we must notify them at least 15 days prior to doing so.  We must receive the Board’s approval prior to engaging in the acquisition of a South Carolina state chartered bank or another South Carolina bank holding company.

First National Bank of the South

          The bank operates as a national banking association incorporated under the laws of the United States and subject to examination by the Office of the Comptroller of the Currency.  The bank operates as First National Bank of Spartanburg in Spartanburg County.  The bank’s s lending division operates under the name First National Business Capital.  Deposits in the bank are insured by the Federal Deposit Insurance Corporation (“FDIC”) up to a maximum amount, which is generally $100,000 per depositor for demand deposit accounts and $250,000 for retirement accounts subject to the aggregation rule.

          The Office of the Comptroller of the Currency and the FDIC regulate or monitor virtually all areas of the bank’s operations, including

 

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security devices and procedures;

 

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adequacy of capitalization and loss reserves;

 

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loans;

 

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investments;

 

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borrowings;

 

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deposits;

 

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mergers;

 

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issuances of securities;

 

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payment of dividends;

 

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interest rates payable on deposits;

 

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interest rates or fees chargeable on loans;

 

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establishment of branches;

 

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corporate reorganizations;

 

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maintenance of books and records; and

 

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adequacy of staff training to carry on safe lending and deposit gathering practices.


          The Office of the Comptroller of the Currency requires the bank to maintain specified capital ratios and imposes limitations on the bank’s aggregate investment in real estate, bank premises and furniture and fixtures.  The Office of the Comptroller of the Currency also requires the bank to prepare annual reports on the bank’s financial condition and to conduct an annual audit of its financial affairs in compliance with its minimum standards and procedures.

          Under the FDIC Improvement Act, all insured institutions must undergo regular on-site examinations by their appropriate banking agency.  The cost of examinations of insured depository institutions and any affiliates may be assessed by the appropriate agency against each institution or affiliate as it deems necessary or appropriate.  Insured institutions are required to submit annual reports to the FDIC, their federal regulatory agency and state supervisor, when applicable.  The FDIC Improvement Act directs the FDIC to develop a method for insured depository institutions to provide supplemental disclosure of the estimated fair market value of assets and liabilities, to the extent feasible and practicable, in any balance sheet, financial statement, report of condition or any other report of any insured depository institution.  The FDIC Improvement Act also requires the federal banking regulatory agencies to prescribe, by regulation, standards for all insured depository institutions and depository institution holding companies relating, among other things, to the following:

 

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internal controls;

 

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information systems and audit systems;

 

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loan documentation;

 

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credit underwriting;

 

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interest rate risk exposure; and

 

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asset quality.


          National banks and their holding companies which have been chartered or registered or have undergone a change in control within the past two years or which have been deemed by the Office of the Comptroller of the Currency or the Federal Reserve Board to be troubled institutions must give the Office of the Comptroller of the Currency or the Federal Reserve Board 30 days prior notice of the appointment of any senior executive officer or director.  Within the 30 day period, the Office of the Comptroller of the Currency or the Federal Reserve Board, as the case may be, may approve or disapprove any such appointment.

          Deposit Insurance.   The FDIC has adopted a risk-based assessment system for determining an insured depository institutions’ insurance assessment rate.  The system takes into account the risks attributable to different categories and concentrations of assets and liabilities.  An institution is placed into one of three capital categories:  (1) well capitalized; (2) adequately capitalized or (3) undercapitalized.  The FDIC also assigns an institution to one of three supervisory subgroups, based on the FDIC’s determination of the institution’s financial condition and the risk posed to the deposit insurance funds.  Assessments range from 0 to 27 cents per $100 of deposits, depending on the institution’s capital group and supervisory subgroup.  In addition, the FDIC imposes assessments to help pay off the $780 million in annual interest payments on the $8 billion Financing Corporation bonds issued in the late 1980s as part of the government rescue of the thrift industry.  Our FDIC assessment rate is currently 1A or .000032 per million of insured deposits, but may change in the future.  The FDIC may increase or decrease the assessment rate schedule on a semiannual basis.  An increase in the BIF assessment rate could have a material adverse effect on our earnings, depending on the amount of the increase.

          The FDIC may terminate its insurance of deposits if it finds that the institution has engaged in unsafe and unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC.

          Transactions with Affiliates and Insiders.  The bank is subject to the provisions of Section 23A of the Federal Reserve Act, which places limits on the amount of loans or extensions of credit to, or investments in or certain other transactions with affiliates and on the amount of advances to third parties collateralized by the securities or obligations of affiliates.  The aggregate of all covered transactions is limited in amount, as to any one affiliate, to 10% of the bank’s capital and surplus and, as to all affiliates combined, to 20% of the bank’s capital and surplus.  Furthermore, within the foregoing limitations as to amount, each covered transaction must meet specified collateral requirements.  Compliance is also required with certain provisions designed to avoid the taking of low quality assets. 

          The bank also is subject to the provisions of Section 23B of the Federal Reserve Act which, among other things, prohibits an institution from engaging in certain transactions with certain affiliates unless the transactions are on terms substantially the same, or at least as favorable to such institution or its subsidiaries, as those prevailing at the time for comparable transactions with nonaffiliated companies.  The bank is subject to certain restrictions on extensions of credit to executive officers, directors, certain principal shareholders and their related interests.  Such extensions of credit (i) must be made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with third parties and (ii) must not involve more than the normal risk of repayment or present other unfavorable features.

          The Federal Reserve Board has recently issued Regulation W which codifies prior regulations under Sections 23A and 23B of the Federal Reserve Act and interpretative guidance with respect to affiliate transactions.  Regulation W incorporates the exemption from the affiliate transaction rules but expands the exemption to cover the purchase of any type of loan or extension of credit from an affiliate.  In addition, under Regulation W:

 

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

 

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

 

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


          Regulation W generally excludes all non-bank and non-savings association subsidiaries of banks from treatment as affiliates, except to the extent that the Federal Reserve Board decides to treat these subsidiaries as affiliates.  Concurrently with the adoption of Regulation W, the Federal Reserve Board has proposed a regulation which would further limit the amount of loans that could be purchased by a bank from an affiliate to not more than 100% of the bank’s capital and surplus.  This regulation has not yet been adopted.

          Dividends.  A national bank may not pay dividends from its capital.  All dividends must be paid out of undivided profits then on hand, after deducting expenses, including reserves for losses and bad debts.  In addition, a national bank is prohibited from declaring a dividend on its shares of common stock until its surplus equals its stated capital, unless there has been transferred to surplus no less than one-tenth of the bank’s net profits of the preceding two consecutive half-year periods (in the case of an annual dividend).  The approval of the Office of the Comptroller of the Currency is required if the total of all dividends declared by a national bank in any calendar year exceeds the total of its net profits for that year, combined with its retained net profits for the preceding two years, less any required transfers to surplus.

          Branching.  National banks are required by the National Bank Act to adhere to branch office banking laws applicable to state banks in the states in which they are located.  Under current South Carolina law, the bank may open branch offices throughout South Carolina with the prior approval of the Office of the Comptroller of the Currency.  In addition, with prior regulatory approval, the bank is able to acquire existing banking operations in South Carolina.  Furthermore, federal legislation permits interstate branching, including out-of-state acquisitions by bank holding companies, interstate branching by banks if allowed by state law and interstate merging by banks.  South Carolina law, with limited exceptions, currently permits branching across state lines through interstate mergers.

          Community Reinvestment Act.  The Community Reinvestment Act requires that, in connection with examinations of financial institutions within their respective jurisdictions, the Federal Reserve, the FDIC or the Office of the Comptroller of the Currency, shall evaluate the record of each financial institution in meeting the credit needs of its local community, including low and moderate income neighborhoods.  These factors are also considered in evaluating mergers, acquisitions and applications to open a branch or facility.  Failure to adequately meet these criteria could impose additional requirements and limitations on our bank.

          The Gramm-Leach-Bliley Act.   Under the Gramm-Leach-Bliley Act, subject to certain conditions imposed by their respective banking regulators, national and state-chartered banks are permitted to form “financial subsidiaries” that may conduct financial or incidental activities, thereby permitting bank subsidiaries to engage in certain activities that previously were impermissible.  The Gramm-Leach-Bliley Act imposes several safeguards and restrictions on financial subsidiaries, including that the parent bank’s equity investment in the financial subsidiary be deducted from the bank’s assets and tangible equity for purposes of calculating the bank’s capital adequacy.  In addition, the Gramm-Leach-Bliley Act imposes new restrictions on transactions between a bank and its financial subsidiaries similar to restrictions applicable to transactions between banks and nonbank affiliates.

          The Gramm-Leach-Bliley Act also contains provisions regarding consumer privacy.  These provisions require financial institutions to disclose their policy for collecting and protecting confidential information.  Customers generally may prevent financial institutions from sharing personal financial information with nonaffiliated third parties except for third parties that market an institution’s own products and services.  Additionally, financial institutions generally may not disclose consumer account numbers to any nonaffiliated third party for use in telemarketing, direct mail marketing or other marketing to the consumer.

          Other Regulations.  Interest and other charges collected or contracted for by the bank are subject to state usury laws and federal laws concerning interest rates.  The bank’s loan operations are also subject to federal laws applicable to credit transactions, such as:

 

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the federal Truth-In-Lending Act, governing disclosures of credit terms to consumer borrowers;

 

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the Home Mortgage Disclosure Act of 1975, requiring financial institutions to provide information to enable the public and public officials to determine whether a financial institution is fulfilling its obligation to help meet the housing needs of the community it serves;

 

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the Equal Credit Opportunity Act, prohibiting discrimination on the basis of race, creed or other prohibited factors in extending credit;

 

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the Fair Credit Reporting Act of 1978, governing the use and provision of information to credit reporting agencies;

 

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the Fair Debt Collection Act, governing the manner in which consumer debts may be collected by collection agencies; and

 

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the rules and regulations of the various federal agencies charged with the responsibility of implementing such federal laws.


The deposit operations of the bank also are subject to:

 

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the Right to Financial Privacy Act, which imposes a duty to maintain confidentiality of consumer financial records and prescribes procedures for complying with administrative subpoenas of financial records; and

 

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the Electronic Funds Transfer Act and Regulation E issued by the Federal Reserve Board to implement that Act, which governs automatic deposits to and withdrawals from deposit accounts and customers’ rights and liabilities arising from the use of automated teller machines and other electronic banking services.


          Capital Regulations.   The federal bank regulatory authorities have adopted risk-based capital guidelines for banks and bank holding companies that are designed to make regulatory capital requirements more sensitive to differences in risk profiles among banks and bank holding companies and account for off-balance sheet items.  The guidelines are minimums, and the federal regulators have noted that banks and bank holding companies contemplating significant expansion programs should not allow expansion to diminish their capital ratios and should maintain ratios in excess of the minimums.  We have not received any notice indicating that either First National Bancshares, Inc. or First National Bank of the South is subject to higher capital requirements.  The current guidelines require all bank holding companies and federally-regulated banks to maintain a minimum risk-based total capital ratio equal to 8%, of which at least 4% must be Tier 1 capital.  Tier 1 capital includes common shareholders’ equity, qualifying perpetual preferred stock and minority interests in equity accounts of consolidated subsidiaries, but excludes goodwill and most other intangibles and the allowance for loan and lease losses.  Tier 2 capital includes the excess of any preferred stock not included in Tier 1 capital, mandatory convertible securities, hybrid capital instruments, subordinated debt and intermediate term-preferred stock and general reserves for loan and lease losses up to 1.25% of risk-weighted assets.

          Under these guidelines, banks’ and bank holding companies’ assets are given risk-weights of 0%, 20%, 50% or 100%.  In addition, certain off-balance sheet items are given credit conversion factors to convert them to asset equivalent amounts to which an appropriate risk-weight applies.  These computations result in the total risk-weighted assets.  Most loans are assigned to the 100% risk category, except for first mortgage loans fully secured by residential property and, under certain circumstances, residential construction loans, both of which carry a 50% rating.  Most investment securities are assigned to the 20% category, except for municipal or state revenue bonds, which have a 50% rating, and direct obligations of or obligations guaranteed by the United States Treasury or United States Government agencies, which have a 0% rating.

          The federal bank regulatory authorities also have implemented a leverage ratio, which is equal to Tier 1 capital as a percentage of average total assets less intangibles, to be used as a supplement to the risk-based guidelines.  The principal objective of the leverage ratio is to place a constraint on the maximum degree to which a bank holding company may leverage its equity capital base.  The minimum required leverage ratio for top-rated institutions is 3%, but most institutions are required to maintain an additional cushion of at least 100 to 200 basis points.

          The FDIC Improvement Act established a new capital-based regulatory scheme designed to promote early intervention for troubled banks, which requires the FDIC to choose the least expensive resolution of bank failures.  The new capital-based regulatory framework contains five categories of compliance with regulatory capital requirements, including “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” and “critically undercapitalized.”  To qualify as a “well capitalized” institution, a bank must have a leverage ratio of no less than 5%, a Tier 1 risk-based ratio of no less than 6% and a total risk-based capital ratio of no less than 10%, and the bank must not be under any order or directive from the appropriate regulatory agency to meet and maintain a specific capital level.  Currently, we qualify as “well capitalized.”

          Under the FDIC Improvement Act regulations, the applicable agency can treat an institution as if it were in the next lower category if the agency determines (after notice and an opportunity for hearing) that the institution is in an unsafe or unsound condition or is engaging in an unsafe or unsound practice.  The degree of regulatory scrutiny of a financial institution increases, and the permissible activities of the institution decrease, as it moves downward through the capital categories.  Institutions that fall into one of the three undercapitalized categories may be required to do some or all of the following:

 

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submit a capital restoration plan;

 

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raise additional capital;

 

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restrict their growth, deposit interest rates, and other activities;

 

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improve their management;

 

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eliminate management fees; or

 

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divest themselves of all or a part of their operations.


          These capital guidelines can affect us in several ways.  If we grow at a rapid pace, our capital may be depleted too quickly, and a capital infusion from our holding company may be necessary which could impact our ability to pay dividends.  Our capital levels currently are adequate; however, rapid growth, poor loan portfolio performance, poor earnings performance or a combination of these factors could change our capital position in a relatively short period of time.  If we fail to meet these capital requirements, our bank would be required to develop and file a plan with the Office of the Comptroller of the Currency describing the means and a schedule for achieving the minimum capital requirements.  In addition, our bank would generally not receive regulatory approval of any application that requires the consideration of capital adequacy, such as a branch or merger application, unless our bank could demonstrate a reasonable plan to meet the capital requirement within a reasonable period of time.  A bank that is not “well capitalized” is also subject to certain limitations relating to so-called “brokered” deposits.  Bank holding companies controlling financial institutions can be called upon to boost the institutions’ capital and to partially guarantee the institutions’ performance under their capital restoration plans.

          Enforcement Powers.  The Financial Institutions Reform Recovery and Enforcement Act expanded and increased civil and criminal penalties available for use by the federal regulatory agencies against depository institutions and certain “institution-affiliated parties.”  Institution-affiliated parties primarily include management, employees and agents of a financial institution, as well as independent contractors and consultants such as attorneys and accountants and others who participate in the conduct of the financial institution’s affairs.  These practices can include the failure of an institution to timely file required reports, the filing of false or misleading information or the submission of inaccurate reports.  Civil penalties may be as high as $1,000,000 a day for such violations.  Criminal penalties for some financial institution crimes have been increased to twenty years.  In addition, regulators are provided with greater flexibility to commence enforcement actions against institutions and institution-affiliated parties.  Possible enforcement actions include the termination of deposit insurance.  Furthermore, banking agencies’ power to issue cease-and-desist orders were expanded.  Such orders may, among other things, require affirmative action to correct any harm resulting from a violation or practice, including restitution, reimbursement, indemnifications or guarantees against loss.  A financial institution may also be ordered to restrict its growth, dispose of certain assets, rescind agreements or contracts or take other actions as determined by the ordering agency to be appropriate.

          Effect of Governmental Monetary Policies.  Our earnings are affected by domestic economic conditions and the monetary and fiscal policies of the United States government and its agencies.  The Federal Reserve Bank’s monetary policies have had, and are likely to continue to have, an important impact on the operating results of commercial banks through its power to implement national monetary policy in order, among other things, to curb inflation or combat a recession.  The monetary policies of the Federal Reserve Board have major effects upon the levels of bank loans, investments and deposits through its open market operations in United States government securities and through its regulation of the discount rate on borrowings of member banks and the reserve requirements against member bank deposits.  It is not possible to predict the nature or impact of future changes in monetary and fiscal policies.

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

Competition

          The banking business is highly competitive, and we experience competition in our markets from many other financial institutions.  Competition among financial institutions is based upon interest rates offered on deposit accounts, interest rates charged on loans, other credit and service charges relating to loans, the quality and scope of the services rendered, the convenience of banking facilities, and, in the case of loans to commercial borrowers, relative lending limits.  We compete with commercial banks, credit unions, savings and loan associations, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market funds, and other mutual funds, as well as other super-regional, national, and international financial institutions that operate offices in the Spartanburg and Charleston markets and elsewhere.

          As of June 30, 2005, there were 13 other financial institutions in Spartanburg County and 16 other financial institutions in Charleston County.  We compete with institutions in these markets both in attracting deposits and in making loans.  In addition, we have to attract our customer base from other existing financial institutions and from new residents.  Many of our competitors are well established, larger financial institutions with substantially greater resources and lending limits, such as BB&T, Bank of America, Wachovia, and Carolina First Bank.  These institutions offer some services, such as extensive and established branch networks, that we do not provide.  Other local or regional financial institutions, such as First Citizens Bank of South Carolina and Arthur State Bank in Spartanburg, and The Bank of South Carolina and Community FirstBank in Charleston, have considerable business relationships and ties in their respective communities that assist them in competing for attracting customers. 

          We also compete with credit unions, in particular, in attracting deposits from retail customers.  Additionally, many of our non-bank competitors are not subject to the same extensive federal regulations that govern bank holding companies and federally-insured banks.

          We believe our emphasis on decision-making by our market executives and our management’s and directors’ ties to the communities in which we operate provide us with a competitive advantage.

Employees

          As of March 1, 2006, we had 77 employees, of which 69 were full time.  These employees provide the majority of their services to our bank.

RISK FACTORS

          Our business, financial condition, and results of operations could be harmed by any of the following risks, or other risks that have not been identified or which we believe are immaterial or unlikely.

Our decisions regarding credit risk may materially and adversely affect our business .

          Making loans and other extensions of credit is an essential element of our business.  Although we seek to mitigate risks inherent in lending by adhering to specific underwriting practices, we may incur losses on loans that meet our underwriting criteria, and these losses may exceed our loan loss reserves.  The risk of nonpayment is affected by a number of factors, including:

 

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the duration of the credit;

 

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credit risks of a particular customer;

 

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changes in economic and industry conditions; and

 

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in the case of a collateralized loan, risks resulting from uncertainties about the future value of the collateral.


          While we generally underwrite the loans in our portfolio in accordance with our own internal underwriting guidelines and regulatory supervisory limits, in certain circumstances we have made loans that exceed either our internal underwriting guidelines, supervisory limits, or both.  As of December 31, 2005, approximately $13.6 million, or approximately 5.4%, of our loans had loan-to-value ratios that exceeded regulatory supervisory limits.  We generally consider making such loans only after taking into account the financial strength of the borrower.  The number of loans in our portfolio with loan-to-value ratios in excess of supervisory limits, our internal guidelines, or both could increase the risk of delinquencies or defaults in our portfolio.  Any such delinquencies or defaults could have an adverse effect on our results of operations and financial condition.

The success of our growth strategy depends on our ability to identify and retain individuals with experience and relationships in the markets in which we intend to expand.

          We intend to expand our banking network over the next several years, not just in our core market areas of Spartanburg and Charleston, but also in other fast-growing markets throughout South Carolina, such as Columbia and Greenville, and in contiguous markets.  We believe that to expand into new markets successfully, we must identify and retain experienced key management members with local expertise and relationships in these markets.

We expect that competition for qualified management in the markets in which we expand will be intense and that there will be a limited number of qualified persons with knowledge of and experience in the community banking industry in these markets.  Even if we identify individuals that we believe could assist us in establishing a presence in a new market, we may be unable to recruit these individuals away from more established banks.  In addition, the process of identifying and recruiting individuals with the combination of skills and attributes required to carry out our strategy is often lengthy.  Our inability to identify, recruit, and retain talented personnel to manage new offices effectively and in a timely manner would limit our growth and could materially adversely affect our business, financial condition, and results of operations.  We may fail to open any additional offices and, if we open these offices, they may not be profitable. 

The lack of seasoning of our loan portfolio makes it difficult to assess the adequacy of our loan loss reserves accurately.

          We attempt to maintain an appropriate allowance for loan losses to provide for potential losses in our loan portfolio.  We periodically determine the amount of the allowance based on consideration of several factors, including:

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an ongoing review of the quality, mix, and size of our overall loan portfolio;

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our historical loan loss experience;

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evaluation of economic conditions;

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regular reviews of loan delinquencies and loan portfolio quality; and

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the amount and quality of collateral, including guarantees, securing the loans.


          However, there is no precise method of predicting credit losses, since any estimate of loan losses is necessarily subjective and the accuracy depends on the outcome of future events.  In addition, due to our rapid growth over the past several years and our limited operating history, a large portion of the loans in our loan portfolio was originated recently.  In general, loans do not begin to show signs of credit deterioration or default until they have been outstanding for some period of time, a process referred to as seasoning.  As a result, a portfolio of older loans will usually behave more predictably than a newer portfolio.  Because our loan portfolio is relatively new, the current level of delinquencies and defaults may not be representative of the level that will prevail when the portfolio becomes more seasoned, which may be higher than current levels.  If charge-offs in future periods increase, we may be required to increase our provision for loan losses, which would decrease our net income and possibly our capital.

Changes in interest rates may reduce our profitability.

          Our profitability depends in large part on our net interest income, which is the difference between interest income from interest-earning assets, such as loans and mortgage-backed securities, and interest expense on interest-bearing liabilities, such as deposits and borrowings.  We believe that we are asset sensitive, which means that our net interest income will generally rise in higher interest rate environments and decline in lower interest rate environments.  Our net interest income will be adversely affected if the market interest rate changes such that the interest we pay on deposits and borrowings increases faster than the interest we earn on loans and investments. Many factors cause changes in interest rates, including governmental monetary policies and domestic and international economic and political conditions.  While we intend to manage the effects of changes in interest rates by adjusting the terms, maturities, and pricing of our assets and liabilities, our efforts may not be effective, which could adversely affect our financial condition and results of operations. 

          Because of the differences in maturities and repricing characteristics of our interest-earning assets and interest-bearing liabilities, changes in interest rates do not produce equivalent changes in interest income earned on interest-earning assets and interest paid on interest-bearing liabilities. Accordingly, fluctuations in interest rates could adversely affect our net interest income and, in turn, our profitability. In addition, loan volumes are affected by market interest rates on loans. Rising interest rates generally are associated with a lower volume of loan originations while lower interest rates are usually associated with higher loan originations. Conversely, in rising interest rate environments, loan repayment rates will decline and in falling interest rate environments, loan repayment rates will increase. Interest rates also affect how much money we can lend. When interest rates rise, the cost of borrowing increases. Accordingly, changes in market interest rates could materially and adversely affect our net interest income, asset quality, and loan origination volume.

An economic downturn, especially one affecting the Spartanburg or Charleston areas, could reduce our customer base, our level of deposits, and demand for financial products such as loans.

          Our success significantly depends upon the general economic conditions in our markets of Spartanburg and Charleston.  If the communities in which we operate do not grow or if prevailing economic conditions locally or nationally are unfavorable, our business may not succeed.  An economic downturn would likely contribute to the deterioration of the quality of our loan portfolio and reduce our level of deposits, which in turn would hurt our business.  Interest received on loans represented approximately 89.2% of our interest income for the year ended December 31, 2005.  If an economic downturn occurs in the economy as a whole, or in the Spartanburg, Charleston, or Greenville areas, borrowers may be less likely to repay their loans as scheduled. 

          Moreover, the value and liquidity of real estate or other collateral that may secure our loans could be adversely affected by an economic downturn.  Real estate values in our market areas have risen substantially over the last several years.  If the value of real estate decreases or does not continue to rise, our business could be adversely affected.  Unlike many larger institutions, we are not able to spread the risks of unfavorable local economic conditions across a large number of diversified economies or markets.  An economic downturn could, therefore, result in losses that materially and adversely affect our business.

Our recent operating results may not be indicative of our future operating results.

          We may not be able to sustain our historical rate of growth.  Because of our relatively small size and short operating history, it will be difficult for us to replicate our historical earnings growth as we continue to expand.  Consequently, our historical results of operations will not necessarily be indicative of our future operations.  Various factors, such as economic conditions, regulatory and legislative considerations, and competition, may also impede our ability to expand our market presence.  If we experience a significant decrease in our historical rate of growth, our results of operations and financial condition may be adversely affected because a high percentage of our operating costs are fixed expenses.

We depend on key individuals, and the loss of one or more of these key individuals could curtail our growth and adversely affect our prospects.

          Jerry L. Calvert, our president and chief executive officer, has substantial experience with our operations and has contributed significantly to our growth since our founding.  If we lose Mr. Calvert’s services, he would be difficult to replace and our business and development could be materially and adversely affected.  Our success also depends in part on our continued ability to attract and retain experienced loan originators, as well as other management personnel, including Kitty B. Payne, Robert W. Murdoch, Jr., and David H. Zabriskie. The loss of the services of several of such key personnel could adversely affect our growth strategy and prospects to the extent we are unable to replace such personnel.   

We are subject to extensive regulation that could limit or restrict our activities.

          We operate in a highly regulated industry and are subject to examination, supervision, and comprehensive regulation by the Office of the Comptroller of the Currency, or OCC, the FDIC, and the Federal Reserve Board.  Our compliance with these regulations is costly and restricts certain of our activities, including payment of dividends, mergers and acquisitions, investments, loans and interest rates charged, interest rates paid on deposits, and locations of offices.  We must also meet regulatory capital requirements.  If we fail to meet these capital and other regulatory requirements, our financial condition, liquidity, and results of operations would be materially and adversely affected.  Our failure to remain “well capitalized” and “well managed” for regulatory purposes could affect customer confidence, our ability to grow, our cost of funds and FDIC insurance, our ability to pay dividends on common stock, and our ability to make acquisitions. 

          The laws and regulations applicable to the banking industry could change at any time, and we cannot predict the effects of these changes on our business and profitability.  For example, new legislation or regulation could limit the manner in which we may conduct our business, including our ability to obtain financing, attract deposits, and make loans.  Many of these regulations are intended to protect depositors, the public, and the FDIC, not shareholders.  In addition, the burden imposed by these regulations may place us at a competitive disadvantage compared to competitors who are less regulated.  The laws, regulations, interpretations, and enforcement policies that apply to us have been subject to significant change in recent years, sometimes retroactively applied, and may change significantly in the future.  Our cost of compliance could adversely affect our ability to operate profitably.  See “Supervision and Regulation.”

We face strong competition for customers, which could prevent us from obtaining customers and may cause us to pay higher interest rates to attract deposits.

          The banking business is highly competitive, and we experience competition in our markets from many other financial institutions.  We compete with commercial banks, savings and loan associations, mortgage banking firms, consumer finance companies, credit unions, securities brokerage firms, insurance companies, money market funds, and other mutual funds, as well as other super-regional, national, and international financial institutions that operate offices in our primary market areas and elsewhere.  Competitors that are not depository institutions are generally not subject to the extensive regulations that apply to us.

          We compete with these institutions both in attracting deposits and in making loans.  In addition, we have to attract our customer base from other existing financial institutions and from new residents.  Many of our competitors are well-established, larger financial institutions, such as BB&T, Bank of America, and Wachovia.  These institutions offer some services, such as extensive and established branch networks, that we do not provide.  In new markets that we enter, we will also compete against well-established community banks that have developed relationships within the community.  There is a risk that we will not be able to compete successfully with other financial institutions in our markets, and that we may have to pay higher interest rates to attract deposits, resulting in reduced profitability. 

Our growth may require us to raise additional capital that may not be available when it is needed, or at all.

          We are required by regulatory authorities to maintain adequate levels of capital to support our operations.  We anticipate that our capital resources following this offering will satisfy our capital requirements for the foreseeable future.  We may at some point, however, need to raise additional capital to support our continued growth.  Our ability to raise additional capital, if needed, will depend in part on conditions in the capital markets at that time, which are outside our control, and on our financial performance.  Accordingly, we may be unable to raise additional capital, if and when needed, on terms acceptable to us, or at all.  If we cannot raise additional capital when needed, our ability to further expand our operations through internal growth and acquisitions could be materially impaired.  In addition, if we issue additional equity capital, your interest would be diluted.

Efforts to comply with the Sarbanes-Oxley Act will involve significant expenditures, and non-compliance with the Sarbanes-Oxley Act may adversely affect us.

          The Sarbanes-Oxley Act of 2002, and the related rules and regulations promulgated by the Securities and Exchange Commission that are now applicable to us, have increased the scope, complexity, and cost of corporate governance, reporting, and disclosure practices.  We have experienced, and we expect to continue to experience, greater compliance costs, including costs related to internal controls, as a result of the Sarbanes-Oxley Act.  We expect these new rules and regulations to continue to increase our accounting, legal, and other costs, and to make some activities more difficult, time consuming, and costly.  In the event that we are unable to maintain or achieve compliance with the Sarbanes-Oxley Act and related rules, we may be adversely affected.  The SEC has extended the compliance deadline applicable to us until the first Annual Report filed for fiscal years ending on or after July 15, 2007. As a result, we must now include the internal control report with the Annual Report on Form 10-K for the fiscal year ended December 31, 2007.

          We are evaluating our internal control systems in order to allow management to report on, and our independent registered public accounting firm to attest to, our internal control over financial reporting, as required by Section 404 of the Sarbanes-Oxley Act.  If we identify significant deficiencies or material weaknesses in our internal control over financial reporting that we cannot remediate in a timely manner, or if we are unable to receive a positive attestation from our independent registered public accounting firm with respect to our internal control over financial reporting, the trading price of our common stock could decline, our ability to obtain any necessary equity or debt financing could suffer, and our common stock could ultimately be delisted from the NASDAQ National Market.  In this event, the liquidity of our common stock would be severely limited and the market price of our common stock would likely decline significantly.

          In addition, the new rules adopted as a result of the Sarbanes-Oxley Act could make it more difficult or more costly for us to obtain certain types of insurance, including directors’ and officers’ liability insurance, which could make it more difficult for us to attract and retain qualified persons to serve on our board of directors or as executive officers. 

We will face risks with respect to expansion.

          We plan to expand into new markets or lines of business or offer new products or services.  These activities would involve a number of risks, including:

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taking additional time and creating expense associated with evaluating new markets for expansion, hiring experienced local management, and opening new offices, as there may be a substantial time lag between these activities before we generate sufficient assets and deposits to support the costs of the expansion;

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taking a significant amount of time negotiating a transaction or working on expansion plans, resulting in management’s attention being diverted from the operation of our existing business; and

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creating an adverse short-term effect on our results of operations.


          We may not be successful in overcoming these risks or other problems encountered in connection with expansion activities.  Our inability to overcome these risks could have a material adverse effect on our ability to achieve our business strategy and on our financial condition and results of operations. 

We will face risks with respect to future acquisitions or mergers.

          Although we do not have any current plans to do so, we may also seek to acquire other financial institutions or parts of those institutions.  Risks of these activities may include the following:

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difficulties and expense associated with identifying and evaluating potential acquisitions and merger partners;

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inaccuracies in estimates and judgments to evaluate credit, operations, management, and market risks with respect to the target institution or assets;

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dilutive effects of an acquisition on our existing shareholders;

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difficulties and expense in integrating the operations and personnel of the combined businesses;

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loss of key employees and customers as a result of an acquisition that is poorly received; and

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the incurrence and possible impairment of goodwill associated with an acquisition and possible adverse short-term effects on our result of operations.


          We expect to compete with other financial institutions regarding any potential acquisitions.  We may be unable to identify attractive acquisition candidates or to complete acquisitions on terms favorable to us, or at all.  We may not be able to integrate any banks we acquire successfully.  We may not be successful in overcoming these risks or any other problems encountered in connection with potential acquisitions.  We have never acquired another institution before and therefore lack experience in handling any of these risks.  Our inability to overcome these risks could have a material adverse effect on our ability to achieve our business strategy and on our financial condition and results of operations.