-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, SR/1yoX3rlzQStE8x6/zy88qkkgPlyvidsjFrFecFY4WdvSROy6D5r3Ameo5nwSB w9ayM8LItCIe63L8DYXvzQ== 0001157523-08-002195.txt : 20080312 0001157523-08-002195.hdr.sgml : 20080312 20080312172600 ACCESSION NUMBER: 0001157523-08-002195 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 7 CONFORMED PERIOD OF REPORT: 20071231 FILED AS OF DATE: 20080312 DATE AS OF CHANGE: 20080312 FILER: COMPANY DATA: COMPANY CONFORMED NAME: FOUR OAKS FINCORP INC CENTRAL INDEX KEY: 0001040799 STANDARD INDUSTRIAL CLASSIFICATION: STATE COMMERCIAL BANKS [6022] IRS NUMBER: 562028446 STATE OF INCORPORATION: NC FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: 1934 Act SEC FILE NUMBER: 000-22787 FILM NUMBER: 08684316 BUSINESS ADDRESS: STREET 1: 6144 US 301 SOUTH STREET 2: P O BOX 309 CITY: FOUR OAKS STATE: NC ZIP: 27524 BUSINESS PHONE: 9199632177 10-K 1 a5631643.txt FOUR OAKS FINCORP, INC. 10-K UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2007 Commission File Number 000-22787 FOUR OAKS FINCORP, INC. (Exact name of registrant as specified in its charter) North Carolina 56-2028446 -------------- ---------- (State or other jurisdiction of (IRS Employer Identification incorporation or organization) Number) 6114 U.S. 301 South Four Oaks, North Carolina 27524 ------------------------- ----- (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (919) 963-2177 -------------- Securities registered under Section 12(b) of the Act: NONE Securities registered under Section 12(g) of the Act: Common Stock, par value $1.00 per share --------------------------------------- (Title of Class) Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. YES |_| NO |X| Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. YES |_| NO |X| Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days: |X|YES [ ]NO Indicate by check mark whether disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. |X| Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act: Large accelerated filer [ ] Accelerated filer |X| Non-accelerated filer [ ] Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act): YES [ ] NO |X| $108,252,293 ------------ (Aggregate market value of voting and non-voting common equity held by non-affiliates of the registrant based on the price at which the registrant's Common Stock, par value $1.00 per share was sold on June 30, 2007) 6,207,191 --------- (Number of shares of Common Stock, par value $1.00 per share, outstanding as of March 6, 2008) Documents Incorporated by Reference Where Incorporated - ----------------------------------- ------------------ (1) Proxy Statement for the 2007 Annual Part III Meeting of Shareholders to be held April 28, 2008 1 Forward-Looking Information Information set forth in this Annual Report on Form 10-K under the caption "Business" and "Management's Discussion and Analysis of Financial Condition and Results of Operations" contains various "forward looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, which statements represent our judgment concerning the future and are subject to business, economic and other risks and uncertainties, both known and unknown, that could cause our actual operating results and financial position to differ materially. Such forward looking statements can be identified by the use of forward looking terminology, such as "may," "will," "expect," "anticipate," "estimate," or "continue" or the negative thereof or other variations thereof or comparable terminology. We caution that any such forward looking statements are further qualified by important factors that could cause our actual operating results to differ materially from those in the forward looking statements, including, without limitation, the effects of future economic conditions, governmental fiscal and monetary policies, legislative and regulatory changes, the risks of changes in interest rates on the level and composition of deposits, the effects of competition from other financial institutions, the failure of assumptions underlying the establishment of the allowance for possible loan losses and the low trading volume of our common stock and the risks discussed in Item 1A. Risk Factors below. Any forward looking statements contained in this Annual Report on Form 10-K are as of the date hereof and we undertake no duty to update them if our view changes later. These forward looking statements should not be relied upon as representing our view as of any date subsequent to the date hereof. PART I Item 1 - Business. Four Oaks Bank & Trust Company (referred to herein as the "bank") was incorporated under the laws of the State of North Carolina in 1912. On February 5, 1997, the bank formed Four Oaks Fincorp, Inc. (referred to herein as the "company"; references herein to "we," "us" and "our" refer to the company and its consolidated subsidiaries, unless the context otherwise requires) for the purpose of serving as a holding company for the bank. Our corporate offices and banking offices are located in eastern North Carolina in the counties of Johnston (our corporate headquarters), Wake, Sampson, Lee, Duplin and Harnett counties. We have no significant assets other than cash, the capital stock of the bank and its membership interest in Four Oaks Mortgage Services, L.L.C., as well as $1,153,000 in securities available for sale. In addition, we have an interest in Four Oaks Statutory Trust I, a wholly owned Delaware statutory business trust (the "Trust"), for the sole purpose of issuing trust preferred securities. The Trust is not consolidated with our financial statements of the Company pursuant to the provisions of Financial Accounting Standards Board ("FASB") Interpretation No. 46, "Consolidation of Variable Interest Entities (revised December 2003) - an interpretation of ARB No. 51" ("FIN 46R"). We formed the Trust for the sole purpose of issuing $12.0 million of trust preferred securities (the "Trust Preferred Securities"). The Trust has invested the net proceeds from the sale of the Trust Preferred Securities in Junior Subordinated Deferrable Interest (the "Debentures") issued by us and recorded in borrowings on the accompanying consolidated balance sheet. The Trust Preferred Securities pay cumulative cash distributions quarterly at an annual rate, reset quarterly, equal to three month LIBOR plus 1.35%. The dividends paid to holders of the Trust Preferred Securities, which are recorded as interest expense, are deductible for income tax purposes. As of December 31, 2007, we had assets of $708.3 million, net loans outstanding of $538.6 million and deposits of $537.8 million. We have enjoyed considerable growth over the past five (5) years as evidenced by a 122.5% increase in assets, a 137.6% increase in net loans outstanding, and a 114.6% increase in deposits since December 31, 2002. We had net income of $5.7 million and $7.0 million and basic earnings per share of $.92 and $1.15 for the years ended December 31, 2007 and 2006, respectively. Net income of $5.0 million and basic earnings per share of $0.84 were recorded for the year ended December 31, 2005. The bank continues to remain a community-focused bank engaging in general commercial banking business to the communities we serve in Johnston, Harnett, Wake, Sampson, Lee and Duplin counties of North Carolina. The bank provides a full range of banking services, including such services as: o checking accounts; o savings accounts; o individual retirement accounts; 2 o NOW accounts; o money market accounts; o certificates of deposit; o a student checking and savings program; o loans for businesses, agriculture, real estate, personal uses, home improvement and automobiles; o mortgage loans; o equity lines of credit; o credit cards; o safe deposit boxes; o electronic funds transfer services, including wire transfers; internet banking and bill pay services; o telephone banking; o gift cards; o cashier's checks; o traveler's check cards; and o free notary services to all bank customers. The bank also provides financial services, offering a complete line of insurance and investment services, including financial strategies, mutual funds, annuities, insurance, stock brokerage, IRAs, discount brokerage services, employee benefit plans, 401(k)'s and simplified employee pension plans. In addition, the bank provides its customers access to automated teller machines ("ATMs) through its own ATMs throughout its communities served as well as access to worldwide ATMs for cash withdrawals through the services of the Star, Cirrus, or Visa networks by using ATM or Visa check cards. The Visa check cards may also be used at merchant locations worldwide through the Star, Cirrus, or Visa networks. Through an arrangement with Jefferson Pilot Securities Corporation, the Bank also makes available a complete line of insurance and investment services, including financial strategies, mutual funds, annuities, insurance, stock brokerage, IRA's, discount brokerage services, employee benefit plans, 401(K)'s and simplified employee pension plans. At present, the bank does not provide the services of a trust department. We maintain a website at www.fouroaksbank.com where our periodic reports on Form 10-Q and 10-K and our current reports on Form 8-K are available under "Investor Relations". We are registered as a bank holding company with the Federal Reserve System. We are a state-chartered member of the Federal Reserve System and the Federal Deposit Insurance Corporation (the "FDIC") insures its deposits up to applicable limits. Our corporate offices are located at 6114 US 301 South, Four Oaks, North Carolina, 27524. Our common stock is traded on the OTC Bulletin Board under the symbol "FOFN". Our market area is concentrated in the eastern North Carolina counties of Johnston, Wake, Sampson, Lee, Duplin, and Harnett. Johnston County is contiguous to Wake, Wayne, Wilson, Harnett, Sampson and Nash counties. Wake County is contiguous to Johnston, Durham, Harnett, Nash, Franklin, Granville and Chatham counties. Sampson County is contiguous to Duplin, Pender, Bladen, Harnett, Cumberland, Johnston, and Wayne counties. Lee County is contiguous to Chatham, Moore and Harnett counties. Duplin County is contiguous to Pender, Sampson, Wayne, Lenoir, Jones and Onslow counties. Harnett County is contiguous to Cumberland, Moore, Lee, Chatham, Wake, Johnston and Sampson counties. From its headquarters located in Four Oaks and its fourteen locations in Four Oaks, Clayton, Smithfield, Garner, Benson, Fuquay-Varina, Wallace, Holly Springs, Harrells, Sanford, Zebulon, and Dunn, the bank serves a major portion of Johnston County, and part of Wake, Harnett, Duplin, Sampson and Lee counties. Johnston County has a diverse economy and is not dependent on any one particular industry. The leading industries in the area include retail trade, manufacturing, pharmaceuticals, government, services, construction, wholesale trade and agriculture. The population for Johnston County in 2006 was estimated in excess of 152,000. As of June 2007, the bank ranked first in deposit market share for Johnston County at 28%. In Four Oaks, the main office is located at 6144 US 301 South and an additional branch is located at 111 North Main Street. The bank also operates a branch office in Clayton at 102 East Main Street, two in Smithfield at 128 North Second Street, and 403 South Brightleaf Boulevard, one in Garner at 200 Glen Road, one in Benson at 200 East Church Street, one in Fuquay-Varina at 325 North Judd Parkway Northeast, one in Wallace at 406 East Main Street, one in Holly Springs at 101 West Center Street, one in Harrells at 590 Tomahawk Highway, one in Sanford at 830 Spring Lane, one in Zebulon at 130 North Arendell Avenue, and one in Dunn at 604-A Erwin Road. The majority of the bank's customers are individuals and small to medium-size businesses located in Johnston, Wake, Sampson, Lee, Duplin and Harnett counties and surrounding areas. The deposits and loans are well diversified with no material concentration in a single industry or group of related industries. There are no seasonal factors that would have any material adverse effect on the bank's business, and the bank does not rely on foreign sources of funds or income. 3 In an effort to offer a more diversified and competitive product line to better serve our customers and community, in 2003 we discontinued our provision of secondary market-type mortgages through the bank and, through a joint venture with Centex Corporation, formed Four Oaks Mortgage Company, L.P. Since 2003, Four Oaks Mortgage Company, L.P. has provided secondary market-type mortgages and has been the vehicle through which all of our mortgage business is run. Four Oaks Mortgage Company, L.P. is owned 49.99% by our wholly-owned subsidiary, Four Oaks Mortgage Services, L.L.C., and 50.01% by its general partner, CTX Mortgage Ventures, LLC, a wholly-owned indirect subsidiary of Centex Corporation. Amounts spent on research activities relating to the development or improvement of services has been immaterial over the past two years. At December 31, 2007, the bank employed 177 full time equivalent employees. Our employees are extremely important to our continued success and the bank considers its relationship with its employees to be good. Management continually seeks ways to improve upon their benefits and well being. The following table sets forth certain of our financial data and ratios for the years ended December 31, 2007, 2006 and 2005 derived from our audited financial statements and notes. This information should be read in conjunction with and is qualified in its entirety by reference to the more detailed audited financial statements and notes thereto included in this report:
2007 2006 2005 ------------ ------------ ------------ (In thousands, except ratios) Net income $ 5,652 $ 7,017 $ 5,003 Average equity capital accounts $ 52,246 $ 45,541 $ 39,613 Ratio of net income to average equity capital accounts 10.82% 15.41% 12.63% Average daily total deposits $ 505,494 $ 435,991 $ 355,214 Ratio of net income to average daily total deposits 1.12 1.61 1.41 Average daily loans (gross) $ 494,426 $ 426,768 $ 351,103 Ratio of average daily loans to average daily total deposits 97.81% 97.88% 98.84%
Proposed Merger with LongLeaf Community Bank On December 10, 2007, we announced that we had entered into a definitive agreement with LongLeaf Community Bank ("LongLeaf") pursuant to which LongLeaf will merge with and into the bank. Under the terms of the Agreement, each share of LongLeaf common stock will be automatically converted into the right to receive either (i) $16.50 in cash, without interest, (ii) 1.0 share of Company common stock multiplied by an exchange ratio or (iii) 0.60 shares of Company common stock multiplied by the exchange ratio plus an amount equal to $6.60 in cash, all on and subject to the terms and conditions contained in the Agreement. The exchange ratio is equal to $16.50 divided by the volume weighted average of the daily closing sales price of our common stock as quoted on the OTC Bulletin Board during the 20 consecutive trading days ending three business days prior to the closing date of the Merger (the "Average Closing Price"). Pursuant to the Agreement, the Average Closing Price can be no higher than $19.3397452 per share and no lower than $14.2945943 per share. In addition, if (a) as of the later of the date of receipt of the required approval of regulatory authorities or the date of approval by LongLeaf shareholders, the average closing price of our common stock is less than 75% of the Average Closing Price as of the date the Agreement was executed and (b) we do not agree to adjust the exchange ratio as permitted by the Agreement, then LongLeaf will have a right to terminate the Agreement. Finally, certain allocation procedures will be used to cause the stock consideration to be paid to LongLeaf shareholders to be between 50% and 70% of the total merger consideration. On January 30, 2008, we filed a Registration Statement on Form S-4 with the Securities and Exchange Commission (the "SEC") to register up to 708,461 shares of our common stock that could be issued in connection with the proposed transaction. LongLeaf mailed the related proxy statement/prospectus to its shareholders on or about February 28, 2008, setting forth matters relating to the transaction to be voted upon at its upcoming special Meeting of Shareholders to be held on April 10, 2008. The Form S-4 describes the proposed transaction in detail and provides, among other things, highlights and terms of the proposed merger and pro forma financial information. Subject to receipt of approval by LongLeaf's shareholders and certain other closing conditions, we plan to consummate the bank merger in the second quarter of 2008. 4 We believe that the proposed merger presents an important opportunity for us to increase shareholder value by acquiring a well-respected community bank in Richmond and Moore counties in North Carolina, both of which are desirable markets for the bank. We believe these counties represent natural extensions of the bank's existing market areas, as Moore County is contiguous to Lee County where the bank is already located, and Richmond County is contiguous to Moore County. The bank's existing Sanford office located in Lee County is situated just off US 1 as are the two offices of LongLeaf. The bank also expects to realize profitability improvements in the LongLeaf operations due to merging its back office functions into those of the bank. We also believe that we will be able to further leverage LongLeaf's existing customer base, branch network and reputation as a method to implement and accelerate the bank's growth strategy and objectives. In addition, we believe that customers of LongLeaf will benefit from the combination by having access to a larger community bank that offers a full array of products and services at competitive prices. Competition Commercial banking in North Carolina is extremely competitive due in large part to North Carolina's early adoption of statewide branching. As a result, many commercial banks have branches located in several communities. The bank competes in its market area with some of the largest banking organizations in the state and the country and other financial institutions, such as federally and state-chartered savings and loan institutions. At June 2007, we operated branches in Johnston, Wake, Sampson, Duplin, and Lee counties, North Carolina. At that time in Johnston County, North Carolina, the bank's primary market, there were a total of approximately $1.3 billion in deposits and 39 branches represented by the top eleven financial institutions in the county based on deposit share, all commercial banks. The bank operated seven of the 39 branches with deposits of $352.3 million, placing the bank first in the top eleven based on deposit share. Many of the bank's competitors have broader geographic markets and higher lending limits than those of the bank and are also able to provide more services and make greater use of media advertising. Therefore, in our market area, the bank has significant competition for deposits and loans from other depository institutions. Other financial institutions such as credit unions, as well as consumer finance companies, mortgage companies and other lenders engaged in the business of extending credit with varying degrees of regulatory restrictions also compete in our market area. Additionally, credit unions have been permitted to expand their membership criteria and expand their loan services to include traditional bank services such as commercial lending creating a greater competitive disadvantage to tax-paying financial institutions. The enactment of legislation authorizing interstate banking has caused great increases in the size and financial resources of some of the bank's competitors. See "Holding Company Regulation" below for a description of this legislation. In addition, as a result of interstate banking, out-of-state commercial banks may acquire North Carolina banks and heighten the competition among banks in North Carolina. Although the competition in its market areas is expected to continue to be significant, the bank believes that it has certain competitive advantages that distinguish it from its competition. The bank believes that its primary competitive advantages are its strong local identity, its affiliation with the community and its emphasis on providing specialized services to small and medium-sized business enterprises, as well as professional and upper-income individuals. The bank offers customers modern, high-tech banking without forsaking community values such as prompt, personal service and friendliness. The bank offers many personalized services and attracts and retains customers by being responsive and sensitive to their individualized needs. The bank also relies on goodwill and referrals from our shareholders and the bank's satisfied customers, as well as traditional media, to attract new customers. To enhance a positive image in the community, the bank supports and participates in local events and its officers and directors serve on boards of local civic and charitable organizations. Governmental Regulation Holding companies, banks and many of their non-bank affiliates are extensively regulated under both federal and state law. The following is a brief summary of certain statutes, rules and regulations affecting us and the bank. This summary is qualified in its entirety by reference to the particular statutory and regulatory provisions referred to below and are not intended to be an exhaustive description of the statutes or regulations applicable to the business of the company or bank. Supervision, regulation and examination of the company and the bank by bank regulatory agencies is intended primarily for the protection of the bank's depositors rather than the company's shareholders. 5 Holding Company Regulation General. Four Oaks Fincorp, Inc. is a holding company registered with the Board of Governors of the Federal Reserve System under the Bank Holding Company Act of 1956 (the "BHCA"). As such, we are subject to the supervision, examination and reporting requirements contained in the BHCA and the regulation of the Federal Reserve. The bank is also subject to the BHCA. The BHCA requires that a bank holding company obtain the prior approval of the Federal Reserve before (i) acquiring direct or indirect ownership or control of more than five percent of the voting shares of any bank, (ii) taking any action that causes a bank to become a subsidiary of the bank holding company, (iii) acquiring all or substantially all of the assets of any bank or (iv) merging or consolidating with any other bank holding company. The BHCA generally prohibits a bank holding company, with certain exceptions, from engaging in activities other than banking, or managing or controlling banks or other permissible subsidiaries, and from acquiring or retaining direct or indirect control of any company engaged in any activities other than those activities determined by the Federal Reserve to be closely related to banking, or managing or controlling banks, as to be a proper incident thereto. In determining whether a particular activity is permissible, the Federal Reserve must consider whether the performance of such an activity can reasonably be expected to produce benefits to the public, such as greater convenience, increased competition or gains in efficiency, that outweigh possible adverse effects, such as undue concentration of resources, decreased or unfair competition, conflicts of interest or unsound banking practices. For example, banking, operating a thrift institution, extending credit or servicing loans, leasing real or personal property, providing securities brokerage services, providing certain data processing services, acting as agent or broker in selling credit life insurance and certain other types of insurance underwriting activities have all been determined by regulations of the Federal Reserve to be permissible activities. Pursuant to delegated authority, the Federal Reserve Bank of Richmond has authority to approve certain activities of holding companies within its district, including us, provided the nature of the activity has been approved by the Federal Reserve. Despite prior approval, the Federal Reserve has the power to order a holding company or its subsidiaries to terminate any activity or to terminate its ownership or control of any subsidiary when it believes that continuation of such activity or such ownership or control constitutes a serious risk to the financial safety, soundness or stability of any bank subsidiary of that bank holding company. Financial Holding Companies. The Gramm-Leach-Bliley Modernization Act of 1999 (the "GLB"), which was enacted on November 12, 1999, allows bank holding companies that meet certain new regulatory standards regarding management, capital and the Community Reinvestment Act of 1997 (the "CRA"), to engage in a broader range of non-banking activities than previously permissible, including insurance underwriting and making merchant banking investments in commercial and financial companies; allows insurers and other financial services companies to acquire banks; removes various restrictions that applied to bank holding company ownership of securities firms and mutual fund advisory companies; and establishes the overall regulatory structure applicable to bank holding companies that also engage in insurance and securities operations. At the present time, we have elected to remain a bank holding company, and therefore we remain subject to the same regulatory framework as before the enactment of the GLB. However, the financial holding company structure created by the GLB permits insurance companies or securities firms operating under the financial holding company structure to acquire us, and, if we elect to become a financial holding company in the future, we could acquire insurance companies or securities firms. In addition to creating the more flexible financial holding company structure, the GLB introduced several additional customer privacy protections that will apply to us and the bank. The GLB's privacy provisions require financial institutions to, among other things: (i) establish and annually disclose a privacy policy, (ii) give consumers the right to opt out of disclosures to nonaffiliated third parties, with certain exceptions, (iii) refuse to disclose consumer account information to third-party marketers and (iv) follow regulatory standards to protect the security and confidentiality of consumer information. Pursuant to the GLB's rulemaking provisions, the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation and the Office of Thrift Supervision adopted regulations, establishing standards for safeguarding customer information. Such regulations provide financial institutions guidance in establishing and implementing administrative, technical and physical safeguards to protect the security, confidentiality and integrity of customer information. 6 Mergers and Acquisitions. The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the "IBBEA") permits interstate acquisitions of banks and bank holding companies without geographic limitation, subject to any state requirement that the bank has been organized for a minimum period of time, not to exceed five (5) years, and the requirement that the bank holding company, prior to or following the proposed acquisition, controls no more than ten percent (10%) of the total amount of deposits of insured depository institutions in the U.S. and no more than thirty percent (30%) of such deposits in any state (or such lesser or greater amount set by state law). In addition, the IBBEA permits a bank to merge with a bank in another state as long as neither of the states has opted out of the IBBEA prior to May 31, 1997. In 1995, the state of North Carolina "opted in" to such legislation. In addition, a bank may establish and operate a de novo branch in a state in which the bank does not maintain a branch if that state expressly permits de novo interstate branching. As a result of North Carolina having opted-in, unrestricted interstate de novo branching is permitted in North Carolina. Additional Restrictions and Oversight. Subsidiary banks of a bank holding company are subject to certain restrictions imposed by the Federal Reserve on any extensions of credit to the bank holding company or any of its subsidiaries, investments in the stock or securities thereof and the acceptance of such stock or securities as collateral for loans to any borrower. A bank holding company and its subsidiaries are also prevented from engaging in certain tie-in arrangements in connection with any extension of credit, lease or sale of property or furnishing of services. An example of a prohibited tie-in would be any arrangement that would condition the provision or cost of services on a customer obtaining additional services from the bank holding company or any of its other subsidiaries. The Federal Reserve may issue cease and desist orders against bank holding companies and non-bank subsidiaries to stop actions believed to present a serious threat to a subsidiary bank. The Federal Reserve also regulates certain debt obligations, changes in control of bank holding companies and capital requirements. Under the provisions of the North Carolina law, we are registered with and subject to supervision by the North Carolina Commissioner of Banks. Capital Requirements. The Federal Reserve has established risk-based capital guidelines for bank holding companies and state member banks. The minimum standard for the ratio of capital to risk-weighted assets (including certain off balance sheet obligations, such as standby letters of credit) is eight percent (8%). At least half of this capital must consist of common equity, retained earnings and a limited amount of perpetual preferred stock and minority interests in the equity accounts of consolidated subsidiaries, less goodwill items and certain other items ("Tier 1 capital"). The remainder ("Tier 2 capital") may consist of mandatory convertible debt securities and a limited amount of other preferred stock, subordinated debt and loan loss reserves. In addition, the Federal Reserve has established minimum leverage ratio guidelines for bank holding companies. These guidelines provide for a minimum leverage ratio of Tier 1 capital to adjusted average quarterly assets less certain amounts ("Leverage Ratio") equal to three percent for bank holding companies that meet certain specified criteria, including having the highest regulatory rating. All other bank holding companies will generally be required to maintain a Leverage Ratio of between four percent and five percent. The guidelines also provide that bank holding companies experiencing significant growth, whether through internal expansion or acquisitions, will be expected to maintain strong capital ratios well above the minimum supervisory levels without significant reliance on intangible assets. The same heightened requirements apply to bank holding companies with supervisory, financial, operational or managerial weaknesses, as well as to other banking institutions if warranted by particular circumstances or the institution's risk profile. Furthermore, the guidelines indicate that the Federal Reserve will continue to consider a "tangible Tier 1 Leverage Ratio" (deducting all intangibles) in evaluating proposals for expansion or new activity. The Federal Reserve has not advised us of any specific minimum Leverage Ratio or tangible Tier 1 Leverage Ratio applicable to us. As of December 31, 2007, we had Tier 1 risk-adjusted, total regulatory capital and leverage capital of approximately 11.70%, 12.87% and 10.16%, respectively, all in excess of the minimum requirements to be considered well-capitalized under prompt corrective action provisions. Dividends. During 2007, we paid cash dividends of $.29 per share on our common stock, a 20.8% increase over 2006. North Carolina banking law requires that dividends be paid out of retained earnings as determined pursuant to North Carolina General Statues Section 53-87. At present, the company has sufficient cash from its operations to pay cash dividends on its common stock. In the past, we have received cash dividends from our bank and may continue to do so from time to time in the future as necessary for cash flow purposes. Also, applicable federal banking law contains additional limitations and restrictions on the payment of dividends by a bank holding company. Accordingly, shareholders receive dividends from us only to the extent that funds are available from our operations or the bank. In addition, the Federal Reserve generally prohibits bank holding companies from paying dividends except out of operating earnings, and the prospective rate of earnings retention appears consistent with the bank holding company's capital needs, asset quality and overall financial condition. 7 USA Patriot Act of 2001. Title III of the USA Patriot Act of 2001 contains the International Money Laundering Abatement and Financial Anti-Terrorism Act of 2001 (the "IMLAFA"). The anti-money laundering provisions of IMLAFA impose affirmative obligations on a broad range of financial institutions, including banks, brokers, and dealers. Among other requirements, IMLAFA requires all financial institutions to establish anti-money laundering programs that include, at minimum, internal policies, procedures, and controls; specific designation of an anti-money laundering compliance officer; ongoing employee training programs; and an independent audit function to test the anti-money laundering program. IMLAFA requires financial institutions that establish, maintain, administer, or manage private banking accounts for non-United States persons or their representatives to establish appropriate, specific, and, where necessary, enhanced due diligence policies, procedures, and controls designed to detect and report money laundering. Additionally, IMLAFA provides for the Department of Treasury to issue minimum standards with respect to customer identification at the time new accounts are opened. As of the date of this filing, we believe that IMLAFA has not had a material impact on the bank's operations. The bank has established policies and procedures to ensure compliance with the IMLAFA, which are overseen by an Anti-Money Laundering Officer who was appointed by our Board of Directors. Bank Regulation The bank is subject to numerous state and federal statutes and regulations that affect its business, activities, and operations, and is supervised and examined by the North Carolina Commissioner of Banks and the Federal Reserve. The Federal Reserve and the North Carolina Commissioner of Banks regularly examine the operations of banks over which they exercise jurisdiction. They have the authority to approve or disapprove the establishment of branches, mergers, consolidations, and other similar corporate actions, and to prevent the continuance or development of unsafe or unsound banking practices and other violations of law. The Federal Reserve and the North Carolina Commissioner of Banks regulate and monitor all areas of the operations of banks and their subsidiaries, including loans, mortgages, issuances of securities, capital adequacy, loss reserves, and compliance with the CRA, as well as other laws and regulations. Interest and certain other charges collected and contracted for by banks are also subject to state usury laws and certain federal laws concerning interest rates. The deposit accounts of the bank are insured by the Deposit Insurance Fund (the "DIF") of the Federal Deposit Insurance Corporation (the "FDIC") up to a maximum of one hundred thousand dollars ($100,000) per insured depositor, with the exception of retirement accounts, which were increased to $250,000 by the FDIC effective April 1, 2006. Any insured bank that is not operated in accordance with or does not conform to FDIC regulations, policies, and directives may be sanctioned for noncompliance. Civil and criminal proceedings may be instituted against any insured bank or any director, officer or employee of such bank for the violation of applicable laws and regulations, breaches of fiduciary duties or engaging in any unsafe or unsound practice. The FDIC has the authority to terminate insurance of accounts pursuant to procedures established for that purpose. Under the North Carolina Business Corporation Act, we may not pay a dividend or distribution, if after giving it effect we would not be able to pay our debts as they become due in the usual course of business or our total assets would be less than our liabilities. All dividends paid by the bank are paid to us, the sole shareholder of the bank. In general, our ability to pay cash dividends is dependent in part upon the amount of dividends paid to us by the bank. The ability of the bank to pay dividends to us is subject to statutory and regulatory restrictions on the payment of cash dividends, including the requirement under the North Carolina banking laws that cash dividends be paid only out of undivided profits and only if the bank has surplus of a specified level. The Federal Reserve also imposes limits on the bank's payment of dividends. The amount of future dividends paid to us by the bank will in general be a function of the profitability of the bank, which cannot be accurately estimated or assured. We expect the bank will continue to pay us dividends in the foreseeable future from time to time as needed to pay cash dividends to our shareholders. Like us, the bank is required by federal regulations to maintain certain minimum capital levels. The levels required of the bank are the same as those required of us. At December 31, 2007, the bank had Tier 1 risk-adjusted, total regulatory capital and leverage capital of approximately 10.71%, 11.88% and 8.85%, respectively, in excess of the minimum requirements to be considered well-capitalized under prompt corrective action provisions. 8 The bank is subject to insurance assessments imposed by the FDIC, including a risk-based assessment schedule providing for annual assessment rates ranging from 5 to 43 cents per $100 in assessable deposits, applicable to institutions insured by the DIF. The FDIC may change the assessment schedule quarterly. The actual assessment to be paid by each insured institution is based on the institution's assessment risk classification, which focuses on whether the institution is considered "well capitalized," "adequately capitalized" or "under capitalized," as such terms are defined in the applicable federal regulations. Within each of these three risk classifications, each institution will be assigned to one of three subgroups based on supervisory risk factors. In particular, regulators will assess supervisory risk based on whether the institution is financially sound with only a few minor weaknesses (Subgroup A), whether it has weaknesses which, if not corrected, could result in an increased risk of loss to the DIF (Subgroup B) or whether such weaknesses pose a substantial probability of loss to the DIF unless effective corrective action is taken (Subgroup C). The FDIC also is authorized to impose one or more special assessments in an amount deemed necessary to enable repayment of amounts borrowed by the FDIC from the United States Treasury Department and, beginning in 1997, all banks are required to pay additional annual assessments as set by the Financing Corporation, which was established by the Competitive Equality Banking Act of 1987. In 2007, we received a one-time assessment credit of approximately $197,000, which has been applied to payments due during the year. FDIC deposit insurance expense was $57,000, $52,000, and $46,000 for the years ended December 31, 2007, 2006 and 2005, respectively. The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") provides for, among other things, (i) publicly available annual financial condition and management reports for certain financial institutions, including audits by independent accountants, (ii) the establishment of uniform accounting standards by federal banking agencies, (iii) the establishment of a "prompt corrective action" system of regulatory supervision and intervention, based on capitalization levels, with greater scrutiny and restrictions placed on depository institutions with lower levels of capital, (iv) additional grounds for the appointment of a conservator or receiver and (v) restrictions or prohibitions on accepting brokered deposits, except for institutions which significantly exceed minimum capital requirements. FDICIA also provides for increased funding of the FDIC insurance funds and the implementation of risk-based premiums. A central feature of FDICIA is the requirement that the federal banking agencies take "prompt corrective action" with respect to depository institutions that do not meet minimum capital requirements. Pursuant to FDICIA, the federal bank regulatory authorities have adopted regulations setting forth a five-tiered system for measuring the capital adequacy of the depository institutions that they supervise. Under these regulations, a depository institution is classified in one of the following capital categories: "well capitalized," "adequately capitalized," "under capitalized," "significantly undercapitalized," or "critically undercapitalized." An institution may be deemed by the regulators to be in a capitalization category that is lower than is indicated by its actual capital position if, among other things, it receives an unsatisfactory examination rating with respect to asset quality, management, earnings or liquidity. FDICIA provides the federal banking agencies with significantly expanded powers to take enforcement action against institutions which fail to comply with capital or other standards. Such action may include the termination of deposit insurance by the FDIC or the appointment of a receiver or conservator for the institution. Banks are also subject to the CRA, which requires the appropriate federal bank regulatory agency, in connection with its examination of a bank, to assess such bank's record in meeting the credit needs of the community served by that bank, including low and moderate-income neighborhoods. Each institution is assigned one of the following four ratings of its record in meeting community credit needs: "outstanding," "satisfactory," "needs to improve" or "substantial noncompliance." The regulatory agency's assessment of the bank's record is made available to the public. Further, such assessment is required of any bank which has applied to (i) charter a national bank, (ii) obtain deposit insurance coverage for a newly chartered institution, (iii) establish a new branch office that will accept deposits, (iv) relocate an office or (v) merge or consolidate with, or acquire the assets or assume the liabilities of, a federally regulated financial institution. In the case of a bank holding company applying for approval to acquire a bank or other bank holding company, the Federal Reserve will assess the record of each subsidiary bank of the applicant bank holding company, and such records may be the basis for denying the application. In addition, the GLB's "CRA Sunshine Requirements" call for financial institutions to disclose publicly certain written agreements made in fulfillment of the CRA. Banks that are parties to such agreements also must report to federal regulators the amount and use of any funds expended under such agreements on an annual basis, along with such other information as regulators may require. This annual reporting requirement is effective for any agreements made after May 12, 2000. 9 Monetary Policy and Economic Controls Both the company and the bank are directly affected by governmental policies and regulatory measures affecting the banking industry in general. Of primary importance is the Federal Reserve Board, whose actions directly affect the money supply which, in turn, affects banks' lending abilities by increasing or decreasing the cost and availability of funds to banks. The Federal Reserve Board regulates the availability of bank credit in order to combat recession and curb inflationary pressures in the economy by open market operations in United States government securities, changes in the discount rate on member bank borrowings, changes in reserve requirements against bank deposits, and limitations on interest rates that banks may pay on time and savings deposits. Deregulation of interest rates paid by banks on deposits and the types of deposits that may be offered by banks have eliminated minimum balance requirements and rate ceilings on various types of time deposit accounts. The effect of these specific actions and, in general, the deregulation of deposit interest rates has generally increased banks' cost of funds and made them more sensitive to fluctuations in money market rates. In view of the changing conditions in the national economy and money markets, as well as the effect of actions by monetary and fiscal authorities, no prediction can be made as to possible future changes in interest rates, deposit levels, or loan demand on our business and earnings or those of the bank. As a result, banks, including the bank, face a significant challenge to maintain acceptable net interest margins. Our Executive Officers The following table sets forth certain information with respect to our executive officers: Positions and offices with Four Oaks Fincorp, Inc. and Four Oaks Bank & Year first Trust Company and business experience Name Age employed during past five (5) years - -------------------------------------------------------------------------------- Ayden R. Lee, Jr. 59 1980 Chief Executive Officer, President and Chairman of the Board of Directors of Four Oaks Fincorp, Inc. and Four Oaks Bank & Trust Company. Previously Director of Four Oaks Fincorp, Inc. and Four Oaks Bank & Trust Company. Clifton L. Painter 58 1986 Senior Executive Vice President, Chief Operating Officer of Four Oaks Fincorp, Inc. and Four Oaks Bank & Trust Company. Nancy S. Wise 52 1991 Executive Vice President, Chief Financial Officer of Four Oaks Fincorp, Inc. and Four Oaks Bank & Trust Company. Previously, Senior Vice President, Chief Financial Officer of Four Oaks Fincorp, Inc. and Four Oaks Bank & Trust Company. W. Leon Hiatt, III 40 1994 Executive Vice President of Four Oaks Fincorp, Inc. and Four Oaks Bank & Trust Company, Chief Administrative Officer of Four Oaks Bank & Trust Company. Previously, Senior Vice President Four Oaks Fincorp, Inc. and Four Oaks Bank & Trust Company, Loan Administrator of Four Oaks Bank & Trust Company. Jeff D. Pope 51 1991 Executive Vice President of Four Oaks Fincorp, Inc. and Four Oaks Bank & Trust Company, Branch Administrator of Four Oaks Bank & Trust Company. Previously, Senior Vice President, Loan Officer and Regional Branch Administrator of Four Oaks Bank and Trust Company. 10 Item 1A. Risk Factors Our Results Are Impacted by the Economic Conditions of Our Principal Operating Regions The majority of our customers are individuals and small to medium-size businesses located in North Carolina's Johnston, Wake, Duplin, Sampson, Harnett, and Lee counties and surrounding areas. As a result of this geographic concentration, our results may correlate to the economic conditions in these areas. Declines in these markets' economic conditions may adversely affect the quality of our loan portfolio and the demand for our products and services, and accordingly, our results of operations. We Are Exposed to Risks in Connection with the Loans We Make A significant source of risk for us arises from the possibility that loan losses will be sustained because borrowers, guarantors and related parties fail to perform in accordance with the terms of their loans. Our policy dictates that we maintain an allowance for loan losses. The amount of the allowance is based on management's evaluation of our loan portfolio, the financial condition of the borrowers, current economic conditions, past and expected loan loss experience, and other factors management deems appropriate. Such policies and procedures, however, may not prevent unexpected losses that could adversely affect our results of operations. We Compete with Larger Companies for Business Commercial banking in North Carolina is extremely competitive due in large part to North Carolina's early adoption of statewide branching. The bank competes in the North Carolina market area with some of the largest banking organizations in the state and the country and other financial institutions, such as federally and state-chartered savings and loan institutions and credit unions, as well as consumer finance companies, mortgage companies and other lenders engaged in the business of extending credit. Many of these competitors have broader geographic markets, higher lending limits, more services, and more media advertising. We may not be able to compete effectively in our markets, and our results of operations could be adversely affected by the nature or pace of change in competition. We Are Exposed to Certain Market Risks Like most financial institutions, our most significant market risk exposure is the risk of economic loss resulting from adverse changes in market prices and interest rates. Our market risk stems primarily from interest rate risk inherent in our lending and deposit-taking activities. Our policy allows that we may maintain derivative financial instruments, such as interest rate swap agreements, to manage such risk. To manage the risk of potentially decreasing interest rates for our variable rate loan portfolio, from time to time we may use an interest rate swap agreement whereby we contract to receive fixed rate payments and in turn, we agree to make variable interest payments for a defined time period. In addition, we use fixed rate time deposits, such as certificates of deposit, for use in our lending and investment activities. If the interest rates decline, we face the risk of being committed to pay a fixed rated that is higher than the fair value rate of such deposits. To manage this risk, we use interest rate swaps whereby we contract to make a series of floating rate payments in exchange for receiving a series of fixed rate payments. Because the value of derivative contracts is tied to an independent instrument, index or reference rate, the contracts are written in abstract amounts that only provide the basis for calculating payments between counterparties, i.e., notional amounts. Credit risk arises when amounts receivable from the counterparty exceed amounts payable, or when the counterparty fails to pay. The counterparties to these contracts are primarily large commercial banks and investment banks. We control our risk of loss on derivative contracts by subjecting each contracting counterparty to credit reviews and approvals similar to those used in making loans and other extensions of credit, and we continuously monitor these agreements. Other risks include the effect on fixed rate positions during periods of changing interest rates, e.g., when interest rates fall, the notional amounts decrease more rapidly, whereas when interest rates rise, the notional amounts decrease more slowly. Technological Advances The banking industry undergoes frequent technological changes with introductions of new technology-driven products and services. In addition to improving customer services, the effective use of technology increases efficiency and enables financial institutions to reduce costs. Our future success will depend, in part, on our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands for convenience as well as to create additional efficiencies in our operations. Many of our competitors, however, have substantially greater resources to invest in technological improvements. 11 Compliance with Changing Laws, Regulations and Standards May Result in Additional Risks and Expenses We are subject to changing laws, regulations and standards, including the BHCA, the GLB, the IBBEA, the USA Patriot Act of 2001, the FDIC, the CRA, the North Carolina Business Corporation Act, the Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley"), and new SEC regulations to name a few. Sarbanes-Oxley and new SEC regulations, in particular, are creating uncertainty for companies such as ours because they are subject to varying interpretations in many cases. As a result, their application in practice may evolve over time as new guidance is provided by regulatory and governing bodies, which could result in continuing uncertainty regarding compliance matters and higher costs necessitated by ongoing revisions to disclosure and governance practices. We are committed to maintaining high standards of corporate governance and public disclosure. As a result, our efforts to comply with evolving laws, regulations and standards have resulted in, and are likely to continue to result in, increased expenses and a diversion of management time and attention. Specifically, our efforts to comply with Section 404 of Sarbanes-Oxley and the related regulations regarding management's required assessment of our internal control over financial reporting and our external auditors' audit of that assessment has required the commitment of significant financial and managerial resources. We expect these efforts to require the continued commitment of significant resources. Further, the members of our board of directors, members of the audit or compensation committees, our chief executive officer, our chief financial officer and certain other of our executive officers could face an increased risk of personal liability in connection with the performance of their duties. In addition, it may become more difficult and more expensive to obtain director and officer liability insurance. As a result, our ability to attract and retain executive officers and qualified board and committee members could be more difficult. Government Regulations May Prevent or Impair Our Ability to Pay Dividends, Engage in Acquisitions or Operate in Other Ways Current and future legislation and the policies established by federal and state regulatory authorities will affect our operations. We are subject to supervision and a periodic examination by the Federal Reserve Bank and the North Carolina State Banking Commission. Banking regulations, designed primarily for the protection of depositors, may limit our growth and the return to you, our investors, by restricting certain of our activities, such as: o payment of dividends to our shareholders; o possible mergers with or acquisitions of or by other institutions; o our desired investments; o loans and interest rates on loans; o payment of interest, interest rates on deposits; o the possible expansion of branch offices; and/or o our ability to make other financial services available. We also are subject to capitalization guidelines set forth in federal regulations, and could be subject to enforcement actions to the extent that we are found by regulatory examiners to be undercapitalized. We cannot predict what changes, if any, will be made to existing federal and state legislation and regulations or the effect that such changes may have on our future business and earnings prospects. The cost of compliance with regulatory requirements including those imposed by the SEC may adversely affect our ability to operate profitably. Our Proposed Transaction with LongLeaf Community Bank is Subject to Uncertainties. Our proposed transaction with LongLeaf is subject to customary closing conditions, including shareholder approval by LongLeaf shareholders. If any of the conditions to closing are not satisfied or waived, the proposed transaction would not be completed. In addition, the merger agreement relating to the proposed transaction can be terminated prior to completion of the transaction under certain circumstances, including where LongLeaf receives an acquisition proposal from a third party that its board believes is more favorable to its shareholders than the proposed transaction (after following specific procedures described in our merger agreement with LongLeaf). If the merger agreement is terminated, the proposed transaction would not be completed, and, in certain circumstances, LongLeaf could be required to pay us a termination fee of $350,000. If the merger is not completed, the value of our common stock could decline. We are currently targeting to close the proposed transaction, assuming the satisfaction or waiver of all conditions, in the second quarter of 2008. The closing of the proposed transaction could be delayed beyond the second quarter of 2008 due to many factors, including factors beyond the control of either party. 12 We May Not Be Able To Successfully Integrate Bank Mergers and Acquisitions, Including the Merger of LongLeaf into the Bank. Our proposed merger of the bank with LongLeaf involves the combination of two banks that previously have operated independently. Difficulties may arise in the integration of the business and operations of any banks that we acquire and, as a result, we may not be able to achieve the cost savings and synergies that we expect will result from such transactions. Achieving cost savings is dependent on consolidating certain operational and functional areas, eliminating duplicative positions and terminating certain agreements for outside services. Additional operational savings are dependent upon the integration of the acquired or merged entity's businesses with ours, the conversion of core operating systems, data systems and products and the standardization of business practices. Complications or difficulties in the conversion of the core operating systems, data systems and products may result in the loss of customers, damage to our reputation within the financial services industry, operational problems, one-time costs currently not anticipated or reduced cost savings resulting from such mergers or acquisitions. Annual cost savings in each such transaction may be materially less than anticipated if the merger or acquisition is delayed unexpectedly, the integration of operations is delayed beyond what is anticipated or the conversion to a single data system is not accomplished on a timely basis. Difficulty in integrating an acquired company may cause us not to realize expected revenue increases, cost savings, increases in geographic or product presence and/or other projected benefits from the acquisition. The integration could result in higher than expected deposit attrition, loss of key employees, disruption of our businesses or the businesses of the acquired company, or otherwise adversely affect our ability to maintain relationships with customers and employees or achieve the anticipated benefits of the acquisition. We Depend Heavily on our Key Management Personnel Our success depends in part on our ability to retain key executives and to attract and retain additional qualified management personnel who have experience both in sophisticated banking matters and in operating a small to mid-size bank. Competition for such personnel is strong in the banking industry and we may not be successful in attracting or retaining the personnel we require. We expect to compete effectively in this area by offering competitive financial packages that include incentive-based compensation. We Have a High Concentration of Loans Secured by Real Estate A significant portion of our loan portfolio is dependent on real estate. In addition to the financial strength and cash flow characteristics of the borrower in each case, often loans are secured with real estate collateral. At December 31, 2007, approximately 88.5% of our loans have real estate as a primary or secondary component of collateral. The real estate 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. An adverse change in the economy affecting values of real estate generally or in our primary markets specifically could significantly impair the value of collateral and our ability to sell the collateral upon foreclosure. Furthermore, it is likely that, in a decreasing real estate market, we would be required to increase our allowance for loan losses. If we are required to liquidate the collateral securing a loan to satisfy the debt during a period of reduced real estate values or to increase our allowance for loan losses, our profitability and financial condition could be adversely impacted. Our Allowance for Probable Loan Losses May Be Insufficient We maintain an allowance for probable loan losses, which is a reserve established through a provision for probable loan losses charged to expense. This allowance represents management's best estimate of probable losses that have been incurred within the existing portfolio of loans. The allowance, in the judgment of management, is necessary to reserve for estimated loan losses and risks inherent in the loan portfolio. The level of the allowance reflects management's continuing evaluation of industry concentrations; specific credit risks; loan loss experience; current loan portfolio quality; present economic, political and regulatory conditions and unidentified losses inherent in the current loan portfolio. The determination of the appropriate level of the allowance for probable loan losses inherently involves a high degree of subjectivity and requires us to make significant estimates and assumptions regarding current credit risks and future trends, all of which may undergo material changes. Changes in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside our control, may require an increase in the allowance for probable loan losses. In addition, bank regulatory agencies periodically review our allowance for loan losses and may require an increase in the provision for probable loan losses or the recognition of further loan charge-offs, based on judgments different than those of management. In addition, if charge-offs in future periods exceed the allowance for probable loan losses; we will need additional provisions to increase the allowance for probable loan losses. Any increases in the allowance for probable loan losses will result in a decrease in net income and, possibly, capital, and may have a material adverse effect on our financial condition and results of operations. See Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations for further discussion related to our process for determining the appropriate level of the allowance for probable loan losses. 13 We Are Subject To Environmental Liability Risk Associated With Lending Activities A significant portion of our loan portfolio is secured by real property. During the ordinary course of business, we may foreclose on and take title to properties securing certain loans. In doing so, there is a risk that hazardous or toxic substances could be found on these properties. If hazardous or toxic substances are found, we may be liable for remediation costs, as well as for personal injury and property damage. Environmental laws may require us to incur substantial expenses and may materially reduce the affected property's value or limit our ability to use or sell the affected property. In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase our exposure to environmental liability. Although we have policies and procedures to perform an environmental review before initiating any foreclosure action on nonresidential real property, these reviews may not be sufficient to detect all potential environmental hazards. The remediation costs and any other financial liabilities associated with an environmental hazard could have a material adverse effect on our financial condition and results of operations. Our Controls and Procedures May Fail or Be Circumvented Management regularly reviews and updates our internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of our controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on our business, results of operations and financial condition. The Holders of Our Subordinated Debentures Have Rights That Are Senior to Those of Our Shareholders As described below, we have issued $12.0 million of subordinated debentures in connection with a trust preferred securities issuance by our subsidiary, the Trust. We unconditionally guarantee payments of the principal and interest on the trust preferred securities. Our subordinated debentures are senior to our shares of common stock. As a result, we must make payments on the subordinated debentures (and the related trust preferred securities) before any dividends can be paid on our common stock and, in the event of bankruptcy, dissolution or liquidation, the holders of the debentures must be satisfied before any distributions can be made to the holders of common stock. Our Information Systems May Experience an Interruption or Breach in Security We rely heavily on communications and information systems to conduct our business. Any failure, interruption or breach in security of these systems could result in failures or disruptions in our customer relationship management, general ledger, deposit, loan and other systems. While we have policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of our information systems, there can be no assurance that we can prevent any such failures, interruptions or security breaches or, if they do occur, that they will be adequately addressed. The occurrence of any failures, interruptions or security breaches of our information systems could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our financial condition and results of operations. An Investment in Our Common Stock Is Not an Insured Deposit Our common stock is not a bank deposit and, therefore, is not insured against loss by the FDIC, any other deposit insurance fund or by any other public or private entity. Investment in our common stock is inherently risky for the reasons described in this "Risk Factors" section and elsewhere in this report and is subject to the same market forces that affect the price of common stock in any company. As a result, if you acquire our common stock, you may lose some or all of your investment. 14 Consumers May Decide Not To Use Banks to Complete Their Financial Transactions Technology and other changes are allowing parties to complete financial transactions that historically have involved banks through alternative methods. For example, consumers can now maintain funds that historically would have been held as bank deposits in brokerage accounts or mutual funds. Consumers can also complete transactions such as paying bills and/or transferring funds directly without the assistance of banks. The process of eliminating banks as intermediaries could result in the loss of fee income, as well as the loss of customer deposits and the related income generated from those deposits. The loss of these revenue streams and the lower cost deposits as a source of funds could have a material adverse effect on our financial condition and results of operations. Item 1B - Unresolved Staff Comments. Not applicable. Item 2 - Properties. The bank owns its main office, which is located at 6144 US 301 South, Four Oaks, North Carolina. The main office, which was constructed by the bank in 1985, is a 12,000 square foot facility on 1.64 acres of land. The bank leases a limited-service facility in downtown Four Oaks located at 111 North Main Street from M.S. Canaday, who is a former director of the company as well as a former director of the bank. Under the terms of the lease, which the bank believes to be arms-length, the bank paid $995 per month in rent in 2007. The lease is month-to-month and we review its terms on an annual basis. The bank also leases a branch office located at 101 West Center Street, Holly Springs, North Carolina. Under the terms of the lease, the bank will pay $2,500 per month for a period of five years ending April 1, 2008, with a 3% increase per year for the next 5 years until March 31, 2013. The bank's Harrells office located at 590 Tomahawk Highway, Harrells, North Carolina is under a lease with terms specifying the bank will pay $600 each month for a period of four years ending December 31, 2009. In addition, the bank has entered into a ten-year lease on its Sanford office located at 830 Spring Lane Sanford, North Carolina. Under the terms of the lease, the bank will pay $7,170 each month with an annual rate increase not to exceed 2.5% over a 10 year period. On September 17, 2007, the bank entered into a two year lease on its Dunn office located at 604-A Erwin Road, Dunn, North Carolina. Under the terms of the lease, the bank will pay $1,500 each month for the period beginning September 17, 2007 and ending August 31, 2009. The bank owns a 5,000 square foot facility renovated in 1992 on 1.15 acres of land located at 5987 US 301 South, Four Oaks, North Carolina which houses its training center. The bank also owns a 15,000 square foot facility built in 2000 located at 6114 US 301 South, Four Oaks, North Carolina, which houses its administrative offices, data operations, loan operations and wide area network central link. In addition, the bank owns the following: 15 Location Year Built Present Function Square Feet - -------- ---------- ---------------- ----------- 102 East Main Street Clayton, North Carolina 1986 Branch Office 4,900 200 East Church Street Benson, North Carolina 1987 Branch Office 2,300 128 North Second Street Smithfield, North Carolina 1991 Branch Office 5,500 403 South Brightleaf Boulevard Smithfield, North Carolina 1995 Limited-Service 860 Facility 200 Glen Road Garner, North Carolina 1996 Branch Office 3,500 325 North Judd Parkway Northeast Fuquay-Varina, North Carolina 2002 Branch Office 8,900 406 East Main Street Wallace, North Carolina 2006 Branch Office 9,300 805 N. Arendell Avenue Zebulon, North Carolina 2007 Branch Office 6,100 Management believes each of the properties referenced above is adequately covered by insurance. In addition to the above locations, we have one ATM located inside Blackmon's Country store in Four Oaks and 15 ATMs in Food Lion grocery stores in the cities and towns of Clayton, Benson, Sanford, Wallace, Fuquay-Varina, Holly Springs, Garner, Zebulon and Wendell, North Carolina. The net book value for our properties, including land, buildings, and furniture and equipment was $12.6 million at December 31, 2007. Additional information disclosed in Note D "Bank Premises and Equipment" to our consolidated financial statements presented under Item 8 of Part II of this Form 10-K. Item 3 - Legal Proceedings. We are not involved in any material legal proceedings at the present time. Item 4 - Submission of Matters to a Vote of Security Holders. None. PART II Item 5 - Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities. Our common stock trades on the OTC Bulletin Board under the symbol "FOFN." The range of high and low bid prices of our common stock for each quarter during the two most recent fiscal years, as published by the OTC Bulletin Board, adjusted for stock splits, is as follows (prices reflect inter-dealer prices, without retail mark-up, mark-down or commissions and may not necessarily represent actual transactions): 16 Fiscal Year Ended December 31, ------------------------------ 2006 2007 ---------------------- ---------------------- High Low High Low ---------- ---------- ---------- ---------- First quarter $ 18.00 $ 16.00 $ 24.77 $ 23.64 Second quarter 23.25 17.64 23.64 20.00 Third quarter 21.82 18.00 20.00 18.82 Fourth quarter 24.55 21.45 19.09 15.50 As of March 6, 2008, the approximate number of holders of record of our common stock was 1,700. We have no other class of equity securities. The bank's ability to declare a dividend to us and the company's ability to pay dividends are subject to the restrictions of the North Carolina Business Corporation Act. There also are state banking laws that require a surplus of at least 50% of paid-in capital stock be maintained in order for the bank to declare a dividend to the company. Subject to the legal availability of funds to pay dividends, cash dividends paid by us in 2007 and 2006, after giving effect to the 10% stock dividend in 2007 and a 5-for-4 stock split during 2006 were $0.29 and $0.24 per share, respectively. We did not sell any securities in 2007 that were not registered under the Securities Act of 1933 as amended. During 2007, we repurchased 75,807 shares of our equity securities registered pursuant to Section 12 of the Securities Exchange Act of 1934, as amended. The following table provides information with respect to purchases made by or on behalf of the Company or any "affiliated purchaser" (as defined in Rule 10b-18(a)(3) under the Exchange Act) of the Company's common stock during the three months ended December 31, 2007:
Total Number of Shares Maximum Number of Total Number Purchased as Part of a Shares That May Yet of Shares Average Price Paid Publicly Announced Be Purchased Under Purchased (1) Per Share Program (2) the Program (2) ----------------------------------------------------------------------------------- October 1, 2007 to October 31, 2007 - - - 390,969 ----------------------------------------------------------------------------------- November 1, 2007 to November 30, 2007 - - - 390,969 ----------------------------------------------------------------------------------- December 1, 2007 to December 31, 2007 1,100 15.95 40,000 350,969 ----------------------------------------------------------------------------------- Total 1,100 15.95 40,000 350,969 -----------------------------------------------------------------------------------
(1) This represents purchases of stock by the company on behalf of the Employee Stock Ownership Plan. (2) The company is authorized to repurchase shares of its common stock through a program first approved by its board of directors in 2001. The program currently approved by the company's board of directors extends through December 31, 2008 and allows the company to repurchase up to an aggregate of 500,000 shares, with the limit aggregated from 2001 through December 31, 2008. The company repurchased 40,000 shares of stock under the program during the three months ended December 31, 2007. As of December 31, 2007, of the 500,000 authorized shares of its common stock designated for repurchase an aggregate of 149,031 shares have already been repurchased and 350,969 shares remained authorized for repurchase under the program. Item 6 - Selected Financial Data The following table sets forth certain historical consolidated financial data for the periods indicated. The selected historical annual consolidated statement of operations and balance sheet data as of each of the fiscal years ended December 31, 2007 and 2006 and are derived from, and are qualified in their entirety by, our audited consolidated financial statements included elsewhere in this report. The selected historical annual consolidated statement of operations data for each of the years ended December 31, 2004 and 2003 and balance sheet date as of each of the years ended December 31, 2005, 2004 and 2003 are derived from audited consolidated financial statements not included herein. Historical results are not necessarily indicative of the results to be expected in the future. You should read the following data together with "Item 1. Business," "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations," and our audited consolidated financial statements and the related notes appearing in "Item 8. Financial Statements." (dollars in thousands, except per share data). 17
As of and for the Year Ended December 31, -------------------------------------------------------------------- 2007 2006 2005 2004 2003 ------------ ------------ ------------ ------------ ------------ Operating Data: Total interest income $ 47,513 $ 40,556 $ 29,404 $ 21,748 $ 18,943 Total interest expense 23,699 17,817 9,983 5,811 5,922 ------------ ------------ ------------ ------------ ------------ Net interest income 23,814 22,739 19,421 15,937 13,021 Provision for loan losses 1,362 873 1,403 1,596 1,373 ------------ ------------ ------------ ------------ ------------ Net interest income after provision 22,452 21,866 18,018 14,341 11,648 Noninterest income 4,071 4,337 3,077 3,849 3,470 Noninterest expense 17,684 15,559 13,354 11,507 10,588 ------------ ------------ ------------ ------------ ------------ Income before income taxes 8,839 10,644 7,741 6,683 4,530 Provision for income taxes 3,187 3,627 2,738 2,308 1,612 ------------ ------------ ------------ ------------ ------------ Net income $ 5,652 $ 7,017 $ 5,003 $ 4,375 $ 2,918 ============ ============ ============ ============ ============ Per Share Data: (Note A) Earnings per share - basic $ 0.92 $ 1.15 $ 0.84 $ 0.75 $ 0.51 Earnings per share - diluted 0.91 1.14 0.83 0.75 0.50 Cash dividends declared 0.29 0.24 0.22 0.19 0.16 Market price High 24.77 28.00 25.00 20.00 16.64 Low 15.50 17.40 17.60 13.44 11.26 Close 15.75 26.75 22.61 17.60 13.44 Book value 8.86 8.04 6.91 6.31 5.72 Weighted average shares outstanding Basic 6,170,140 6,080,778 5,972,073 5,839,186 5,768,245 Diluted 6,192,559 6,137,222 6,016,319 5,872,418 5,788,820 Selected Year-End Balance Sheet Data: Total assets $ 708,303 $ 608,137 $ 522,872 $ 398,500 $ 341,721 Loans 545,270 461,763 397,094 312,815 272,623 Allowance for loan losses 6,653 5,566 4,965 4,055 3,430 Deposits 537,763 466,868 398,341 315,307 272,918 Short-term borrowings 97,000 73,400 74,140 43,160 33,160 Subordinated Debentures 12,372 12,372 - - - Shareholders' equity 54,630 49,323 41,612 37,295 32,880 Selected Average Balances: Total assets $ 655,157 $ 560,689 $ 449,462 $ 376,422 $ 324,222 Loans 494,426 426,768 351,103 298,783 249,240 Total interest-earning assets 619,340 528,056 419,307 349,596 300,672 Deposits 505,494 435,991 355,214 295,524 255,038 Total interest-bearing liabilities 521,957 435,131 340,798 282,743 244,024 Shareholders' Equity 52,246 45,541 39,613 35,135 32,341 Selected Performance Ratios: Return on average assets 0.86% 1.25% 1.11% 1.16% 0.90% Return on average equity 10.82% 15.41% 12.63% 12.45% 9.02% Net interest spread 3.13% 3.59% 4.08% 4.16% 3.87% Net interest margin (yield) 3.84% 4.31% 4.63% 4.56% 4.33% Net Income to average daily deposits 1.12% 1.61% 1.41% 1.48% 1.14% Noninterest income to total revenue 7.89% 9.66% 9.47% 15.04% 15.48% Noninterest income to average assets 0.62% 0.77% 0.68% 1.02% 1.07% Noninterest expense to average assets 2.70% 2.77% 2.97% 3.06% 3.27% Efficiency ratio 63.49% 57.43% 58.51% 58.58% 66.15% Dividend payout ratio 31.66% 20.80% 26.26% 25.36% 31.63%
18
2007 2006 2005 2004 2003 ------------ ------------ ------------ ------------ ------------ Asset Quality Ratios: Nonperforming loans to period-end loans 0.23% 0.18% 0.25% 0.30% 0.39% Allowance for loan losses to period-end loans 1.22% 1.21% 1.25% 1.30% 1.26% Allowance for loan losses to nonperforming loans 530.54% 663.41% 497.99% 429.56% 323.89% Nonperforming assets to total assets 0.42% 0.20% 0.25% 0.39% 0.52% Net loan charge-offs to average loans 0.06% 0.06% 0.14% 0.32% 0.32% Capital Ratios: Total risk-based capital - Bank 10.71% 11.63% 10.40% 11.80% 12.30% Tier 1 risk-based capital - Bank 11.88% 12.79% 9.19% 10.60% 11.10% Leverage ratio - Bank 8.85% 9.31% 7.66% 8.60% 9.00% Equity to assets ratio 7.71% 8.11% 7.96% 9.36% 9.62% Equity to assets ratio (averages) 7.97% 8.12% 8.81% 9.33% 9.97% Average interest earning assets to average total assets 94.53% 94.18% 93.29% 92.87% 92.74% Average loans to average total deposits 97.81% 97.88% 98.84% 101.10% 97.73% Average interest bearing liabilities to average interest earning assets 84.28% 82.40% 81.28% 80.88% 81.16% Other Data: Number of banking offices 14 13 12 10 10 Number of full time equivalent employees 177 156 135 131 126
Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations. The following discussion and analysis provides information about the major components of our results of operations and financial condition, liquidity and capital resources and should be read in conjunction with our audited consolidated financial statements and notes thereto which are contained in this report. Additional discussion and analysis related to fiscal year 2007 is contained in our Quarterly Reports on Form 10-Q for the fiscal quarters ended March 31, 2007, June 30, 2007 and September 30, 2007, respectively. Overview As a community-focused commercial bank, our primary business consists of providing a full range of banking services to our customers with an emphasis on quality personal service. Our core products consist of loans secured by real estate and commercial and consumer loans as well as various deposit products to meet our customers' needs. Our primary source of income is generated from net interest income, the difference between interest income received on our loans and securities and interest expense paid on deposits and borrowings. Our income is also affected by our ability to price our products competitively and maximize the interest rate spread between the interest yield on loans and securities and the interest rate paid on deposits and borrowings. Our products also generate other income through product related fees and commissions. We incur operating expenses consisting primarily of salaries and benefits, occupancy and equipment and other professional and miscellaneous expenses. Our assets have increased from $341.7 million at December 31, 2003 to $708.3 million at December 31, 2007, primarily due to increased loan demand, while our total deposits have increased from $272.9 million to $537.8 million over that same period. In addition, for 71 consecutive years, we have paid dividends (prior to 1997 when we reorganized into a holding company, it was our wholly owned subsidiary, Four Oaks Bank & Trust Company, which paid dividends). For the past five years, dividends have averaged 26.4% of our average net income. Return on average equity and return on average assets for 2007 were 10.82% and .86%, respectively, decreasing from returns of 15.41% and 1.25%, respectively, for 2006. We set interest rates on deposits and loans at competitive rates. We have maintained spreads of 3.13% and 3.59% in 2007 and 2006, respectively, between interest earned on average loans and investments and interest paid on average interest-bearing deposits and borrowings. Our gross loans have increased from $272.6 million at December 31, 2003 to $545.3 million at December 31, 2007; while our average net annual charge-offs over the same period were approximately $563,000. The sustained growth provided by operations resulted in increases in total assets of 16.5%, 16.3%, and 31.2%, for 2007, 2006 and 2005, respectively. Our gross loans grew 18.1% and 16.3% in 2007 and 2006, respectively. Our total investments (including interest-earning deposits and FHLB stock) increased 12.7% and 16.9% in 2007 and 2006, respectively, due to the decision to build the portfolio as yields have continued to improve throughout 2006 and 2007. We closely monitor changes in the financial markets in order to maximize the yield on our assets. The growth in loans for 2007 and 2006 was funded by deposit growth of 15.2% and 17.2%, respectively. Earnings decreased in 2007, ending the year with net income of $5.7 million, a decrease of 19.5% over 2006's net income of $7.0 million, as a result of a challenging economic environment. 19 During 2007 and 2006, Four Oaks Mortgage Company, L.P. provided secondary market-type mortgages which contributed $112,000 and $135,000 to our revenue for the years 2007 and 2006, respectively. Four Oaks Mortgage Company, L.P. is owned 49.99% by our wholly owned subsidiary, Four Oaks Mortgage Services, L.L.C., and 50.01% by its general partner, CTX Mortgage Ventures, LLC, a wholly owned indirect subsidiary of Centex Corporation. In December 2004, we added the Retail Real Estate Lending division, which works with individuals, developers and contractors involved in real estate acquisition and development. Management historically has attempted to monitor and control increases in overhead expenses while being committed to developing the skills and enhancing the professionalism of our employees. Employee turnover has been minimal historically, while the number of our full-time equivalent employees has increased from 126 at December 31, 2003 to 177 at December 31, 2007. As described in more detail in the Business section of this Annual Report on Form 10-K, on December 10, 2008, we announced that we had entered into a definitive agreement with LongLeaf pursuant to which LongLeaf will merge with and into the bank. Subject to receipt of approval by LongLeaf's shareholders and certain other closing conditions, we plan to consummate the bank merger in the second quarter of 2008. While the proposed merger will likely dilute our earnings per share for the period in which it is completed, subject to the amount and timing of projected cost savings that the proposed merger realizes and to the amount of merger-related expenses charged against our earnings, it is expected that the proposed merger will be accretive to its earnings in future periods. Results of Operations Comparison of Financial Condition at December 31, 2007 and 2006 During 2007, our total assets increased by $100.2 million, or 16.5%, from $608.1 million at December 31, 2006 to $708.3 million at December 31, 2007. This increase in our total assets resulted primarily from growth in our net loans, which increased from $456.2 million at December 31, 2006 to $538.6 million at December 31, 2007, an increase of $82.4 million, or 18.1%. The sustained growth in our loan portfolio continues to reflect a trend towards growth in commercial real estate lending primarily in real estate construction as a result of a continued shift in our markets from an agricultural focus to a suburban focus. Loans secured by real estate at December 31, 2007 of which $58.0 million was related to construction and land development loans, grew $78.4 million over 2006. In addition to loan growth, our securities portfolio increased $12.9 million to $114.3 million at December 31, 2007 from $101.4 million at December 31, 2006. Our loan growth and increases in our securities portfolio were primarily funded by deposit growth of $70.9 million, or 15.2%, during 2007 to $537.8 million at December 31, 2007 compared with $466.9 million at December 31, 2006. Our local market customers continue to be our primary source for deposit growth, funding deposit growth predominantly in savings and time deposits. Deposits from our local market customers provided $65.6 million of the December 31, 2007 increase in deposits over December 31, 2006, and with the remaining $5.3 million increase coming from deposits outside our local customer base. We believe the growth in deposits was encouraged by targeted deposit campaigns and branch calling efforts within our competitive market, in spite of the national prime decrease from 8.25% at January 1, 2007 to 7.25% at December 31, 2007. Shareholders' equity increased by $5.3 million as of December 31, 2007 as compared to December 31, 2006. This increase resulted from our net income of $5.7 million, dividend reinvestment plan proceeds of $1.3 million, proceeds from the exercise of stock options of $362,000 and employee stock purchase plan proceeds of $141,000, net of dividends paid of $1.8 million, stock repurchase expenses of $1.5 million and other comprehensive gain of $855,000 comprised of unrealized gains on securities available for sale of $613,000, net of tax and unrealized gains on cash flow hedging activities of $242,000 net of tax. 20 Comparison of Operating Results for the Years Ended December 31, 2007 and 2006 Net Income During 2007, we earned net income of $5.7 million, or $.92 basic net income per share, which was a 19.5% decrease over 2006 net income of $7.0 million, or $1.15 basic net income per share. Increased competition for deposits in our local markets caused interest expense to increase, causing a decline in our net interest margin. The resulting $1.1 million, or 4.7%, increase in interest income failed to absorb a 13.7% increase in non-interest expense for 2007 over 2006. A full year of opening and operating two new full-service offices during 2007 contributed to increased salaries and benefits, occupancy and equipment and other operating costs, along with costs associated with the completion of the new building for Zebulon and the upfitting of the new Dunn location. In addition to the new offices, rising costs in employee salaries contributed to increased personnel expense in 2007. Compliance costs related to the Sarbanes-Oxley Act of 2002 increased costs for outside professional services for 2007. Net Interest Income Like most financial institutions, the primary component of earnings for the bank is net interest income. Net interest income is the difference between interest income, principally from loan and investment securities, and interest expense, principally on customer deposits and borrowings. Changes in net interest income result from changes in volume, spread and margin. For this purpose, volume refers to the average dollar level of interest-earning assets and interest-bearing liabilities, spread refers to the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities, and margin refers to net interest income divided by average interest-earning assets. Margin is influenced by the level and relative mix of interest-earning assets and interest-bearing liabilities, as well as by levels of non-interest-bearing liabilities and capital. Net interest income increased by $1.1 million to $23.8 million in 2007, with a net yield of 3.84% compared to $22.7 million and a net yield of 4.31% in 2006. However, the yield for 2007 decreased overall 47 basis points from 2006 due to the increasing costs of deposits and borrowings. The increase in net interest income primarily was generated by an increased volume of $5.4 million in average net interest-earning assets, which produced $1.1 million in net interest income. The additional interest income over interest expense was driven by steady loan growth, acquisition of higher yielding investments as well as an increase of $2.1 million in average non-interest-bearing demand deposits. The rates earned on a substantial portion of our loans reprice to correspond with each prime rate increase. Most of our interest-bearing liabilities, however, have fixed interest rates until maturity and as a result do not reprice as quickly or in the same increments as our loan portfolio. The national prime decreased 100 basis points during 2007 to 7.25% at December 31, 2007 from 8.25% at January 1, 2007. Prime rate decreased three times in late 2007, which accounts for the decrease in net interest margin for 2007. On average, our interest-earning assets grew $91.3 million during 2007 over 2006. A substantial portion of the increase in interest-earning assets was achieved through increased loan demand. Average loans increased by $67.7 million during 2007 over 2006 to $494.4 million, generating additional interest income of $5.5 million. An increase in volume of interest-bearing liabilities of $85.8 million in 2007 resulted in additional interest expense of $3.7 million, while increased competition for deposits in our local markets resulted in increased interest expense of $2.2 million. The increase in interest expense in 2007 primarily resulted from a $27.0 million increase in more expensive other time deposits at an average rate paid on these deposits of 5.02%, which was an increase of 77 basis points over 2006. However, an increase of $36.7 million in less expensive NOW and money market deposits at an average rate paid of 3.59% and an increase of $2.1 million in interest free demand deposits in 2007 partially offset the increased cost of other time deposits. Interest expense on subordinated debt associated with our Trust Preferred Securities increased from $626,000 in 2006 to $850,000 in 2007. The average outstanding balance of subordinated debt increased from $9.4 million in 2006 to $12.4 million in 2007, as we completed a $12 million offering of Trust Preferred Securities in late March 2006. The Trust Preferred Securities pay cumulative cash distributions quarterly at an annual rate, reset quarterly, equal to three month LIBOR plus 1.35%. Provision for Loan Losses and Asset Quality Our provision for loan losses was $1.4 million during 2007 and $873,000 million during 2006. Net charge-offs in 2007 increased to $275,000 compared to $272,000 in 2006. As a percent of average loans, net charge-offs were 0.06%, the lowest level in the past five years and unchanged from 2006. The lower level of net-charge-offs and nonperforming assets is attributable to continued efforts to improve asset quality, including improved underwriting. 21 The provision for loan losses is charged to bring the allowance for loan losses to the level deemed appropriate by management after adjusting for recoveries of amounts previously charged off. Loans are charged against the allowance for loan losses when management believes that the uncollectibility of a loan balance is confirmed. The allowance for loan losses is maintained at a level deemed adequate to absorb probable losses inherent in the loan portfolio and results from management's consideration of such factors as the financial condition of borrowers, past and expected loss experience, current economic conditions, and other factors management feels deserve recognition in establishing an appropriate reserve. Although management attempts to maintain the allowance at a level deemed adequate, future additions to the allowance may be necessary based upon changes in market conditions or the status of the loans included in the loan portfolio. In addition, various regulatory agencies periodically review our allowance for loan losses. These agencies may require us to make adjustments based upon their judgments about information available to them at the time of their examination. See "Allowance for Loan Losses and Summary of Loan Loss Experience" below. We evaluate our loan portfolio in accordance with Statement of Financial Accounting Standards ("SFAS") No. 114, Accounting by Creditors for Impairment of a Loan, as amended by SFAS No. 118, Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosures. Under these standards, a loan is considered impaired, based on current information and events, if it is probable that we will be unable to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan agreement. Uncollateralized loans are measured for impairment based on the present value of expected future cash flows discounted at the historical effective interest rate or the loan's observable market price, while all collateral-dependent loans are measured for impairment based on the fair value of the collateral. If the recorded investment in the loan exceeds the measure of fair value, a valuation allowance is established as a component of the allowance for loan losses. This evaluation is inherently subjective as it requires material estimates that may be susceptible to significant change. Our non-performing assets, which consist of loans past due 90 days or more, real estate acquired in the settlement of loans, and loans in nonaccrual status, increased to $3.0 million at December 31, 2007 from $1.3 million at December 31, 2006. This increase was primarily due to properties valued at approximately $2.6 million being added to other real estate owned during 2007, and to a lesser degree, the contraction of the housing market and subsequent slowdown of real estate construction. Our allowance for loan losses, expressed as a percentage of gross loans, was 1.22% and 1.21% at December 31, 2007 and 2006, respectively. At December 31, 2007, the allowance for loan losses amounted to $6.7 million, which management believes is adequate to absorb losses inherent in our loan portfolio. Non-interest Income Non-interest income before gains and losses on sales of securities, hedging activity and loans decreased $744,000, or 16.1%, from $4.6 million during 2006 to $3.9 million in 2007. Our non-interest income is comprised primarily of service charges on deposit accounts, financial services commissions, merchant fees, changes in the value of bank-owned life insurance and various other sources of miscellaneous operating income. Net gains of $512,000 on sales of investment securities and interest rate hedging activity were recognized in 2007. The primary component of the decrease in non-interest income is a loss on the surrender of the previous bank-owned life insurance policy and the subsequent purchase of a new policy, resulting in a net loss of $205,000 for the year ended December 31, 2007, as compared to a net gain of $549,000 in 2006. Non-interest Expense Our non-interest expense increased from $15.5 million in 2006 to $17.7 million in 2007, an increase of $2.2 million. Although our non-interest expense has continued to increase, our non-interest expense as a percent of our average assets has declined over the last five years, down to 2.70% for 2007, our lowest level in the last five years. Approximately 70.3% of the $2.2 million increase in non-interest expense over 2006 was due to increases in salaries and benefits. Salaries increased 17.9% while employee benefits increased 14.4%, primarily due a 13.5% increase in the number of employees in 2007 over 2006. In addition to normal salary increases and increased costs for employee benefits overall, personnel costs grew due to additional staffing needs throughout the bank. In total, our number of full time equivalent employees grew from 156 employees for the year 2006 to 177 employees for the year 2007. The increased personnel costs reflect the costs of additional personnel for the new Dunn loan production office as well as increased staffing for the administration and operations departments. In addition to personnel costs, additional costs during 2007 were incurred for occupancy expense. For 2007, occupancy expense increased $118,000 over 2006. Additional testing and documentation required for compliance with the Sarbanes-Oxley Act of 2002 continued to increase our fees paid for outside professional services in 2007, contributing to an increase of $80,000 over 2006. The primary increases in other non-interest expense for 2007 over 2006 included advertising expense, up $28,000, printing and office supplies, up $21,000, auto expense, up $17,000, meals, entertainment and travel, up $30,000, donations and charities expense, up $58,000, ATM expense, up $77,000, postage, up $32,000, and expenses relating to the collection of non-performing loans and sale of repossessed assets, up $34,000. There were no other significant increases in the remaining other non-interest expense categories. 22 Comparison of Operating Results for the Years Ended December 31, 2006 and 2005 Net Income During 2006, we earned net income of $7.0 million, or $1.15 basic net income per share, which was a 40.3% increase over 2005 net income of $5.0 million, or $0.84 basic net income per share. We believe strategic pricing of both our loans and deposits improved our net interest margin by managing our overall cost of funds and allowing us to attract the higher balance, higher quality loans in our markets. The resulting $3.3 million, or 17.1%, increase in net interest income absorbed a 16.5% increase in non-interest expense for 2006 over 2005. A full year of opening and operating two new full-service offices during 2006 contributed to increased salaries and benefits, occupancy and equipment and other operating costs, along with costs associated with the completion of the new building for Wallace and the upfitting of the new Sanford location. In addition to the new offices, rising costs in employee benefits contributed to increased personnel expense. Compliance costs related to Sarbanes-Oxley increased costs for outside professional services. Net Interest Income Net interest income increased by $3.3 million to $22.7 million in 2006, with a net yield of 4.31% compared to $19.4 million and a net yield of 4.63% in 2005. However, the 2006 yield decreased an overall 32 basis points from 2005 due to the increasing costs of deposits and borrowings. The increase in net interest income primarily was generated by an increased volume of $14.4 million in average net interest-earning assets, which produced $3.3 million in net interest income. The additional interest income over interest expense was driven by strong loan demand in a rising rate environment, acquisition of higher yielding investments as well as an increase of $7.6 million in average non-interest-bearing demand deposits. The rates earned on a substantial portion of our loans reprice to correspond with each prime rate increase. Most of our interest-bearing liabilities, however, have fixed interest rates until maturity and as a result do not reprice as quickly or in the same increments as our loan portfolio. The national prime increased 100 basis points during 2006 to 8.25% at December 31, 2006 from 7.25% at January 1, 2006. Since the last prime rate increase was June 29, 2006, our loan repricing leveled off in the latter part of 2006, while our deposits continued to reprice upwards as they reached maturity, which accounts for the decrease in net interest margin for 2006. On average, interest-earning assets grew $108.7 million during 2006 over 2005. A substantial portion of the increase in interest-earning assets was achieved through increased loan demand. Average loans increased $75.7 million during 2006 over 2005 to $426.8 million, generating additional interest income of $3.6 million. Rising interest rates generated additional interest income of $2.8 million on the bank's loan portfolio. An increase in volume of interest-bearing liabilities of $94.3 million resulted in additional interest expense of $3.6 million while repricing due to rising interest rates increased interest expense by $4.2 million. The increase in interest expense primarily resulted from a $33.2 million increase in higher costing jumbo time deposits at an average rate paid on these deposits of 4.42% an increase of 113 basis points over 2005. However, an increase of $24.5 million in lower costing NOW and money market deposits at an average rate paid of 2.89% and an increase of $7.6 million in interest free demand deposits partially offset the increased cost of the jumbo time deposits. Interest expense on subordinated debt associated with our offering of the Trust Preferred Securities increased from zero in 2005 to $626,000 in 2006. The average outstanding balance of subordinated debt increased from zero in 2005 to $9.4 million in 2006, as we completed a $12 million offering of Trust Preferred Securities in late March 2006. The Trust Preferred Securities pay cumulative cash distributions quarterly at an annual rate, reset quarterly, equal to three month LIBOR plus 1.35%. Provision for Loan Losses and Asset Quality Our provision for loan losses was $873,000 during 2006 and $1.4 million during 2005. Net charge-offs in 2006 declined to $272,000 compared to $493,000 in 2005. As a percent of average loans, net charge-offs were 0.06%, the lowest level in the past five years. The lower level of net-charge-offs and nonperforming assets is attributable to continued efforts to improve asset quality, including improved underwriting. 23 The provision for loan losses is charged to bring the allowance for loan losses to the level deemed appropriate by management after adjusting for recoveries of amounts previously charged off. Loans are charged against the allowance for loan losses when management believes that the uncollectibility of a loan balance is confirmed. The allowance for loan losses is maintained at a level deemed adequate to absorb probable losses inherent in the loan portfolio and results from management's consideration of such factors as the financial condition of borrowers, past and expected loss experience, current economic conditions, and other factors management feels deserve recognition in establishing an appropriate reserve. Although management attempts to maintain the allowance at a level deemed adequate, future additions to the allowance may be necessary based upon changes in market conditions or the status of the loans included in the loan portfolio. In addition, various regulatory agencies periodically review our allowance for loan losses. These agencies may require us to make adjustments based upon their judgments about information available to them at the time of their examination. See "Allowance for Loan Losses and Summary of Loan Loss Experience" below. We evaluate our loan portfolio in accordance with Statement of Financial Accounting Standards ("SFAS") No. 114, Accounting by Creditors for Impairment of a Loan, as amended by SFAS No. 118, Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosures. Under these standards, a loan is considered impaired, based on current information and events, if it is probable that we will be unable to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan agreement. Uncollateralized loans are measured for impairment based on the present value of expected future cash flows discounted at the historical effective interest rate or the loan's observable market price, while all collateral-dependent loans are measured for impairment based on the fair value of the collateral. If the recorded investment in the loan exceeds the measure of fair value, a valuation allowance is established as a component of the allowance for loan losses. This evaluation is inherently subjective as it requires material estimates that may be susceptible to significant change. Our non-performing assets, which consist of loans past due 90 days or more, real estate acquired in the settlement of loans, and loans in nonaccrual status, remained unchanged at $1.3 million at December 31, 2005 and December 31, 2006. Our allowance for loan losses, expressed as a percentage of gross loans, was 1.21% and 1.25% at December 31, 2006 and 2005, respectively. At December 31, 2006, the allowance for loan losses amounted to $5.6 million, which management believes is adequate to absorb losses inherent in our loan portfolio. Non-interest Income Non-interest income before gains and losses on sales of securities, hedging activity and loans increased $756,000, or 19.9%, from $3.8 million during 2005 to $4.6 million in 2006. Our non-interest income is comprised primarily of service charges on deposit accounts, financial services commissions, merchant fees, bank-owned life insurance income and various other sources of miscellaneous operating income. Fees charged on deposit accounts, our largest component of non-interest income, increased $178,000 for 2006 compared to 2005, primarily due to an increase in overdraft charges. Merchant fees increased $13,000 from $389,000 during 2005 to $402,000 in 2006, primarily due to increased customer use of debit cards. During the same period, other service charges, commissions and fees increased $316,000, of which $29,000 was attributable to increased profits from our investment in Four Oaks Mortgage Company, L.P., $117,000 was attributable to increased commissions from our financial services department, $235,000 was attributable to the return on investment in the Triangle Mezzanine Fund and $19,000 from the equity earnings in The Four Oaks Statutory Trust. Income from bank-owned life insurance increased $249,000. Net gains of $400,000 on sales of investment securities and interest rate hedging activity were recognized in 2006. Our net gains on sales of loans increased to $103,000 in 2006 from $61,000 recorded in 2005. The increase in loan sales was driven by strong loan demand in a rising rate environment. 24 Non-interest Expense Our non-interest expense increased from $13.4 million in 2005 to $15.5 million in 2006, an increase of $2.1 million. Although our non-interest expense has continued to increase, our non-interest expense as a percent of our average assets has declined over the last five years, down to 2.76% for 2006, our lowest level in the last five years. Approximately 60.7% of the $2.1 million increase in non-interest expense over 2005 was due to increases in salaries and benefits. Salaries increased 18.7% while employee benefits increased 13.0%, primarily due a 15.6% increase in the number of employees in 2006 over 2005. In addition to normal salary increases and increased costs for employee benefits overall, personnel costs grew due to additional staffing needs throughout the bank. In total, our number of full time equivalent employees grew from 135 employees for the year 2005 to 156 employees for the year 2006. The increased personnel costs reflect the costs of a full year of staffing for our new Zebulon office which opened in January 2006, and the increased staffing in Sanford when we converted that office from a loan production office to a full-service branch. In addition to personnel costs, additional costs during 2006 were incurred in occupancy and equipment due to the additional staff, operating new offices, as well as general upgrades in technology throughout the bank. For 2006, occupancy and equipment expense increased $132,000 and $125,000, respectively, over 2005. Additional testing and documentation required for compliance with the Sarbanes-Oxley Act of 2002 continued to increase our fees paid for outside professional services in 2006, contributing to an increase of $218,000 in professional and consulting fees over 2005. The primary increases in other non-interest expense for 2006 over 2005 included advertising expense, up $111,000, printing and office supplies, up $42,000, telephone expense, up $15,000, auto expense, up $18,000, directors fees, up $26,000, meals, entertainment and travel, up $24,000, donations and charities expense up, $21,000, ATM expense, up $20,000, and servicing expense, up $16,000. There were no other significant increases in the remaining other non-interest expense categories. (The remainder of this page left blank.) 25 Liquidity and Capital Resources Our liquidity position is primarily dependent upon the bank's need to respond to loan demand, the short-term demand for funds caused by withdrawals from deposit accounts (other than time deposits) and the liquidity of its assets. The bank's primary liquidity sources include cash and amounts due from other banks, U.S Government Agency and other short-term investment securities. In addition, the bank has the ability to borrow funds from the Federal Reserve Bank and the Federal Home Loan Bank of Atlanta ("FHLB"), to purchase federal funds from other financial institutions, to obtain wholesale deposits, and repurchase agreements. At December 31, 2007, the bank had available lines of credit totaling $54.7 million with the FHLB and $22.7 million lines of credit from various financial institutions to purchase federal funds. As of December 31, 2007, we have no outstanding commitments for facility construction. Management believes that our liquidity sources are adequate to meet our operating needs and the operating needs of the bank for the next eighteen months. Total shareholders' equity was $54.6 million, or 7.71% of total assets at December 31, 2007, and $49.3 million or 8.11% of total assets at December 31, 2006. Off-Balance Sheet Arrangements As part of its normal course of business to meet the financing needs of its customers, the bank is at times a party to financial instruments with off-balance sheet credit risk. Such instruments include commitments to extend credit and standby letters of credit. At December 31, 2007, the bank's outstanding commitments to extend credit consisted of undisbursed lines of credit, other commitments to extend, undisbursed portion of construction loans and stand-by letters of credit of $144.1 million. Additional detail regarding the bank's off-balance sheet risk exposure is presented in Note J and K to the accompanying consolidated financial statements. Interest Rate Sensitivity Analysis As a part of our interest rate risk management policy, we periodically perform an interest rate sensitivity analysis. Interest rate sensitivity analysis is a common, though imperfect, measure of interest rate risk, which measures the relative dollar amounts of interest-earning assets and interest-bearing liabilities that reprice within a specific time period, either through maturity or rate adjustment. Any resulting interest rate "gap" is the difference between the amounts of such assets and liabilities that are subject to repricing. A positive gap for a given period means that the amount of interest-earning assets maturing or otherwise repricing within that period exceeds the amount of interest-bearing liabilities maturing or otherwise repricing within the same period. Accordingly, in a declining interest rate environment, an institution with a positive gap would generally be expected, absent the effects of other factors, to experience a decrease in the yield on its assets greater than the decrease in the cost of its liabilities, and its net interest income should be negatively affected. Conversely, the yield on its assets for an institution with a positive gap would generally be expected to increase more quickly than the cost of funds in a rising interest rate environment, and such institution's net interest income generally would be expected to be positively affected by rising interest rates. Changes in interest rates generally have the opposite effect on an institution with a negative gap. The table below sets forth the amounts of our interest-earning assets and interest-bearing liabilities outstanding as of December 31, 2007 that are projected to reprice or mature in each of the future time periods shown. Except as stated below, the amounts of assets and liabilities shown that reprice or mature within a particular period were determined in accordance with the contractual terms of the assets or liabilities. Loans with adjustable rates are shown as being due at the end of the next upcoming adjustment period. Money market deposit accounts and negotiable order of withdrawal or other transaction accounts are assumed to be subject to immediate repricing and depositor availability and have been placed in the shortest period. In making the gap computations, none of the traditional assumptions regarding prepayment rates and deposit decay rates have been used for any interest-earning assets or interest-bearing liabilities. In addition, the table does not reflect scheduled principal payments that will be received throughout the lives of the loans or investments. The interest rate sensitivity of our assets and liabilities illustrated in the following table would vary substantially if different assumptions were used or if actual experience differs from that indicated by such assumptions. (dollars in thousands). 26
Interest Rate Sensitivity as of December 31, 2007 ---------------------------------------------------------------------------- 3 Months Over 3 Months Total Within Over 12 or Less to 12 Months 12 Months Months Total ------------ ------------ ------------ ------------ ------------ Interest-earning assets: Loans $ 269,976 $ 51,052 $ 321,028 $ 224,242 $ 545,270 Securities available for sale - 590 590 113,711 114,301 Other earning assets 3,881 - 3,881 5,010 8,891 ------------ ------------ ------------ ------------ ------------ Total interest-earning assets $ 273,857 $ 51,642 $ 325,499 $ 342,963 $ 668,462 ============ ============ ============ ============ ============ Percent of total interest-earning assets 40.97% 7.73% 48.69% 51.31% 100.00% Cumulative percent of total interest- earning assets 40.97% 48.69% 48.69% 100.00% 100.00% Interest-bearing liabilities Fixed maturity deposits $ 84,481 $ 176,709 $ 261,190 $ 47,545 $ 308,735 All other deposits 154,341 - 154,341 - 154,341 Borrowings 10,000 10,000 20,000 77,000 97,000 ------------ ------------ ------------ ------------ ------------ Total interest-bearing liabilities $ 248,822 $ 186,709 $ 435,531 $ 124,545 $ 560,076 ============ ============ ============ ============ ============ Percent of total interest-bearing liabilities 44.43% 33.34% 77.76% 22.24% 100.00% Cumulative percent of total interest- bearing liabilities 44.43% 77.76% 77.76% 100.00% 100.00% Interest sensitivity gap $ 25,035 $ (135,067) $ (110,032) $ 218,418 $ 108,386 Cumulative interest sensitivity gap 25,035 (110,032) (110,032) 108,386 108,386 Cumulative interest sensitivity gap as a percent of total interest-earning assets 3.75% -16.46% -16.46% 16.21% 16.21% Cumulative ratio of interest-sensitive assets to interest-sensitive liabilities 110.06% 74.74% 74.74% 119.35% 119.35% Contractual Obligations and Commitments In the normal course of business there are various outstanding contractual obligations that require future cash outflows. The following table shows our expected contractual obligations and future operating lease commitments as of December 31, 2007 (in thousands): Payments Due by Period ---------------------------------------------------------------------------- Less than 1 More than Total year 1-3 years 3-5 years 5 years ------------ ------------ ------------ ------------ ------------ Borrowings $ 97,000 $ 20,000 $ 10,000 $ - $ 67,000 Subordinated debentures 12,372 - - - $ 12,372 Operating leases 1,106 144 265 256 441 Deposits 308,736 261,462 43,723 3,551 - ------------ ------------ ------------ ------------ ------------ Total $ 419,214 $ 281,606 $ 53,988 $ 3,807 $ 79,813 ============ ============ ============ ============ ============
27 The following table shows our undisbursed lines of credit, other commitments to extend, undisbursed portion of construction loans and stand-by letters of credit as of December 31, 2007 (in thousands):
Amount of Commitment Expiration Per Period ---------------------------------------------------------------------------- Less than 1 More than Total year 1-3 years 3-5 years 5 years ------------ ------------ ------------ ------------ ------------ Undisbursed lines of credit $ 33,757 $ 3,509 $ 9,644 $ 1,149 $ 19,455 Other commitments to extend 30,860 22,872 7,302 686 - Undisbursed portion of construction loans 76,894 65,097 10,479 1,134 183 Stand-by letters of credit 2,611 2,399 72 140 - ------------ ------------ ------------ ------------ ------------ Total $ 144,122 $ 93,877 $ 27,497 $ 3,109 $ 19,638 ============ ============ ============ ============ ============
Inflation The effect of inflation on financial institutions differs somewhat from the effect it has on other businesses. The performances of banks, with assets and liabilities that are primarily monetary in nature, are affected more by changes in interest rates than by inflation. Interest rates generally increase as the rate of inflation increases, but the magnitude of the change in rates may not be the same. During periods of high inflation, there are normally corresponding increases in the money supply, and banks will normally experience above average growth in assets, loans and deposits. Also, general increases in the price of goods and services will generally result in increased operating expenses. Income Taxes Income taxes, as a percentage of income before income taxes, for 2007 and 2006 were 36.06% and 34.08%, respectively. The increase was the result of management's redirection of funds between loans and different types of taxable and tax exempt interest-bearing assets in response to economic conditions and the bank's liquidity requirements. 28 Distribution of Assets, Liabilities and Shareholders' Equity; Interest Rates and Interest Differential The following schedule presents average balance sheet information for the years 2007, 2006 and 2005, along with related interest earned and average yields for interest-earning assets and the interest paid and average rates for interest-bearing liabilities. Nonaccrual notes are included in loan amounts.
Average Daily Balances, Interest Income/Expense, Average Yield/Rate For the Years Ended December 31, -------------------------------------------------------------------------------------------- 2007 2006 2005 ------------------------------ ------------------------------ ------------------------------ Average Average Average Average Average Average Balance Interest Rate Balance Interest Rate Balance Interest Rate ---------- ---------- ------ ---------- ---------- ------ ---------- ---------- ------ (dollars in thousands) Interest-earning assets: Loans $ 494,426 $ 40,967 8.29% $ 426,768 $ 35,457 8.31% $ 351,103 $ 26,612 7.58% Investment securities - taxable 111,837 5,873 5.25% 89,195 4,503 5.05% 57,242 2,389 4.17% Investment securities - tax exempt 4,846 178 3.68% 4,123 152 3.69% 3,175 118 3.72% Other interest-earning assets 8,231 495 6.01% 7,970 444 5.57% 7,787 285 3.66% ---------- ---------- ------ ---------- ---------- ------ ---------- ---------- ------ Total interest-earning assets 619,340 47,513 7.67% 528,056 40,556 7.68% 419,307 29,404 7.01% ---------- ------ ---------- ------ ---------- ------ Other assets 35,817 32,633 30,155 ---------- ---------- ---------- Total assets $ 655,157 $ 560,689 $ 449,462 ========== ========== ========== Interest-bearing liabilities: Deposits: NOW and money market deposits $ 107,520 $ 3,860 3.59% $ 71,981 $ 2,079 2.89% $ 57,928 $ 808 1.39% Savings deposits 30,068 800 2.66% 37,304 1,079 2.89% 26,858 599 2.23% Time deposits, $100,000 and over 166,744 8,164 4.90% 157,497 6,961 4.42% 124,248 4,066 3.27% Other time deposits 125,875 6,317 5.02% 96,058 4,083 4.25% 80,610 2,350 2.92% Borrowed funds 79,378 3,708 4.67% 63,885 2,989 4.68% 51,154 2,160 4.22% Subordinated debentures 12,372 850 6.87% 9,389 626 6.67% - - 0.00% ---------- ---------- ------ ---------- ---------- ------ ---------- ---------- ------ Total interest-bearing liabilities 521,958 23,699 4.54% 436,114 17,817 4.09% 340,798 9,983 2.93% ---------- ------ ---------- ------ ---------- ------ Noninterest-bearing deposits 75,286 73,151 65,570 Other liabilities 5,668 5,883 3,481 Stockholders' equity 52,246 45,541 39,613 ---------- ---------- ---------- Total liabilities and stockholders' equity $ 655,157 $ 560,689 $ 449,462 ========== ========== ========== Net interest income and interest rate spread $ 23,814 3.13% $ 22,739 3.59% $ 19,421 4.08% ========== ====== ========== ====== ========== ====== Net yield on average interest- earning assets 3.84% 4.31% 4.63% ====== ====== ====== Ratio of average interest- earning assets to average interest-bearing liabilities 118.66% 121.08% 123.04% ========== ========== ==========
29 The following table shows changes in interest income and expense by category and rate/volume variances for the years ended December 31, 2007 and 2006. The changes due to rate and volume were allocated on their absolute values:
Year Ended Year Ended December 31, 2007 vs. 2006 December 31, 2006 vs. 2005 ---------------------------------- ---------------------------------- Increase (Decrease) Due to Increase (Decrease) Due to ---------------------------------- ---------------------------------- Volume Rate Total Volume Rate Total ---------- ---------- ---------- ---------- ---------- ---------- (In thousands) Interest income: Loans $ 5,614 $ (103) $ 5,511 $ 6,011 $ 2,834 $ 8,845 Investment securities - taxable 1,166 204 1,370 1,473 641 2,114 Investment securities - tax exempt 26 - 26 35 (1) 34 Other interest-earning assets 17 34 51 10 149 159 ---------- ---------- ---------- ---------- ---------- ---------- Total interest income 6,823 135 6,958 7,529 3,623 11,152 ---------- ---------- ---------- ---------- ---------- ---------- Interest expense: Deposits NOW and money market deposits 1,151 630 1,781 301 970 1,271 Savings deposits (202) (77) (279) 268 212 480 Time deposits over $100,000 431 772 1,203 1,279 1,615 2,894 Other time deposits 1,383 851 2,234 552 1,182 1,735 Borrowed funds 725 (6) 719 567 262 829 Subordinated Debentures 202 22 224 626 - 626 ---------- ---------- ---------- ---------- ---------- ---------- Total interest expense 3,690 2,192 5,882 3,593 4,241 7,835 ---------- ---------- ---------- ---------- ---------- ---------- Net interest income increase (decrease) $ 3,133 $ (2,057) $ 1,076 $ 3,936 $ (618) $ 3,317 ========== ========== ========== ========== ========== ==========
Market Risk Like most financial institutions, our most significant market risk exposure is the risk of economic loss resulting from adverse changes in market price and interest rates. This risk of loss can be reflected in diminished current market values and/or reduced potential net interest income in future periods. Our market risk arises primarily from interest rate risk inherent in our lending and deposit-taking activities. The structure of our loan and deposit portfolios is such that a significant decline in interest rates may adversely impact net market values and net interest income. We do not maintain a trading account nor are we subject to currency exchange risk or commodity price risk. Interest rate risk is monitored as part of the bank's asset/liability management function. The following table presents information about the contractual maturities, average interest rates and estimated fair values of our financial instruments we considered market risk sensitive as of December 31, 2007. Loans include nonaccrual loans but not the allowance for loan losses. (dollars in thousands). 30
Beyond Five Average Estimated 2008 2009 2010 2011 2012 Years Total Interest Rate Fair Value ---- ---- ---- ---- ---- ---------- -------- ------------- ------------ Financial Assets Loans: Fixed rate $ 66,072 $ 55,974 $ 57,708 $ 46,845 $ 53,950 $ 9,837 $290,386 7.38% $289,967 Variable Rate 254,884 - - - - - 254,884 7.99% 254,517 Securities available for sale 587 276 12,103 3,524 4,346 92,727 113,561 5.24% 114,301 Other earning assets 3,881 - - - - - 3,881 5.51% 3,881 -------- -------- -------- -------- -------- -------- -------- ----- -------- Total $325,424 $ 56,250 $ 69,811 $ 50,368 $ 58,296 $102,563 $662,712 7.24% $662,666 ======== ======== ======== ======== ======== ======== ======== ======== Financial Liabilities Money market, NOW and savings deposits $154,341 - - - - - $154,341 2.05% $156,641 Time deposits 261,468 16,605 27,111 1,459 2,092 - 308,735 5.03% 301,102 Borrowings 20,000 - 10,000 - - 67,000 97,000 4.67% 99,095 Subordinated debentures - - - 12,372 - - 12,372 6.87% 12,381 -------- -------- -------- -------- -------- -------- -------- ----- -------- Total $435,809 $ 16,605 $ 37,111 $ 13,831 $ 2,092 $ 67,000 $572,448 4.20% $569,219 ======== ======== ======== ======== ======== ======== ======== ========
Derivative Financial Instruments A derivative is a financial instrument that derives its cash flows, and therefore its value, by reference to an underlying instrument, index or reference rate. These instruments primarily consist of interest rate swaps, caps, floors, financial forward and futures contracts and options written or purchased. Derivative contracts are written in amounts referred to as notional amounts. Notional amounts only provide the basis for calculating payments between counterparties and do not represent amounts to be exchanged between parties and are not a measure of financial risk. Credit risk arises when amounts receivable from a counterparty exceed amounts payable. We control our risk of loss on derivative contracts by subjecting counterparties to credit reviews and approvals similar to those used in making loans and other extensions of credit. We have used interest rate swaps in the management of interest rate risk. Interest rate swaps are contractual agreements between two parties to exchange a series of cash flows representing interest payments. A swap allows both parties to alter the repricing characteristics of assets or liabilities without affecting the underlying principal positions. Through the use of a swap, assets and liabilities may be transformed from fixed to floating rates, from floating rates to fixed rates, or from one type of floating rate to another. At December 31, 2007, swap derivatives with a total notional value of $33.3 million, with remaining terms ranging up to three years, were outstanding. Although off-balance sheet derivative financial instruments do not expose us to credit risk equal to the notional amount, such agreements generate credit risk to the extent of the fair value gain in an off-balance sheet derivative financial instrument if the counterparty fails to perform. We minimize such risk by evaluating the creditworthiness of the counterparties and consistently monitoring these agreements. The counterparties to these arrangements are primarily large commercial banks and investment banks. Where appropriate, master netting agreements are arranged or collateral is obtained in the form of rights to securities. At December 31, 2007, our interest rate swaps reflected a net unrealized loss of $16,000. Other risks associated with interest-sensitive derivatives include the effect on fixed rate positions during periods of changing interest rates. Indexed amortizing swaps' notional amounts and maturities change based on certain interest rate indices. Generally, as rates fall the notional amounts decline more rapidly, and as rates increase notional amounts decline more slowly. As of December 31, 2007, we had no indexed amortizing swaps outstanding. Under unusual circumstances, financial derivatives also increase liquidity risk, which could result from an environment of rising interest rates in which derivatives produce negative cash flows while being offset by increased cash flows from variable rate loans. We consider such risk to be insignificant due to the relatively small derivative positions we hold. 31 A discussion of derivatives is presented in Note J to our consolidated financial statements, which are presented under Item 8 of Part II in this Form 10-K. Quarterly Financial Information The following table sets forth, for the periods indicated, certain of our consolidated quarterly financial information. This information is derived from our unaudited financial statements, which include, in the opinion of management, all normal recurring adjustments that management considers necessary for a fair presentation of the results for such periods. This information should be read in conjunction with our consolidated financial statements included under Item 8 of Part II in this Form 10-K. The results for any quarter are not necessarily indicative of results for any future period. (dollars in thousands, except per share data).
Year Ended December 31, 2007 Year Ended December 31, 2006 ------------------------------------------ ------------------------------------------- Fourth Third Second First Fourth Third Second First Quarter Quarter Quarter Quarter Quarter Quarter Quarter Quarter ----------- --------- --------- ---------- ---------- --------- ---------- ----------- Operating Data: Total interest income $ 12,480 $ 12,310 $ 11,594 $ 11,128 $ 11,097 $ 10,547 $ 9,673 $ 9,239 Total interest expense 6,203 6,134 5,891 5,471 5,283 4,762 4,176 3,596 ----------- --------- --------- ---------- ---------- --------- ---------- ----------- Net interest income 6,277 6,176 5,703 5,657 5,814 5,785 5,497 5,643 Provision for loan losses 587 280 232 262 187 332 168 186 ----------- --------- --------- ---------- ---------- --------- ---------- ----------- Net interest income after provision 5,690 5,896 5,471 5,395 5,627 5,453 5,329 5,457 Noninterest income 1,037 1,218 750 1,067 835 1,656 861 923 Noninterest expense 4,510 4,306 4,607 4,262 4,313 3,889 3,786 3,509 ----------- --------- --------- ---------- ---------- --------- ---------- ----------- Income before income taxes 2,218 2,808 1,614 2,200 2,149 3,220 2,404 2,871 Provision for income taxes 876 996 565 750 653 1,074 869 1,031 ----------- --------- --------- ---------- ---------- --------- ---------- ----------- Net income $ 1,341 $ 1,812 $ 1,050 $ 1,450 $ 1,496 $ 2,146 $ 1,535 $ 1,840 =========== ========= ========= ========== ========== ========= ========== =========== Per Share Data: Net income: Basic $ 0.22 $ 0.27 $ 0.17 $ 0.24 $ 0.25 $ 0.35 $ 0.25 $ 0.30 Diluted 0.22 0.27 0.17 0.24 0.24 0.35 0.25 0.30 Cash dividends declared 0.08 0.08 0.07 0.06 0.07 0.06 0.06 0.06 Common stock price: High $ 19.09 $ 20.00 $ 23.64 $ 24.77 $ 24.55 $ 21.82 $ 23.25 $ 18.00 Low 15.50 18.82 20.00 23.64 21.45 18.00 17.64 16.00
32 Investment Portfolio The valuations of investment securities at December 31, 2007, 2006 and 2005, respectively, were as follows (in thousands):
Available for Sale -------------------------------------------------------------------------- 2007 2006 2005 ----------------------------- ---------------------- ------------------- Amortized cost Estimated Amortized Estimated Amortized Estimated fair value cost fair cost fair value value --------------- -------------- ------------- --------- --------- --------- U.S. Government and agency securities $ 92,651 $ 93,208 $ 85,730 $ 85,247 $69,108 $68,431 State and municipal securities 6,136 6,148 4,623 4,609 3,963 3,910 Mortgage-backed securities 12,985 13,087 9,882 9,860 7,003 6,904 Other 1,789 1,858 1,441 1,677 685 964 -------------- ------------- ------------ -------- -------- --------- Total securities $ 113,561 $ 114,301 $ 101,676 $101,393 $80,759 $80,209 ============== ============= ============ ======== ======== ========= Pledged securities $ 98,540 $ 69,239 $65,159 ============= ======== ========= The following table sets forth the carrying value of our available for sale investment portfolio at December 31, 2007 (in thousands): Carrying Value ------------------------------------------------------------------ 1 year After 1 year After 5 After 10 Total through 5 years years years through 10 years ------------ ----------------- ------------ ------------ --------- U.S. Government and agency securities - $ 17,100 $ 69,115 $ 6,994 $ 93,208 State and municipal securities - 1,527 1,413 3,208 6,148 Mortgage-backed securities $ 590 1,682 - 10,815 13,087 Other - - - 1,858 1,858 ------------ ---------------- ----------- ----------- --------- Total $ 590 $ 20,309 $ 70,528 $ 22,874 $114,301 ============ ================ =========== =========== ========= The following table sets forth the weighted average yield by maturity of our available for sale investment portfolio at December 31, 2007 amortized cost: Weighted Average Yields ----------------------------------------------------------------- 1 year After 1 year After 5 After 10 Total through 5 years years years through 10 years ----------- ---------------- ----------- ----------- --------- U.S. Government and agency securities - 4.59% 5.59% 5.62% 5.41% State and municipal securities - 4.12% 4.14% 4.27% 4.20% Mortgage-backed securities 4.27% 4.29% - 5.20% 5.04% Other - - - 4.63% 4.63% ----------- ---------------- ----------- ----------- --------- Total weighted average yields 4.27% 4.53% 5.56% 5.01% 5.24% =========== ================ =========== =========== =========
33 Loan Portfolio
2007 2006 2005 2004 2003 ------------ ------------- ---------- ---------- ------------ Loans secured by real estate: Construction and land development $ 252,449 $ 194,460 $142,592 $ 90,742 $ 66,242 Secured by farmland 12,700 12,326 11,650 15,203 13,384 Secured by 1-4 family residential properties: Revolving open-end loans & lines of credit 24,579 22,868 23,581 23,295 18,879 All other 76,776 68,196 66,140 58,158 55,113 Secured by multifamily residential properties 5,123 3,913 4,085 5,088 3,634 Secured by nonfarm nonresidential properties 110,769 102,217 84,189 72,611 63,372 Loans to finance agricultural production and other loans to farmers 3,119 2,724 3,729 4,020 5,084 Commercial and industrial loans 45,653 37,622 34,166 26,005 27,872 Loans to individuals for household, family and other personal expenditures Credit cards and related plans 4,331 4,778 3,933 3,807 3,574 Other 8,235 11,840 22,438 13,400 14,458 Obligations of states and political subdivisions in the U.S.: Tax exempt obligations 744 199 113 225 332 All other loans 1,030 897 787 628 836 Lease financing receivables 5 5 9 12 13 Deferred cost (unearned income) on loans (243) (283) (318) (379) (170) ------------ ------------- ---------- ---------- ------------ Total loans 545,270 461,763 397,094 312,815 272,623 Allowance for loan losses (6,653) (5,566) (4,965) (4,055) (3,430) ------------ ------------- ---------- ---------- ------------ Net loans $ 538,617 $ 456,197 $392,129 $308,760 $ 269,193 ============ ============= ========== ========== ============ Commitments and contingencies: Commitments to make loans 141,511 140,539 97,183 89,377 68,731 Standby letters of credit 2,611 4,711 4,796 1,726 1,003
34 Certain Loan Maturities The maturities and carrying amounts of certain loans as of December 31, 2007 are summarized as follows (in thousands): Commerical Real Estate Financial Construction and and Land Agricultural Development Total ------------- ------------ ----------- Due within one year $ 44,695 $ 165,523 $ 210,218 Due after one year to five years: Fixed rate 89,350 65,392 154,743 Variable rate 24,130 17,520 41,650 Due after five years: Fixed rate 5,299 1,481 6,780 Variable rate 4,426 - 4,426 ------------- ------------ ----------- Total $ 167,900 $ 249,916 $ 417,816 ============ ============ =========== Risk Elements Past due and nonaccrual loans, as extracted from the Call Reports of December 31, 2007, 2006, 2005, 2004 and 2003 were as follows (in thousands):
2007 2006 2005 2004 2003 --------- ---------- ---------- ---------- --------- Nonaccrual loans: Real estate loans $ 1,038 $ 859 $ 535 $ 614 $ 739 Installment loans 40 58 114 80 96 Commercial and all other loans 176 50 348 250 224 --------- ---------- ---------- ---------- --------- Total $ 1,254 $ 967 $ 997 $ 944 $ 1,059 ========= ========== ========== ==================== Agricultural loans included above $ 164 $ - $ 252 $ 197 $ 110 ========= ========== ========== ========== ========= Past due 90 days or more and still accruing: Real estate loans $ 30 $ 33 $ 64 $ 188 $ 597 Installment loans - - - 1 5 Credit cards and related plans 22 - 10 11 18 Commercial and all other loans - - - 26 15 --------- ---------- ---------- ---------- --------- Total $ 52 $ 33 $ 74 $ 226 $ 635 ========= ========== ========== ========== ========= Agricultural loans included above $ - $ - $ - $ 26 $ - ========= ========== ========== ========== =========
Loans, including impaired loans, are generally classified as nonaccrual if they are past due as to maturity or payment of principal or interest for a period of more than 90 days, unless such loans are well-secured and in the process of collection. The gross interest income that would have been recorded for loans accounted for on a nonaccrual basis at December 31, 2007 was approximately $88,000. This amount represents interest income that would have been recorded if the loans had been current in accordance with their original terms and had been outstanding throughout the period or since origination, if held for part of period. 35 Foreclosed assets (included in other assets) were $1.7 million, $327,000, $247,000, $404,000, and $75,000, at December 31, 2007, 2006, 2005, 2004, and 2003, respectively. The amount of interest recognized on impaired loans during the portion of 2007 that they were impaired was not material. Allowance for Loan Losses and Summary of Loan Loss Experience As a matter of policy, the bank maintains an allowance for loan losses. The allowance for loan losses is created by direct charges to income and by recoveries of amounts previously charged off. The allowance is reduced as losses on loans are charged against the allowance when realized. We evaluate our loan portfolio in accordance with SFAS No. 114, Accounting by Creditors for Impairment of a Loan, as amended by SFAS No. 118, Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosure. Under these standards, a loan is considered impaired, based on current information and events, if it is probable that the company will be unable to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan agreement. Uncollateralized loans are measured for impairment based on the present value of expected future cash flows discounted at the historical effective interest rate or the loan's observable market price, while all collateral-dependent loans are measured for impairment based on the fair value of the collateral. If the recorded investment in the loan exceeds the measure of fair value, a valuation allowance is established as a component of the allowance for loan losses. This evaluation is inherently subjective as it requires material estimates that may be susceptible to significant change. The loan portfolio and the adequacy of the allowance are evaluated by management at least quarterly. In addition, our Loan Committee reviews our loan portfolio and credit quality quarterly. The amount of the allowance is based on management's evaluation of the loan portfolio including trends in composition, growth and terms, historical and expected loan loss experience, economic conditions and conditions that may affect the borrowers' ability to pay, and other factors management deems appropriate. In addition, regulatory examiners may require the bank to recognize changes to the allowance for loan losses based on their judgments about information available to them at the time of their examination. The bank's management believes its allowance for loan losses is adequate under existing economic conditions to absorb loan losses inherent in its loan portfolio. Although management attempts to maintain the allowance at a level deemed adequate, future additions to the allowance may be necessary based upon changes in market conditions or the status of the loans included 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. Loans are charged against the allowance for loan losses when management believes that the uncollectibility of a loan balance is confirmed. In addition to the review of loans considered impaired as discussed above, the allowance for loan losses is also based upon such factors as changes in the trends in volumes and terms of loans, levels and trends of charge-offs and recoveries, national and local economic trends and conditions that may affect the borrowers' ability to pay, effects of changes in risk selection and underwriting standards as well as overall portfolio quality. If conditions change substantially from the assumptions used to evaluate the allowance for loan losses, it is possible that management's assessment of the allowance may change. 36 The following table summarizes the bank's loan loss experience for the years ending December 31, 2007, 2006, 2005, 2004 and 2003 (in thousands, except ratios):
2007 2006 2005 2004 2003 ------------ ------------ ------------ ------------ ------------ Balance at beginning of period $ 5,566 $ 4,965 $ 4,055 $ 3,430 $ 2,860 Charge-offs: Commercial and other 104 135 245 417 311 Real estate 144 87 158 395 342 Installment loans to individuals 217 178 198 237 396 Credit cards and related plans 39 58 95 297 88 ------------ ------------ ------------ ------------ ------------ 504 458 696 1,346 1,137 ------------ ------------ ------------ ------------ ------------ Recoveries: Commercial and other 26 49 49 206 31 Real estate 71 32 19 27 134 Installment loans 88 65 69 56 159 Credit cards and related plans 44 40 66 86 10 ------------ ------------ ------------ ------------ ------------ 229 186 203 375 334 ------------ ------------ ------------ ------------ ------------ Net charge-offs 275 272 493 971 803 ------------ ------------ ------------ ------------ ------------ Additions charged to operations 1,362 873 1,403 1,596 1,373 ------------ ------------ ------------ ------------ ------------ Balance at end of year $ 6,653 $ 5,566 $ 4,965 $ 4,055 $ 3,430 ============ ============ ============ ============ ============ Ratio of net charge-offs during the year to average gross loans outstanding during the year 0.06% 0.06% 0.14% 0.32% 0.32% The following table summarizes the bank's allocation of allowance for loan losses at December 31, 2007, 2006, 2005, 2004 and 2003 (in thousands, except ratios): At December 31, ----------------------------------------------------------------------- 2007 2006 2005 ------------------------- ------------------------ -------------------- Amount % of Total Amount % of Total Amount % of Total Loans (1) Loans (1) Loans (1) ----------------------------------------------------------------------- Real estate loans $ 5,883 88% $ 4,866 87% $ 4,150 84% Commercial and industrial loans 595 9% 486 9% 474 10% Installment loans 153 2% 200 4% 330 7% Unallocated 22 0% 14 0% 11 0% ------------ ------------ ------------ ----------- --------- ---------- Total $ 6,653 100% $ 5,566 100% $ 4,965 100% ============ ============ ============ =========== ========= ==========
37 At December 31, ---------------------------------------------- 2004 2003 -------------------- --------------------- % of Total Amount % of Total Amount Loans (1) Loans (1) -------------------- --------------------- Real estate loans $ 3,432 85% $ 2,773 81% Commercial and industrial loans 389 10% 415 12% Installment loans 223 6% 227 7% Unallocated 11 0% 15 0% --------- ---------- ---------- ---------- Total $ 4,055 100% $ 3,430 100% ========= ========== ========== ========== - ------------------------------------------ (1) Represents total of all outstanding loans in each category as a percentage of total loans outstanding. Deposits Time certificates in amounts of $100,000 or more outstanding at December 31, 2007 by maturity were as follows (in thousands): Three months or less $ 42,167 Over three months through six months 51,296 Over six months through twelve months 39,506 Over twelve months through three years 37,671 Over three years 1,873 ----------- Total $ 172,513 =========== Borrowings The bank borrows funds principally from the FHLB. Information regarding such borrowings is as follows (in thousands, except rates): 2007 2006 2005 ----------- ----------- ------------ Balance outstanding at December 31 $ 97,000 $ 70,000 $ 63,000 Weighted average rate at December 31 4.44% 4.65% 4.44% Maximum borrowings during the year $ 97,000 $ 70,000 $ 63,000 Average amounts outstanding during year $ 78,405 $ 62,103 $ 48,945 Weighted average rate during year 4.73% 4.65% 4.23% There were no short-term advances outstanding from the FHLB at December 31, 2007 and 2006. For 2007 and 2006, average outstanding short-term balances were $973,000 and $1,221,000, respectively. In addition, the bank may purchase federal funds through unsecured federal funds lines of credit with various banks aggregating $32.7 million. These lines are intended for short-term borrowings and are payable on demand and bear interest based upon the daily federal funds rate. For 2007 and 2006, average federal funds purchased were $3.6 million and $1.8 million, respectively. At December 31, 2007 the bank had $10.0 million of federal funds borrowings outstanding under these lines. At December 31, 2006, there were $3.4 million federal funds borrowings outstanding. The bank completed a $12 million offering of Trust Preferred Securities on March 30, 2006. Net proceeds from the sale of the Trust Preferred Securities were invested in Junior Subordinated Deferrable Interest Debentures issued by the Company. 38 Critical Accounting Estimates and Policies We prepare our consolidated financial statements in conformity with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amount of revenues and expenses during the reporting period. Actual results could differ from those estimates. Critical accounting estimates and policies are those we believe are both most important to the portrayal of our financial condition and results, and require our most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. Judgments and uncertainties affecting the application of those policies may result in materially different amounts being reported under different conditions or using different assumptions. We believe that the allowance for loan losses represents a particularly sensitive accounting estimate. The amount of the allowance is based on management's evaluation of the collectibility of the loan portfolio, including the maturity of the loan portfolio, credit concentration, trends in historical loss experience, specific impaired loans and general economic conditions. See Note A to the consolidated financial statements for a comprehensive discussion of our accounting policy for the allowance for loan losses. New Accounting Standards The Emerging Issues Task Force ("EITF") reached a consensus at its September 2006 meeting regarding EITF 06-4, Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements. The scope of EITF 06-4 is limited to the recognition of a liability and related compensation costs for endorsement split-dollar life insurance policies that provide a benefit to an employee that extends to postretirement periods. Therefore, this EITF would not apply to a split-dollar life insurance arrangement that provides a specified benefit to an employee that is limited to the employee's active service period with an employer. This EITF 06-4 is effective for fiscal years beginning after December 15, 2007, with earlier application permitted. We do not expect EITF 06-4 to have a material impact on its financial position, results of operations or cash flows upon adoption. In September 2006, the FASB issued SFAS No. No. 157, Fair Value Measurements, which defines fair value, establishes guidelines for measuring fair value and expands disclosures regarding fair value measurements. SFAS No. 157 does not require any new fair value measurements but rather eliminates inconsistencies in guidance found in various prior accounting pronouncements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. However, on December 14, 2007, the FASB issued proposed FASB Staff Position ("FSP") SFAS 157-b ("FSP 157-b"), which would delay the effective date of SFAS NO. 157 for all non-financial assets and non-financial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). FSP 157-b partially defers the effective date of SFAS No. 157 to fiscal years beginning after November 15, 2008, and interim periods within those fiscal years for items within the scope of FSP 157-b. We will adopt SFAS No. 157 during 2008, except as it applies to those non-financial assets and non-financial liabilities as noted in proposed FSP 157-b. The partial adoption of SFAS No. 157 is not expected to have a material impact on our financial position, results of operations or cash flows. In July 2006, the FASB issued Financial Interpretation ("FIN") 48, Accounting for Uncertainty in Income Taxes ("FIN 48"). FIN 48 is an interpretation of SFAS No. 109, Accounting for Income Taxes. FIN 48 provides interpretive guidance for the financial statement recognition and measurement of a tax position taken, or expected to be taken, in a tax return. FIN 48 requires the affirmative evaluation that it is more likely than not, based on the technical merits of a tax position, that an enterprise is entitled to economic benefits resulting from positions taken in income tax returns. If a tax position does not meet the "more-likely-than-not" recognition threshold, the benefit of that position is not recognized in the financial statements. FIN 48 also requires companies to disclose additional quantitative and qualitative information in their financial statements about uncertain tax positions. FIN 48 was effective for fiscal year beginning January 1, 2007. The adoption of FIN 48 did not have a material impact on our financial position, results of operations or cash flows. In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, Including an Amendment of FASB Statement No. 115. SFAS No. 159 permits entities to choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value and establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. SFAS No. 159 is effective for financial statements issued for fiscal years beginning after November 15, 2007. We do not expect SFAS No. 159 to 39 have a material impact on its financial position, results of operations or cash flows upon adoption. In November 2007, the SEC issued SAB No. 109, Written Loan Commitments Recorded at Fair Value Through Earnings. SAB No. 109 supersedes guidance provided by SAB No. 105, Loan Commitments Accounted for as Derivative Instruments, and provides guidance on written loan commitments accounted for at fair value through earnings. Specifically, SAB No. 109 addresses the inclusion of expected net future cash flows related to the associated servicing of a loan in the measurement of all written loan commitments accounted for at fair value through earnings. In addition, SAB No. 109 retains the SEC's position on the exclusion of internally-developed intangible assets as part of the fair value of a derivative loan commitment originally established in SAB No.105. SAB No. 109 is effective for fiscal years ending after December 15, 2007. Our adoption of SAB No. 109 did not have a material impact on our financial position, results of operations or cash flows. From time to time the FASB issues exposure drafts for proposed statements of financial accounting standards. Such exposure drafts are subject to comment from the public, to revisions by the FASB and to final issuance by the FASB as statements of financial accounting standards. Management considers the effect of the proposed statements on our consolidated financial statements and monitors the status of changes to and proposed effective dates of exposure drafts. Item 7A - Quantitative and Qualitative Disclosures About Market Risk. This information is included under Item 7 of this report under the captions "Interest Rate Sensitivity Analysis," "Market Risk," and "Derivative Financial Instruments." Item 8 - Financial Statements and Supplementary Data. 40 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Shareholders Four Oaks Fincorp, Inc. Four Oaks, North Carolina We have audited the accompanying consolidated balance sheets of Four Oaks Fincorp, Inc. and Subsidiaries as of December 31, 2007 and 2006 and the related consolidated statements of operations, comprehensive income, shareholders' equity and cash flows for each of the years in the three-year period ended December 31, 2007. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Four Oaks Fincorp, Inc. and Subsidiaries as of December 31, 2007 and 2006, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2007 in conformity with accounting principles generally accepted in the United States of America. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness Four Oaks Fincorp, Inc.'s internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated March 12, 2008 expressed an unqualified opinion on the effectiveness of the Company's internal control over financial reporting. /s/ Dixon Hughes PLLC Raleigh, North Carolina March 12, 2008 41 Four Oaks Fincorp, Inc. Consolidated Balance Sheets December 31, 2007 and 2006 - --------------------------------------------------------------------------------
2007 2006 --------------------- ---------------------- (Amounts in thousands, except share data) ASSETS Cash and due from banks $ 14,394 $ 13,960 Interest-earning deposits 3,881 3,751 Investment securities available for sale, at fair value 114,301 101,393 Loans 545,270 461,763 Allowance for loan losses (6,653) (5,566) --------------------- ---------------------- Net loans 538,617 456,197 Accrued interest receivable 3,564 3,614 Bank premises and equipment, net 12,627 11,630 FHLB stock 5,010 4,194 Investment in life insurance 10,041 8,424 Other assets 5,868 4,974 --------------------- ---------------------- Total assets $ 708,303 $ 608,137 ===================== ====================== LIABILITIES AND SHAREHOLDERS' EQUITY Deposits: Noninterest-bearing demand $ 74,687 $ 72,087 Money market and NOW accounts 126,300 89,615 Savings 28,041 31,424 Time deposits, $100,000 and over 172,513 164,497 Other time deposits 136,222 109,245 --------------------- ---------------------- Total deposits 537,763 466,868 Borrowings 97,000 73,400 Subordinated debentures 12,372 12,372 Accrued interest payable 4,055 3,258 Other liabilities 2,483 2,916 --------------------- ---------------------- Total liabilities 653,673 558,814 --------------------- ---------------------- Commitments and Contingencies (Notes C, J, K, N and S) Shareholders' equity: Common stock; $1.00 par value, 10,000,000 shares authorized; 6,165,197 and 5,577,862 shares issued and outstanding at December 31, 2007 and 2006, respectively 6,165 5,578 Additional paid-in capital 21,545 10,016 Retained earnings 26,477 34,141 Accumulated other comprehensive income (loss) 443 (412) --------------------- ---------------------- Total shareholders' equity 54,630 49,323 --------------------- ---------------------- Total liabilities and shareholders' equity $ 708,303 $ 608,137 ===================== ======================
The accompanying notes are an integral part of these consolidated financial statements. 42 Four Oaks Fincorp, Inc. Consolidated Statements of Operations For the Years Ended December 31, 2007, 2006 and 2005 - --------------------------------------------------------------------------------
2007 2006 2005 ---------------- ---------------- ---------------- (Amounts in thousands, except per share data) Interest and dividend income: Loans, including fees $ 40,967 $ 35,457 $ 26,612 Investment securities: Taxable 5,873 4,503 2,389 Tax-exempt 178 152 118 Dividends 390 287 155 Interest-earning deposits 105 157 130 ---------------- ---------------- ---------------- Total interest and dividend income 47,513 40,556 29,404 ---------------- ---------------- ---------------- Interest expense: Deposits 19,142 14,202 7,823 Borrowings 4,557 3,615 2,160 ---------------- ---------------- ---------------- Total interest expense 23,699 17,817 9,983 ---------------- ---------------- ---------------- Net interest income 23,814 22,739 19,421 Provision for loan losses 1,362 873 1,403 ---------------- ---------------- ---------------- Net interest income after provision for loan losses 22,452 21,866 18,018 ---------------- ---------------- ---------------- Non-interest income: Service charges on deposit accounts 2,098 2,053 1,875 Other service charges, commissions and fees 1,544 1,613 1,235 Losses on sale of investment securities (36) (121) (386) Gains (losses) on hedges, net 165 (262) (397) Gains on sale of loans 69 103 61 Merchant fees 436 402 389 Income (loss) from investment in life insurance (205) 549 300 ---------------- ---------------- ---------------- Total non-interest income 4,071 4,337 3,077 ---------------- ---------------- ---------------- Non-interest expenses: Salaries 8,444 7,163 6,033 Employee benefits 1,690 1,477 1,306 Occupancy expenses 799 681 549 Equipment expenses 1,409 1,438 1,313 Professional and consulting fees 1,263 1,183 965 Other taxes and licenses 275 271 248 Merchant processing expenses 370 355 341 Other operating expenses 3,434 2,991 2,599 ---------------- ---------------- ---------------- Total non-interest expenses 17,684 15,559 13,354 ---------------- ---------------- ---------------- Income before income taxes 8,839 10,644 7,741 Provision for income taxes 3,187 3,627 2,738 ---------------- ---------------- ---------------- Net income $ 5,652 $ 7,017 $ 5,003 ================ ================ ================ Basic net income per common share $ 0.92 $ 1.15 $ 0.84 ================ ================ ================ Diluted net income per common share $ 0.91 $ 1.14 $ 0.83 ================ ================ ================
The accompanying notes are an integral part of these consolidated financial statements. 43 Four Oaks Fincorp, Inc. Consolidated Statements of Comprehensive Income For the Years Ended December 31, 2007, 2006 and 2005 - --------------------------------------------------------------------------------
2007 2006 2005 ----------------- ----------------- ----------------- (Amounts in thousands) Net income $ 5,652 $ 7,017 $ 5,003 ----------------- ----------------- ----------------- Other comprehensive income (loss): Securities available for sale: Unrealized holding gains (losses) on available for sale securities 987 145 (1,326) Tax effect (395) (57) 529 Reclassification of losses recognized in net income 36 121 386 Tax effect (14) (48) (154) ----------------- ----------------- ----------------- Net of tax amount 613 161 (565) ----------------- ----------------- ----------------- Cash flow hedging activities: Unrealized holding gains (losses) on cash flow hedging activities 402 314 (290) Tax effect (160) (127) 117 ----------------- ----------------- ----------------- Net of tax amount 242 187 (173) ----------------- ----------------- ----------------- Total other comprehensive income (loss) 855 348 (738) ----------------- ----------------- ----------------- Comprehensive income $ 6,507 $ 7,365 $ 4,265 ================= ================= =================
The accompanying notes are an integral part of these consolidated financial statements. 44 Four Oaks Fincorp, Inc. Consolidated Statements of Shareholders' Equity For the Years Ended December 31, 2007, 2006 and 2005 - --------------------------------------------------------------------------------
Accumulated Additional other Total Common stock paid-in Retained comprehensive shareholders Shares Amount capital earnings income (loss) equity ------------ ---------- ---------- ----------- ------------- ------------ (Amounts in thousands, except share data) BALANCE, DECEMBER 31, 2004 3,438,107 $ 3,438 $ 8,788 $ 25,091 $ (22) $ 37,295 Net income - - - 5,003 - 5,003 Other comprehensive loss - - - - (738) (738) Effect of 5-for-4 stock split 872,060 872 (872) - - - Issuance of common stock 69,091 69 1,161 - - 1,230 Current income tax benefit - - 101 - - 101 Cash dividends of $.22 per share - - - (1,279) - (1,279) ------------ ---------- ---------- ----------- ------------- ------------ BALANCE, DECEMBER 31, 2005 4,379,258 $ 4,379 $ 9,178 $ 28,815 $ (760) $ 41,612 Net income - - - 7,017 - 7,017 Other comprehensive income - - - - 348 348 Effect of 5-for-4 stock split 1,109,543 1,110 (1,110) - - - Issuance of common stock 98,896 98 1,511 - - 1,609 Current income tax benefit - - 293 - - 293 Stock based compensation - - 144 - - 144 Purchases and retirement of common stock (9,835) (9) - (243) - (252) Cash dividends of $.24 per share - - - (1,448) - (1,448) ------------ ---------- ---------- ----------- ------------- ----------- BALANCE, DECEMBER 31, 2006 5,577,862 $ 5,578 $ 10,016 $ 34,141 $ (412) $ 49,323 Net income - - - 5,652 - 5,652 Other comprehensive income - - - - 855 855 Effect of 10% stock dividend 562,345 562 9,532 (10,094) - - Issuance of common stock 100,797 100 1,565 - - 1,665 Current income tax benefit - - 203 - - 203 Stock based compensation - - 229 - - 229 Purchases and retirement of common stock (75,807) (76) - (1,437) - (1,513) Cash dividends of $.29 per share - - - (1,784) - (1,784) ------------ ---------- ---------- ----------- ------------- ----------- BALANCE, DECEMBER 31, 2007 6,165,197 $ 6,165 $ 21,545 $ 26,477 $ 443 $ 54,630 ============ ========== ========== =========== ============= ===========
The accompanying notes are an integral part of these consolidated financial statements. 45 Four Oaks Fincorp, Inc. Consolidated Statements of Cash Flows For the Years Ended December 31, 2007, 2006 and 2005 - --------------------------------------------------------------------------------
2007 2006 2005 ------------ ------------ ------------ (Amounts in thousands) Cash flows from operating activities: Net income $ 5,652 $ 7,017 $ 5,003 Adjustments to reconcile net income to net cash provided by operations: Provision for loan losses 1,362 873 1,403 Provision for depreciation and amortization 1,009 1,022 1,038 Deferred income tax benefit (523) (319) (672) Net amortization of bond premiums and discounts 32 (28) 18 Stock based compensation 229 144 - Gain on sale of loans (69) (103) (61) (Gain) loss on sale of investment securities 36 121 386 (Gain) loss on sale of foreclosed assets 20 (2) - Loss on disposition of premises and equipment 77 73 - (Income) loss from investment in life insurance 205 (549) (300) (Gain) loss on hedges (165) 262 397 Changes in assets and liabilities: Other assets 407 (1,365) 50 Interest receivable 50 (664) (740) Other liabilities 134 (3,556) 4,003 Interest payable 797 1,003 1,054 ------------ ------------ ------------ Net cash provided by operating activities 9,253 3,929 11,579 ------------ ------------ ------------ Cash flows from investing activities: Proceeds from sales and calls of investment securities available for sale 78,027 36,759 36,783 Proceeds from maturities of investment securities available for sale 2,000 275 - Purchase of investment securities available for sale (91,980) (58,045) (65,994) Purchase of FHLB stock (1,320) (1,825) (1,034) Redemption of FHLB stock 504 1,286 - Net increase in loans (86,283) (65,107) (85,142) Purchases of bank premises and equipment (2,070) (3,028) (558) Purchases of bank-owned life insurance (1,822) - (1,521) Proceeds from sale of foreclosed assets 1,299 193 589 Expenditures on foreclosed assets (110) (1) (1) ------------ ------------ ------------ Net cash used by investing activities (101,755) (89,493) (116,878) ------------ ------------ ------------ Cash flows from financing activities: Net proceeds from borrowings 23,600 (740) 30,980 Net increase in deposit accounts 70,895 68,526 83,034 Proceeds from subordinated debentures - 12,372 - Proceeds from issuance of common stock 1,665 1,609 1,230 Excess tax benefits from stock options 203 293 - Purchases and retirement of common stock (1,513) (252) - Cash dividends paid (1,784) (1,448) (1,279) ------------ ------------ ------------ Net cash provided by financing activities 93,066 80,360 113,965 ------------ ------------ ------------ Net increase (decrease) in cash and cash equivalents 564 (5,204) 8,666 Cash and cash equivalents at beginning of year 17,711 22,915 14,249 ------------ ------------ ------------ Cash and cash equivalents at end of year $ 18,275 $ 17,711 $ 22,915 ============ ============ ============
The accompanying notes are an integral part of these consolidated financial statements. 46 Four Oaks Fincorp, Inc. Notes to Consolidated Financial Statements December 31, 2007, 2006 and 2005 - -------------------------------------------------------------------------------- NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation The consolidated financial statements include the accounts and transactions of Four Oaks Fincorp, Inc. (the "Company"), a bank holding company incorporated under the laws of the State of North Carolina, and its wholly owned subsidiaries, Four Oaks Bank & Trust Company, Inc. (the "Bank") and Four Oaks Mortgage Services, LLC, the Company's mortgage origination subsidiary. All significant intercompany transactions have been eliminated. In March 2006, the Company formed Four Oaks Statutory Trust I, a wholly owned Delaware statutory business trust (the "Trust"), for the sole purpose of issuing Trust Preferred Securities (as defined in Note G below). The Trust is not included in the consolidated financial statements of the Company, in accordance with Financial Accounting Standards Board ("FASB") Interpretation No. 46, "Consolidation of Variable Interest Entities (revised December 2003) - an interpretation of ARB No. 51" ("FIN 46R"). Nature of Operations The Company was incorporated under the laws of the State of North Carolina on February 5, 1997. The Company's primary function is to serve as the holding company for its wholly owned subsidiaries, the bank and Four Oaks Mortgage Services, LLC. The bank operates fourteen offices in eastern and central North Carolina, and its primary source of revenue is derived from loans to customers and from its securities portfolio. The loan portfolio is comprised mainly of real estate, commercial and consumer loans. These loans are primarily collateralized by residential and commercial properties, commercial equipment, and personal property. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Use of Estimates Preparing consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan losses. Cash and Cash Equivalents For the purpose of presentation in the consolidated statements of cash flows, cash and cash equivalents are defined as those amounts included in the balance sheet captions cash and due from banks and interest-earning deposits. Federal regulations require institutions to set aside specified amounts of cash as reserves against transactions and time deposits. As of December 31, 2007, the daily average gross reserve requirement was $3.1 million. Investment Securities Investment securities are classified into three categories: (1) Held to Maturity - Debt securities that the Company has the positive intent and the ability to hold to maturity are classified as held to maturity and reported at amortized cost; (2) Trading - Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and reported at fair value, with unrealized gains and losses included in earnings; and 47 NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) (3) Available for Sale - Debt and equity securities not classified as either securities held to maturity or trading securities are reported at fair value, with unrealized gains and losses excluded from earnings and reported, net of income taxes, as other comprehensive income, a separate component of shareholders' equity. The Company has historically classified all securities as available for sale. Gains and losses on sales of securities, computed based on specific identification of adjusted cost of each security, are included in income at the time of the sale. Premiums and discounts are amortized into interest income using a method that approximates the interest method over the period to maturity. Loans and Allowance for Loan Losses Loans are stated at the amount of unpaid principal, reduced by an allowance for loan losses. Interest on loans is calculated by using the simple interest method on daily balances of the principal amount outstanding. Loan origination fees are deferred, as well as certain direct loan origination costs. Such costs and fees are recognized as an adjustment to yield over the contractual lives of the related loans utilizing the interest method. The Company evaluates its loan portfolio in accordance with Statement of Financial Accounting Standards ("SFAS") No. 114, Accounting by Creditors for Impairment of a Loan, as amended by SFAS No. 118, Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosure. Under these standards, a loan is considered impaired, based on current information and events, if it is probable that the Company will be unable to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan agreement. Uncollateralized loans are measured for impairment based on the present value of expected future cash flows discounted at the historical effective interest rate or the loan's observable market price, while all collateral-dependent loans are measured for impairment based on the fair value of the collateral. If the recorded investment in the loan exceeds the measure of fair value, a valuation allowance is established as a component of the 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. Loans are charged against the allowance for loan losses when management believes that the uncollectibility of a loan balance is confirmed. In addition to the review of loans considered impaired as discussed above, the allowance for loan losses is also based upon such factors as changes in the trends in volumes and terms of loans, levels and trends of charge-offs and recoveries, national and local economic trends and conditions that may affect the borrowers' ability to pay, effects of changes in risk selection and underwriting standards as well as overall portfolio quality. If conditions change substantially from the assumptions used to evaluate the allowance for loan losses, it is possible that management's assessment of the allowance may change. In addition, regulatory examiners may require the bank to recognize changes to the allowance for loan losses based on their judgments about information available to them at the time of their examination. Income Recognition on Impaired and Nonaccrual Loans Loans, including impaired loans, are generally classified as nonaccrual if they are past due as to maturity or payment of principal or interest for a period of more than 90 days, unless such loans are well-secured and in the process of collection. If a loan or a portion of a loan is classified as doubtful or is partially charged-off, the loan is generally classified as nonaccrual. Loans that are on a current payment status or past due less than 90 days may also be classified as nonaccrual if repayment in full of principal and/or interest is in doubt. Loans may be returned to accrual status when all principal and interest amounts contractually due (including arrearages) are reasonably assured of repayment within an acceptable period of time and there is a sustained period of repayment performance (generally a minimum of six months) by the borrower, in accordance with the contractual terms. 48 NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) While a loan is classified as nonaccrual and the future collectibility of the recorded loan balance is doubtful, collections of interest and principal are generally applied as a reduction to the principal outstanding, except in the case of loans with scheduled amortizations where the payment is generally applied to the oldest payment due. When the future collectibility of the recorded loan balance is expected, interest income may be recognized on a cash basis. In the case where a nonaccrual loan had been partially charged-off, recognition of interest on a cash basis is limited to that which would have been recognized on the recorded loan balance at the contractual interest rate. Receipts in excess of that amount are recorded as recoveries to the allowance for loan losses until prior charge-offs have been fully recovered. Foreclosed Assets Assets acquired as a result of foreclosure are valued at fair value at the date of foreclosure establishing a new cost basis. After foreclosure, valuations of the property are periodically performed by management and the assets are carried at the lower of cost or fair value minus estimated costs to sell. Losses from the acquisition of property in full or partial satisfaction of debt are treated as credit losses. Routine holding costs, subsequent declines in value, and gains or losses on disposition are included in other income and expense. Bank Premises and Equipment Land is carried at cost. Buildings, furniture and equipment are stated at cost less accumulated depreciation. Depreciation is computed using the straight-line method based on the estimated useful lives of assets. Useful lives range from 5 to 10 years for furniture and equipment and 40 years for buildings. Expenditures for repairs and maintenance are charged to expense as incurred. Income Taxes Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the tax bases of assets and liabilities and their carrying amounts for financial reporting purposes. Deferred tax assets are also recognized for operating loss carry-forwards. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which the temporary differences are expected to be recovered or settled. Deferred tax assets are reduced by a valuation allowance if it is more likely than not that the tax benefits will not be realized. Stock in Federal Home Loan Bank of Atlanta As a requirement for membership, the Company invests in stock of the FHLB of Atlanta. This investment is carried at cost. Due to the redemptive provisions of the FHLB, the Company estimated that fair value equals cost and that this investment was not impaired as of December 31, 2007. Comprehensive Income Comprehensive income is defined as the change in equity during a period for non-owner transactions and is divided into net income and other comprehensive income. Other comprehensive income includes revenues, expenses, gains, and losses that are excluded from earnings under current accounting standards. Components of other comprehensive income for the Company consist of the unrealized gains and losses, net of taxes, in the Company's available for sale securities portfolio and unrealized gains and losses, net of taxes, in the Company's cash flow hedge instruments. 49 NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Accumulated other comprehensive income at December 31, 2007 and 2006 consists of the following: 2007 2006 ------- ------- (Amounts in thousands) Unrealized holding gains (losses) - investment securities available for sale $ 740 $ (283) Deferred income taxes (297) 113 ------- ------- Net unrealized holding gains (losses) - investment securities available for sale 443 (170) ------- ------- Unrealized holding losses - cash flow hedge instruments - (402) Deferred income taxes - 160 ------- ------- Net unrealized holding losses - cash flow hedge instruments - (242) ------- ------- Total accumulated other comprehensive income (loss) $ 443 $ (412) ======= ======= Stock Compensation Plans Effective January 1, 2006, the Company adopted SFAS No. 123 (revised 2004), Share-Based Payment ("SFAS No. 123R"), which was issued by the FASB in December 2004. SFAS No. 123R revises SFAS No. 123 Accounting for Stock Based Compensation, and supersedes Accounting Principles Board Opinion ("APB") No. 25, Accounting for Stock Issued to Employees, and its related interpretations. SFAS No. 123R requires recognition of the cost of employee services received in exchange for an award of equity instruments in the financial statements over the period the employee is required to perform the services in exchange for the award (usually the vesting period). SFAS No. 123R also requires measurement of the cost of employee services received in exchange for an award based on the grant-date fair value of the award. SFAS No. 123R also amends SFAS No. 95, Statement of Cash Flows, to require that excess tax benefits be reported as financing cash inflows, rather than as a reduction of taxes paid, which is included within operating cash flows. The Company adopted SFAS No. 123R using the modified prospective application as permitted under SFAS No. 123R. Accordingly, prior period amounts have not been restated. Under this application, the Company is required to record compensation expense for all awards granted after the date of adoption and for the unvested portion of previously granted awards that remain outstanding at the date of adoption. Prior to the adoption of SFAS No. 123R, the Company used the intrinsic value method as prescribed by APB No. 25 and thus recognized no compensation expense for options granted with exercise prices equal to the fair market value of the Company's common stock on the date of grant. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123R to options granted under the Company's stock option plans for the year ended December 31, 2005. For purposes of this pro forma disclosure, the value of the options is estimated using the Black-Scholes option-pricing model and amortized to expense over the options' vesting periods. 50 NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) For the Year Ended December 31, 2005 (Dollars in thousands) ---------------------- Net income: As reported $ 5,003 Deduct: Total stock-based employee compensation expense determined under fair value method for all awards, net of related tax effects (88) -------- Pro forma $ 4,915 ======== Basic earnings per share: As reported $ .84 Pro forma $ .82 Diluted earnings per share: As reported $ .83 Pro forma $ .82 Net Income Per Common Share and Common Shares Outstanding Basic earnings per share represents income available to common shareholders divided by the weighted average number of common shares outstanding during the period. Diluted earnings per share reflect additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income that would result from the assumed issuance. All references to net income per share, weighted average shares outstanding, and dividends per share have been retroactively adjusted for a 10% stock dividend issued on October 3, 2007 and five for four stock splits distributed in the form of 25% stock dividend on November 10, 2006, November 25, 2005, and October 29, 51 2004. Potential common shares that may be issued by the Company relate solely to outstanding stock options. Basic and diluted net income per common share have been computed based upon net income as presented in the accompanying consolidated statements of operations divided by the weighted average number of common shares outstanding or assumed to be outstanding as summarized below:
2007 2006 2005 -------------- -------------- -------------- Weighted average number of common shares used in computing basic net income per share 6,170,140 6,080,778 5,972,073 Effect of dilutive stock options 22,419 56,444 44,246 -------------- -------------- -------------- Weighted average number of commons shares and dilutive potential common shares used in computing diluted net income per share 6,192,559 6,137,222 6,016,319 ============== ============== ==============
There were no antidilutive shares outstanding for the years ended December 31, 2007, 2006 and 2005. 52 NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Derivative Instruments The Company utilizes interest rate swaps in the management of interest rate risk. Interest rate swaps are contractual agreements between two parties to exchange a series of cash flows representing interest payments. A swap allows both parties to alter the repricing characteristics of assets or liabilities without affecting the underlying principal positions. Through the use of a swap, assets and liabilities may be transformed from fixed to floating rates, from floating rates to fixed rates, or from one type of floating rate to another. Swap terms generally range from one year to ten years depending on the need. The net interest payable or receivable on interest rate swaps that are designated as hedges is accrued and recognized as an adjustment to the interest income or expense of the related asset or liability. Gains and losses from early terminations of derivatives are deferred and amortized as yield adjustments over the shorter of the remaining term of the hedged asset or liability or the remaining term of the derivative instrument. Upon disposition or settlement of the asset or liability being hedged, deferral accounting is discontinued and any gains or losses are recognized in income. Unrealized holding gains and losses on derivatives designated as cash flow hedges are reported, net of applicable income tax effect, in accumulated other comprehensive income. Derivative financial instruments that fail to qualify as a hedge are carried at fair value with gains and losses recognized in current earnings. New Accounting Standards The Emerging Issues Task Force ("EITF") reached a consensus at its September 2006 meeting regarding EITF 06-4, Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements. The scope of EITF 06-4 is limited to the recognition of a liability and related compensation costs for endorsement split-dollar life insurance policies that provide a benefit to an employee that extends to postretirement periods. Therefore, this EITF would not apply to a split-dollar life insurance arrangement that provides a specified benefit to an employee that is limited to the employee's active service period with an employer. This EITF 06-4 is effective for fiscal years beginning after December 15, 2007, with earlier application permitted. The Company does not expect EITF 06-4 to have a material impact on its financial position, results of operations or cash flows upon adoption. In September 2006, the FASB issued SFAS No. No. 157, Fair Value Measurements, which defines fair value, establishes guidelines for measuring fair value and expands disclosures regarding fair value measurements. SFAS No. 157 does not require any new fair value measurements but rather eliminates inconsistencies in guidance found in various prior accounting pronouncements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. However, on December 14, 2007, the FASB issued proposed FASB Staff Position ("FSP") SFAS 157-b ("FSP 157-b"), which would delay the effective date of SFAS No. 157 for all non-financial assets and non-financial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). FSP 157-b partially defers the effective date of SFAS No. 157 to fiscal years beginning after November 15, 2008, and interim periods within those fiscal years for items within the scope of FSP 157-b. The Company will adopt SFAS No. 157 during 2008, except as it applies to those non-financial assets and non-financial liabilities as noted in proposed FSP 157-b. The partial adoption of SFAS No. 157 is not expected to have a material impact on the Company's financial position, results of operations or cash flows. 53 NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) The Company adopted the provisions of Financial Accounting Standards Board ("FASB") Interpretation No. 48 ("FIN 48"), Accounting for Uncertainty in Income Taxes - an Interpretation of FASB Statement No. 109, on April 1, 2007. The Company has analyzed filing positions in all of the federal and state jurisdictions where it is required to file income tax returns, as well as all open tax years in these jurisdictions. The periods subject to examination for the Company's federal return are the fiscal 2006 and 2007 tax years. The company did not have any unrecognized tax benefits and there was no effect on our financial condition or results of operations as a result of implementing FIN 48. It is the Company policy to recognize interest and penalties accrued on any unrecognized tax benefits as a component of income tax expense. As of the date of adoption of FIN 48, the Company did not have any accrued interest or penalties associated with any unrecognized tax benefits, nor was any interest expense recognized during the quarter. In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, Including an Amendment of FASB Statement No. 115. SFAS No. 159 permits entities to choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value and establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. SFAS No. 159 is effective for financial statements issued for fiscal years beginning after November 15, 2007. The Company does not expect SFAS No. 159 to have a material impact on its financial position, results of operations or cash flows upon adoption. In November 2007, the SEC issued SAB No. 109, Written Loan Commitments Recorded at Fair Value Through Earnings. SAB No. 109 supersedes guidance provided by SAB No. 105, Loan Commitments Accounted for as Derivative Instruments, and provides guidance on written loan commitments accounted for at fair value through earnings. Specifically, SAB No. 109 addresses the inclusion of expected net future cash flows related to the associated servicing of a loan in the measurement of all written loan commitments accounted for at fair value through earnings. In addition, SAB No. 109 retains the SEC's position on the exclusion of internally-developed intangible assets as part of the fair value of a derivative loan commitment originally established in SAB No.105. SAB No. 109 is effective for fiscal years ending after December 15, 2007. The Company adoption of SAB No. 109 did not have a material impact on its financial position, results of operations or cash flows. From time to time the FASB issues exposure drafts for proposed statements of financial accounting standards. Such exposure drafts are subject to comment from the public, to revisions by the FASB and to final issuance by the FASB as statements of financial accounting standards. Management considers the effect of the proposed statements on the consolidated financial statements of the Company and monitors the status of changes to and proposed effective dates of exposure drafts. Reclassifications Certain items included in the 2006 and 2005 consolidated financial statements have been reclassified to conform to the 2007 presentation. These reclassifications have no effect on the net income or shareholders' equity previously reported. 54 NOTE B - INVESTMENT SECURITIES The amortized cost, gross unrealized gains, gross unrealized losses and fair values of securities available for sale as of December 31, 2007 and 2006 are as follows:
Amortized Gross Unrealized Gross Unrealized Cost Gains Losses Fair Value --------------- --------------- --------------- --------------- (Amounts in thousands) 2007: U.S. government and agency securities $ 92,651 $ 559 $ 2 $ 93,208 State and municipal securities 6,136 17 5 $ 6,148 Mortgage-backed securities 12,985 122 20 $ 13,087 Other 1,789 69 - $ 1,858 --------------- --------------- --------------- --------------- $ 113,561 $ 767 $ 27 $ 114,301 =============== =============== =============== =============== Amortized Gross Unrealized Gross Unrealized Cost Gains Losses Fair Value --------------- --------------- --------------- --------------- (Amounts in thousands) 2006: U.S. government and agency securities $ 85,730 $ 83 $ 566 $ 85,247 State and municipal securities 4,623 16 30 $ 4,609 Mortgage-backed securities 9,882 52 74 $ 9,860 Other 1,441 236 - $ 1,677 --------------- --------------- --------------- --------------- $ 101,676 $ 387 $ 670 $ 101,393 =============== =============== =============== ===============
The following table shows gross unrealized losses and fair values of investment securities, aggregated by investment category and length of time that the individual securities have been in a continuous unrealized loss position, at December 31, 2007 and 2006. As of December 31, 2007, the unrealized losses relate to eight U.S. government agency securities, three mortgage-backed securities and five municipal securities. Four of the municipal securities and three of the mortgage backed securities had continuous unrealized losses for more than twelve months. The unrealized losses relate to debt securities that have incurred fair value reductions due to higher market interest rates since the securities were purchased. The unrealized losses are not likely to reverse unless and until market interest rates decline to the levels that existed when the securities were purchased. Since none of the unrealized losses relate to the marketability of the securities or the issuer's ability to honor redemption obligations, none of the securities are deemed to be other than temporarily impaired. 55 NOTE B - INVESTMENT SECURITIES (Continued)
2007 ---------------------------------------------------------------------------------- Less Than 12 Months 12 Months or More Total -------------------------- -------------------------- -------------------------- Fair Unrealized Fair Unrealized Fair Unrealized value losses value losses value losses ------------ ------------ ------------ ------------ ------------ ------------ (Amounts in thousands) Securities available for sale: U.S. government and agency securities $ 14,983 $ 2 $ - $ - $ 14,983 $ 2 State and municipal securities 139 - 1,519 5 1,658 5 Mortgage-backed securities - - 2,439 20 2,439 20 ------------ ------------ ------------ ------------ ------------ ------------ Total temporarily impaired securities $ 15,122 $ 2 $ 3,958 $ 25 $ 19,080 $ 27 ============ ============ ============ ============ ============ ============ 2006 ---------------------------------------------------------------------------------- Less Than 12 Months 12 Months or More Total -------------------------- -------------------------- -------------------------- Fair Unrealized Fair Unrealized Fair Unrealized value losses value losses value losses -------------------------- ------------ ------------ ------------ ------------ (Amounts in thousands) Securities available for sale: U.S. government and agency securities $ 11,967 $ 22 $ 48,225 $ 544 $ 60,192 $ 566 State and municipal securities 138 - 2,349 30 2,487 30 Mortgage-backed securities 549 - 4,320 74 4,869 74 ------------ ------------ ------------ ------------ ------------ ------------ Total temporarily impaired securities $ 12,654 $ 22 $ 54,894 $ 648 $ 67,548 $ 670 ============ ============ ============ ============ ============ ============
The amortized cost and fair value of available for sale securities at December 31, 2007 by contractual maturities are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Amortized Cost Fair Value ---------------- ---------------- (Amounts in thousands) Due within one year $ 587 $ 590 Due after one year through five years 20,248 20,309 Due after five years through ten years 70,028 70,528 Due after ten years 22,699 22,874 ---------------- ---------------- $ 113,561 $ 114,301 ================ ================ 56 NOTE B - INVESTMENT SECURITIES (Continued) Securities with a carrying value of approximately $98.5 million and $69.2 million at December 31, 2007 and 2006, respectively, were pledged to secure public deposits and for other purposes required or permitted by law. Sales and calls of securities available for sale during 2007, 2006 and 2005 generated gross realized gains of $82,000, $15,000, and $74,000, respectively and gross realized losses of $119,000, $135,000, and $460,000, respectively. NOTE C - LOANS AND ALLOWANCE FOR LOAN LOSSES Major classifications of loans as of December 31, 2007 and 2006 are summarized as follows: 2007 2006 ---------- ---------- (Amounts in thousands) Real estate - residential and other $ 217,247 $ 197,195 Real estate - agricultural 12,700 12,326 Construction and land development 252,449 194,460 Other agricultural 3,119 2,724 Consumer loans 12,566 16,618 Commercial loans 45,653 37,622 Other loans 1,779 1,101 ---------- ---------- 545,513 462,046 Less: Net deferred loan costs (243) (283) Allowance for loan losses (6,653) (5,566) ---------- ---------- $ 538,617 $ 456,197 ========== ========== Nonperforming assets at December 31, 2007 and 2006 consist of the following: 2007 2006 ---------- ---------- (Amounts in thousands) Loans past due ninety days or more $ 52 $ 33 Nonaccrual loans 1,254 967 Foreclosed assets (included in other assets) 1,688 327 ---------- ---------- $ 2,994 $ 1,327 ========== ========== At December 31, 2007, the recorded investment in loans considered impaired in accordance with SFAS No. 114 totaled $5.6 million. This amount consisted of both accrual and nonaccrual loans in the amount of $4.4 million and $1.2 million, respectively. At December 31, 2006, the investment in loans considered impaired consisted of both accrual and nonaccrual loans in the amount of $4.4 million and $1.0 million, respectively. Impaired loans of $4.4 million and $4.4 million had related allowances for loan losses of $2.2 million and $1.7 million at December 31, 2007 and 2006, respectively. For the years ended December 31, 2007 and 2006, the average recorded investment in impaired loans was approximately $5.0 million and $4.9 million, respectively. The amount of interest recognized on impaired loans during the portion of the year that they were impaired was not material. 57 NOTE C - LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued) A summary of the allowance for loan losses for the years ended December 31, 2007, 2006 and 2005 is as follows: 2007 2006 2005 ---------- ---------- --------- (Amounts in thousands) Balance, beginning $ 5,566 $ 4,965 $ 4,055 Provision for loan losses 1,362 873 1,403 Loans charged-off (504) (458) (696) Recoveries of loans previously charged-off 229 186 203 ---------- ---------- --------- Balance, ending $ 6,653 $ 5,566 $ 4,965 ========== ========== ========= The Company had loan and deposit relationships with most of its directors and executive officers and with companies with which certain directors and executive officers are associated. The following is a reconciliation of loans directly outstanding to executive officers, directors, and their affiliates (amounts in thousands): Balance at December 31, 2006 $ 7,254 New loans 2,752 Principal repayments (3,060) --------- Balance at December 31, 2007 $ 6,946 ========= As a matter of policy, these loans and credit lines are approved by the Company's Board of Directors and are made with interest rates, terms, and collateral requirements comparable to those required of other borrowers. In the opinion of management, these loans do not involve more than the normal risk of collectibility. At December 31, 2007, the Company had pre-approved but unused lines of credit totaling $1.4 million to executive officers, directors and their affiliates. 58 NOTE D - BANK PREMISES AND EQUIPMENT Company premises and equipment at December 31, 2007 and 2006 are as follows: 2007 2006 ---------- ---------- (Amounts in thousands) Land $ 2,815 2,814 Buildings 9,501 8,410 Furniture and equipment 9,159 8,383 ---------- ---------- 21,475 19,607 Less accumulated depreciation (8,848) (7,977) ---------- ---------- $ 12,627 $ 11,630 ========== ========== Depreciation expense for the years ended December 31, 2007, 2006 and 2005 amounted to $1.0 million for each year. NOTE E - DEPOSITS At December 31, 2007, the scheduled maturities of time deposits are as follows (amounts in thousands): Less than $100,000 Total $100,000 more ---------------------------------- Within one year $ 128,493 $ 132,969 $ 261,462 Over one year through three years 6,052 37,671 43,723 Over three years 1,677 1,873 3,550 ---------- ---------- ---------- $ 136,222 $ 172,513 $ 308,735 ========== ========== ========== 59 NOTE F - BORROWINGS At December 31, 2007 and 2006, borrowed funds included the following FHLB advances (amounts in thousands): Maturity Interest Rate 2007 2006 - ----------------- --------------------- ----------- --------- June 27, 2008 4.40% Variable 10,000 10,000 July 19, 2010 5.75% Fixed 10,000 10,000 November 16, 2011 5.39% Variable - 8,000 August 12, 2015 3.77% Fixed - 10,000 May 25, 2016 4.46% Fixed 5,000 5,000 October 3, 2016 4.01% Fixed - 10,000 October 19, 2016 4.13% Fixed - 5,000 November 17, 2016 4.11% Fixed 5,000 5,000 November 30, 2016 4.09% Fixed 7,000 7,000 June 5, 2017 4.35% Fixed 10,000 - July 3, 2017 4.36% Fixed 13,000 - July 24, 2017 4.34% Fixed 5,000 - July 31, 2017 4.35% Fixed 5,000 - August 14, 2017 4.08% Fixed 5,000 - August 14, 2017 3.94% Fixed 5,000 - October 4, 2017 3.95% Fixed 7,000 - ----------- --------- $ 87,000 $70,000 =========== ========= The above advances are secured by a floating lien covering the Company's loan portfolio of qualifying residential (1-4 units) first mortgage loans. At December 31, 2007, the Company has available lines of credit totaling $141.7 million with the FHLB for borrowing dependent on adequate collateralization. The weighted average rates for the above borrowings at December 31, 2007 and 2006 were 4.73% and 4.65%, respectively. The Company has no short-term FHLB advances outstanding as of December 31, 2007 and 2006. In addition to the above advances, the Company has lines of credit of $32.7 million from various financial institutions to purchase federal funds on a short-term basis. The Company has $10.0 million outstanding as of December 31, 2007. The Company had $3.4 million outstanding as of December 31, 2006. 60 NOTE G - TRUST PREFERRED SECURITIES On March 30, 2006, $12.0 million of trust preferred securities ("Trust Preferred Securities") were placed through the Trust. The Trust has invested the net proceeds from the sale of the Trust Preferred Securities in Junior Subordinated Deferrable Interest Debentures (the "Debentures") issued by the Company and recorded in borrowings on the accompanying consolidated balance sheet. The Trust Preferred Securities pay cumulative cash distributions quarterly at an annual rate, reset quarterly, equal to three month LIBOR plus 1.35%. The dividends paid to holders of the Trust Preferred Securities, which will be recorded as interest expense, are deductible for income tax purposes. The Trust Preferred Securities are redeemable on June 15, 2011 or afterwards in whole or in part, on any June 15, September 15, December 15 or March 15. Redemption is mandatory by June 15, 2036. The Company has fully and unconditionally guaranteed the Trust Preferred Securities through the combined operation of the Debentures and other related documents. The Company's obligation under the guarantee is unsecured and subordinate to senior and subordinated indebtedness of the Company. The Trust Preferred Securities qualify as Tier I capital for regulatory capital purposes subject to certain limitations. NOTE H - INCOME TAXES Allocation of income tax expense between current and deferred portions is as follows: Years Ended December 31, -------------------------- 2007 2006 2005 -------- -------- -------- (Amounts in thousands) Current tax expense: Federal $3,384 $3,513 $2,947 State 326 433 463 -------- -------- -------- 3,710 3,946 3,410 -------- -------- -------- Deferred tax expense: Federal (426) (269) (559) State (97) (50) (113) -------- -------- -------- (523) (319) (672) -------- -------- -------- $3,187 $3,627 $2,738 ======== ======== ======== The reconciliation of expected income tax at the statutory federal rate of 34% with income tax expense is as follows: Years Ended December 31, -------------------------- 2007 2006 2005 -------- -------- -------- (Amounts in thousands) Expense computed at statutory rate of 34% $3,005 $3,619 $2,631 Effect of state income taxes, net of federal benefit 151 253 232 Tax exempt income (59) (51) (36) (Income) loss from investment in life insurance 70 (187) (102) Other, net 20 (7) 13 -------- -------- -------- $3,187 $3,627 $2,738 ======== ======== ======== 61 NOTE H - INCOME TAXES (Continued) Deferred income taxes consist of the following: Years Ended December 31, ------------------------ 2007 2006 -------- -------- (Amounts in thousands) Deferred tax assets: Allowance for loan losses $ 2,520 $ 2,101 Non-qualified stock options 148 60 Unamortized investment premiums 15 1 Net deferred loan fees 94 109 Other comprehensive loss - 273 Other 97 57 -------- -------- Total deferred tax assets 2,874 2,601 -------- -------- Deferred tax liabilities: Property and equipment $ 640 641 Unrealized gain on securities 297 - Prepaid expense 132 105 Unaccreted investment discounts - 20 Other 16 - -------- -------- Total deferred tax liabilities 1,085 766 -------- -------- Net deferred tax asset included in other assets $ 1,789 $ 1,835 ======== ======== NOTE I - REGULATORY RESTRICTIONS The Bank, as a North Carolina banking corporation, may pay dividends to the Company only out of undivided profits as determined pursuant to North Carolina General Statutes Section 53-87. However, regulatory authorities may limit payment of dividends by any bank when it is determined that such a limitation is in the public interest and is necessary to ensure the financial soundness of the bank. Current Federal regulations require that the Bank maintain a minimum ratio of total capital to risk weighted assets of 8%, with at least 4% being in the form of Tier 1 capital, as defined in the regulations. In addition, the Bank must maintain a leverage ratio of 4%. As of December 31, 2007, the Bank's capital exceeded the current capital requirements. The Bank currently expects to continue to exceed these minimums without altering current operations or strategy. The Bank is subject to various regulatory capital requirements administered by the federal and state banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Bank's financial statements. Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios, as set forth in the table below. Management believes, as of December 31, 2007, that the Bank meets all capital adequacy requirements to which it is subject. As of December 31, 2007, the most recent notification from the FDIC categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Bank must maintain minimum amounts and ratios as set forth in the table below. There are no conditions or events since that notification that management believes have changed the Bank's category. 62 NOTE I - REGULATORY RESTRICTIONS (Continued) The Bank's actual capital amounts and ratios are also presented in the table below (dollars in thousands):
Actual Minimum for Capital Minimum To Be Well Adequacy Purposes Capitalized Under Prompt Corrective Action Provisions --------------------------------------- ------------------- Amount Ratio Amount Ratio Amount Ratio --------------------------------------- ------------------- As of December 31, 2007: - --------------------------------- Total Capital (to Risk Weighted Assets) $67,505 11.9% $45,458 8.0% $56,822 10.0% Tier I Capital (to Risk Weighted Assets) 60,852 10.7% 22,729 4.0% 34,093 6.0% Tier I Capital (to Average Assets) 60,852 8.9% 27,501 4.0% 34,376 5.0% As of December 31, 2006: - --------------------------------- Total Capital (to Risk Weighted Assets) $61,618 12.8% $38,543 8.0% $48,179 10.0% Tier I Capital (to Risk Weighted Assets) 56,052 11.6% 19,272 4.0% 28,908 6.0% Tier I Capital (to Average Assets) 56,052 9.3% 24,070 4.0% 30,090 5.0%
The Company is also subject to these capital requirements. At December 31, 2007 and 2006, the Company's total capital to risk weighted assets, Tier 1 capital to risk weighted assets and Tier 1 capital to average assets were 11.7%, 12.9%, and 10.2%, and 12.9%, 14.0%, and 10.3%, respectively. NOTE J - DERIVATIVES Derivative Financial Instruments The Company has stand-alone derivative financial instruments in the form of interest rate swap agreements, which derive their value from underlying interest rates. These transactions involve both credit and market risk. The notional amounts are amounts on which calculations, payments, and the value of the derivative are based. Notional amounts do not represent direct credit exposures. Direct credit exposure is limited to the net difference between the calculated amounts to be received and paid, if any. Such difference, which represents the fair value of the derivative instruments, is reflected on the Company's consolidated balance sheets as derivative assets and derivative liabilities. The Company is exposed to credit-related losses in the event of nonperformance by the counterparties to these agreements. The Company controls the credit risk of its financial contracts through credit approvals, limits and monitoring procedures, and does not expect any counterparties to fail their obligations. The Company deals only with primary dealers. Derivative instruments are generally either negotiated over-the-counter ("OTC") contracts or standardized contracts executed on a recognized exchange. Negotiated OTC derivative contracts are generally entered into between two counterparties that negotiate specific agreements terms, including the underlying instruments, amount, exercise prices and maturity. 63 NOTE J - DERIVATIVES (Continued) Risk Management Policies - Hedging Instruments The primary focus of the Company's asset/liability management program is to monitor the sensitivity of the Company's net portfolio value and net income under varying interest rate scenarios to take steps to control its risks. On a quarterly basis, the Company simulates the net portfolio value and net income expected to be earned over a twelve-month period following the date of simulation. The simulation is based on a projection of market interest rates at varying levels and estimates the impact of such market rates on the levels of interest-earning assets and interest-bearing liabilities during the measurement period. Based upon the outcome of the simulation analysis, the Company considers the use of derivatives as a means of reducing the volatility of net portfolio value and projected net income within certain ranges of projected changes in interest rates. The Company evaluates the effectiveness of entering into any derivative instrument agreement by measuring the cost of such an agreement in relation to the reduction in net portfolio value and net income volatility within an assumed range of interest rates. Interest Rate Risk Management - Cash Flow Hedging Instruments The Company originates variable rate loans for its loan portfolio. These loans expose the Company to variability in cash flows, primarily from interest receipts due to changes to interest rates. If interest rates increase, interest income increases. Conversely, if interest rates decrease, interest income decreases. Management believes it is prudent to limit the variability of a portion of its cash flows on variable rate loans therefore, generally hedges a portion of its variable-rate receipts. To meet this objective, management enters into interest rate swap agreements whereby the Company receives fixed rate payments and makes variable rate payments during the contract period. At December 31, 2007 there were no outstanding interest rate swap agreements used to hedge variable rate loans. At December 31, 2006, the information pertaining to an outstanding interest rate swap agreement used to hedge variable rate loans is as follows (dollars in thousands): Notional amount $ 25,000 Weighted average pay rate 7.96% Weighted average receive rate 5.85% Weighted average maturity in years 0.7 Unrealized loss relating to interest rate swaps $ (402) This agreement requires the Company to make payments at a variable rate determined by a specified index (prime) in exchange for receiving payments at a fixed rate. At December 31, 2006, the Company's interest rate swap used to hedge variable rate loans reflected an unrealized loss of $402,000. The unrealized loss is included in other comprehensive income, net of tax, in the accompanying consolidated balance sheet. Risk management results for the year ended December 31, 2006 related to the balance sheet hedging of variable rate loans indicate that the hedge was 100% effective and that there was no component of the derivative instrument's gain or loss which was excluded from the assessment of hedge effectiveness. At December 31, 2006 the unrealized loss relating to use of the interest rate swap was recorded in derivative liabilities in accordance with SFAS No. 133. Changes in the fair value of interest rate swaps designated as hedging instruments of the variability of cash flows associated with variable rate loans are reported in other comprehensive income. 64 NOTE J - DERIVATIVES (Continued) Interest Rate Risk Management - Fair Value Hedging Instruments The Company uses funds from fixed rate time deposits in its lending and investment activities and for other general purposes. These debt obligations expose the Company to variability in their fair value due to changes in the level of interest rates. Management believes that it is prudent to limit the variability in the fair value of a portion of its fixed-rate funding. It is the Company's objective to hedge the change in fair value of fixed-rate funding coverage levels that are appropriate, given anticipated or existing interest rate levels and other market considerations, as well as the relationship of change in this liability to other liabilities of the Company. To meet this objective, the Company utilized interest rate swaps as an asset/liability management strategy to hedge the change in value of the funding due to changes in expected interest rate assumptions. These interest rate swap agreements are contracts to make a series of floating rate payments in exchange for receiving a series of fixed rate payments. At December 31, 2007 and 2006, the information pertaining to outstanding interest rate swap agreements used to hedge fixed-rate funding is as follows (dollars in thousands): 2007 2006 ------- ------- Notional amount $33,301 $38,611 Weighted average pay rate 4.93% 5.32% Weighted average receive rate 4.25% 3.90% Weighted average maturity in years 2.2 3.1 Unrealized gain (loss) relating to interest rate swaps $ (16) $ (145) These agreements require the Company to make payments at variable-rate determined by a specified index (LIBOR) in exchange for receiving payments at a fixed-rate. The interest rate swap agreement used to hedge variable rate loans expired July 30, 2007. No other interest rate swaps were terminated during 2007 or 2006. At December 31, 2007 and 2006, the Company's interest rate swaps used to hedge fixed-rate funding reflected an unrealized loss of $16,000 and $145,000, respectively. For the years ended December 31, 2007 and 2006, the Company's interest rate swaps not designated as a fair value hedge reflected a gain of $165,000 and a loss of $262,000, respectively. The above interest rate swaps are recorded in other liabilities in the accompanying consolidated balance sheet. NOTE K - COMMITMENTS AND CONTINGENCIES The Company is a party to financial instruments with off-balance sheet credit risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheet. The contract or notional amounts of those instruments reflect the extent of involvement the Bank has in particular classes of financial instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. 65 NOTE K - COMMITMENTS AND CONTINGENCIES (Continued) Commitments to extend credit are agreements to lend to a customer as long as there is no violation of conditions 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 borrower. Collateral obtained varies but may include real estate, stocks, bonds, and certificates of deposit. Unfunded commitments under lines of credit are commitments for possible future extensions of credit to existing customers. These lines of credit usually do not contain a specified maturity date and may not be drawn upon to the total extent to which the Bank is committed. Stand-by letters of credit are conditional lending commitments issued by the Bank to guarantee the performance of a customer to a third party. Those letters of credit are primarily issued to support public and private borrowing arrangements. Essentially all letters of credit issued have expiration dates within one year. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. A summary of the contract amount of the Bank's exposure to off-balance sheet credit risk as of December 31, 2007 is as follows (dollars in thousands): Financial instruments whose contract amounts represent credit risk: Commitments to extend credit $ 110,651 Undisbursed lines of credit 30,860 Financial stand-by letters of credit 575 Performance stand-by letters of credit 2,036 NOTE L - STOCK OPTION PLAN The Company has a non-qualified stock option plan for certain key employees under which it is authorized to issue options for up to 1,342,773 shares of common stock. Options are granted at the discretion of the Company's Board of Directors at an exercise price approximating market value, as determined by a committee of Board members. All options granted subsequent to a 1997 amendment will be 100% vested one year from the grant date and will expire after such a period as is determined by the Board at the time of grant. Options granted prior to the amendment have ten year lives and a five year level vesting provision. A summary of option activity under the Plan for the year ended December 31, 2007, after giving retroactive effect to the 10% stock dividend, is presented below: 66 NOTE L - STOCK OPTION PLAN (Continued)
Weighted- Average Remaining Aggregate Option Price Contractual Intrinsic Shares Per Share Term Value --------- ------------ ------------- ------------ Outstanding at January 1, 2007 177,309 $ 12.05 Granted 41,140 24.41 Exercised (42,237) 8.65 Forfeited (2,578) 13.24 Expired (7,606) 6.76 --------- Balance December 31, 2007 166,028 $ 16.20 1.67 $ 601,000 ========= ============ ============= ============ Excercisable at December 31, 2007 124,888 $ 13.50 1.18 $ 281,000 ========= ============ ============= ============
The weighted average exercise price of all exercisable options at December 31, 2007 is $13.50. There were 419,271 shares reserved for future issuance at December 31, 2007. As of December 31, 2007, there was $20,000 of unrecognized compensation cost related to non-vested share-based compensation arrangements. That cost is expected to be recognized in 2008. Additional information concerning the Company's stock options at December 31, 2007 is as follows: Remaining Exercise Price Number Contractual Number Outstanding Life Exercisable - -------------------------------------------------------------------------- $10.24 41,791 0.15 years 41,791 $13.24 37,860 1.15 years 37,860 $16.73 45,237 2.15 years 45,237 $24.41 41,140 3.16 years - ----------- ------------ 166,028 124,888 =========== ============ 67 NOTE L - STOCK OPTION PLAN (Continued) The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions used for grants in 2007, 2006 and 2005: 2007 2006 2005 -------------- -------------- ------------- Dividend yield 1.20% 1.53% 1.84% Expected volatility 23.76% 20.72% 24.31% Risk free interest rate 4.65% 4.73% 3.75% Expected life 4 years 4 years 4 years The weighted average fair value of options granted during 2007, 2006 and 2005 was $5.76, $3.84, and $3.04, respectively. NOTE M - OTHER EMPLOYEE BENEFITS Supplemental Retirement In 1998, the Company's subsidiary, Four Oaks Bank & Trust Company, adopted a Supplemental Executive Retirement Plan ("SERP") for its president. The Company has purchased life insurance policies in order to provide future funding of benefit payments. SERP benefits will accrue and vest during the period of employment and will be paid in annual benefit payments over the officer's remaining life commencing with the officer's retirement. The liability accrued under the SERP plan amounts to $175,000 and $147,000 at December 31, 2007 and 2006, respectively. During 2007, 2006, and 2005, the expense attributable to the SERP amounted to $28,000, $25,000, and $23,000, respectively. Employment Agreements The Company has entered into employment agreements with certain of its executive officers to ensure a stable and competent management base. The agreements provide for benefits as spelled out in the contracts and cannot be terminated by the Company's Board of Directors, except for cause, without prejudicing the officers' rights to receive certain vested rights, including compensation. In addition, the Company has entered into severance compensation agreements with certain of its executive officers and key employees to provide them with severance pay benefits in the event of a change in control of the Company, as outlined in the agreements; the acquirer will be bound to the terms of the contracts. Defined Contribution Plan The Company sponsors a contributory profit-sharing plan in effect for substantially all employees. Participants may make voluntary contributions resulting in salary deferrals in accordance with Section 401(k) of the Internal Revenue Code. The plans provide for employee contributions up to $15,500 of the participant's annual salary and an employer contribution of 25% matching of the first 6% of pre-tax salary contributed by each participant. Expenses related to these plans for the years ended December 31, 2007, 2006 and 2005 were $97,000, $66,000, and $79,000, respectively. Contributions under the plan are made at the discretion of the Company's Board of Directors. 68 NOTE M - OTHER EMPLOYEE BENEFITS (Continued) Employee Stock Ownership Plan The Company sponsors an employee stock ownership plan (ESOP) which makes the employees of the Company, owners of stock in the Company. The Four Oaks Bank & Trust Company's Employee Stock Ownership Trust is available to full-time employees at least 21 years of age after six months of service. Contributions are voluntary by the Company and employees cannot contribute. Stock issued is purchased on the open market and the Company does not issue new shares in conjunction with this plan. Voluntary contributions are determined by the Company's Board of Directors annually based on Company performance and are allocated to employees based on annual compensation. Contribution expenses for this plan for the years ended 2007, 2006, and 2005 were $300,000, $249,000, and $223,000, respectively. Employee Stock Purchase and Bonus Plan The Employee Stock Purchase and Bonus Plan (the "Purchase Plan") is a voluntary plan that enables full-time employees of the Company and its subsidiaries to purchase shares of the Company's common stock. The Purchase Plan is administered by a committee of the Board of Directors, which has broad discretionary authority to administer the Purchase Plan. The Company's Board of Directors may amend or terminate the Purchase Plan at any time. The Purchase Plan is not intended to be qualified as an employee stock purchase plan under Section 423 of the Internal Revenue Code of 1986, as amended. Once a year, participants in the Purchase Plan purchase the Company's common stock at fair market value. Participants are permitted to purchase shares under the Purchase Plan up to (5%) of their compensation, with a maximum purchase amount of $1,000 per year. The Company matches, in cash, fifty percent (50%) of the amount of each participant's purchase, up to $500. After withholding for income and employment taxes, participants use the balance of the Company's matching grant to purchase shares of the Company's common stock. As of December 31, 2007, 268,555 shares of the Company's common stock had been reserved for issuance under the Purchase Plan, and 170,388 shares had been purchased. During the years ended December 31, 2007 and 2006, 5,785 and 8,554 shares, respectively, were purchased under the Purchase Plan. NOTE N - LEASES The Company has entered into non-cancelable operating leases for three branch facilities. Future minimum lease payments under the leases for future years are as follows (amounts in thousands): 2008 $ 144 2009 142 2010 123 2011 127 2012 129 2013 and beyond 441 ---------- $ 1,106 ========== In addition, the Company has leased a building from one of its former directors for approximately $1,000 per month in 2007 and 2006, under an operating lease on a month-to-month basis. Total rental expense under operating leases for the years ended December 31, 2007, 2006 and 2005 amounted to $152,000, $116,000 and $57,000, respectively. 69 NOTE O - PARENT COMPANY FINANCIAL INFORMATION Condensed financial information of Four Oaks Fincorp, Inc., the parent company, at December 31, 2007 and 2006 and for the years ended December 31, 2007, 2006 and 2005 is presented below: 2007 2006 ----------- ------- (Amounts in thousands) Condensed Balance Sheets Assets: Cash and cash equivalents $3,686 $4,409 Equity investment in subsidiaries 62,187 56,324 Securities available for sale 1,153 1,015 Other assets 33 76 ----------- ------- Total assets $67,059 $61,824 =========== ======= Liabilities and Shareholders' Equity: Other liabilities $57 $129 Subordinated debentures 12,372 12,372 Shareholders' equity 54,630 49,323 ----------- ------- Total liabilities and shareholders' equity $67,059 $61,824 =========== ======= 70 NOTE O - PARENT COMPANY FINANCIAL INFORMATION (Continued) For the Years Ended December 31, ------------------------ 2007 2006 2005 ------- -------- ------- (Amounts in thousands) Condensed Statements of Operations Dividends received from bank subsidiary $1,784 $1,448 $937 Equity in undistributed earnings of subsidiaries 4,464 6,021 4,035 Interest income 228 187 81 Other income 83 65 17 Other expenses (907) (704) (67) ------- -------- ------- Net income $5,652 $7,017 $5,003 ======= ======== ======= 2007 2006 2005 ------- -------- ------- (Amounts in thousands) Condensed Statements of Cash Flows Operating activities: Net income $5,652 $7,017 $5,003 Equity in undistributed earnings of subsidiaries (4,464) (6,021) (4,035) Decrease (increase) in other assets 43 (76) - (Decrease) increase in other liabilities (72) 17 - ------- -------- ------- Net cash provided by operating activities 1,159 937 968 ------- -------- ------- Investing activities: Investment in subsidiaries (315) (12,695) - Purchase of securities available for sale (138) (347) (53) ------- -------- ------- Net cash used by investing activities (453) (13,042) (53) ------- -------- ------- Financing activities: Proceeds from issuance of common stock 1,665 1,609 1,230 Excess tax benefits from stock options 203 293 - Proceeds from issuance of subordinated debentures - 12,372 - Purchases and retirements of common stock (1,513) (252) - Dividends paid (1,784) (1,448) (1,279) ------- -------- ------- Net cash (used) provided by financing activities (1,429) 12,574 (49) ------- -------- ------- Net (decrease) increase in cash and cash equivalents (723) 469 866 Cash and cash equivalents, beginning of year 4,409 3,940 3,074 ------- -------- ------- Cash and cash equivalents, end of year $3,686 $4,409 $3,940 ======= ======== ======= 71 NOTE P - FAIR VALUE OF FINANCIAL INSTRUMENTS SFAS No. 107, Disclosures about Fair Value of Financial Instruments, requires the disclosure of estimated fair values for financial instruments. Quoted market prices, if available, are utilized as an estimate of the fair value of financial instruments. Because no quoted market prices exist for a significant part of the Company's financial instruments, the fair value of such instruments has been derived based on management's assumptions with respect to future economic conditions, the amount and timing of future cash flows and estimated discount rates. Different assumptions could significantly affect these estimates. Accordingly, the net realizable value could be materially different from the estimates presented below. In addition, the estimates are only indicative of individual financial instruments' values and should not be considered an indication of the fair value of the Company taken as a whole. The following methods and assumptions were used to estimate the fair value of each class of financial instrument. Cash and Cash Equivalents The carrying amounts of cash and cash equivalents are equal to the fair value due to the liquid nature of the financial instruments. Investment Securities Available for Sale Fair values of investment securities available for sale are based on quoted market prices. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities. Loans Fair values have been estimated by type of loan: residential real estate loans, consumer loans, and commercial and other loans. For variable-rate loans that reprice frequently and with no significant credit risk, fair values are based on carrying values. The fair values of fixed rate loans are estimated by discounting the future cash flows using the current rates at which loans with similar terms would be made to borrowers with similar credit ratings and for the same remaining maturities. The Company has assigned no fair value to off-balance sheet financial instruments since they are either short term in nature or subject to immediate repricing. FHLB Stock The carrying amount of FHLB stock approximates fair value. Investment in Life Insurance The carrying value of life insurance approximates fair value because this investment is carried at cash surrender value, as determined by the insurer. Deposits The fair value of demand deposits, savings accounts and money market deposits is the amount payable on demand at year-end. Fair value of time deposits is estimated by discounting the future cash flows using the current rate offered for similar deposits with the same maturities. Borrowings and Subordinated Debentures The fair values are based on discounting expected cash flows at the interest rate for debt with the same or similar remaining maturities and collection requirements. 72 NOTE P - FAIR VALUE OF FINANCIAL INSTRUMENTS (Continued) Accrued Interest Receivable and Payable The carrying amounts of accrued interest approximate fair value. Derivative Financial Instruments Fair values for interest rate swap agreements are based upon the amounts required to settle the contracts. The following table presents information for financial assets and liabilities as of December 31, 2007 and 2006
2007 2006 ------------------------------- -------------------------------- Carrying Value Estimated Fair Carrying Value Estimated Fair Value Value --------------- -------------- -------------- -------------- Financial assets: Cash and cash equivalents $ 18,275 $ 18,275 $ 17,711 $ 17,711 Securities available for sale 114,301 114,301 101,393 101,393 Loans, net 538,617 537,831 456,197 449,550 FHLB stock 5,010 5,010 4,194 4,194 Investment in life insurance 10,041 10,041 8,424 8,424 Accrued interest receivable 3,564 3,564 3,614 3,614 Financial liabilities: Deposits $ 537,763 $ 522,212 $ 466,868 $ 449,771 Subordinated debentures 12,372 12,381 12,372 12,384 Borrowings 97,000 99,905 73,400 74,042 Accrued interest payable 4,055 4,055 3,258 3,258 Derivative financial instruments: Interest rate swap agreements: Liabilities, net loss 80 80 1,108 1,108
73 NOTE Q - CASH FLOW SUPPLEMENTAL DISCLOSURES The following information is supplemental information regarding the cash flows for the years ended December 31, 2007, 2006 and 2005:
2007 2006 2005 ----------- ------------ ------------ (Amounts in thousands) Cash paid for: Interest on deposits and borrowings $ 22,902 $ 16,814 $ 8,929 Income taxes 2,981 4,057 3,684 Summary of noncash investing and financing activities: Transfer from loans to foreclosed assets 2,570 269 431 Tax benefit from the exercise of non-qualified stock options 203 293 101 Increase (decrease) in fair value of securities available for sale, net of tax 613 161 (565) Increase (decrease) in fair value of cash flow hedge, net of tax 242 187 (173)
74 NOTE R - STOCK PURCHASE PLAN On December 10, 2001, the Company's Board of Directors approved a Stock Purchase Program authorizing the Company to purchase up to 100,000 shares, or approximately 4.7% of the then outstanding shares of common stock. On December 20, 2006, the Board of Directors increased the purchase authorization to 200,000 shares. On November 26, 2007 the Board of Directors increased the purchase authorization to 500,000 shares and on December 17, 2007 authorized the extension of the Company's Stock Purchase Program through December 31, 2008. During 2007, the Company purchased 75,807 shares at an average cost of $19.97. At December 31, 2007, there were 350,969 share available for repurchase. NOTE S - PROPOSED MERGER WITH LONGLEAF COMMUNITY BANK On December 10, 2007, the Company announced that it had entered into a definitive agreement (the "Agreement") with LongLeaf Community Bank ("LongLeaf") pursuant to which LongLeaf will merge with and into the Bank. Under the terms of the Agreement, each share of LongLeaf common stock will be automatically converted into the right to receive either (i) $16.50 in cash, without interest, (ii) 1.0 share of Company common stock multiplied by an exchange ratio or (iii) 0.60 shares of Company common stock multiplied by the exchange ratio plus an amount equal to $6.60 in cash, all on and subject to the terms and conditions contained in the Agreement. The exchange ratio is equal to $16.50 divided by the volume weighted average of the daily closing sales price of the Company's common stock as quoted on the OTC Bulletin Board during the 20 consecutive trading days ending three business days prior to the closing date of the Merger (the "Average Closing Price"). Pursuant to the Agreement, the Average Closing Price can be no higher than $19.3397452 per share and no lower than $14.2945943 per share. In addition, if (a) as of the later of the date of receipt of the required approval of regulatory authorities or the date of approval by LongLeaf shareholders, the average closing price of the Company's common stock is less than 75% of the Average Closing Price as of the date the Agreement was executed and (b) the Company and Four Oaks do not agree to adjust the exchange ratio as permitted by the Agreement, then LongLeaf will have a right to terminate the Agreement. Finally, certain allocation procedures will be used to cause the stock consideration to be paid to LongLeaf shareholders to be between 50% and 70% of the total merger consideration. On January 30, 2008, the Company filed a Registration Statement on Form S-4 with the Securities and Exchange Commission to register up to 708,461 shares of its common stock that could be issued in connection with the proposed transaction. LongLeaf mailed the related proxy statement/prospectus to its shareholders on or about February 28, 2008, setting forth matters relating to the transaction to be voted upon at its upcoming Special Meeting of Shareholders to be held on April 10, 2008. The Form S-4 describes the proposed transaction in detail and provides, among other things, highlights and terms of the proposed merger and pro forma financial information. Subject to receipt of approval by LongLeaf's shareholders and certain other closing conditions, the Company plans to consummate the bank merger in the second quarter of 2008. 75 Item 9 - Changes In and Disagreements with Accountants on Accounting and Financial Disclosure. Not Applicable. Item 9A - Controls and Procedures. Disclosure Controls and Procedures As required by paragraph (b) of Rule 13a-15 under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), an evaluation was carried out under the supervision and with the participation of the Company's management, including its Chief Executive Officer and Chief Financial Officer, of the effectiveness of the Company's disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this Annual Report. As defined in Rule 13a-15(e) and 15d-15(e) under the Exchange Act, the term disclosure controls and procedures means controls and other procedures of an issuer that are designed to ensure that information required to be disclosed by the issuer in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission's (the "SEC's") rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Exchange Act is accumulated and communicated to the issuer's management, including its principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. Based on their evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that as of the end of the period covered by this Annual Report, the Company's disclosure controls and procedures are effective, in that they provide reasonable assurances that information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods required by the SEC's rules and forms. Management's Report on Internal Control Over Financial Reporting The management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting. The Company's internal control system was designed to provide reasonable assurance to its management and board of directors regarding the preparation and fair presentation of published financial statements. All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation. The Company's management assessed the effectiveness of the Company's internal control over financial reporting as of December 31, 2007. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission ("COSO") in Internal Control - - Integrated Framework. Based on that assessment, we believe that, as of December 31, 2007, the Company maintained effective internal control over financial reporting based on those criteria. Four Oaks' independent auditors have issued an audit report on our assessment and on the Company's internal control over financial reporting. This report appears on page 77. Changes in Internal Control Over Financial Reporting There have been no changes in the Company's internal control over financial reporting (as such term is defined in Rules 13d-15(f) and 15(d)-15(f) under the Exchange Act) that occurred during the fourth quarter of 2007 that the Company believes have materially affected or is likely to materially affect, its internal control over financial reporting. 76 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders Four Oaks Fincorp, Inc. and Subsidiaries We have audited Four Oaks Fincorp, Inc. and Subsidiaries (the "Company")'s internal control over financial reporting as of December 31, 2007 based on criteria established in Internal Control--Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management's Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company's internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, Four Oaks Fincorp, Inc. and Subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control--Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements of Four Oaks Fincorp, Inc. and Subsidiaries as of and for the year ended December 31, 2007, and our report dated March 12, 2008, expressed an unqualified opinion on those consolidated financial statements. /s/ Dixon Hughes PLLC Raleigh, North Carolina March 12, 2008 77 Item 9B - Other Information. Not Applicable. PART III This Part incorporates certain information from the definitive proxy statement (the "2008 Proxy Statement") for the Company's 2008 Annual Meeting of Shareholders, to be filed with the SEC within 120 days after the end of the Company's fiscal year. Item 10 - Directors, Executive Officers and Corporate Governance. Director information is incorporated by reference from the sections entitled "Information about Our Board of Directors," "Election of Directors," and under the section entitled "Section 16(a) Beneficial Ownership Reporting Compliance," in the 2008 Proxy Statement. Information on our executive officers is included under the caption "Our Executive Officers" on Page 9 of this report. Information about our Code of Ethics is incorporated by reference from the section entitled "Code of Ethics," in the 2007 Proxy Statement. Information about the procedures by which shareholder nominations to our board of directors may be submitted, including material changes to such procedures, if any, is incorporated by reference from the section entitled "Information About our Board of Directors-- Board Committees--The Corporate Governance and Nominating Committee" in the 2008 Proxy Statement. Information regarding the Company's audit committee is hereby incorporated by reference from the section entitled "Information About our Board of Directors--Board Committees--The Audit Committee" in the 2008 Proxy Statement. Item 11 - Executive Compensation. This information is incorporated by reference from the section entitled "Executive Compensation" and "Compensation Committee Interlocks and Insider Participation" in the 2008 Proxy Statement. Item 12 - Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters. This information is incorporated by reference from the section entitled "Security Ownership of Management and Certain Beneficial Owners" and the sections entitled "Equity Compensation Plan Information," "Nonqualified Stock Option Plan" and "Employee Stock Purchase and Bonus Plan" in the 2008 Proxy Statement. Item 13 - Certain Relationships and Related Transactions, and Director Independence. Information about certain relationships and related transactions is incorporated by reference from the section entitled "Certain Transactions" in the 2008 Proxy Statement. Information about director independence is incorporated by reference from the section entitled "Information About our Board of Directors--General" in the 2008 Proxy Statement. Item 14 - Principal Accountant Fees and Services Information regarding principal accountant fees and services is incorporated by reference from the section entitled "Audit Firm Fee Summary" in the 2008 Proxy Statement. 78 Item 15 - Exhibits, Financial Statement Schedules. (a)(1) Financial Statements. The following financial statements and supplementary data are included in Item 8 of Part II of this Annual Report on Form 10-K.
Form 10-K Page Financial Statements Report of Independent Registered Public Accounting Firm, Dixon Hughes PLLC, 41 dated March xx, 2008 Consolidated Balance Sheets as of December 31, 2007 and 2006 42 Consolidated Statements of Operations for the years ended December 31, 2007, 43 2006 and 2005 Consolidated Statements of Comprehensive Income for the years ended December 31, 44 2007, 2006 and 2005 Consolidated Statements of Shareholders' Equity for the years ended December 31, 45 2007, 2006 and 2005 Consolidated Statements of Cash Flows for the years ended December 31, 2007, 46 2006 and 2005 Notes to Consolidated Financial Statements 47
(a)(2) Financial Statement Schedules. All applicable financial statement schedules required under Regulation S-X have been included in the Notes to Consolidated Financial Statements. (a)(3) Exhibits. The following exhibits are filed as part of this Annual Report on Form 10-K. Exhibit No. Description of Exhibit 2.1 Merger Agreement, dated as of December 10, 2007, by and among Four Oaks Fincorp, Inc., Four Oaks Bank & Trust Company and LongLeaf Community Bank (incorporated by reference to Exhibit 2.1 to the Company's Current Report on Form 8-K filed on December 13, 2007) 2.2 List of Schedules Omitted from Merger Agreement included as Exhibit 2.1 above (incorporated by reference to Exhibit 2.2 to the Company's Current Report on Form 8-K filed on December 13, 2007) 3.1 Articles of Incorporation of Four Oaks Fincorp, Inc. including Articles of Amendment to Articles of Incorporation (incorporated by reference to Exhibit 3.1 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2004) 3.2 Bylaws of Four Oaks Fincorp, Inc. (incorporated by reference to Exhibit 3.2 to the Company's Current Report on Form 8-K12G3 filed with the SEC on July 2, 1997) 4 Specimen of Certificate for Four Oaks Fincorp, Common Stock (incorporated by reference to Exhibit 4 to the Company's Current Report on Form 8-K12G3 filed with the SEC on July 2, 1997) 10.1 Employment Agreement with Ayden R. Lee, Jr. (incorporated by reference to Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the period ended June 30, 1997) (management contract or compensatory plan, contract or arrangement) 10.2 Severance Compensation Agreement with Ayden R. Lee, Jr. (incorporated by reference to Exhibit 10.2 to the Company's Quarterly Report on Form 10-Q for the period ended June 30, 1997) (management contract or compensatory plan, contract or arrangement) 79 Exhibit No. Description of Exhibit 10.3 Amended and Restated Nonqualified Stock Option Plan (incorporated by reference to Exhibit 10.2 to the Company's Quarterly Report on Form 10-Q for the period ended June 30, 2004) (management contract or compensatory plan, contract or arrangement) 10.4 Amended and Restated Employee Stock Purchase and Bonus Plan (incorporated by reference to Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the period ended June 30, 2004) (management contract or compensatory plan, contract or arrangement) 10.5 Second Amended and Restated Dividend Reinvestment and Stock Purchase Plan (incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K filed with the SEC on December 21, 2006) (management contract or compensatory plan, contract or arrangement) 10.6 Four Oaks Bank & Trust Company Supplemental Executive Retirement Plan (incorporated by reference to Exhibit 10.6 to the Company's Annual Report on Form 10-KSB for the fiscal year ended December 31, 1998) (management contract or compensatory plan, contract or arrangement) 10.7 Employment Agreement with Clifton L. Painter (incorporated by reference to Exhibit 10.7 to the Company's Annual Report on Form 10-KSB for the fiscal year ended December 31, 2001) (management contract or compensatory plan, contract or arrangement) 10.8 Severance Compensation Agreement with Clifton L. Painter (incorporated by reference to Exhibit 10.8 to the Company's Annual Report on Form 10-KSB for the period ended December 31, 2002) (management contract or compensatory plan, contract or arrangement) 10.9 Executive Employment Agreement with W. Leon Hiatt, III (incorporated by reference to Exhibit 10.9 to the Company's Annual Report on Form 10-KSB for the period ended December 31, 2003) (management contract or compensatory plan, contract or arrangement) 10.10 Severance Compensation Agreement with W. Leon Hiatt, III (incorporated by reference to Exhibit 10.10 to the Company's Annual Report on form 10-KSB for the period ended December 31, 2003) (management contract or compensatory plan, contract or arrangement) 10.11 Executive Employment Agreement with Nancy S. Wise (incorporated by reference to Exhibit 10.11 to the Company's Annual Report on Form 10-KSB for the period ended December 31, 2003) (management contract or compensatory plan, contract or arrangement) 10.12 Severance Compensation Agreement with Nancy S. Wise (incorporated by reference to Exhibit 10.12 to the Company's Annual Report on Form 10-KSB for the period ended December 31, 2003) (management contract or compensatory plan, contract or arrangement) 10.13 Form of Stock Option Agreement (Non-Employee Director) (incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K filed with the SEC on March 1, 2005) (management contract or compensatory plan, contract or arrangement) 10.14 Form of Stock Option Agreement (Employee) (incorporated by reference to Exhibit 10.2 to the Company's Current Report on Form 8-K filed with the SEC on March 1, 2005) (management contract or compensatory plan, contract or arrangement) 10.15 Executive Employment Agreement with Jeff D. Pope (incorporated by reference to Exhibit 10.15 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2004) (management contract or compensatory plan, contract or arrangement) 10.16 Severance Compensation Agreement with Jeff D. Pope (incorporated by reference to Exhibit 10.16 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2004) (management contract or compensatory plan, contract or arrangement) 10.17 Summary of Non-Employee Director Compensation 80 (incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K filed with the SEC on January 25, 2006) (management contract or compensatory plan, contract or arrangement) 10.18 Amended and Restated Declaration of Trust of Four Oaks Statutory Trust I, dated as of March 30, 2006 (incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K filed with the SEC on April 4, 2006) 10.19 Guarantee Agreement of Four Oaks Fincorp, Inc. dated as of March 30, 2006 (incorporated by reference to Exhibit 10.2 to the Company's Current Report on Form 8-K filed with the SEC on April 4, 2006) 10.20 Indenture, dated as of March 30, 2006 by and between Four Oaks Fincorp, Inc. and Wilmington Trust Company, as Trustee, relating to Junior Subordinated Debt Securities due June 15, 2036 (incorporated by reference to Exhibit 10.3 to the Company's Current Report on Form 8-K filed with the SEC on April 4, 2006) 21 Subsidiaries of Four Oaks Fincorp, Inc. 23 Consent of Dixon Hughes PLLC 31.1 Certification of Chief Executive Officer Pursuant to Rule 13a-14/15d-14 as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 31.2 Certification of Chief Financial Officer Pursuant to Rule 13a-14/15d-14 as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 32.1 Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. [This exhibit is being furnished pursuant to Section 905 of the Sarbanes-Oxley Act of 2002 and shall not, except to the extent required by that Act, be deemed to be incorporated by reference into any document or filed herewith for the purposes of liability under the Securities Exchange Act of 1934, as amended, or the Securities Act of 1933, as amended, as the case may be.] 32.1 Certification of Chief Financial Officer to Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 [This exhibit is being furnished pursuant to Section 905 of the Sarbanes-Oxley Act of 2002 and shall not, except to the extent required by that Act, be deemed to be incorporated by reference into any document or filed herewith for the purposes of liability under the Securities Exchange Act of 1934, as amended, or the Securities Act of 1933, as amended, as the case may be.] (b) See (a) (3) above. (c) See (a) (2) above. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. FOUR OAKS FINCORP, INC. Date: March 12, 2008 By: /s/ Ayden R. Lee, Jr. --------------------- Ayden R. Lee, Jr. Chairman, President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Date: March 12, 2008 /s/ Ayden R. Lee, Jr. --------------------- Ayden R. Lee, Jr. Chairman, President and Chief Executive Officer Date: March 12, 2008 /s/ Nancy S. Wise ----------------- Nancy S. Wise Executive Vice President and Chief Financial Officer Date: March 12, 2008 /s/ William J. Edwards ---------------------- William J. Edwards Director Date: March 12, 2008 /s/ Warren L. Grimes -------------------- Warren L. Grimes Director Date: March 12, 2008 /s/ Dr. R. Max Raynor, Jr. -------------------------- Dr. R. Max Raynor, Jr. Director Date: March 12, 2008 /s/ Percy Y. Lee ---------------- Percy Y. Lee Director Date: March 12, 2008 /s/ Paula C. Bowman ------------------- Paula C. Bowman Director Date: March 12, 2008 /s/ William Ashley Turner ------------------------- William Ashley Turner Director Date: March 12, 2008 /s/ Michael A. Weeks -------------------- Michael A. Weeks Director 82 Exhibit No. Description of Exhibit 2.1 Merger Agreement, dated as of December 10, 2007, by and among Four Oaks Fincorp, Inc., Four Oaks Bank & Trust Company and LongLeaf Community Bank (incorporated by reference to Exhibit 2.1 to the Company's Current Report on Form 8-K filed on December 13, 2007) 2.2 List of Schedules Omitted from Merger Agreement included as Exhibit 2.1 above (incorporated by reference to Exhibit 2.2 to the Company's Current Report on Form 8-K filed on December 13, 2007) 3.1 Articles of Incorporation of Four Oaks Fincorp, Inc. including Articles of Amendment to Articles of Incorporation (incorporated by reference to Exhibit 3.1 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2004) 3.2 Bylaws of Four Oaks Fincorp, Inc. (incorporated by reference to Exhibit 3.2 to the Company's Current Report on Form 8-K12G3 filed with the SEC on July 2, 1997) 4 Specimen of Certificate for Four Oaks Fincorp, Common Stock (incorporated by reference to Exhibit 4 to the Company's Current Report on Form 8-K12G3 filed with the SEC on July 2, 1997) 10.1 Employment Agreement with Ayden R. Lee, Jr. (incorporated by reference to Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the period ended June 30, 1997) (management contract or compensatory plan, contract or arrangement) 10.2 Severance Compensation Agreement with Ayden R. Lee, Jr. (incorporated by reference to Exhibit 10.2 to the Company's Quarterly Report on Form 10-Q for the period ended June 30, 1997) (management contract or compensatory plan, contract or arrangement) 10.3 Amended and Restated Nonqualified Stock Option Plan (incorporated by reference to Exhibit 10.2 to the Company's Quarterly Report on Form 10-Q for the period ended June 30, 2004) (management contract or compensatory plan, contract or arrangement) 10.4 Amended and Restated Employee Stock Purchase and Bonus Plan (incorporated by reference to Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the period ended June 30, 2004) (management contract or compensatory plan, contract or arrangement) 10.5 Second Amended and Restated Dividend Reinvestment and Stock Purchase Plan (incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K filed with the SEC on December 21, 2006) (management contract or compensatory plan, contract or arrangement) 10.6 Four Oaks Bank & Trust Company Supplemental Executive Retirement Plan (incorporated by reference to Exhibit 10.6 to the Company's Annual Report on Form 10-KSB for the fiscal year ended December 31, 1998) (management contract or compensatory plan, contract or arrangement) 10.7 Employment Agreement with Clifton L. Painter (incorporated by reference to Exhibit 10.7 to the Company's Annual Report on Form 10-KSB for the fiscal year ended December 31, 2001) (management contract or compensatory plan, contract or arrangement) 10.8 Severance Compensation Agreement with Clifton L. Painter (incorporated by reference to Exhibit 10.8 to the Company's Annual Report on Form 10-KSB for the period ended December 31, 2002) (management contract or compensatory plan, contract or arrangement) 10.9 Executive Employment Agreement with W. Leon Hiatt, III (incorporated by reference to Exhibit 10.9 to the Company's Annual Report on Form 10-KSB for the period ended December 31, 2003) (management contract or compensatory plan, contract or arrangement) 10.10 Severance Compensation Agreement with W. Leon Hiatt, III (incorporated by reference to Exhibit 10.10 to the Company's Annual Report on form 10-KSB for the period ended December 31, 2003) (management contract or compensatory plan, contract or arrangement) 43 10.11 Executive Employment Agreement with Nancy S. Wise (incorporated by reference to Exhibit 10.11 to the Company's Annual Report on Form 10-KSB for the period ended December 31, 2003) (management contract or compensatory plan, contract or arrangement) 10.12 Severance Compensation Agreement with Nancy S. Wise (incorporated by reference to Exhibit 10.12 to the Company's Annual Report on Form 10-KSB for the period ended December 31, 2003) (management contract or compensatory plan, contract or arrangement) 10.13 Form of Stock Option Agreement (Non-Employee Director) (incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K filed with the SEC on March 1, 2005) (management contract or compensatory plan, contract or arrangement) 10.14 Form of Stock Option Agreement (Employee) (incorporated by reference to Exhibit 10.2 to the Company's Current Report on Form 8-K filed with the SEC on March 1, 2005) (management contract or compensatory plan, contract or arrangement) 10.15 Executive Employment Agreement with Jeff D. Pope (incorporated by reference to Exhibit 10.15 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2004) (management contract or compensatory plan, contract or arrangement) 10.16 Severance Compensation Agreement with Jeff D. Pope (incorporated by reference to Exhibit 10.16 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2004) (management contract or compensatory plan, contract or arrangement) 10.17 Summary of Non-Employee Director Compensation (incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K filed with the SEC on January 25, 2006) (management contract or compensatory plan, contract or arrangement) 10.18 Amended and Restated Declaration of Trust of Four Oaks Statutory Trust I, dated as of March 30, 2006 (incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K filed with the SEC on April 4, 2006) 10.19 Guarantee Agreement of Four Oaks Fincorp, Inc. dated as of March 30, 2006 (incorporated by reference to Exhibit 10.2 to the Company's Current Report on Form 8-K filed with the SEC on April 4, 2006) 10.20 Indenture, dated as of March 30, 2006 by and between Four Oaks Fincorp, Inc. and Wilmington Trust Company, as Trustee, relating to Junior Subordinated Debt Securities due June 15, 2036 (incorporated by reference to Exhibit 10.3 to the Company's Current Report on Form 8-K filed with the SEC on April 4, 2006) 21 Subsidiaries of Four Oaks Fincorp, Inc. 23 Consent of Dixon Hughes PLLC 31.1 Certification of Chief Executive Officer Pursuant to Rule 13a-14/15d-14 as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 31.2 Certification of Chief Financial Officer Pursuant to Rule 13a-14/15d-14 as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 32.1 Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. [This exhibit is being furnished pursuant to Section 905 of the Sarbanes-Oxley Act of 2002 and shall not, except to the extent required by that Act, be deemed to be incorporated by reference into any document or filed herewith for the purposes of liability under the Securities Exchange Act of 1934, as amended, or the Securities Act of 1933, as amended, as the case may be.] 32.1 Certification of Chief Financial Officer to Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 [This exhibit is being furnished pursuant to Section 905 of the Sarbanes-Oxley Act of 2002 and shall not, except to the extent required by that Act, be deemed to be incorporated by reference into any document or filed herewith for the purposes of liability under the Securities Exchange Act of 1934, as amended, or the Securities Act of 1933, as amended, as the case may be.] EX-21 2 a5631643ex21.txt EXHIBIT 21 Exhibit 21 Subsidiary Jurisdiction Four Oaks Bank & Trust Company North Carolina Four Oaks Mortgage Services, L.L.C. North Carolina Four Oaks Mortgage Company, L.P. Texas Four Oaks Statutory Trust I Delaware EX-23 3 a5631643ex23.txt EXHIBIT 23 Exhibit 23 CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTANTS We consent to the incorporation by reference in the registration statements of Four Oaks Fincorp, Inc. on Form S-4 (File No. 333-148944), Form S-8 (File Nos. 333-30677 and 333-69792) and Form S-3 (File No. 333-33527) of our reports dated March 12, 2008, with respect to the consolidated financial statements of Four Oaks Fincorp, Inc. and the effectiveness of internal control over financial reporting, which reports appear in Four Oaks Fincorp, Inc.'s 2007 Annual Report on Form 10-K. /s/ Dixon Hughes PLLC Raleigh, North Carolina EX-31.1 4 a5631643ex31_1.txt EXHIBIT 31.1 Exhibit 31.1 Certification by Chief Executive Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 I, Ayden R. Lee, Jr., certify that: 1. I have reviewed this annual report on Form 10-K of Four Oaks Fincorp, Inc.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; (c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (d) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal controls over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: March 12, 2008 By: /s/ Ayden R. Lee, Jr. ----------------------------------- Ayden R. Lee, Jr. Chairman, President and Chief Executive Officer 47 EX-31.2 5 a5631643ex31_2.txt EXHIBIT 31.2 Exhibit 31.2 Certification by Chief Financial Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 I, Nancy S. Wise, certify that: 1. I have reviewed this annual report on Form 10-K of Four Oaks Fincorp, Inc.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; (c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (d) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal controls over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: March 12, 2008 By: /s/ Nancy S. Wise ----------------------------------- Nancy S. Wise Executive Vice President and Chief Financial Officer EX-32.1 6 a5631643ex32_1.txt EXHIBIT 32.1 Exhibit 32.1 Certification by Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 In connection with the Annual Report of Four Oaks Fincorp, Inc. (the "Company") on Form 10-K for the year ending December 31, 2007 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Ayden R. Lee, Jr., Chairman, President and Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, to my knowledge, that: (1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. /s/ Ayden R. Lee, Jr. ----------------------------------- Ayden R. Lee, Jr. Chairman, President and Chief Executive Officer March 12, 2008 This Certification is being furnished solely to accompany the Report pursuant to 18 U.S.C. ss. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, and shall not be deemed "filed" by the Company for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, and shall not be incorporated by reference into any filing of the Company under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, whether made before or after the date of this Report, irrespective of any general incorporation language contained in such filing. A signed original of this written statement required by Section 906 of the Sarbanes-Oxley Act of 2002 has been provided to the Company and will be retained by the Company and furnished to the Securities and Exchange Commission or its staff upon request. EX-32.2 7 a5631643ex32_2.txt EXHIBIT 32.2 Exhibit 32.2 Certification by Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 In connection with the Annual Report of Four Oaks Fincorp, Inc. (the "Company") on Form 10-K for the year ending December 31, 2007 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Nancy S. Wise, Executive Vice President and Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, to my knowledge, that: (1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. /s/ Nancy S. Wise ----------------------------------- Nancy S. Wise Executive Vice President and Chief Financial Officer March 12, 2008 This Certification is being furnished solely to accompany the Report pursuant to 18 U.S.C. ss. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, and shall not be deemed "filed" by the Company for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, and shall not be incorporated by reference into any filing of the Company under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, whether made before or after the date of this Report, irrespective of any general incorporation language contained in such filing. A signed original of this written statement required by Section 906 of the Sarbanes-Oxley Act of 2002 has been provided to the Company and will be retained by the Company and furnished to the Securities and Exchange Commission or its staff upon request. -----END PRIVACY-ENHANCED MESSAGE-----