Bank of the Carolinas (BCAR) 10-Q 2013 Q1 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended March 31, 2013

Commission File No.: 000-52195

BANK OF THE CAROLINAS CORPORATION

(Exact name of registrant as specified in its charter)

NORTH CAROLINA	20-4989192
(State or other jurisdiction of incorporation or organization)	(IRS Employer Identification No.)
135 Boxwood Village Drive Mocksville, North Carolina	27028
(Address of principal executive offices)	(Zip Code)

Registrant’s telephone number, including area code:(336) 751-5755

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web site, if any, every interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (Section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

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

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

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

On May 15, 2013 there were 3,895,840 outstanding shares of the registrant’s common stock.

BANK OF THE CAROLINAS CORPORATION

FORM 10-Q

March 31, 2013

INDEX

Part I. FINANCIAL INFORMATION		3
Item 1. Financial Statements		3
	Consolidated Balance Sheets at March 31, 2013 and December 31, 2012	3
	Consolidated Statements of Operations for the Three Months Ended March 31, 2013 and 2012	4
	Consolidated Statements of Comprehensive Income (Loss) for the Three Months Ended March 31, 2013 and 2012	5
	Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2013 and 2012	6
	Consolidated Statements of Changes in Stockholders’ Equity for the Three Months Ended March 31, 2013 and 2012	7
	Notes to Consolidated Financial Statements	8
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		26
Item 3. Quantitative and Qualitative Disclosures about Market Risk		34
Item 4. Controls and Procedures		34
Part II. OTHER INFORMATION		34
Item 1. Legal Proceedings		34
Item 1A. Risk Factors		34
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		34
Item 3. Defaults Upon Senior Securities		34
Item 4. Mine Safety Disclosures		34
Item 5. Other Information		34
Item 6. Exhibits		35
SIGNATURES		36
EXHIBIT INDEX		37

2

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

Bank of the Carolinas Corporation

Consolidated Balance Sheets

(amounts in thousands, except share and per share data)

	March 31 2013			December 31 2012*
	(Unaudited)
Assets:
Cash and due from banks, noninterest-bearing	$	12,967		$	5,942
Interest-bearing deposits in banks		2,053			1,844
Cash and cash equivalents		15,020			7,786
Federal funds sold		24,930			27,370
Investment securities		99,666			106,931
Loans receivable		268,970			270,374
Less: Allowance for loan losses		(6,498	)		(6,890	)
Total loans, net		262,472			263,484
Premises and equipment		11,683			11,843
Other real estate owned		3,884			4,976
Bank owned life insurance		10,623			10,536
Deferred tax assets		753			607
Prepaid FDIC insurance assessment		269			630
Accrued interest receivable		1,283			1,315
Other assets		1,600			1,914
Total Assets	$	432,183		$	437,392
Liabilities:
Deposits:
Noninterest-bearing demand deposits	$	34,211		$	36,622
Interest-checking deposits		39,199			37,768
Savings and money market deposits		108,047			111,459
Time deposits		185,010			187,123
Total deposits		366,467			372,972
Securities sold under agreements to repurchase		46,500			45,362
Subordinated debt		7,855			7,855
Other liabilities		2,096			2,138
Total Liabilities		422,918			428,327
Commitments and contingencies (Note 6)		—			—
Stockholders’ Equity:
Preferred stock, no par value		13,179			13,179
Discount on preferred stock		(341	)		(419	)
Common stock, $5 per share par value		19,479			19,479
Additional paid-in capital		12,991			12,991
Retained deficit		(36,392	)		(36,748	)
Accumulated other comprehensive income		349			583
Total Stockholders’ Equity		9,265			9,065
Total Liabilities and Stockholders’ Equity	$	432,183		$	437,392
Preferred shares authorized		3,000,000			3,000,000
Preferred shares issued and outstanding		13,179			13,179
Unaccrued preferred stock dividend	$	1,400		$	1,235
Common shares authorized		15,000,000			15,000,000
Common shares issued and outstanding		3,895,840			3,895,840

* Derived from audited consolidated financial statements.

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

3

Bank of the Carolinas Corporation

Consolidated Statements of Operations

(Unaudited)

(dollars in thousands, except per share data)

	Three Months Ended March 31
	2013			2012
Interest income
Interest and fees on loans	$	3,216		$	3,786
Interest on securities		589			737
Other interest income		14			17
Total interest income		3,819			4,540
Interest expense
Interest on deposits		621			899
Interest on borrowed funds		557			564
Total interest expense		1,178			1,463
Net interest income		2,641			3,077
Provision for loan losses		(1,146	)		1,292
Net interest income after provision for loan losses		3,787			1,785
Noninterest income
Customer service fees		281			281
Increase in value of bank owned life insurance		87			91
Gains on sales of investment securities		—			748
Other income (loss)		(2	)		7
Total noninterest income		366			1,127
Noninterest expense
Salaries and benefits		1,598			1,758
Occupancy and equipment		452			504
FDIC insurance assessments		367			418
Data processing services		269			239
Valuation provisions and net operating costs associated with foreclosed real estate		365			839
Other		668			1,262
Total noninterest expense		3,719			5,020
Income (loss) before income taxes		434			(2,108	)
Provision for income taxes		—			368
Net income (loss)		434			(2,476	)
Dividends and accretion on preferred stock		(243	)		(237	)
Net income (loss) available to common stockholders	$	191		$	(2,713	)
Earnings (loss) per common share:
Basic	$	0.05		$	(0.70	)
Diluted	$	0.05		$	(0.70	)

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

4

Bank of the Carolinas Corporation

Consolidated Statements of Comprehensive Income (Loss)

(Unaudited)

(dollars in thousands)

	Three Months Ended March 31
	2013			2012
Net income (loss)	$	434		$	(2,476	)
Other comprehensive loss:
Unrealized holding losses on securities available-for-sale		(380	)		(207	)
Reclassification adjustment for gains realized in net loss		—			(748	)
Income tax effect		146			368
Total other comprehensive loss, net of income tax effect		(234	)		(587	)
Total comprehensive income (loss)	$	200		$	(3,063	)

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

5

Bank of the Carolinas Corporation

Consolidated Statements of Cash Flows

(Unaudited)

(dollars in thousands)

	Three Months Ended March 31
	2013			2012
Cash flows from operating activities:
Net income (loss)	$	434		$	(2,476	)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Provision for loan losses		(1,146	)		1,292
Deferred tax expense		—			368
Stock based compensation expense		—			1
Depreciation and amortization		174			228
Change in valuation allowance on other real estate owned		349			542
(Gain) loss on sale of other real estate owned		(47	)		84
Gains on sales of investment securities		—			(748	)
Loss on disposal of premises and equipment		8			—
Increase in bank owned life insurance		(87	)		(91	)
Net amortization/accretion of premiums and discounts on investments		143			231
Net change in other assets		502			536
Net change in other liabilities		(42	)		44
Net cash provided by operating activities		288			11
Cash flows from investing activities:
Net change in federal funds sold		2,440			(16,080	)
Purchases of premises and equipment		(22	)		(255	)
Purchases of securities		—			(14,740	)
Proceeds from sales, calls, maturities and principal repayments of securities available for sale		6,742			23,024
Redemption of FHLB stock		205			—
Proceeds from sales of other real estate owned		1,116			2,019
Net decrease in loans		1,832			8,847
Net cash provided by investing activities		12,313			2,815
Cash flows from financing activities:
Net decrease in deposits		(6,505	)		(3,228	)
Net increase in repurchase agreements		1,138			37
Cash dividends paid on preferred stock		—			—
Net cash used by financing activities		(5,367	)		(3,191	)
Net increase (decrease) in cash and cash equivalents		7,234			(365	)
Cash and cash equivalents at beginning of period		7,786			7,601
Cash and cash equivalents at end of period	$	15,020		$	7,236
Supplemental disclosure of cash flow information:
Cash paid during the period for interest	$	1,123		$	1,403
Noncash investing and financing activities:
Change in fair value of securities available for sale, net of tax	$	(234	)	$	(587	)
Transfer from loans to other real estate owned	$	326		$	1,623

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

6

Bank of the Carolinas Corporation

Consolidated Statements of Changes in Stockholders’ Equity

(Unaudited)

(dollars in thousands)

																	Accumulated
					Discount							Additional					Other			Total
	Preferred Stock				on Preferred			Common Stock				Paid-In		Retained			Comprehensive			Stockholders’
	Shares		Amount		Stock			Shares		Amount		Capital		Deficit			Income			Equity
Balance, December 31, 2011		13,179	$	13,179	$	(716	)		3,895,840	$	19,479	$	12,991	$	(32,453	)	$	1,553		$	14,033
Net loss		—		—		—			—		—		—		(2,476	)		—			(2,476	)
Other comprehensive loss		—		—		—			—		—		—		—			(587	)		(587	)
Stock based compensation benefit		—		—		—			—		—		1		—			—			1
Discount accretion on preferred stock		—		—		72			—		—		—		(72	)		—			—
Dividends accrued on preferred stock		—		—		—			—		—		—		(165	)		—			(165	)
Balance, March 31, 2012		13,179	$	13,179	$	(644	)		3,895,840	$	19,479	$	12,992	$	(35,166	)	$	966		$	10,806
Balance, December 31, 2012		13,179	$	13,179	$	(419	)		3,895,840	$	19,479	$	12,991	$	(36,748	)	$	583		$	9,065
Net income		—		—		—			—		—		—		434			—			434
Other comprehensive loss		—		—		—			—		—		—		—			(234	)		(234	)
Discount accretion on preferred stock		—		—		78			—		—		—		(78	)		—			—
Dividends accrued on preferred stock		—		—		—			—		—		—		—			—			—
Balance, March 31, 2013		13,179	$	13,179	$	(341	)		3,895,840	$	19,479	$	12,991	$	(36,392	)	$	349		$	9,265

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

7

Bank of the Carolinas Corporation

Notes to Consolidated Financial Statements

(Unaudited)

NOTE 1. BASIS OF PRESENTATION

In the opinion of management, the financial information included in these unaudited financial statements reflects all adjustments (consisting of normal recurring adjustments) necessary for a fair presentation of the financial information as of March 31, 2013 and December 31, 2012 and for the three-month periods ended March 31, 2013 and 2012, in conformity with accounting principles generally accepted in the United States of America.

The preparation of financial statements requires management to make estimates and assumptions that affect reported amounts of assets and liabilities at the date of the financial statements, as well as the amounts of income and expense during the reporting period. Actual results could differ from those estimates. Operating results for the three-month period ended March 31, 2013 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2013.

The results presented here are for Bank of the Carolinas Corporation (“the Company”), the parent company of Bank of the Carolinas (“the Bank”). The organization and business of the Company, accounting policies followed by the Company and other relevant information are contained in the notes to the financial statements filed as part of the Company’s annual report on Form 10-K for the year ended December 31, 2012. This quarterly report should be read in conjunction with the annual report. Because the Company has no separate operations and conducts no business on its own other than owning the Bank, this discussion concerns primarily the business of the Bank. However, because the financial statements are presented on a consolidated basis, the Company and the Bank are collectively referred to as “the Company” unless otherwise noted.

NOTE 2. EARNINGS PER SHARE

Basic earnings (loss) per share represents income (loss) available to common stockholders divided by the weighted average number of common shares outstanding during the period. When applicable, the weighted average shares outstanding for the diluted earnings per share computations are adjusted to reflect the assumed conversion of shares available under stock options using the treasury stock method.

Earnings (loss) per share have been computed based on the following (dollars in thousands):

	Three months ended
	March 31,
	2013		2012
Net income (loss) applicable to common stockholders	$	191	$	(2,713	)
Weighted average number of common shares outstanding		3,895,840		3,895,840
Weighted average number of diluted common shares outstanding		3,895,840		3,895,840
Common stock options and common stock warrants - anti-dilutive		497,605		497,605

The common stock warrants referred to above were issued to the United States Treasury in connection with the Company’s April 17, 2009 participation in the Capital Purchase Program, which was authorized as a part of the TARP legislation passed by Congress during 2008.

8

NOTE 3. INVESTMENT SECURITIES

The amortized cost, estimated fair values and carrying values of the investment securities portfolios at the indicated dates are summarized as follows (dollars in thousands):

	March 31, 2013
			Gross		Gross
	Amortized		Unrealized		Unrealized		Estimated		Carrying
	Cost		Gains		Losses		Fair Value		Value
Investment securities available for sale:
U.S. Government agencies securities	$	44,514	$	258	$	143	$	44,629	$	44,629
State and municipal bonds		10,349		50		68		10,331		10,331
Mortgage-backed securities		43,265		464		23		43,706		43,706
Total investment securities available for sale		98,128		772		234		98,666		98,666
Investment securities held to maturity:
Corporate securities		1,000		—		190		810		1,000
Total investment securities	$	99,128	$	772	$	424	$	99,476	$	99,666

	December 31, 2012
			Gross		Gross
	Amortized		Unrealized		Unrealized		Estimated		Carrying
	Cost		Gains		Losses		Fair Value		Value
Investment securities available for sale:
U.S. Government agencies securities	$	47,792	$	406	$	80	$	48,118	$	48,118
State and municipal bonds		10,364		44		82		10,326		10,326
Mortgage-backed securities		45,861		648		17		46,492		46,492
Total investment securities available for sale		104,017		1,098		179		104,936		104,936
Investment securities held to maturity:
Corporate securities		1,995		12		190		1,817		1,995
Total investment securities	$	106,012	$	1,110	$	369	$	106,753	$	106,931

Management of the Bank believes all unrealized losses on available-for-sale securities as of March 31, 2013 represent temporary impairments related to market fluctuations. The unrealized losses on our securities are a nominal portion of the total value of the portfolio. The Bank has no intention of selling these securities before their maturity and has the appropriate sources of liquidity to hold these securities until maturity in order to minimize the likelihood that recognized losses will occur.

9

The fair values of securities with unrealized losses at March 31, 2013 and December 31, 2012 are as follows (dollars in thousands):

March 31, 2013:
	Less than 12 Months				12 Months or More				Total
	Estimated		Unrealized		Estimated		Unrealized		Estimated		Unrealized
	Fair Value		Losses		Fair Value		Losses		Fair Value		Losses
Temporarily impaired securities:
U.S. Government agency securities	$	14,813	$	143	$	—	$	—	$	14,813	$	143
State and municipal bonds		6,408		68		—		—		6,408		68
Mortgage-backed securities		6,692		23		—		—		6,692		23
Corporate securities		—		—		810		190		810		190
Total	$	27,913	$	234	$	810	$	190	$	28,723	$	424

December 31, 2012:
	Less than 12 Months				12 Months or More				Total
	Estimated		Unrealized		Estimated		Unrealized		Estimated		Unrealized
	Fair Value		Losses		Fair Value		Losses		Fair Value		Losses
Temporarily impaired securities:
U.S. Government agency securities	$	9,881	$	80	$	—	$	—	$	9,881	$	80
State and municipal bonds		7,340		82		—		—		7,340		82
Mortgage-backed securities		4,490		17		—		—		4,490		17
Corporate securities		—		—		810		190		810		190
Total	$	21,711	$	179	$	810	$	190	$	22,521	$	369

NOTE 4. LOANS

The loan portfolio as of the dates indicated is summarized below (dollars in thousands):

	March 31,			December 31,
	2013			2012
Real estate loans:
Residential, 1-4 family	$	76,197		$	72,595
Commercial real estate		111,287			110,527
Construction and development		28,094			28,976
Home equity		29,095			29,462
Total real estate loans		244,673			241,560
Commercial business and other loans		19,894			22,992
Consumer loans:
Installment		2,920			3,158
Other		1,483			2,664
Total consumer loans		4,403			5,822
Gross loans receivable		268,970			270,374
Allowance for loan losses		(6,498	)		(6,890	)
Loans, net	$	262,472		$	263,484

10

Impaired loans, segregated by class of loans, are summarized as follows as of the dates indicated (dollars in thousands):

	March 31, 2013										December 31, 2012
			Unpaid				Average		Interest				Unpaid				Average		Interest
	Recorded		Principal		Related		Recorded		Income		Recorded		Principal		Related		Recorded		Income
	Investment		Balance		Allowance		Investment		Recognized		Investment		Balance		Allowance		Investment		Recognized
With no related allowance:
Commercial - Non Real Estate	$	936	$	1,112	$	—	$	1,134	$	15	$	948	$	1,125	$	—	$	1,185	$	59
Commercial Real Estate
Owner occupied		3,126		3,435		—		3,449		42		5,622		5,926		—		5,961		304
Income producing		3,225		3,364		—		3,371		38		3,274		3,394		—		3,422		135
Multifamily		—		—		—		—		—		—		—		—		—		—
Construction & Development
1 - 4 Family		—		—		—		—		—		—		—		—		—		—
Other		1,683		2,017		—		2,030		29		2,329		2,657		—		2,718		141
Farmland		354		362		—		362		7		362		362		—		362		19
Residential
Equity Lines		660		746		—		751		6		93		95		—		164		7
1 - 4 Family		6,483		7,475		—		7,498		92		6,510		7,472		—		7,546		350
Junior Liens		205		225		—		226		3		236		255		—		259		15
Consumer - Non Real Estate		69		83		—		84		1		72		85		—		87		6
Total loans with no allowance	$	16,741	$	18,819	$	—	$	18,905	$	233	$	19,446	$	21,371	$	—	$	21,704	$	1,036
With an allowance recorded:
Commercial - Non Real Estate	$	1,326	$	1,326	$	44	$	1,338	$	11	$	2,279	$	2,279	$	45	$	2,377	$	99
Commercial Real Estate
Owner occupied		4,343		4,344		147		4,369		57		4,157		4,157		153		4,236		218
Income producing		8,448		8,503		145		8,535		101		8,507		8,562		164		8,662		418
Multifamily		1,302		1,335		35		1,340		12		1,311		1,344		43		1,360		50
Construction & Development
1 - 4 Family		367		373		9		374		5		388		395		7		399		20
Other		3,077		3,079		113		3,081		27		3,250		3,252		144		3,314		45
Farmland		—		—		—		—		—		—		—		—		—		—
Residential
Equity Lines		—		—		—		—		—		—		—		—		—		—
1 - 4 Family		6,628		6,643		249		6,657		65		6,366		6,381		197		6,458		262
Junior Liens		345		347		4		348		5		319		321		2		325		18
Consumer - Non Real Estate		11		11		—		12		—		12		12		—		14		1
Total loans with an allowance	$	25,847	$	25,961	$	746	$	26,054	$	283	$	26,589	$	26,703	$	755	$	27,145	$	1,131
Total:
Commercial - Non Real Estate	$	2,262	$	2,438	$	44	$	2,472	$	26	$	3,227	$	3,404	$	45	$	3,562	$	158
Commercial Real Estate	$	20,444	$	20,981	$	327	$	21,064	$	250	$	22,871	$	23,383	$	360	$	23,641	$	1,125
Construction & Development	$	5,481	$	5,831	$	122	$	5,847	$	68	$	6,329	$	6,666	$	151	$	6,793	$	225
Residential	$	14,321	$	15,436	$	253	$	15,480	$	171	$	13,524	$	14,524	$	199	$	14,752	$	652
Consumer - Non Real Estate	$	80	$	94	$	—	$	96	$	1	$	84	$	97	$	—	$	101	$	7
Totals	$	42,588	$	44,780	$	746	$	44,959	$	516	$	46,035	$	48,074	$	755	$	48,849	$	2,167

11

Impaired loans include loans whose contractual terms have been restructured in a manner that grants a concession to a borrower experiencing financial difficulties. Troubled debt restructurings (TDRs) are a subset of impaired loans and totaled $39.9 million at March 31, 2013 and $41.5 million at December 31, 2012.

The following tables illustrate TDR information for the three months ended March 31, 2013 and 2012 (dollars in thousands):

	For the three months ended March 31, 2013
Troubled Debt Restructuring	Number of Contracts		Pre-Modification Recorded Investment		Post-Modification Recorded Investment
Commercial - Non Real Estate		1	$	32	$	32
Commercial - Real Estate		1		238		238
Construction & Development		—		—		—
Residential		2		293		293
Consumer - Non Real Estate		—		—		—
Totals		4	$	563	$	563

	For the three months ended March 31, 2012
Troubled Debt Restructuring	Number of Contracts		Pre-Modification Recorded Investment		Post-Modification Recorded Investment
Commercial - Non Real Estate		4	$	72	$	72
Commercial - Real Estate		3		1,333		1,333
Construction & Development		2		104		104
Residential		14		1,577		1,577
Consumer - Non Real Estate		1		18		18
Totals		24	$	3,104	$	3,104

For the purposes of this report, default is defined as being 90-days past due or on non-accrual status without performance. There were no loans restructured in the twelve months prior to March 31, 2013 and 2012 that went into default during the three-month periods ended March 31, 2013 and 2012.

Some loan modifications classified as TDRs may not ultimately result in the full collection of principal and interest, as modified, and may result in potential incremental losses. These potential incremental losses have been factored into our overall allowance for loan losses estimate. The level of any re-defaults will likely be affected by future economic conditions. Once a loan becomes a TDR, it will continue to be reported as a TDR until it is ultimately repaid in full, reclassified to loans held for sale, or foreclosed and sold. Included in the allowance for loan losses at March 31, 2013 and 2012 was an impairment reserve for TDRs in the amount of $746,000 and $779,000, respectively.

12

Non-accrual loans and an age analysis of past due loans, segregated by class of loans, were as follows (dollars in thousands):

													90 Days
	30 - 59		60 - 89		90 Days								Past Due
	Days		Days		or More		Total				Total		and Still		Non-accrual
	Past Due		Past Due		Past Due		Past Due		Current		Loans		Accruing		Loans
March 31, 2013:
Commercial - Non Real Estate	$	151	$	—	$	—	$	151	$	19,743	$	19,894	$	—	$	247
Commercial Real Estate
Owner occupied		160		26		—		186		56,522		56,708		—		260
Income producing		175		—		354		529		46,928		47,457		—		354
Multifamily		—		—		—		—		7,122		7,122		—		—
Construction & Development
1 - 4 Family		—		—		—		—		1,981		1,981		—		—
Other		—		492		292		784		24,695		25,479		—		690
Farmland		—		—		354		354		280		634		—		354
Residential
Equity Lines		38		49		177		264		28,831		29,095		—		661
1 - 4 Family		3,143		62		622		3,827		71,099		74,926		—		1,280
Junior Liens		27		—		—		27		1,244		1,271		—		32
Consumer - Non Real Estate		20		1		—		21		2,899		2,920		—		5
Other		—		—		—		—		1,483		1,483		—		—
Total	$	3,714	$	630	$	1,799	$	6,143	$	262,827	$	268,970	$	—	$	3,883

														90 Days
	30 - 59		60 - 89		90 Days									Past Due
	Days		Days		or More		Total				Total			and Still		Non-accrual
	Past Due		Past Due		Past Due		Past Due		Current		Loans			Accruing		Loans
December 31, 2012:
Commercial - Non Real Estate	$	228	$	190	$	—	$	418	$	22,574	$	22,992		$	—	$	202
Commercial Real Estate
Owner occupied		192		—		2,466		2,658		53,073		55,731	��		—		2,735
Income producing		21		—		361		382		47,205		47,587			—		1,418
Multifamily		—		—		—		—		7,209		7,209			—		—
Construction & Development
1 - 4 Family		—		20		—		20		1,989		2,009			—		20
Other		737		202		432		1,371		24,954		26,325			—		860
Farmland		—		—		—		—		642		642			—		—
Residential
Equity Lines		191		50		35		276		29,186		29,462			—		93
1 - 4 Family		431		160		518		1,109		70,173		71,282			—		2,365
Junior Liens		—		—		—		—		1,313		1,313			—		33
Consumer - Non Real Estate		70		—		7		77		3,081		3,158			—		7
Other		—		—		—		—		2,664		2,664			—		—
Total	$	1,870	$	622	$	3,819	$	6,311	$	264,063	$	270,374		$	—	$	7,733

The Bank categorizes loans and leases into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. This categorization is made on all commercial, commercial real estate, and construction and development loans. The Bank uses the following definitions for risk ratings:

Pass - Loans and leases classified as pass should be performing relatively close to expectations, with adequate evidence that the borrower is continuing to generate adequate cash flow to service debt. There should be no significant departure from the intended source and timing of repayment, and there should be no undue reliance on secondary sources of repayment. To the extent that some variance exists in one or more criteria being measured, it may be offset by the relative strength of other factors and/or collateral pledged to secure the transaction.

Special Mention - Loans and leases classified as special mention, while still adequately protected by the borrower’s capital adequacy and payment capability, exhibit distinct weakening trends and/or elevated levels of exposure to external conditions. If left unchecked or uncorrected, these potential weaknesses may result in deteriorated prospects of repayment. These exposures require management’s close attention so as to avoid becoming undue or unwarranted credit exposures.

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Substandard - Loans and leases classified as substandard are inadequately protected by the borrower’s current financial condition and payment capability or of the collateral pledged, if any. Loans and leases so classified have a well-defined weakness or weaknesses that jeopardize the orderly repayment of debt. They are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected.

Doubtful - Loans and leases classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or orderly repayment in full, on the basis of current existing facts, conditions and values, highly questionable and improbable. Possibility of loss is extremely high, but because of certain important and reasonably specific factors that may work to the advantage and strengthening of the exposure, its classification as an estimated loss is deferred until its more exact status may be determined. The Company’s practice is to charge-off the portion of the loan amount determined to be doubtful in the quarter that the determination is made if the repayment of the loan is collateral dependent.

Loss - Loans and leases classified as loss are considered to be non-collectible and of such little value that their continuance as bankable assets is not warranted. This does not mean the loan has absolutely no recovery value, but rather it is neither practical nor desirable to defer writing off the loan, even though partial recovery may be obtained in the future. Losses are taken in the period in which they surface as uncollectible.

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Commercial loans that do not require individual analysis as part of the above described process are considered to be pass-rated loans. As of March 31, 2013 and December 31, 2012, and based on the most recent analysis performed, the loans and leases were categorized as follows (dollars in thousands):

	March 31, 2013
			Special
Internal Risk Rating Grades	Pass		Mention		Substandard		Doubtful		Loss
Commercial - Non Real Estate	$	14,891	$	3,976	$	1,027	$	—	$	—
Commercial Real Estate
Owner occupied		39,232		10,927		6,549		—		—
Income producing		25,633		14,973		6,851		—		—
Multifamily		5,183		1,939		—		—		—
Construction & Development
1 - 4 Family		1,345		269		367		—		—
Other		14,057		8,835		2,587		—		—
Farmland		280		—		354		—		—
Totals	$	100,621	$	40,919	$	17,735	$	—	$	—
Total:
Commercial - Non Real Estate	$	14,891	$	3,976	$	1,027	$	—	$	—
Commercial Real Estate	$	70,048	$	27,839	$	13,400	$	—	$	—
Construction & Development	$	15,682	$	9,104	$	3,308	$	—	$	—
Totals	$	100,621	$	40,919	$	17,735	$	—	$	—

	December 31, 2012
			Special
Internal Risk Rating Grades	Pass		Mention		Substandard		Doubtful		Loss
Commercial - Non Real Estate	$	17,728	$	2,671	$	2,593	$	—	$	—
Commercial Real Estate
Owner occupied		32,843		13,902		8,986		—		—
Income producing		25,537		13,411		8,639		—		—
Multifamily		5,197		1,956		56		—		—
Construction & Development
1 - 4 Family		1,346		275		388		—		—
Other		15,246		8,817		2,262		—		—
Farmland		280		—		362		—		—
Totals	$	98,177	$	41,032	$	23,286	$	—	$	—
Total:
Commercial - Non Real Estate	$	17,728	$	2,671	$	2,593	$	—	$	—
Commercial Real Estate	$	63,577	$	29,269	$	17,681	$	—	$	—
Construction & Development	$	16,872	$	9,092	$	3,012	$	—	$	—
Totals	$	98,177	$	41,032	$	23,286	$	—	$	—

15

All consumer-related loans, including residential real estate and non-real estate, are evaluated and monitored based upon payment activity. Once a consumer-related loan becomes past due on a recurring basis, the Company will pull that loan out of the homogenized pool and evaluate it individually for impairment. At this time, the consumer-related loan may be placed on the Company’s internal watch list and risk rated either special mention or substandard, depending upon the individual circumstances. Consumer-related loans at March 31, 2013 and December 31, 2012, segregated by class of loans, were as follows (dollars in thousands):

	March 31, 2013				December 31, 2012
			Non-				Non-
Risk Based on Payment Activity	Performing		Performing		Performing		Performing
Residential
Equity Lines	$	28,956	$	139	$	29,369	$	93
1 - 4 Family		74,322		604		69,619		1,663
Junior Liens		1,271		—		1,313		—
Consumer - Non Real Estate
Credit Cards		—		—		—		—
Other		2,920		—		3,158		—
Totals	$	107,469	$	743	$	103,459	$	1,756
Total:
Residential	$	104,549	$	743	$	100,301	$	1,756
Consumer - Non Real Estate	$	2,920	$	—	$	3,158	$	—
Totals	$	107,469	$	743	$	103,459	$	1,756

NOTE 5. ALLOWANCE FOR LOAN LOSSES

The allowance for loan losses is a reserve established through a provision for loan losses charged to expense, which represents management’s best estimate of probable losses that have been incurred within the existing portfolio of loans. The allowance is necessary to reserve for, in the judgment of management, estimated loan losses and risks inherent in the loan portfolio. The Company’s allowance for loan loss methodology includes allowance allocations calculated in accordance with ASC Topic 310, “Receivables” and allowance allocations calculated in accordance with ASC Topic 450, “Contingencies.” Accordingly, the methodology is based on historical loss experience by type of credit and internal risk grade, specific homogeneous risk pools and specific loss allocations, with adjustments for current events and conditions. The Company’s process for determining the appropriate level of the allowance for loan losses is designed to account for credit deterioration as it occurs. The provision for loan losses reflects loan quality trends, including the levels of and trends related to non-accrual loans, past due loans, potential problem loans, criticized loans and net charge-offs or recoveries, among other factors. The provision for loan losses also reflects the totality of actions taken on all loans for a particular period. In other words, the amount of the provision reflects not only the necessary increases in the allowance for loan losses related to newly identified criticized loans, but it also reflects actions taken related to other loans including, among other things, any necessary increases or decreases in required allowances for specific loans.

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. Portions of the allowance may be allocated for specific credits; however, the entire allowance is available for any credit that, in management’s judgment, should be charged off. While management utilizes its best judgment and information available, the ultimate adequacy of the allowance is dependent upon a variety of factors beyond the Company’s control, including, among other things, the performance of the Company’s loan portfolio, the economy, changes in interest rates and the view of the regulatory authorities toward loan classifications.

The Company’s allowance for loan losses consists of three elements: (i) specific valuation allowances determined in accordance with accounting principles regarding receivables based on probable losses on specific loans; (ii) historical valuation allowances determined in accordance with accounting principles regarding contingencies based on historical loan loss experience for similar loans with similar characteristics and trends, adjusted, as necessary, to reflect the impact of current conditions; and (iii) general valuation allowances determined in accordance with accounting principles regarding contingencies based on general economic conditions and other qualitative risk factors both internal and external to the Company.

16

Historical valuation allowances are calculated based on the historical loss experience of specific types of loans at the time they were charged-off. The Company calculates historical loss ratios for pools of similar loans with similar characteristics based on the proportion of actual charge-offs experienced to the total population of loans in the pool. The historical loss ratios are periodically updated based on actual charge-off experience. A historical valuation allowance is established for each pool of similar loans based upon the product of the historical loss ratio and the total dollar amount of the loans in the pool. The Company’s pools of similar loans include commercial and industrial loans, commercial real estate loans, construction and development loans, residential real estate loans, and consumer and other loans. General valuation allowances are based on general economic conditions and other qualitative risk factors both internal and external to the Company. In general, such valuation allowances are determined by evaluating, among other things: (i) levels and trends in delinquencies and impaired loans; (ii) levels of and trends in charge-offs and recoveries; (iii) levels of non-impaired substandard loans; (iv) trends in volume and terms of loans; (v) effects of changes in risk selection and underwriting practices; (vi) experience, ability, and depth of lending management and staff; (vii) national and local economic trends and conditions; (viii) industry conditions; and (ix) effect of changes in credit concentrations. Management evaluates the degree of risk that each one of these components has on the quality of the loan portfolio on a quarterly basis. Loans identified as losses by management, internal loan review and/or regulatory examiners are charged-off.

Changes in the allowance for loan losses by segment, since their respective year-end, are as follows (dollars in thousands):

	March 31, 2013												March 31, 2012
	Beginning										Ending		Beginning										Ending
	Balance		Chargeoffs			Recoveries		Provision			Balance		Balance		Chargeoffs			Recoveries		Provision			Balance
Commercial - Non Real Estate	$	1,209	$	(9	)	$	1,290	$	(1,855	)	$	635	$	2,247	$	(269	)	$	89	$	179		$	2,246
Commercial Real Estate
Owner occupied		1,359		(216	)		12		325			1,480		1,794		(442	)		—		326			1,678
Income producing		773		(21	)		20		(1	)		771		547		—			—		26			573
Multifamily		78		—			—		(9	)		69		80		—			—		23			103
Construction & Development
1 - 4 Family		78		(5	)		—		8			81		58		—			1		(25	)		34
Other		728		—			2		(61	)		669		661		(653	)		7		767			782
Farmland		—		(8	)		—		9			1		—		—			—		—			—
Residential
Equity Lines		314		(198	)		10		238			364		279		(18	)		4		11			276
1 - 4 Family		1,267		(126	)		3		93			1,237		1,168		(132	)		78		33			1,147
Consumer - Non Real Estate		98		(11	)		11		(6	)		92		143		(14	)		4		6			139
Unallocated		986		—			—		113			1,099		1,124		—			—		(54	)		1,070
Total	$	6,890	$	(594	)	$	1,348	$	(1,146	)	$	6,498	$	8,101	$	(1,528	)	$	183	$	1,292		$	8,048

17

As of March 31, 2013 and December 31, 2012, loans were evaluated for impairment as follows (dollars in thousands):

	Individually Evaluated for Impairment
	March 31, 2013				December 31, 2012
	Allowance		Total Loans		Allowance		Total Loans
Commercial - Non Real Estate	$	44	$	2,262	$	45	$	3,227
Commercial Real Estate
Owner occupied		147		7,469		153		9,779
Income producing		145		11,673		164		11,781
Multifamily		35		1,302		43		1,311
Construction & Development
1 - 4 Family		9		367		7		388
Other		113		4,760		144		5,579
Farmland		—		354		—		362
Residential
Equity Lines		—		660		—		93
1 - 4 Family		253		13,661		199		13,431
Consumer - Non Real Estate		—		80		—		84
Unallocated		—		—		—		—
Total	$	746	$	42,588	$	755	$	46,035

	Collectively Evaluated for Impairment
	March 31, 2013				December 31, 2012
	Allowance		Total Loans		Allowance		Total Loans
Commercial - Non Real Estate	$	591	$	17,632	$	1,164	$	19,765
Commercial Real Estate
Owner occupied		1,333		49,239		1,206		45,952
Income producing		626		35,784		609		35,806
Multifamily		34		5,820		35		5,898
Construction & Development
1 - 4 Family		72		1,614		71		1,621
Other		556		20,719		584		20,746
Farmland		1		280		—		280
Residential
Equity Lines		364		28,435		314		29,369
1 - 4 Family		984		62,536		1,068		59,164
Consumer - Non Real Estate		92		2,840		98		3,074
Unallocated		1,099		1,483		986		2,664
Total	$	5,752	$	226,382	$	6,135	$	224,339

18

NOTE 6. COMMITMENTS AND CONTINGENCIES

The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, lines of credit and standby letters of credit. These instruments involve elements of credit risk in excess of amounts recognized in the accompanying financial statements.

The Company’s risk of loss related to unfunded loan commitments and lines of credit or standby letters of credit is represented by the contractual amount of these instruments. The Company uses the same credit policies in making commitments under such instruments as it does for on-balance sheet instruments. The amount of collateral obtained, if any, is based on management’s credit evaluation of the borrower. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The following table presents a summary of outstanding financial instruments whose contract amounts represent credit risk as of March 31, 2013 (dollars in thousands):

Unfunded loan commitments	$	28,309
Financial standby letters of credit		172
Total unused commitments	$	28,481

NOTE 7. RECENT ACCOUNTING PRONOUNCEMENTS

In July 2012, the FASB issued Accounting Standards Update 2012-02,Intangibles - Goodwill and Other (Topic 350). The amendments in this Update are intended to reduce cost and complexity by providing an entity with the option to make a qualitative assessment about the likelihood that an indefinite-lived intangible asset is impaired to determine whether it should perform a quantitative impairment test. The amendments also enhance the consistency of impairment testing guidance among long-lived asset categories by permitting an entity to assess qualitative factors to determine whether it is necessary to calculate the asset’s fair value when testing an indefinite-lived intangible asset for impairment, which is equivalent to the impairment testing requirements for other long-lived assets. The amendments have not had a significant impact on the Company.

In October 2012, the FASB issued Accounting Standards Update 2012-06,Business Combinations (Topic 805). When a reporting entity recognizes an indemnification asset (in accordance with Subtopic 805-20) as a result of a government-assisted acquisition of a financial institution and subsequently a change in the cash flows expected to be collected on the indemnification asset occurs (as a result of a change in cash flows expected to be collected on the assets subject to indemnification), the reporting entity should subsequently account for the change in the measurement of the indemnification asset on the same basis as the change in the assets subject to indemnification. Any amortization of changes in value should be limited to the contractual term of the indemnification agreement (that is, the lesser of the term of the indemnification agreement and the remaining life of the indemnified assets). For public and nonpublic entities, the amendments in this Update are effective for fiscal years, and interim periods within those years, beginning on or after December 15, 2012. Early adoption is permitted. The amendments should be applied prospectively to any new indemnification assets acquired after the date of adoption and to indemnification assets existing as of the date of adoption arising from a government-assisted acquisition of a financial institution. The amendments have not had a significant impact on the Company.

In January 2013, the FASB issued Accounting Standards Update 2013-01,Balance Sheet (Topic 210). The amendments in this Update affect entities that have derivatives accounted for in accordance with Topic 815, including bifurcated embedded derivatives, repurchase agreements and reverse repurchase agreements, and securities borrowing and securities lending transactions that are either offset in accordance with Section 210-20-45 or Section 815-10-45 or subject to an enforceable master netting arrangement or similar agreement. Entities with other types of financial assets and financial liabilities subject to a master netting arrangement or similar agreement also are affected because these amendments make them no longer subject to the disclosure requirements in Update 2011-11. The amendments clarify the intended scope of the disclosures required by Section 210-20-50. The FASB concluded that the clarified scope will reduce significantly the operability concerns expressed by preparers while still providing decision-useful information about certain transactions involving master netting arrangements. The amendments provide a user of financial statements with comparable information as it relates to certain reconciling differences between financial statements prepared in accordance with U.S. GAAP and those financial statements prepared in accordance with International Financial Reporting Standards (IFRS). The amendments are not expected to have a significant impact on the Company.

19

In February 2013, the FASB issued Accounting Standards Update 2013- 02,Comprehensive Income (Topic 220). The amendments do not change the current requirements for reporting net income or other comprehensive income in financial statements. However, the amendments require an entity to provide information about the amounts reclassified out of accumulated other comprehensive income by component. In addition, an entity is required to present, either on the face of the statement where net income is presented or in the notes, significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income but only if the amount reclassified is required under U.S. GAAP to be reclassified to net income in its entirety in the same reporting period. For other amounts that are not required under U.S. GAAP to be reclassified in their entirety to net income, an entity is required to cross-reference to other disclosures required under U.S. GAAP that provide additional detail about those amounts. Substantially all of the information that this Update requires already is required to be disclosed elsewhere in the financial statements under U.S. GAAP. However, the new requirement about presenting information about amounts reclassified out of accumulated other comprehensive income and their corresponding effect on net income will present, in one place, information about significant amounts reclassified and, in some cases, cross-references to related footnote disclosures. Currently, this information is presented in different places throughout the financial statements. The amendments are not expected to have a significant impact on the Company.

In February 2013, the FASB issued Accounting Standards Update 2013-03,Financial Instruments (Topic 825). The amendments clarify that the requirement to disclose “the level of the fair value hierarchy within which the fair value measurements are categorized in their entirety (Level 1, 2, or 3)” does not apply to nonpublic entities for items that are not measured at fair value in the statement of financial position but for which fair value is disclosed. The amendments are not expected to have a significant impact on the Company.

In April 2013, the FASB issued Accounting Standards Update 2013-07,Presentation of Financial Statements (Topic 205). The amendments require an entity to prepare its financial statements using the liquidation basis of accounting when liquidation is imminent. Liquidation is imminent when the likelihood is remote that the entity will return from liquidation and either (a) a plan for liquidation is approved by the person or persons with the authority to make such a plan effective and the likelihood is remote that the execution of the plan will be blocked by other parties or (b) a plan for liquidation is being imposed by other forces (for example, involuntary bankruptcy). If a plan for liquidation was specified in the entity’s governing documents from the entity’s inception (for example, limited-life entities), the entity should apply the liquidation basis of accounting only if the approved plan for liquidation differs from the plan for liquidation that was specified at the entity’s inception.

The amendments require financial statements prepared using the liquidation basis of accounting to present relevant information about an entity’s expected resources in liquidation by measuring and presenting assets at the amount of the expected cash proceeds from liquidation. The entity should include in its presentation of assets any items it had not previously recognized under U.S. GAAP but that it expects to either sell in liquidation or use in settling liabilities (for example, trademarks).

An entity should recognize and measure its liabilities in accordance with U.S. GAAP that otherwise applies to those liabilities. The entity should not anticipate that it will be legally released from being the primary obligor under those liabilities, either judicially or by creditor(s). The entity also is required to accrue and separately present the costs that it expects to incur and the income that it expects to earn during the expected duration of the liquidation, including any costs associated with sale or settlement of those assets and liabilities.

Additionally, the amendments require disclosures about an entity’s plan for liquidation, the methods and significant assumptions used to measure assets and liabilities, the type and amount of costs and income accrued, and the expected duration of the liquidation process. The amendments are not expected to have a significant impact on the Company.

From time to time the FASB issues Proposed Accounting Standards Updates. Such proposed updates are subject to comment from the public, to revisions by the FASB and to final issuance by the FASB as Accounting Standards Updates. Management considers the effect of the proposed updates on the consolidated financial statements of the Company and monitors the status of changes to and proposed effective dates of proposed updates.

NOTE 8. FAIR VALUE

Accounting principles generally accepted in the United States of America require that companies measure and record certain assets and liabilities at fair value and record any adjustments to the fair value of those assets. Securities are recorded at fair value on a recurring basis while other assets, such as impaired loans, are recorded at fair value on a non-recurring basis.

20

The Company uses three levels of measurement to group those assets measured at fair value. These groupings are made based on the markets the assets are traded in and the reliability of the assumptions used to determine fair value. The groupings include:

• Level 1 pricing for an asset or liability is derived from the most likely actively traded markets and considered very reliable. Quoted prices on actively traded equities, for example, fall into this category.

• Level 2 pricing is derived from observable data including market spreads, current and projected rates, prepayment data and credit quality. Our bond price adjustments fall into this category as well as impaired loans and other real estate owned that use appraisals or brokered price opinions to determine fair value.

• Level 3 pricing is derived without observable data. In such cases, mark-to-market strategies are typically employed. These types of instruments often have no active market, possess unique characteristics and are thinly traded.

The Company’s investment securities are measured on a recurring basis through a model used by our bond agent. All of our bond price adjustments meet Level 2 criteria. Prices are derived from a model which uses actively quoted rates, prepayment models and other underlying credit and collateral data.

The following table summarizes the Company’s assets measured at fair value at the dates indicated (dollars in thousands):

	At March 31, 2013
	Total		Level 1		Level 2		Level 3
Assets valued on a recurring basis
Investment securities:
U.S. government and agency	$	44,629	$	—	$	44,629	$	—
State and municipals		10,331		—		10,331		—
Mortgage-backed		43,706		—		43,706		—
Assets valued on a non-recurring basis
Impaired loans		41,842		—		41,842		—
Other real estate owned		3,884		—		3,884		—
Total	$	144,392	$	—	$	144,392	$	—
	At December 31, 2012
	Total		Level 1		Level 2		Level 3
Assets valued on a recurring basis
Investment securities:
U.S. government and agency	$	48,118	$	—	$	48,118	$	—
State and municipals		10,326		—		10,326		—
Mortgage-backed		46,492		—		46,492		—
Assets valued on a non-recurring basis
Impaired loans		45,280		—		45,280		—
Other real estate owned		4,976		—		4,976		—
Total	$	155,192	$	—	$	155,192	$	—

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NOTE 9. BORROWED FUNDS

A summary of the Company’s outstanding borrowings and the annual rate of interest currently payable on each category is presented in the following table at the dates indicated (dollars in thousands):

	March 31, 2013					December 31, 2012
	Outstanding Balance		Annual Interest Rate			Outstanding Balance		Annual Interest Rate
Securities sold under overnight repurchase agreements	$	1,500		0.15	%	$	362		0.10	%
Securities sold under term repurchase agreements		45,000		4.38			45,000		4.38
Trust preferred securities		5,155		3.20			5,155		3.25
Subordinated debt		2,700		4.00			2,700		4.00
Total borrowed funds	$	54,355		4.13	%	$	53,217		4.22	%

The Bank engages from time-to-time in federal funds purchases from upstream correspondent institutions to meet temporary funding needs. There were none of these transactions outstanding at the close of either period presented in the above table.

The Bank had a total of $45.0 million of borrowings in the form of securities sold under term repurchase agreements that were entered into during 2008. These borrowings are secured by marketable investment securities equal to approximately 109.5% of the principal balances outstanding plus accrued interest and the value of an imbedded interest rate cap. The following table contains certain pertinent information with respect to these agreements at March 31, 2013 (dollars in thousands):

	Outstanding Principal Balance		Annual Effective Interest Rate			Final Maturity Date		Beginning Quarterly Call Dates		Collateral Requirement
Agreement dated 7/8/2008	$	25,000		4.85	%		7/8/2018		7/8/2013	$	8,257
Agreement dated 8/20/2008		20,000		3.78			8/20/2015		8/20/2011		4,106
Total	$	45,000		4.38	%					$	12,363

The Bank utilizes borrowings from the Federal Home Loan Bank (“FHLB”) as a source of liquidity. At March 31, 2013, the Bank had immediately available credit of $7.3 million. There were no advances from the FHLB at quarter-end.

During 2008, the Company issued $5.2 million of junior subordinated debentures to its wholly owned capital trust, Bank of the Carolinas Trust I (the “Trust”), which, in turn, issued $5.0 million in trust preferred securities having a like liquidation amount and $155,000 in common securities (all common securities are owned by the Company). The Company has fully and unconditionally guaranteed the Trust’s obligations related to the trust preferred securities. The Trust has the right to redeem the trust preferred securities in whole or in part, on or after June 15, 2013 at a redemption price equal to 100% of the principal amount plus accrued and unpaid interest.

In addition, the Trust may redeem the trust preferred securities in whole (but not in part) at any time within 90 days following the occurrence of a tax event, an investment company event, or a capital treatment event at a special redemption price (as defined in the debenture). Interest is payable quarterly on the trust preferred securities at the annual rate of 90-day LIBOR plus 300 basis points. In February 2011, the Company announced its election to defer its regularly scheduled interest payments on the junior subordinated debentures related to the trust preferred securities. Furthermore, the Company is party to a written agreement with the Federal Reserve, which restricts the Company’s ability to make interest payments on subordinated debt, as described below.

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

Under the terms of a written agreement between the Company and the Federal Reserve Bank of Richmond, the Company and the Trust may not make any distributions of interest, principal, or other sums on subordinated debentures or trust preferred securities without the prior written approval of the Federal Reserve Bank of Richmond and the Director of the Division of Banking Supervision and Regulation of the Federal Reserve Board of Governors.

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NOTE 10. STOCKHOLDERS’ EQUITY

Preferred Stock:

The Company has 3.0 million shares of preferred stock authorized. There were 13,179 shares of preferred stock issued and outstanding with a $1,000 per share liquidation preference on March 31, 2013 and December 31, 2012. All of the shares were issued on April 17, 2009 in connection with the Company’s participation in the U.S. Treasury’s TARP Capital Purchase Program.

In February 2011, the Company notified the Treasury of its intent to defer the payment of its regular quarterly cash dividend on its Series A Preferred Stock sold to the Treasury. In addition, the Company has entered into a written agreement with the Federal Reserve Bank of Richmond, which prohibits the Company’s payment of any dividends without the prior approval of the Federal Reserve Bank of Richmond and the Director of the Division of Banking Supervision and Regulation of the Federal Reserve Board of Governors.

At March 31, 2013 and December 31, 2012, the cumulative amount of dividends in arrears not declared was $1.4 million and $1.2 million, respectively.

Common Stock:

The Company has 15.0 million shares of $5 par value common stock authorized. There were 3,895,840 shares of common stock issued and outstanding at March 31, 2013 and December 31, 2012, respectively.

Warrants:

In connection with the issuance of the preferred shares under the U.S. Treasury’s TARP Capital Purchase Program, the Company issued the U.S. Treasury a warrant to purchase 475,204 shares of its common stock for $4.16 per share. The warrant expires April 17, 2019.

NOTE 11. INCOME TAXES

The Company utilizes the liability method of computing income taxes. Under the liability method, deferred tax liabilities and assets are established for future tax return effects of the temporary differences between the stated value of assets and liabilities for financial reporting purposes and their tax bases. The focus is on accruing the appropriate balance sheet deferred tax amount, with the statement of income effect being the result of the changes in the balance sheet amounts from period to period. The current portion of income tax expense is provided based upon the actual tax liability incurred for tax return purposes.

An evaluation of the probability of being able to realize the future benefits of deferred tax assets is made. A valuation allowance is provided for the deferred tax asset when it is more likely than not that some portion or all of the deferred tax asset will not be realized. Management has established a deferred tax asset valuation allowance as of March 31, 2013 of $14.3 million. There was a $14.4 million valuation allowance as of December 31, 2012. The valuation allowance has been established because management believes current overall credit trends, as well as actual and forecasted performance, raise significant concern over the ability of the Company to realize the components of its deferred tax assets relating to net operating losses and the allowances for losses on loans and OREO.

NOTE 12. GOING CONCERN

Going Concern Considerations

The consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the discharge of liabilities in the normal course of business for the foreseeable future. It is the responsibility of management to assess the Company’s ability to continue as a going concern. In making this assessment, the Company has taken into account

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all available information about the future, which is at least, but is not limited to, twelve months from the balance sheet date of March 31, 2013. The Company had a history of profitable operations prior to 2008 and sufficient sources of liquidity to meet its short-term and long-term funding needs.

The effects of the current economic environment are being felt across many industries, with financial services and real estate being particularly hard-hit, and have been particularly severe during the last 45 months. The Bank, with a loan portfolio consisting of a concentration in commercial real estate loans, including residential construction and development loans, has seen a decline in the value of the collateral securing its portfolio as well as rapid deterioration in its borrowers’ cash flow and ability to repay their outstanding loans made by the Bank. As a result, the Bank’s level of nonperforming assets increased substantially during 2010 and 2011. The significant losses in 2010, 2011, and 2012, which were primarily related to credit losses and the valuation allowance on deferred tax assets, reduced the Company’s capital levels. In order to again become well capitalized under federal banking agencies’ guidelines, management believes that the Company will need to raise additional capital to recapitalize the Bank and to absorb the potential future credit losses associated with the disposition of its nonperforming assets. Accordingly, management is in the process of evaluating various alternatives to increase tangible common equity and regulatory capital through the issuance of additional equity in public or private offerings. Management is actively evaluating a number of potential capital sources, asset reductions, and other balance sheet management strategies with the goal of increasing its level of regulatory capital to support its balance sheet long-term. Management is currently attempting to reduce and otherwise restructure the Company’s balance sheet to improve capital ratios.

Current market conditions for banking institutions, the overall uncertainty in financial markets, and a depressed stock price are significant barriers to the success of any plan to issue additional equity in public or private offerings. An equity financing transaction would result in substantial dilution to the Company’s current stockholders and could adversely affect the market price of the Company’s common stock. There can be no assurance as to whether these efforts will be successful, either on a short-term or long-term basis. Should these efforts be unsuccessful, due to existing regulatory restrictions on cash payments and dividends between the Bank and the holding company, the Company may be unable to discharge its liabilities in the normal course of business. There can be no assurance that the Company will be successful in any efforts to raise additional capital.

Both the Company and the Bank actively manage liquidity and cash flow needs. The Bank is prohibited from declaring or paying dividends without prior approval of the FDIC and the North Carolina Commissioner of Banks and the Company is prohibited from declaring or paying dividends without the prior approval from the Federal Reserve. Even if these requirements were not in place, the Company does not intend to declare or pay dividends to shareholders at any time in the foreseeable future. At March 31, 2013, the Company had $15.0 million of cash and cash equivalents. The Company has no long-term debt maturing in 2013 or 2014.

Based on current capital levels and continued operating losses, management believes the Company will require additional capital to be able to remain viable. Management has implemented various strategies to provide this needed capital. In spite of management’s best efforts, there is no assurance management will be successful in raising additional capital. The accompanying consolidated financial statements for the Company have been prepared on a going concern basis, which contemplates the realization of assets and the discharge of liabilities in the normal course of business for the foreseeable future, and does not include any adjustments to reflect the possible future effects on the recoverability or classification of assets.

Management’s Plans and Intentions

The Company incurred significant net losses in 2010, 2011 and 2012 primarily from the higher provisions for loan losses due to the significant level of nonperforming assets and increases in foreclosed real estate. The FDIC and the Commissioner issued the Consent Order in April 2011. The Company entered into a written agreement with the FRB in August 2011. The Company’s independent registered public accounting firm issued a report with respect to the Company’s audited financial statements for the fiscal year ended December 31, 2012, which contained an explanatory paragraph indicating that there is substantial doubt about the Company’s ability to continue as a going concern. The Company is attempting to implement the following strategies to improve its financial condition:

Deferring Preferred Stock and Trust Preferred Securities Payments -The Company began deferring the payment of cash dividends on its outstanding Fixed Rate Cumulative Perpetual Preferred Stock, Series A, in February 2011, as well as the payment of interest on the junior subordinated notes related to its outstanding trust preferred securities to enhance the Company’s liquidity. The expense associated with trust preferred securities continues to accrue and is reflected in the Company’s Consolidated Statements of Operations. Accrued but unpaid dividends on preferred stock are shown as an increase to net loss to derive net income or loss to common shareholders in the Consolidated Statements of Operations.

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Balance Sheet Reduction -Management currently is implementing strategies to improve capital ratios through the reduction of assets and off-balance sheet commitments. At March 31, 2013, risk-weighted assets had been reduced by $52.2 million since December 31, 2011. Reductions occurred primarily in the commercial loan portfolio. Management expects future reductions in risk-weighted assets to be moderate and occur primarily in the loan portfolio. To offset the majority of asset reductions, liabilities declined primarily through reductions in brokered and institutional CDs by $39.8 million.

Earnings -In June 2011, the Bank retired $10.0 million in FHLB advances and paid an early redemption penalty of $273,000 to the FHLB for the retirement of these advances. In November 2011, the Bank retired an additional advance of $10.0 million due to the FHLB and paid an early redemption penalty of $7,000. The advances had a remaining average life of 1.0 year and an average interest rate of 1.21%. The Bank is prohibited from accepting or rolling over any brokered certificates of deposit. In 2013, the remaining balance of $15.1 million in brokered CDs will mature with interest rates ranging from 0.95% to 1.05%. As these mature, the Bank will continue to replace these funds with institutional certificates of deposit with average interest rates of 0.51% as needed. In 2012 and continuing into 2013, the Bank was able to start returning loans, previously in a non-accrual status, to accrual status after six months of payment performance. As a result of these changes, the Bank expects a positive impact on its net interest margin in 2013.

Additional Capital -The Company has engaged investment banking firms and is working to secure investors in a capital raise plan that may include issuing common stock, preferred stock or a combination of both, debt, or other financing alternatives that may be treated as capital for capital adequacy ratio purposes. Currently, the Company is working diligently to raise additional capital in the next few months; however, there are no assurances that an offering will be completed or that the Company will succeed in this endeavor. In addition, a transaction would more likely than not involve equity financing, resulting in substantial dilution to current shareholders and an adverse effect on the price of the Company’s common stock. The Company’s ability to raise capital depends to a large degree on the current capital markets and on its financial performance. Available capital markets are not currently favorable, and the Company cannot be certain of its ability to raise capital on any terms.

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Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

GENERAL

Introduction

Bank of the Carolinas Corporation (“the Company”) is the parent holding company of Bank of the Carolinas (“the Bank”). Because the Company has no separate operations and conducts no business on its own other than owning the Bank, the discussion contained in this Management’s Discussion and Analysis concerns primarily the business of the Bank. However, because the financial statements are presented on a consolidated basis, the Company and the Bank are collectively referred to herein as “the Company” unless otherwise noted.

The Bank began operations in December 1998 as a state chartered bank and currently has nine offices in the Piedmont region of North Carolina. The Bank competes for loans and deposits throughout the markets it serves. The Bank, like most community banks, derives most of its revenue from net interest income which is the difference between the income it earns from loans and securities and the interest expense it incurs on deposits and borrowings.

Written Agreement with Federal Reserve

The Company entered into a written agreement (the “Agreement”) with the Federal Reserve Bank of Richmond on August 26, 2011. The description of the Agreement set forth below is qualified in its entirety by reference to the full text of the Agreement, a copy of which is included as Exhibit 10.01 to the Company’s Quarterly Report on Form 10-Q, filed with the Securities and Exchange Commission on November 14, 2011, and incorporated herein by reference.

Source of Strength. The Agreement requires that the Company take appropriate steps to fully utilize its financial and managerial resources to serve as a source of strength to the Bank and ensure that the Bank complies with the requirements of the consent order entered into between the North Carolina Commissioner of Banks, the FDIC, and the Bank.

Dividends, Distributions, and other Payments. The Agreement prohibits the Company’s payment of any dividends without the prior approval of the Federal Reserve Bank of Richmond and the Director of the Division of Banking Supervision and Regulation of the Federal Reserve Board of Governors. It also prohibits the Company from directly or indirectly taking any dividends or any other form of payment representing a reduction in capital from the Bank without the prior written approval of the Federal Reserve Bank of Richmond.

Under the terms of the Agreement, the Company and Bank of the Carolinas Trust I may not make any distributions of interest, principal or other sums on subordinated debentures or trust preferred securities without the prior written approval of the Federal Reserve Bank of Richmond and the Director of the Division of Banking Supervision and Regulation.

Debt and Stock Redemption.The Agreement requires that the Company and any non-bank subsidiary of the Company not, directly or indirectly, incur, increase or guarantee any debt without the prior written approval of the Federal Reserve Bank. The Agreement also requires that the Company not, directly or indirectly, purchase or redeem any shares of its capital stock without the prior written approval of the Federal Reserve Bank of Richmond.

Capital Plan, Cash Flow Projections and Progress Reports.The Agreement requires that the Company file an acceptable capital plan and certain cash flow projections with the Federal Reserve Bank of Richmond. It also requires that the Company file a written progress report within 30 days after the end of each calendar quarter while the Agreement remains in effect.

The Agreement will remain in effect until modified or terminated by the Federal Reserve Bank of Richmond.

Consent Order with Regulators

The Bank entered into a Stipulation to the Issuance of a Consent Order (the “Stipulation”) with the Federal Deposit Insurance Corporation (the “FDIC”) and the North Carolina Office of the Commissioner of Banks (the “Commissioner”) and the FDIC and the Commissioner issued the related Consent Order (the “Order”), effective April 27, 2011. The description of the Stipulation and the Order set forth below is qualified in its entirety by reference to the Stipulation and the Order, copies of which are included as exhibits 10.1 and 10.2, respectively, to the Company’s Current Report on Form 8-K, filed with the Securities and Exchange Commission on May 3, 2011, and incorporated herein by reference.

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Management.The Order required that the Bank have and retain qualified management, including a chief executive officer, senior lending officer, and chief operating officer with qualifications and experience commensurate with their assigned duties and responsibilities within 60 days from the effective date of the Order. Within 30 days of the effective date of the Order, the board of directors was required to retain a bank consultant to develop a written analysis and assessment of the Bank’s management needs. Within 60 days from receipt of the consultant’s management report, the Bank was required to formulate a written management plan that incorporated the findings of the management report, a plan of action in response to each recommendation contained in the management report, and a time frame for completing each action.

Capital Requirements.While the Order is in effect, the Bank must maintain a leverage ratio (the ratio of Tier 1 capital to total assets) of at least 8% and a total risk-based capital ratio (the ratio of qualifying total capital to risk-weighted assets) of at least 10%. If the Bank’s capital ratios are below these levels as of the date of any call report or regulatory examination, the Bank must, within 30 days from receipt of a written notice of capital deficiency from its regulators, present a plan to increase capital to meet the requirements of the Order. At March 31, 2013, the Bank was not in compliance with the capital requirements contained in the Order.

Allowance for Loan and Lease Losses and Call Report.Upon issuance of the Order, the Bank was required to make a provision to replenish the allowance for loan and lease losses (“ALLL”). Within 30 days of the effective date of the Order, the Bank was required to review its call reports filed with its regulators on or after December 31, 2010, and was required to amend those reports if necessary to accurately reflect the financial condition of the Bank. Within 60 days of the effective date of the Order, the Bank was required to submit a comprehensive policy for determining the adequacy of the ALLL.

Concentrations of Credit.Within 60 days of the issuance of the Order, the Bank was required to perform a risk segmentation analysis with respect to its concentrations of credit and develop a written plan for systematically reducing and monitoring the Bank’s commercial real estate and acquisition, construction, and development loans to an amount commensurate with the Bank’s business strategy, management expertise, size, and location.

Charge-Offs, Credits.The Order required that the Bank eliminate from its books, by charge-off or collection, all assets or portions of assets classified “loss” and 50% of those assets classified “doubtful.” If an asset is classified “doubtful,” the Bank may alternatively charge off the amount that is considered uncollectible in accordance with the Bank’s written analysis of loan or lease impairment. The Order also prevents the Bank from extending, directly or indirectly, any additional credit to, or for the benefit of, any borrower who has a loan or other extension of credit from the Bank that has been charged off or classified, in whole or in part, “loss” or “doubtful” and is uncollected. The Bank may not extend, directly or indirectly, any additional credit to any borrower who has a loan or other extension of credit from the Bank that has been classified “substandard.” These limitations do not apply if the Bank’s failure to extend further credit to a particular borrower would be detrimental to the best interests of the Bank.

Asset Growth.While the Order is in effect, the Bank must notify its regulators at least 60 days prior to undertaking asset growth that exceeds 10% or more per year or initiating material changes in asset or liability composition. The Bank’s asset growth cannot result in noncompliance with the capital maintenance provisions of the Order unless the Bank receives prior written approval from its regulators.

Restriction on Dividends and Other Payments.While the Order is in effect, the Bank cannot declare or pay dividends, pay bonuses, or pay any form of payment outside the ordinary course of business resulting in a reduction of capital without the prior written approval of its regulators. In addition, the Bank cannot make any distributions of interest, principal, or other sums on subordinated debentures without prior regulatory approval.

Brokered Deposits.The Order provides that the Bank may not accept, renew, or roll over any brokered deposits unless it is in compliance with the requirements of the FDIC regulations governing brokered deposits. These regulations prohibit undercapitalized institutions from accepting, renewing, or rolling over any brokered deposits and also prohibit undercapitalized institutions from soliciting deposits by offering an effective yield that exceeds by more than 75 basis points the prevailing effective yields on insured deposits of comparable maturity in the institution’s market area. An “adequately capitalized” institution may not accept, renew, or roll over brokered deposits unless it has applied for and been granted a waiver by the FDIC. As of March 31, 2013, the Bank was classified as “undercapitalized.”

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Written Plans and Other Material Terms.Under the terms of the Order, the Bank was required to prepare and submit the following written plans or reports to the FDIC and the Commissioner:

• Plan to improve liquidity, contingency funding, interest rate risk, and asset liability management

• Plan to reduce assets of $500,000 or greater classified “doubtful” and “substandard”

• Revised lending and collection policy to provide effective guidance and control over the Bank’s lending and credit administration functions

• Effective internal loan review and grading system

• Policy for managing the Bank’s other real estate

• Business/strategic plan covering the overall operation of the Bank

• Plan and comprehensive budget for all categories of income and expense for the year 2011

• Policy and procedures for managing interest rate risk

• Assessment of the Bank’s information technology function

Under the Order, the Bank’s board of directors agreed to increase its participation in the affairs of the Bank, including assuming full responsibility for the approval of policies and objectives for the supervision of all of the Bank’s activities. The Bank was also required to establish a board committee to monitor and coordinate compliance with the Order.

The Order will remain in effect until modified or terminated by the FDIC and the Commissioner.

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CHANGES IN FINANCIAL CONDITION

Total Assets

At March 31, 2013, total assets were $432.2 million, a decrease of 1.2% compared to $437.4 million at December 31, 2012. The asset decrease was primarily the result of reductions in investment securities due to maturities and calls. The Company had earning assets of $395.7 million at March 31, 2013 consisting of $269.0 million in loans, $99.7 million in investment securities, and $27.0 million in temporary investments. Stockholders’ equity was $9.3 million at March 31, 2013 compared to $9.1 million at December 31, 2012.

Investment Securities

Investment securities totaled $99.7 million at March 31, 2013, compared to $106.9 million at December 31, 2012. The decrease was primarily a result of the maturity of a corporate security and agency calls. A summary of the Company’s investment securities holdings by major category at March 31, 2013 and December 31, 2012 is included in Note 3 of “Notes to Consolidated Financial Statements”.

Loans and Allowance for Loan Losses

At March 31, 2013, the loan portfolio totaled $269.0 million and represented 62.2% of total assets compared to $270.4 million or 61.8% of total assets at December 31, 2012. Total loans at March 31, 2013 decreased $1.4 million or 0.5% from December 31, 2012. The decrease in loans outstanding in the three-month period is the result of net recoveries of $754,000 and principal repayments in excess of new loans originated due to slower loan demand under the current economic conditions. Real estate loans, including commercial real estate, constituted approximately 90% of the loan portfolio, and commercial business and other loans comprised approximately 10% of the total loan portfolio at both March 31, 2013 and December 31, 2012.

The allowance for loan losses is created by direct charges to income. Losses on loans are charged against the allowance in the period in which such loans, in management’s opinion, become uncollectible. Recoveries during the period are credited to this allowance. The factors that influence management’s judgment in determining the amount charged to operating expense include past loan experience, composition of the loan portfolio, current economic conditions and probable losses.

The appropriateness of the allowance for loan losses is measured on a quarterly basis using an allocation model that assigns reserves to various components of the loan portfolio in order to provide for probable inherent losses. It must be emphasized, however, that the determination of the reserve using the Company’s procedures and methods rests upon various judgments and assumptions about current economic conditions and other factors affecting loans. No assurance can be given that the Company will not in any particular period sustain loan losses that are sizable in relation to amounts reserved or that subsequent evaluations of the loan portfolio, in light of conditions and factors then prevailing, will not require significant changes in the allowance for loan losses or future charges to earnings. In addition, bank regulatory agencies, as an integral part of their routine examination process, periodically review the Company’s allowance. Those agencies may require the Company to recognize adjustments to the allowance based on their judgments about information available to them at the time of their examinations. The Company believes the allowance is appropriate based on management’s current analysis.

The allowance for loan losses at March 31, 2013, amounted to $6.5 million, a decrease of $392,000, or 5.7% from December 31, 2012. The allowance consists of specific reserves of $746,000 and a general allowance $5.8 million. The Bank’s provisions for loan losses amounted to a reversal of $1.1 million during the three months ended March 31, 2013 compared to a $1.3 million provision during the three months ended March 31, 2012. While the Company has not participated in “subprime” lending activities, we have been affected by the economic downturn in our markets. We continue to work with our customers with troubled credit relationships to the extent that it is reasonably possible.

Certain credit risks are inherent in making loans, particularly commercial and consumer loans. Management prudently assesses these risks and attempts to manage them effectively. The Company also attempts to reduce default risks by adhering to internal credit underwriting policies and procedures. These policies and procedures include officer and customer limits, periodic loan documentation review and follow up on exceptions to credit policies. A loan is placed in nonaccrual status when, in management’s judgment, the collection of interest appears doubtful.

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The following table summarizes information regarding our nonaccrual loans, other real estate owned, and 90-day and over past due loans as of March 31, 2013 and December 31, 2012 (dollars in thousands):

	March 31, 2013			December 31, 2012
Loans accounted for on a nonaccrual basis:
Real estate loans:
1-4 family residential	$	1,973		$	2,491
Commercial real estate		614			4,153
Construction and development		1,044			880
Total real estate loans		3,631			7,524
Commercial business and other loans		247			202
Consumer loans		5			7
Total nonaccrual loans		3,883			7,733
Accruing loans which are contractually past due 90 days or more		—			—
Total nonperforming loans		3,883			7,733
Other real estate owned		3,884			4,976
Total nonperforming assets	$	7,767		$	12,709
Total nonperforming loans as a percentage of loans		1.44	%		2.86	%
Allowance for loan losses as a percentage of total nonperforming loans		167.34	%		89.10	%
Allowance for loan losses as a percentage of total loans		2.42	%		2.55	%
Total nonperforming assets as a percentage of loans and other real estate owned		2.85	%		4.62	%
Total nonperforming assets as a percentage of total assets		1.80	%		2.91	%

Deposits

The Company’s deposit services include business and individual checking accounts, interest bearing checking accounts, savings accounts, money market accounts, IRA deposits and certificates of deposit. At March 31, 2013, total deposits were $366.5 million compared to $373.0 million at December 31, 2012. The March 31, 2013 amount represents a decrease of 1.7% from December 31, 2012, which is mainly recognized in customer time deposits and brokered CDs. At March 31, 2013, the deposit mix was comparable to December 31, 2012.

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The following table presents a breakdown of our deposit base at March 31, 2013 and December 31, 2012 (dollars in thousands):

	March 31, 2013			December 31, 2012
Noninterest bearing demand deposits	$	34,211		$	36,622
Interest checking deposits		39,199			37,768
Savings deposits		14,111			13,531
Money market deposits		93,936			97,928
Customer time deposits		178,846			172,039
Brokered certificates of deposit		6,164			15,084
Total deposits	$	366,467		$	372,972
Time deposits $100,000 or more:
Brokered certificates of deposit	$	6,164		$	15,084
Customer time deposits issued in denominations of $100,000 or more		110,081			101,042
Total time deposits issued in denominations of $100,000 or more	$	116,245		$	116,126
As a percent of total deposits:
Noninterest bearing demand deposits		9.34	%		9.82	%
Interest checking deposits		10.70			10.13
Savings deposits		3.85			3.63
Money market deposits		25.63			26.26
Customer time deposits		48.80			46.13
Brokered certificates of deposit		1.68			4.04
Total time deposits issued in denominations of $100,000 or more		31.72			31.14

Liquidity

Liquidity management is the process of managing assets and liabilities, as well as their maturities, to ensure adequate funding for loan and deposit activities. Sources of liquidity come from both balance sheet and off-balance sheet sources. We define balance sheet liquidity as the relationship that net liquid assets have to unsecured liabilities. Net liquid assets are the sum of cash and cash items, less required reserves on demand and interest checking deposits, plus demand deposits due from banks, plus temporary investments, including federal funds sold, plus the fair value of investment securities, less collateral requirements related to public funds on deposit and repurchase agreements. Unsecured liabilities are equal to total liabilities less required cash reserves on noninterest-bearing demand deposits and interest checking deposits less the outstanding balances of all secured liabilities, whether secured by liquid assets or not. We consider off-balance sheet liquidity to include unsecured federal funds lines from other banks and loan collateral which may be used for additional advances from the Federal Home Loan Bank. As of March 31, 2013 our balance sheet liquidity ratio (net liquid assets as a percent of unsecured liabilities) amounted to 20.42% and our total liquidity ratio (balance sheet plus off-balance sheet liquidity) was 21.99%.

In addition, we have the ability to borrow $10.0 million from the discount window of the Federal Reserve subject to our pledge of marketable securities, which could be used for temporary funding needs. We also have the ability to borrow from the Federal Home Loan Bank on similar terms. While we consider these arrangements sources of back-up funding, we do not consider them as liquidity sources because they require our pledge of liquid assets as collateral. We regularly borrow from the Federal Home Loan Bank as a normal part of our business. These advances, of which there were none at March 31, 2013, are secured by various types of real estate-secured loans. The Company closely monitors and evaluates its overall liquidity position. The Company believes its liquidity position at March 31, 2013 is adequate to meet its operating needs.

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Interest Rate Sensitivity

Fluctuating interest rates, increased competition, and changes in the regulatory environment continue to significantly affect the importance of interest rate sensitivity management. Rate sensitivity arises when interest rates on assets change in a different period of time or in a different proportion to interest rates on liabilities. The primary objective of interest rate sensitivity management is to prudently structure the balance sheet so that movements of interest rates on assets and liabilities are highly correlated and produce a reasonable net interest margin even in periods of volatile interest rates. The Company uses an asset/liability simulation model to project potential changes to the Company’s net interest margin, net income, and economic value of equity based on simulated changes to market interest rates, namely the prime rate. Our goal is to maintain an interest rate sensitivity position as close to neutral as practicable whereby little or no change in interest income would occur as interest rates change. On March 31, 2013, we were cumulatively asset sensitive for the next twelve months, which means that our interest bearing assets would reprice more quickly than our interest bearing liabilities. Theoretically, our net interest margin will increase if market interest rates rise or decrease if market interest rates fall. However, the repricing characteristic of assets is different from the repricing characteristics of funding sources. Therefore, net interest income can be impacted by changes in interest rates even if the repricing opportunities of assets and liabilities are perfectly matched.

Capital Adequacy

Regulatory guidelines require banks to hold minimum levels of capital based upon the risk weighting of certain categories of assets as well as any off-balance sheet contingencies. Federal regulators have adopted risk-based capital and leverage capital guidelines for measuring the capital adequacy of banks and bank holding companies. All applicable capital standards must be satisfied for the Company and the Bank to be considered in compliance with regulatory requirements.

As described above, the Bank is subject to a consent order issued by the FDIC and the North Carolina Office of the Commissioner of Banks and the Company is party to a written agreement with the Federal Reserve Bank of Richmond. These regulatory agreements require that the Bank maintain capital levels in excess of normal regulatory minimums, including a Leverage Capital Ratio of at least 8.0% and a Total Risk-Based Capital Ratio of at least 10.0%, and that the Company and the Bank seek the approval of their respective regulators prior to the payment of any cash dividend. At March 31, 2013, the Bank was not in compliance with the minimum capital requirements set forth in the consent order. As a result, the Bank was required to present its federal and state regulators with a plan to increase its capital ratios to the required percentages. The Bank hired a consultant to help formulate this plan and assist in the exploration of other strategic alternatives.

At March 31, 2013, the Company’s leverage and Tier 1 risk-weighted Capital Ratios were 2.62% and 3.62%, respectively, which are below the minimum level required by regulatory guidelines. At March 31, 2013, the Company��s Total risk-weighted Capital Ratio was 6.38%, which is below the minimum level required by regulatory guidelines. At March 31, 2013, the Bank’s leverage and Tier 1 risk-weighted Capital Ratios were 3.75% and 5.17%, respectively, which are below the minimum levels required by regulatory guidelines. At March 31, 2013, the Bank’s Total risk-weighted Capital Ratio was 6.43%, which is below the minimum level required by regulatory guidelines. At March 31, 2013, the Bank’s leverage and Total risk-weighted Capital Ratios were both non-compliant with the levels specified in the above referenced consent order with bank regulators. Banks are placed into one of five capital categories based on the above three separate capital ratios. The five categories are “well-capitalized,” “adequately capitalized,” “under-capitalized,” “significantly under-capitalized,” and “critically under-capitalized.” The Bank was considered “under-capitalized” as of March 31, 2013.

RESULTS OF OPERATIONS

Three Months Ended March 31, 2013 and 2012

Overview. For the three months ended March 31, 2013, the Company had net income available to common shareholders of $191,000, or $0.05 per common share. This compares to a net loss of $2.7 million, or $0.70 per common share, for the three months ended March 31, 2012. The first quarter of 2013 reflected net recoveries related to loan loss and reduced expenses. Costs related to compliance with the Consent Order with the FDIC and the North Carolina Officer of the Commissioner of Banks and the Written Agreement with the Federal Reserve Bank of Richmond are now minimal.

Net Interest Income. The Company’s net interest income for the three months ended March 31, 2013 totaled $2.6 million compared to $3.1 million at March 31, 2012. Net interest income decreased due to the reduction of $46.5 million in interest earning assets compared to March 31, 2012. The net interest margin decreased 7 basis points from 2.81% in the first quarter of 2012 to 2.74% in the first quarter of 2013.

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Provision for Loan Losses. The loan loss provision amounted to a reversal of $1.1 million for the quarter ended March 31, 2013, a decrease of $2.4 million, or 188.7%, from the $1.3 million provision recorded in the comparable quarter of 2012. Net recoveries totaled $754,000 in the first quarter of 2013 compared to net charge-offs of $1.3 million in the first quarter of 2012. The loan loss provision reflects a specific recovery of a $1.25 million loan that was previously charged off in 2011.

Noninterest Income. Noninterest income totaled $366,000 for the three months ended March 31, 2013 compared to $1.1 million for the comparable three-month period of 2012. Noninterest income includes customer service charges on deposit accounts, bank owned life insurance, and gains on investment securities. Excluding gains on sales of investment securities of $748,000 in 2012, noninterest income remained relatively flat for the three months ended March 31, 2013 and 2012. There were no gains on investment securities recognized for the period ended March 31, 2013, which encompasses the large discrepancy in the year-to-date comparison.

Noninterest Expenses. Noninterest expenses totaled $3.7 million and $5.0 million for the three months ended March 31, 2013 and 2012, respectively. Excluding the decrease of other real estate expenses of $474,000, noninterest expenses for the three months decreased by $827,000. Other noninterest expenses affecting overhead cost were: (1) FDIC insurance assessments, which decreased $51,000 due to smaller balance sheet; (2) salaries and benefits, which decreased $160,000 due to staff reductions; and (3) consultant and attorney fees, which decreased $374,000 as a result of decreased needs.

Income Taxes. There was no provision for income taxes made for the first quarter of 2013 as compared to an income tax expense of $368,000 for the first quarter of 2012. Our deferred tax asset has a value of $753,000 at March 31, 2013 as compared to no value at March 31, 2012.

DISCLOSURES ABOUT FORWARD LOOKING STATEMENTS

Statements in this Report relating to plans, strategies, economic performance and trends, projections of results of specific activities or investments, expectations or beliefs about future events or results, and other statements that are not descriptions of historical facts, may be forward-looking statements as defined in Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking information is inherently subject to risks and uncertainties, and actual results could differ materially from those currently anticipated due to a number of factors. Forward-looking statements may be identified by terms such as “may,” “will,” “should,” “could,” “expects,” “plans,” “intends,” “anticipates,” “ feels,” “believes,” “estimates,” “predicts,” “forecasts,” “potential” or “continue,” or similar terms or the negative of these terms, or other statements concerning opinions or judgments of our management about future events. Factors that could influence the accuracy of forward-looking statements include, but are not limited to (a) pressures on our earnings, capital and liquidity resulting from current and future conditions in the credit and capital markets, (b) continued or unexpected increases in nonperforming loans and credit losses in our loan portfolio, (c) continued adverse conditions in the economy and in the real estate market in our banking markets (particularly those conditions that affect our loan portfolio, the abilities of our borrowers to repay their loans, and the values of collateral that secures our loans), (d) the financial success or changing strategies of our customers, (e) actions of government regulators, or changes in laws, regulations or accounting standards, that adversely affect our business, (f) changes in the interest rate environment and the level of market interest rates that reduce our net interest margins and/or the values of loans we make and securities we hold, and changes in general economic conditions and real estate values in our banking market (particularly changes that affect our loan portfolio, the abilities of our borrowers to repay their loans, and the values of loan collateral), (g) changes in competitive pressures among depository and other financial institutions or in our ability to compete effectively against other financial institutions in our banking markets, and (h) other developments or changes in our business that we do not expect. Although we believe that the expectations reflected in the forward-looking statements included in this Report are reasonable, they represent our management’s judgments only as of the date they are made, and we cannot guarantee future results, levels of activity, performance or achievements. As a result, readers are cautioned not to place undue reliance on these forward-looking statements. All forward-looking statements attributable to us are expressly qualified in their entirety by the cautionary statements in this paragraph. We have no obligation, and do not intend to update these forward-looking statements.

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Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Smaller reporting companies such as the Company are not required to provide the information required by this item.

Item 4. CONTROLS AND PROCEDURES

The Company’s management, under the supervision and with the participation of its principal executive officer and principal financial officer, has evaluated the effectiveness of the design and operation of the Company’s disclosure controls and procedures in accordance with Rule 13a-15 of the Securities Exchange Act of 1934 (the “Exchange Act”). Based on their evaluation, the principal executive officer and principal financial officer concluded that, as of the end of the period covered by this report, the Company’s disclosure controls and procedures were effective to provide reasonable assurance that it is able to record, process, summarize and report in a timely manner the information required to be disclosed in reports it files under the Exchange Act.

In connection with the above evaluation of the effectiveness of the Company’s disclosure controls and procedures, no change in the Company’s internal control over financial reporting was identified that occurred during the most recent quarterly period that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II - OTHER INFORMATION

Item 1. Legal Proceedings

There are no material pending legal proceedings to which the Company or the Bank is a party, or of which any of their property is the subject other than routine litigation that is incidental to their business.

Item 1A. Risk Factors

Smaller reporting companies such as the Company are not required to provide the information required by this item.

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

None

Item 3. Defaults Upon Senior Securities.

As disclosed on its Current Report on Form 8-K, filed with the Securities and Exchange Commission on February 18, 2011, the Company has notified the United States Department of the Treasury of its intent to defer the payment of its regular quarterly cash dividends on its fixed rate cumulative perpetual preferred stock, series A, issued to the Treasury in connection with the Company’s participation in the Treasury’s TARP Capital Purchase Program. Therefore, the Company is currently in arrears with the dividend payments on the series A preferred stock. As of March 31, 2013, the amount of the arrearage on the dividend payments for the series A preferred stock was $1,565,006.25.

Item 4. Mine Safety Disclosures

Not applicable

Item 5. Other Information

None

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Item 6. Exhibits

The following exhibits are filed with this report.

31.01	Certification of our principal executive officer pursuant to Rule 13a-14(a)
31.02	Certification of our principal financial officer pursuant to Rule 13a-14(a)
32.01	Certification of our principal executive officer and principal financial officer pursuant to 18 U.S.C. Section 1350
101	Interactive data files providing financial information from the Registrant’s Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2013, in XBRL (eXtensible Business Reporting Language)*

* Pursuant to Regulation 406T of Regulation S-T, these interactive data files are furnished and not filed or part of a registration statement or prospectus for purposes of section 11 or 12 of the Securities Act of 1933, as amended, or section 18 of the Securities Exchange Act of 1934, as amended, and are otherwise not subject to liability.

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SIGNATURES

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

BANK OF THE CAROLINAS CORPORATION

Date: May 15, 2013	By:	/s/ Stephen R. Talbert
	Stephen R. Talbert
	President and Chief Executive Officer
	(principal executive officer)
Date: May 15, 2013	By:	/s/ Megan W. Patton
	Megan W. Patton
	Vice President and Principal Financial Officer
	(principal financial officer)

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EXHIBIT INDEX

Exhibit Number	Description
31.01	Certification of our principal executive officer pursuant to Rule 13a-14(a)
31.02	Certification of our principal financial officer pursuant to Rule 13a-14(a)
32.01	Certification of our principal executive officer and principal financial officer pursuant to 18 U.S.C. Section 1350
101	Interactive data files providing financial information from the Registrant’s Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2013, in XBRL (eXtensible Business Reporting Language)*

* Pursuant to Regulation 406T of Regulation S-T, these interactive data files are furnished and not filed or part of a registration statement or prospectus for purposes of section 11 or 12 of the Securities Act of 1933, as amended, or section 18 of the Securities Exchange Act of 1934, as amended, and are otherwise not subject to liability.

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