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U. S. Securities and Exchange Commission
Washington, D.C. 20549
FORM 10-K
FOR ANNUAL AND TRANSITION REPORTS
PURSUANT TO SECTIONS 13 OR 15 (D) OF THE
SECURITIES EXCHANGE ACT OF 1934
[X] ANNUAL REPORT UNDER SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 1999
[ ] TRANSITION REPORT UNDER SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
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COMMISSION FILE NUMBER 333-26699
CORNERSTONE BANCSHARES, INC.
(Exact name of registrant as specified in its charter)
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Tennessee 62-1173944
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(State of incorporation) (I.R.S. Employer
Identification No.)
5319 HIGHWAY 153
CHATTANOOGA, TENNESSEE 37343
(Address of principal executive offices)(Zip Code)
(423) 385-3000
(Reistrant's telephone number)
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act: None
Check whether the issuer (1) filed all reports required to be filed by
Section 13 or 15(d) of the Exchange Act during the past 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
The aggregate market value of the Registrant's outstanding Common Stock held by
nonaffiliates of the Registrant on March 31, 2000 was approximately $15,166,177.
There were 1,166,629 shares of Common Stock outstanding as of March 27, 2000.
DOCUMENTS INCORPORATED BY REFERENCE
None
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CORNERSTONE BANCSHARES, INC.
ANNUAL REPORT ON FORM 10-K
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1999
TABLE OF CONTENTS
ITEM PAGE
NUMBER NUMBER
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PART I
1. Description of Business...................................... 2
2. Description of Property...................................... 10
3. Legal Proceedings............................................ 10
4. Submission of Matters to a Vote of
Security Holders............................................. 10
PART II
5. Market for Common Equity and
Related Stockholder Matters.................................. 11
6. Selected Financial Statements................................ 12
7. Management's Discussion and Analysis
or Plan of Operation......................................... 13
8. Financial Statements......................................... 39
9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure.......................... 39
PART III
10. Directors, Executive Officers, Promoters
and Control Persons; Compliance with
Section 16(a) of the Exchange Act............................ 40
11. Executive Compensation....................................... 43
12. Security Ownership of Certain Beneficial Owners
and Management............................................... 45
13. Certain Relationships and Related Transactions............... 46
14. Exhibits and Reports on Form 8-K............................. 47
Signatures................................................... 48
Index of Exhibits ........................................... 50
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FORWARD-LOOKING STATEMENTS
This form contains certain forward-looking statements including
statements relating to present or future factors generally affecting the banking
industry and specifically affecting Cornerstone's operations, markets, and
products. Without limiting the foregoing, the words "believes","anticipates",
"intends", "expects" or similar expressions are intended to identify
forward-looking statements that involve certain risks and uncertainities. Actual
results could differ materially from those projected for many reasons including,
without limitation, changing events and trends that have influenced
Cornerstone's assumptions. These trends and events include (i) changes in the
interest rate environment which may reduce margins, (ii) non-achievement of
expected growth, (iii) less favorable than anticipated changes in national and
local business environment and securities markets, (iv) adverse changes in the
regulatory requirements affecting Cornerstone, (v) greater competitive pressures
among financial institutions in Cornerstone's market, and (vi) greater than
expected loan losses. Additional information and other factors that could affect
future financial results are included in Cornerstone's filings with the
Securities and Exchange Commission.
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PART I
ITEM 1. DESCRIPTION OF BUSINESS
OVERVIEW
THE COMPANY
Cornerstone Bancshares, Inc. (the "Company or Cornerstone") was
incorporated under the laws of the State of Tennessee and is a bank holding
company registered under the Bank Holding Company Act of 1956, as amended, and
was formerly known as East Ridge Bancshares, Inc. Its wholly-owned subsidiary,
Cornerstone Community Bank, a Tennessee banking corporation (the "Bank"),
resulted from the merger of The Bank of East Ridge and Cornerstone Community
Bank effective October 15, 1997.
The primary activity of the Company currently is, and is expected to
remain for the foreseeable future, the ownership and operation of the Bank. As a
bank holding company, the Company is intended to facilitate the Bank's ability
to serve its customers' requirements for financial services. The holding company
structure also provides flexibility for expansion through the possible
acquisition of other financial institutions and the provision of additional
banking-related services, as well as certain non-banking services, which a
traditional commercial bank may not provide under present laws. The holding
company structure also affords additional flexibility in terms of capital
formation and financing opportunities.
While the Company may seek in the future to acquire additional banks or
bank holding companies or to engage in other activities appropriate for bank
holding companies under appropriate circumstances as permitted by law, the
Company currently has no plans, understandings or agreements concerning any
other activities other than as described below. The results of operations and
financial condition of the Company for the foreseeable future, therefore, will
be determined primarily by the results of operations and financial condition of
the Bank.
THE BANK
The Bank's business consists primarily of attracting deposits from the
general public and, with these and other funds, originating real estate loans,
consumer loans, business loans, and residential and commercial construction
loans. Funds not invested in the loan portfolio are invested by the Bank
primarily in U.S. Government and agency obligations and obligations of various
states and their political subdivisions. In addition to deposits, sources of
funds for the Bank's loans and other investments include amortization and
prepayment of loans, sales of loans or participations in loans, and sales of its
investment securities. The principal sources of income for the Bank are interest
and fees collected on loans, fees collected on deposit accounts and interest and
dividends collected on other investments. The principal expenses of the Bank are
interest paid on deposits, employee compensation and benefits, office expenses
and other overhead expenses.
EMPLOYEES
As of March 1, 2000, Cornerstone had 62 full-time equivalent employees
of whom 57 are full-time, 5 are part-time and 2 are on long term disability. The
employees are not represented by a collective bargaining unit.
Cornerstone believes its relationship with its employees to be good.
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CUSTOMERS
It is the opinion of management that there is no single customer or
affiliated group of customers whose deposits, if withdrawn, would have a
material adverse effect on the business of Cornerstone.
COMPETITION
All phases of Cornerstone's banking activities are highly competitive.
Cornerstone competes actively with eight commercial banks, as well as finance
companies, credit unions, and other financial institutions located in its
service area, which includes Hamilton County, Tennessee.
Based on total assets of approximately $102,884,000 at December 31,
1999, the Bank represents 2.5% of the deposit base in Hamilton County. Three
major regional banks represent approximately 93% of the deposits in Hamilton
County. The larger financial institutions have greater resources and lending
limits than the Bank, and each of the three institutions have over 25 branches
in the county. There are several credit unions located in Hamilton County. Since
credit unions are not subject to income taxes in the way that commercial banks
are taxed, credit unions have an advantage in offering competitive rates to
potential customers. The Bank also faces competition in certain areas of its
business from mortgage banking companies, consumer finance companies, insurance
companies, money market mutual funds and investment banking firms, some of which
are not subject to the same degree of regulation as the Bank.
The Bank competes for deposits principally by offering depositors a
variety of deposit programs with competitive interest rates, quality service and
convenient locations and hours. The Bank will focus its resources to seek out
and attract small business relationships and take advantage of the Bank's
ability to provide flexible service that meets the needs of this customer class.
Management feels this market niche is the most promising business area for the
future growth of the Bank.
SUPERVISION AND REGULATION
GENERAL
The Company is a bank holding company within the meaning of the Bank
Holding Company Act of 1956, as amended (the "Act") and is registered with and
regulated by the Board of Governors of the Federal Reserve System (the "Board").
The Company is required to file with the Board annual reports and such
additional information as the Board may require pursuant to the Act. The Board
may also make examinations of the Company and its subsidiaries. The Company is
also required to comply with the rules and regulations of the Securities and
Exchange Commission (the "Commission") under federal securities laws.
The Bank is a Tennessee-chartered commercial bank and is subject to the
supervision and regulation of the Tennessee Department of Financial Institutions
(the "TDFI"). In addition, the Bank's deposit accounts are insured up to
applicable limits by the Bank Insurance Fund (the "BIF") of the Federal Deposit
Insurance Corporation (the "FDIC") and is, therefore, also subject to regulation
and supervision by the FDIC. The Bank is not a member of the Federal Reserve
System.
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Federal and state banking laws and regulations govern all areas of the
operation of the Company and the Bank, including reserves, loans, mortgages,
capital, issuance of securities, payment of dividends and establishment of
branches. Federal and state banking agencies also have the general authority to
limit the dividends paid by insured banks if such payments should be deemed to
constitute an unsafe or unsound banking practice. The TDFI, FDIC and Board have
the authority to impose penalties, initiate civil and administrative actions and
take other steps intended to prevent banks from engaging in unsafe or unsound
practices.
INSURANCE OF DEPOSIT ACCOUNTS
Deposits of the Bank are insured by the FDIC to a maximum of $100,000
for each insured depositor through the BIF, one of the two deposit insurance
funds established by federal law. As an insurer, the FDIC issues regulations,
conducts examinations and generally supervises the operations of its insured
institutions (institutions insured by the FDIC hereinafter are referred to as
"insured institutions"). Any insured institution, which does not operate in
accordance with or conform to FDIC regulations, policies and directives may be
sanctioned for non-compliance. For example, proceedings may be instituted
against an insured institution if the institution or any director, officer or
employee thereof engages in unsafe and unsound practices, is operating in an
unsafe or unsound condition, or has violated any applicable law, regulation,
rule, order or condition imposed by the FDIC. If insurance of accounts is
terminated by the FDIC, the deposits in the institution will continue to be
insured by the FDIC for a period of two years following the date of termination.
The FDIC requires an annual audit by independent accountants and also
periodically makes its own examinations of insured institutions. The FDIC may
revalue assets of an institution, based upon appraisals, and require
establishment of specific reserves in amounts equal to the difference between
such reevaluation and the book value of the assets.
On September 15, 1992, the FDIC approved final regulations adopting a
risk-related deposit insurance system. The risk-related regulations, which
became effective January 1, 1993, resulted in a significant spread between the
highest and lowest deposit insurance premiums. Under the risk-related insurance
regulations, each insured depository institution is assigned to one of three
risk classifications: "well capitalized," "adequately capitalized," or "under
capitalized." Within each risk classification, there are three subgroups. Each
insured depository institution is assigned to one of these subgroups within its
risk classification based upon supervisory evaluations submitted to the FDIC by
the institution's primary federal regulator. Depending upon a BIF member's risk
classification and subgroup, applicable regulations provide that its deposit
insurance premium may be as low as .04% of insured deposits or as high as .31%
of insured deposits. Additionally, because the BIF has exceeded its designated
reserve ratio, the FDIC has now reduced to zero the assessment rate that is
applicable to the most highly rated BIF members. The Bank has been notified
that, based on its risk classification and supervisory subgroup, its BIF
assessment rate is zero percent of insured deposits for the period from January
1, to June 30, 1998. This is the most favorable assessment rate applicable to
any insured institution. However, the Deposit Insurance Funds Act of 1998 (DIFA)
requires that a Financing Corporation (FICO) assessment be paid by the Bank in
1998. The annual FICO assessment rate for banks is presently .01256% of
deposits. The Bank paid $24,042 in assessments, which was the minimum set by the
FDIC for that period, during the year ended December 31, 1999.
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Subsequent to the enactment of FIRREA, the FDIC issued risk-based bank
capital guidelines which went into effect in stages through 1992. In accordance
with the FDIC's risk-based standards, an institution's assets and off-balance
sheet activities are categorized into one of four risk categories, with either a
0%, 20%, 50%, or 100% amount of capital to be held against these assets. In
addition, the guidelines divide capital instruments into Tier 1 (core) capital
and Tier 2 (supplementary) capital. The risk-based capital adequacy guidelines
require that (i) Tier 1 capital equal or exceed 4% of risk-weighted assets; (ii)
Tier 2 capital may not exceed 100% of Tier 1 capital, although certain Tier 2
capital elements are subject to additional limitations; (iii) assets and
off-balance sheet items be weighted according to risk; and (iv) the total
capital to risk-weighted assets ratio must be at least 8.0%. The FDIC's current
leverage capital requirement requires banks receiving the highest regulatory
rating based upon the FDIC's routine examination process, to maintain Tier 1
capital equal to 3.0% of the bank's total assets. Banks receiving lower
regulatory ratings are required to maintain Tier 1 capital in an amount that is
at least 100 to 200 basis points higher than 3.0% of total assets.
At December 31, 1999, the Bank had Tier 1 capital of $ 9.7 million or
8.47% of total average assets.
Certain provisions of the Federal Reserve Act, made applicable to the
Bank by Section 18(j) of the Federal Deposit Insurance Act (12 U.S.C.
ss.1828(j)) and administered with respect to the Bank by the FDIC, establish
standards for the terms of, limit the amount of and establish collateral
requirements with respect to any loans or extensions of credit to, and
investments in, affiliates by the Bank as well as set arms-length criteria for
such transactions and for certain other transactions (including payment by the
Bank for services) between the Bank and its affiliates. In addition, related
provisions of the Federal Reserve Act and the Federal Reserve regulations (also
administered with respect to the Bank by the FDIC) limit the amounts of, and
establish required procedures and credit standards with respect to, loans and
other extensions of credit to officers, directors and principal shareholders of
the Bank and to related interests of such persons.
The FDIC may impose sanctions on any insured bank that does not operate
in accordance with FDIC regulations, policies and directives. Proceedings may be
instituted against any insured bank or any director, officer or employee of the
bank that is believed by the FDIC to be engaged in unsafe or unsound practices,
including violation of applicable laws and regulations. The FDIC may revalue
assets of an institution, based upon appraisals, and may require the
establishment of specific reserves in amounts equal to the difference between
such revaluation and the book value of the assets. The FDIC also is empowered to
assess civil penalties against companies or individuals who violate certain
federal statutes, orders or regulations. In addition, the FDIC has the authority
to terminate insurance of accounts, after notice and hearing, upon a finding by
the FDIC that the insured institution is or has engaged in any unsafe or unsound
practice that has not been corrected, or is in an unsafe or unsound condition to
continue operations or has violated any applicable law, regulation, rule or
order of, or condition imposed by, the FDIC. The Bank does not know of any past
or current practice, condition or violation that might lead to termination of
its deposit insurance.
Although the Bank is not a member of the Federal Reserve System, it is
subject to Board regulations that require it to maintain reserves against its
transaction accounts (primarily checking accounts). Because reserves generally
must be maintained in cash or in non-interest bearing accounts, the effect of
the reserve requirements is to increase the Bank's cost of funds. The Board
regulations currently require that average daily reserves be maintained against
transaction accounts in the amount
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of 3% of the aggregate of such net transaction accounts up to $52.6 million,
plus 10% of the total in excess of $52.6 million.
Tennessee Supervision and Regulation
As a Tennessee-chartered commercial bank, the Bank is subject to
various state laws and regulations which limit the amount that can be loaned to
a single borrower, the types of permissible investments, and geographic and new
product expansion, among other things. The Bank must submit an application and
receive the approval of the TDFI before opening a new branch office or merging
with another financial institution. The Commissioner of the TDFI has the
authority to enforce state laws and regulations by ordering a director, officer
or employee of the Bank to cease and desist from violating a law or regulation
or from engaging in unsafe or unsound banking practices.
Tennessee law contains limitations on the interest rates that may be
charged on various types of loans and restrictions on the nature and amount of
loans that may be granted and on the type of investments which may be made. The
operations of banks are also affected by various consumer laws and regulations,
including those relating to equal credit opportunity and regulation of consumer
lending practices. All Tennessee banks, including the Bank, must become and
remain insured under the Federal Deposit Insurance Act (the "FDIA").
State banks are subject to regulation by the TDFI with regard to
capital requirements and the payment of dividends. Tennessee has adopted the
provisions of the Board's Regulation O with respect to restrictions on loans and
other extensions of credit to bank "insiders". Further, under Tennessee law,
state banks are prohibited from lending to any one person, firm or corporation
amounts more than fifteen percent (15%) of the Bank equity capital accounts,
except (i) in the case of certain loans secured by negotiable title documents
covering readily marketable nonperishable staples, or (ii) with the prior
approval of the Bank's board of directors or finance committee (however titled),
the Bank may make a loan to any person, firm or corporation of up to twenty-five
percent (25%) of its equity capital accounts. Tennessee law requires that
dividends be paid only from retained earnings (or undivided profits) except that
dividends may be paid from capital surplus with the prior, written consent of
the TDFI. Tennessee laws regulating banks require certain charges against and
transfers from an institution's undivided profits account before undivided
profits can be made available for the payment of dividends.
Federal Supervision and Regulation
The Company is regularly examined by the Board, and the Bank is
supervised and examined by the FDIC. The Company is required to file with the
Board annual reports and other information regarding its business operations and
the business operations of its subsidiaries. Approval of the Board is required
before the Company may acquire, directly or indirectly, ownership or control of
the voting shares of any bank, if, after such acquisition, the Company would own
or control, directly or indirectly, more than five percent (5%) of the voting
stock of the bank. In addition, pursuant to the provisions of the Act and the
regulations promulgated thereunder, the Company may only enage in, or own or
control companies that engage in, activities deemed by the Board to be so
closely related to banking as to be a proper incident thereto.
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The Bank and the Company are "affiliated" within the meaning of the
Act. Certain provisions of the Act establish standards for the terms of, limits
the amount of and establish collateral requirements with respect to any loans or
extensions of credit to, and investments in, affiliates by the Bank, as well as
set arms-length criteria for such transactions and for certain other
transactions (including payment by the Bank for services and under any contract)
between the Bank and its affiliates. In addition, related provisions of the Act
and the regulations promulgated under the Act, limit the amounts of and
establish required procedures and credit standards with respect to, loans and
other extensions of credit to officers, directors, and principal shareholders of
the Bank, the Company and any other subsidiary of the Company, and to related
interests of such persons.
In addition to the banking regulations imposed on the Company, the
securities of the Company are not exempt from the federal and state securities
laws as are the securities of a bank. Accordingly, an offering of the Company's
securities must be registered under both the Securities Exchange Act of 1934
(the "Exchange Act") and state securities laws or qualify for exemptions from
registration.
Under Section 106(b) of 1970 Amendments to the Act (12 U.S.C. ss.
1972), the Bank is prohibited from extending credit, selling or leasing property
or furnishing any service to any customer on the condition or requirement that
the customer (i) obtain any additional property, service or credit from the
Company; the Bank (other than a loan, discount, deposit, or trust service) or
any other subsidiary of the Company; (ii) refrain from obtaining any property,
credit or service from any competitor of the Company; the Bank or any subsidiary
of the Company; or (iii) provide any credit, property or service to the Company,
the Bank (other than those related to and usually provided in connection with a
loan, discount, deposit or trust service) or any subsidiary of the Company.
Most bank holding companies are required to give the Board prior
written notice of any purchase or redemption of their outstanding equity
securities if the gross consideration for the purchase or redemption, when
combined with the net consideration paid for all such purchases or redemptions
during the preceding 12 months, is equal to 10% or more of the bank holding
company's consolidated net worth. The Board may disapprove such a purchase or
redemption if it determines that the proposal constitutes an unsafe or unsound
practice, would violate any law, regulation, Board order or directive or any
condition imposed by, or written agreement with, the Board. The prior notice
requirement does not apply to certain "well-capitalized" bank holding companies
that meet specified criteria.
In November 1985, the Board adopted its Policy Statement on Cash
Dividends Not Fully Covered by Earnings. The Policy Statement sets forth various
guidelines that the Board believes that a bank holding company should follow in
establishing its dividend policy. In general, the Board stated that bank holding
companies should not pay dividends except out of current earnings and unless the
prospective rate of earnings retention by the holding company appears consistent
with its capital needs, asset quality and overall financial condition.
Cornerstone Community Bank is operating under a Memorandum of
Understanding with the Tennessee Department of Financial Institutions and the
Federal Deposit Insurance Corporation. Among other things, the Memorandum
provides the following:
- - The Board of Directors must develop a written management plan that
addresses Cornerstone Community Bank's plans for size, structure,
growth, earnings, services, information systems, personnel, accounting,
financial reporting and operating matters;
- - Cornerstone Community Bank must maintain a Tier I leverage capital
ratio of equal to or greater than 8%;
- - Cornerstone Community Bank may not pay dividends without the prior
approval of the FDIC; and
- - Cornerstone Community Bank must report its progress on the actions
required by the Memorandum to the FDIC on specific dates.
At September 30, 1999, Cornerstone Community Bank reported to the FDIC
that it was in compliance with all provisions of the Memorandum. However,
because of the increased regulatory scrutiny required by the Memorandum, the
activities of Cornerstone Community Bank and Cornerstone are more restricted,
and these restrictions may affect the flexibility of Cornerstone in conducting
its business operations.
Legislation Affecting the Company and the Bank
The following information describes statutory and regulatory provisions
and is qualified in its entirety by reference to the particular statutory and
regulatory provisions.
Far-reaching legislation, including the Financial Institutions Reform,
Recovery, and Enforcement Act of 1989 ("FIRREA"), and the Federal Deposit
Insurance Corporation Improvement
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Act of 1991 ("FDICIA") have for years impacted the business of banking. FIRREA
primarily affected the regulation of savings institutions rather than the
regulation of state banks and bank holding companies like the Bank and the
Company, but did include provisions affecting deposit insurance premiums,
acquisitions of thrifts by banks and bank holding companies, liability of
commonly controlled depository institutions, receivership and conservatorship
rights and procedures and substantially increased penalties for violations of
banking statutes, regulations and orders.
FDICIA resulted in extensive changes to the federal banking laws. The
primary prupose of FDICIA was to authorize additional borrowings by the FDIC in
order to assist in the resolution of failed and failing financial institutions.
However, the law also instituted certain changes to the supervisory process and
contained various provisions affecting the operations of banks and bank holding
companies.
The additional supervisory powers and regulations mandated by the
FDICIA, include a "prompt corrective action" program based upon five regulatory
zones for banks, in which all banks are placed, largely based on their capital
positions. Regulators are permitted to take increasingly harsh action as a
bank's financial condition declines. Regulators are also empowered to place in
receivership or require the sale of a bank to another depository institution
when a bank's capital leverage ratio reaches two percent. Better capitalized
institutions are generally subject to less onerous regulation and supervision
than banks with lesser amounts of capital. The FDIC has adopted regulations
implementing the prompt corrective action provisions of the FDICIA, which place
financial institutions in the following five categories based upon
capitalization ratios: (1) a "well capitalized" institution has a total
risk-based capital ratio of at least 10%, a Tier 1 risk-based ratio of at least
6% and a leverage ratio of at least 5%; (2) an "adequately capitalized"
institution has a total risk-based ratio of at least 8%, a Tier 1 risk-based
ratio of at least 4% and a leverage ratio of at least 4%; (3) an
"undercapitalized" institution has a total risk-based capital ratio of under 8%,
a Tier 1 risk-based capital ratio of under 4% or a leverage ratio of under 4%;
(4) a "significantly undercapitalized" institution has a total risk-based
capital ratio of under 6%, a Tier 1 risk-based ratio of under 3% or a leverage
ratio of under 3%; and (5) a "critically undercapitalized" institution has a
leverage ratio of 2% or less. Institutions in any of the three undercapitalized
categories would be prohibited from declaring dividends or making capital
distributions. The proposed regulations also establish procedures for
"downgrading" an institution to a lower capital category based on supervisory
factors other than capital. Various other sections of the FDICIA impose
substantial new audit and reporting requirements and increase the role of
independent accountants and outside directors. Set forth below is a list
containing certain significant provisions of the FDICIA:
(i) annual on-site examinations by regulators (except for
smaller, well-capitalized banks with high management ratings, which
must be examined every 18 months);
(ii) mandated annual independent audits by independent
public accountants and an independent audit committee of outside
directors for institutions with more than $500,000,000 in assets;
(iii) new uniform disclosure requirements for interest
rates and terms of deposit accounts; (iv) a requirement that the FDIC
establish a risk-based deposit insurance assessment system by 1994;
(v) authorization for the FDIC to impose one or more
special assessments on its insured banks to recapitalize the BIF;
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(vi) a requirement that each institution submit to its
primary regulators an annual report on its financial condition and
management, which report will be available to the public;
(vii) a ban on the acceptance of brokered deposits except
by well capitalized institutions and by adequately capitalized
institutions with the permission of the FDIC and the regulation of the
brokered deposit market by the FDIC;
(viii) restrictions on the activities engaged in by state
banks and their subsidiaries as principal, including insurance
underwriting, to the same activities permissible for national banks and
their subsidiaries unless the state bank is well capitalized and a
determination is made by the FDIC that the activities do not pose a
significant risk to the insurance fund;
(ix) a review by each regulatory agency of accounting
principles applicable to reports or statements required to be filed
with federal banking agencies and a mandate to devise uniform
requirements for all such filings;
(x) the institution by each regulatory agency of
noncapital safety and soundness standards for each institution it
regulates which cover (1) internal controls, (2) loan documentation,
(3) credit underwriting, (4) interest rate exposure, (5) asset growth,
(6) compensation, fees and benefits paid to employees, officers and
directors, (7) operational and managerial standards, and (8) asset
quality, earnings and stock valuation standards for preserving a
minimum ratio of market value to book value for publicly traded shares
(if feasible);
(xi) uniform regulations regarding real estate lending;
and
(xii) a review by each regulatory agency of the risk-based
capital rules to ensure they take into account adequate interest rate
risk, concentration of credit risk, and the risks of non-traditional
activities.
The activities permissible to the Company and the Bank were
substantially expanded by the recently enacted Gramm-Leach-Bliley Act (the
"Gramm Act") which President Clinton signed into law on November 12, 1999. The
Gramm Act repeals the anti-affiliation provisions of the Glass-Steagall Act to
permit the common ownership of commercial banks, investment banks and insurance
companies. The Gramm Act amended the Act to permit a financial holding company
to engage in any activity and acquire and retain any company that the Board
determines to be (i) financial in nature or incidental to such financial
activity, or (ii) complementary to a financial activity and that does not pose a
substantial risk to the safety and soundness of depository institutions or the
financial system generally. The Gramm Act also modifies current law relating to
financial privacy and community reinvestment. The new financial privacy
provisions generally prohibit financial institutions, including the Bank and the
Company, from disclosing nonpublic personal financial information to third
parties unless customers have the opportunity to "opt out" of the disclosure.
Bills are regularly introduced in both the United States Congress and
the Tennessee general Assembly that contain wide-ranging proposals for altering
the structures, regulations and competitive relationships of the nation's
financial institutions. It cannot be predicted whether or what form any proposed
legislation will be adopted or the extent to which the business of the Company
or the Bank may be affected thereby.
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ITEM 2. DESCRIPTION OF PROPERTY
The Company and the Bank operate five full-service branch offices in
Hamilton County, Tennessee.
5319 Highway 153, Chattanooga, TN
4154 Ringgold Road, East Ridge, TN
610 Georgia Avenue, Chattanooga, TN
2270 Gunbarrel Road, Chattanooga, TN
4976 Highway 58, Chattanooga, TN
It leases the space in which it operates the two branches in
Albertson's Supermarkets located at Gunbarrel Road and Highway 58. These two
branches each are comprised of approximately 450 square feet in each supermarket
and are leased pursuant to lease agreements entered into in August and November
1992 for initial five-year terms. Each lease provides two five-year extensions.
The leases have been renewed for the first renewal period and are due to renew
August and November of 2002. The Georgia Avenue branch contains 1800 square feet
and is leased pursuant to a lease agreement, which provides for an initial term
of three years with two three-year renewal options. The company owns the
remaining two branches.
The company has recently opened a Service center to house all its
non-customer contact functions 6401 Suite B Lee Corners, Chattanooga, TN. The
facility has 7800 square feet and is leased pursuant to a lease agreement, which
provides for an initial term of 5 years with one five-year renewal option.
The Company believes the grocery store branches do not enhance
business development. The Bank will relocate these grocery store branches as
soon as practical.
ITEM 3. LEGAL PROCEEDINGS
As of the end of 1999, the Bank was a party in two separate but related
lawsuits stemming from its relationship with Island Cove Marina (see financial
report note 11 for further comment). Management believes that the complaints are
without merit and that any loss to the Bank would not have a material effect on
the financial condition of the Bank.
The Bank is periodically involved as a plaintiff or defendant in
various legal actions in the ordinary course of its business. Management
believes that those claims are without merit or that the ultimate liability, if
any, resulting from them will not materially affect the Bank's financial
condition.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of shareholders of the Company
during the fourth quarter of the Company's fiscal year ended December 31, 1999.
10
13
PART II
ITEM 5. MARKET FOR THE COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Cornerstone Common stock is not listed, traded or quoted on any
securities exchange or in the over-the -counter market, and no dealer makes a
market in the Common Stock. To Cornerstone management's knowledge, the most
recent transaction with respect to Cornerstone Common Stock without warrants was
$13.00 per share. From July 1, to September 31, of 1999, the company issued
157,168 shares of the company's common stock upon the exercise of warrants held
by existing security holders in transactions exempt under Section 4(2) of the
Securities Act of 1933.
There were approximately 520 holders of record of the common stock as
of March 1, 2000.
Cornerstone currently intends to retain its earnings, if any, for use
in the business and does not anticipate paying any cash dividends in the
foreseeable future. The Board of Directors cannot predict when such dividends,
if any will ever be made. The payment of dividends, if any, shall at all times
be subject to the payment of Cornerstone's expenses, the maintenance of
reasonable working capital and risk reserves, and minimum capitalization
requirements for state banks. As a condition of its approval to complete the
Bank merger with Bank of East Ridge and currently, the Company is restricted by
the Federal Reserve Bank from paying dividends without its prior approval.
11
14
ITEM 6. SELECTED FINANCIAL DATA
(In Thousands) For the years ended December 31,
1999 1998 1997
Summary of Operations
Interest Income 7,687 8,212 4,191
Interest Expense 3,643 4,231 2,154
Net Interest Income 4,044 3,981 2,142
Provision for Loan Losses 855 715 273
Noninterest Income 585 686 326
Noninterest Expense 4,447 3,551 1,722
Income before Income Taxes (673) 400 368
Income Tax Expense (260) 152 144
Net Earnings (413) 248 224
Basic earnings per share (0.39) 0.25 0.35
Diluted earnings per share (0.39) 0.22 0.28
Dividends per common share -- -- --
Book value per share 11 10.16 11.33
Average common shares 1,062 987 650
outstanding
Fully Diluted common shares 1,092 1,137 800
Selected Year-end Balances
Total Assets 105,802 110,506 92,524
Earning Assets 91,388 100,686 80,836
Total Securities 19,063 18,358 18,324
Loans, net of unearned income 72,326 73,893 61,326
Allowance for Loan losses (1,002) (1,400) (915)
Total deposits 91,346 98,012 81,850
Long term debt -- 1,250 855
Redeemable common stock 238 479 857
Stockholder's equity 11,657 10,024 7,358
Selected Average Balances
Total Assets 102,890 105,763 81,053
Earning Assets 91,836 92,930 73,487
Total Securities 18,613 20,269 19,207
Loans, net 69,643 69,356 50,120
Allowance for Loan Losses (1,059) (900) (706)
Total Deposits 89,987 93,206 72,135
Redeemable Stock 239 479 146
Stockholders' equity 10,666 9,799 6,118
12
15
Selected Ratios
Average loans to average deposits 77.39% 74.41% 69.48%
Return on assets -0.40% 0.23% 0.28%
Return on equity -3.87% 2.53% 3.66%
Dividends payout ratio -- -- --
Net charge-off to average loans 1.80% 0.33% 0.03%
Non performing assets to total assets 1.21% 0.57% 0.00%
Non performing loans to total loans 1.20% 0.98% 0.23%
Allowance to total loans 1.39% 1.89% 1.49%
Allowance to total nonperforming loans 115.68% 193.64% 635.42%
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION
GENERAL
The following should be read in conjunction with the information and
tables which follow. For a discussion of liquidity and the impact of inflation,
see "Capital Resources/Liquidity" below.
The 1997 statistical disclosures of Cornerstone under Guide 3 represent
historical financial information presented on a pro forma basis as if the merger
of The Bank of East Ridge and Cornerstone Community Bank occurred as of January
1, 1997. Guide 3 financial information presented on the pro forma basis provides
comparable data that is reasonable and meaningful to the combined banking
operation that began on the merger date of October 15, 1997.
SUMMARY
Net income for 1999 was ($413,123) a 272% decrease from Cornerstone's
net income of $248,332 in 1998. Net income per common share of ($.39) for 1999
was 256% lower than 1998 net income per share of $.25. Pretax income for 1999
decreased $1,073,690 from 1998 pretax income of $400,288.
The decrease in net income per share from 1998 to 1999 is due primarily
to a strategic cleansing of the loan portfolio of all recognizable bad loans and
all the expenses associated with that objective. In 1999, the Bank net loan
charged-off was $1,253,191. In addition the Bank Balance sheet reconcilement
charged off was approximately $200,000.
13
16
BUSINESS OF THE COMPANY
The Company's earnings depend primarily on the Bank's "net interest
income," which is the difference between the interest income it receives from
its assets (primarily its loans and other investments) and the interest expense
(or "cost of funds") which it pays on its liabilities (primarily its deposits).
Net interest income is a function of (i) the difference between rates of
interest earned on interest-earning assets and rates of interest paid on
interest-bearing liabilities (the "interest rate spread" or "net interest
spread") and (ii) the relative amounts of its interest-earning assets and
interest-bearing liabilities. When interest-earning assets approximate or exceed
interest-bearing liabilities, any positive interest rate spread will generate
net interest income. The Bank adheres to an asset and liability management
strategy which is intended to control the impact of interest rate fluctuations
upon the Company's earnings and to make the yields on the Bank's loan portfolio
and other investments more responsive to its cost of funds, in part by more
closely matching the maturities of its interest-earning assets and its
interest-bearing liabilities, while still maximizing net interest income.
Nevertheless, the Bank is and will continue to be affected by changes in the
levels of interest rates and other factors beyond its control.
Unless specifically noted below, the following information is presented
on a consolidated basis reflecting the Company's performance as a whole. The
Company's results of operations are dependent primarily upon the results of
operations of the Bank
For the fiscal years ended December 31, 1999 and 1998, the Company's
weighted average rate earned on all interest-earning assets was 8.37% and 8.84%,
respectively, and the Company's weighted average rate paid on all
interest-bearing liabilities for the same years was 4.54% and 5.04%,
respectively. The Company's interest rate spread for the years ended December
31, 1999 and 1998 therefore was 3.83% and 3.79%, respectively, and its net
interest income for such years was $4,043,984 and $3,980,576, respectively. For
fiscal 1999, the Company recorded a net income loss of $(413,123) or $(.39)
basic earnings per share as compared with net income of $248,332 or $.25 basic
earnings per share for fiscal 1998. The decrease in net income was due primarily
to a large loan loss provision and corrections to the balance sheet. See "Item
7. Management's Discussion and Analysis of Financial Condition and Results of
Operations."
The table below sets forth certain additional measures of the Company's
performance for the periods indicated. Average balances in the table, as well as
all average balances presented elsewhere in this report, were derived based on
daily balances whenever possible. However, some average balances, which require
data from the Company, as opposed to the Bank, were derived based on month-end
balances since the data processing systems for those entities do not provide
daily average balance information. The use of month-end averages does not
materially alter any information given, and all averages are still
representative of the operations of the Company.
Years Ended December 31,
------------------------
1999 1998 1997
---- ---- ----
Net Interest Margin (Net interest
income divided by average interest-
earning assets)........................................................ 4.40% 4.28% 4.80%
Return on Average Assets
(Net income divided by average
total assets).......................................................... (.402)% .235% .277%
Return on Average Equity
(Net income divided by average equity)................................. (3.79)% 2.42% 3.58%
Equity-to-Assets
(Average equity divided by average total assets)....................... 10.60% 9.72% 7.73%
Loans to Deposits
(Average loans divided by average daily deposits)...................... 77.39% 74.41% 69.48%
Dividend Payout Ratio
(Dividends declared by the Company divided by net income).............. 0.00% 0.00% 0.00%
14
17
NET INTEREST INCOME
The following table sets forth information with respect to interest
income from average interest-earning assets, expressed both in dollars and
yields, and interest expense on average interest-bearing liabilities, expressed
both in dollars and rates, for the periods indicated. The table includes loan
yields which reflect the amortization of deferred loan origination and
commitment fees. Interest income from investment securities includes the
accretion of discounts and amortization of premiums.
Years Ended December 31,
----------------------------------------------------------------
1999 1998
----------------------------- -----------------------------
Interest Average Interest Average
(In thousands) Average Income/ Yield/ Average Income/ Yield/
Balance Expense(1) Rate Balance Expense(1) Rate
------- ---------- ---- ------- ---------- ----
ASSETS
Interest-earning assets:
Loans(1)(2) .............................. 69,643 6,361 9.13% 69,356 6,738 9.72%
Investment securities .................... 18,613 1,147 6.16% 20,269 1,297 6.40%
Federal funds sold ....................... 3,580 179 5.01% 3,289 176 5.35%
Other earning assets ...................... -- 0.00% 16 1 6.25%
---------------------------------------------------------------
Total interest-earning assets ............. 91,836 7,687 8.37% 92,930 8,212 8.84%
Allowance for loan losses ................. (1,059) (900)
Cash and other assets ..................... 12,113 13,733
---------------------------------------------------------------
Total assets .......................... 102,890 105,763
LIABILITIES AND STOCKHOLDERS' EQUITY
Interest-bearing liabilities:
Deposits
NOW accounts ............................ 13,604 231 1.70% 12,287 260 2.12%
Money market accounts ................... 9,890 324 3.28% 10,195 374 3.67%
Savings deposits.........................
Time deposits, $100,000 and over ........ 15,897 884 5.56%
Time deposits, other .................... 39,554 2,107 5.33% 60,234 3,507 5.82%
---------------------------------------------------------------
Total interest-bearing deposits ....... 78,945 3,546 4.49% 82,716 4,141 5.01%
Federal Funds Purchased ................... 29 2 5.17% 175 8 4.86%
Securities sold under agreement
to repurchase ............................. 519 30 5.68%
Long-term debt ............................ 732 65 8.88% 1,025 82 7.97%
---------------------------------------------------------------
Total interest-bearing liabilities .... 80,225 3,643 4.54% 83,916 4,231 5.04%6
Other liabilities:
Demand deposits .......................... 11,042 10,490
Accrued interest payable and
other liabilities ........................ 718 1,079
---------------------------------------------------------------
Total other liabilities ............... 11,760 11,569
Total liabilities ................... 91,985 95,485
---------------------------------------------------------------
Redeemable Stock .......................... 239 479
Stockholders' equity ...................... 10,666 9,799
---------------------------------------------------------------
Total liabilities
and stockholders' equity .................. 102,890 105,763
1997
-------------------------------
Interest Average
(In thousands) Average Income/ yield/
Balance Expense(1) Rate
ASSETS
Interest-earning assets:
Loans(1)(2) .............................. 50,120 5,292 10.56%
Investment securities .................... 19,207 1,317 6.86%
Federal funds sold ....................... 713 39 5.47%
Other earning assets ...................... 3,447 189 5.48%
------------------------------
Total interest-earning assets ............. 73,487 6,837 9.30%
Allowance for loan losses ................. (706)
Cash and other assets ..................... 8,272
------------------------------
Total assets .......................... 81,053
LIABILITIES AND STOCKHOLDERS' EQUITY
Interest-bearing liabilities:
Deposits
NOW accounts ............................ 11,104 247 2.22%
Money market accounts ................... 9,430 363 3.85%
Savings deposits
Time deposits, $100,000 and over ........
Time deposits, other .................... 43,705 2,703 6.18%
------------------------------
Total interest-bearing deposits ....... 64,239 3,313 5.16%
Federal Funds Purchased ...................
Securities sold under agreement
to repurchase .............................
Long-term debt ............................
------------------------------
Total interest-bearing liabilities .... 4,239 3,313 5.16%
Other liabilities:
Demand deposits .......................... 7,896
Accrued interest payable and
other liabilities ........................ 2,654
------------------------------
Total other liabilities ............... 10,550
Total liabilities ................... 74,789
------------------------------
Redeemable Stock .......................... 857
Stockholders' equity ...................... 5,407
------------------------------
Total liabilities
and stockholders' equity .................. 81,053
15
18
FINANCIAL RATIOS
Excess of interest-earning
assets over interest-
bearing liabilities ................. 11,611 9,014 9,248
Ratio of interest-earning assets
to interest-bearing liabilities .... 114.47% 110.74% 114.4%
Net interest income ................. 4,044 3,981 3,524
Interest rate spread (difference
between rate earned on interest-
earning assets and rate paid on
interest-bearing liabilities) ...... 3.83% 3.79% 4.15%
Net interest margin (net interest
income divided by average .......... 4.40% 4.28% 4.80%
interest-earning assets)
(1) Interest income on loans includes amortization of deferred loan fees and
other discounts of $ 0, $ 0, and $ 0, for the fiscal years ended December 31,
1999, 1998, and 1997, respectively.
(2) Nonperforming loans are included in the computation of average loan
balances, and interest income on such loans is recognized on a cash basis.
The following table sets forth information regarding the weighted
average contractual yields earned on the Company's interest-earning assets and
the weighted average interest rates paid on the Company's interest-bearing
liabilities outstanding at December 31, 1999. Investment securities are shown at
the Book value, as securities are held available for sale and held to maturity.
Average
(In thousands) Amount Yield/Rate
------ ----------
Interest-earning assets:
Loans................................................ 69,643 9.13%
Investment securities
Taxable securities............................... 18,613 6.16%
Tax-exempt securities
Federal funds sold................................... 3,580 5.01%
----------------------------
Total interest-earning assets.................. 91,836 8.37%
Interest-bearing liabilities:
NOW Accounts....................................... 13,604 1.70%
Money market and savings accounts.................. 9,890 3.28%
Time Deposits of $100,000 or more.................. 15,897 5.56%
Time deposits...................................... 39,554 5.33%
----------------------------
Total deposits.................................. 78,945 4.49%
Federal Funds Purchased............................. 29 5.17%
Securities Sold under agreement to repurchase........ 519 5.68%
Long term debt....................................... 732 8.88%
----------------------------
Total interest-bearing liabilities............. 80,225 4.54%
16
19
Changes in interest income and interest expense are attributable to
three factors: (i) a change in volume or amount of an asset or liability; (ii) a
change in interest rates; or (iii) a change caused by the combination of changes
in asset or deposit mix. The following table describes the extent to which
changes in interest rates and changes in volume of interest-earning assets and
interest-bearing liabilities have affected the Company's interest income and
expense during the periods indicated. For each category of interest-earning
assets and interest-bearing liabilities, information is provided as to changes
attributable to change in volume (change in volume multiplied by current rate)
and change in rates (change in rate multiplied by current volume).
The remaining difference has been allocated to mix.
Year Ended December 31,
1999 Compared to 1998
---------------------
Net
(In thousands) Volume Rate Mix Change
-------------------------------------------------
Interest income:
Loans (1)(2).................................. 26 -405 2 -377
Investment securities ........................ -102 -44 -4 -150
Federal funds sold............................ 15 -12 1 3
Other earning assets......................... 0 0 -1 -1
------------------------------------------------------
Total interest income..................... -524
Interest expense:
NOW accounts.................................. 22 -57 6 -29
Money market and saving accounts.............. -10 -38 -1 -50
Time deposits, $100,000 and over.............. 884 0 0 884
Time deposits, less than $100,000............. -1,102 -195 -102 -1,398
--------------------------------------------------
Total deposits............................ -593
Other borrowings................................ -26 7 3 -17
Fed Funds Purchased............................. -7 0 0 -7
Securities sold under agreement to repurchase... 30 0 0 30
--------------------------------------------------
Total other interest-bearing liabilities...... 6
Total interest expense.................... -587
Change in net interest income (expense)......... 63
- ----------------------------------------------------------------------------------------------------------
17
20
Year Ended December 31,
1998 Compared to 1997
---------------------
Net
Volume Rate Mix Change
------------------------------------------
Interest income:
Loans (1)(2) ................................... 1,869 -585 162 1,446
Investment securities .......................... 68 -93 5 -20
Federal funds sold ............................. 138 -4 3 137
Other earning assets .......................... -127 0 -61 -188
------------------------------------------
Total interest income ...................... 1,374
Interest expense:
NOW accounts ................................... 25 -13 1 13
Money market and saving accounts ............... 28 -19 1 11
Time deposits, $100,000 and over ............... 962 -218 60 804
Time deposits, less than $100,000 .............. 0 0 0 0
-----------------------------------------
Total deposits ............................. 828
Other borrowings ................................. 82 0 0 82
Fed Funds Purchased .............................. 9 0 0 9
Securities sold under agreement to repurchase .... 0 0 0 0
-----------------------------------------
Total other interest-bearing liabilities ....... 91
Total interest expense ..................... 919
Change in net interest income (expense) .......... 455
- ------------------
(1) Loan amounts include non-accruing loans.
(2) Interest income includes the portion of loan fees recognized in the
respective periods.
The following table sets forth the re-pricing of the Company's interest
earning assets and interest-bearing liabilities as of December 31, 1999. The
time periods in the table represent the period, following December 31, 1999,
during which an asset or liability matures or can be repriced. This interest
sensitivity gap table is designed to monitor the Company's interest rate risk
exposure within the designated time period. In order to control interest rate
risk, management regularly monitors the volume of interest sensitive assets
relative to interest sensitive liabilities over specific time intervals. The
Company's interest rate management policy is to attempt to maintain a relatively
stable net interest margin in periods of interest rate fluctuations. The
Company's policy is to attempt to maintain a ratio of cumulative gap to total
18
21
interest sensitive assets of negative 15.00% to positive 15.00% in the time
period of one year or less. Presently the Bank is in a negative one-year
cumulative GAP position of (21.76%) and is actively seeking adjustable rate
loans to reduce the Bank's sensitivity. The table below reflects the Company's
interest-earning assets and interest-bearing liabilities and makes the following
assumptions. Management has assumed saving and money market and NOW accounts
will be less interest rate sensitive and have spread the re-pricing out over a
5-year period. The non-mortgage securities have been scheduled by maturity date
while mortgages have been amortized over the life of the mortgage.
(In thousands) Less than 1 to 5 Over 5
One Year Years Years Total
-------- ----- ----- -----
Interest Sensitive Assets
Fed Funds Sold ......................... 0 0 0 0
Investment Securities
Taxable (1) ......................... 3,008 11,038 5,017 19,063
Tax-exempt (1) ...................... 0 0 0 0
Loans (2)
Fixed rate .......................... 850 12,040 419 13,309
Adjustable rate ..................... 4,755 718 0 5,473
Scheduled payments .................. 27,502 24,886 1,156 53,544
Total Interest-Sensitive Assets ........ 36,115 48,682 6,592 91,389
Interest Sensitive Liabilities
NOW .................................... 6,884 10,326 0 17,210
Money Market ........................... 4,255 1,418 0 5,673
Time Deposits .......................... 42,679 13,360 12 56,051
Other interest-bearing liabilities .... 2,179 0 0 2,179
Long-term debt ......................... 0 0 0 0
Total Interest Sensitive Liabilities ... 55,997 25,105 12 81,114
Interest Sensitivity Gap ............... (19,882) 23,577 6,580 10,275
Cumulative Gap ......................... (19,882) 3,695 10,275
Ratio of cumulative gap to total
Interest sensitive assets ........... (21.76%) 4.04% 11.24%
- ------
(1) All AFS securities are shown at the market value and HTM are shown at book
value.
(2) Non-performing loans are included as interest-earning assets.
LENDING ACTIVITIES
LOAN POLICY
All lending activities of Cornerstone are under the direct supervision
and control of the Directors Loan Committee, which consists of the chief
executive officer, the executive vice president of lending and four outside
directors. The loan committee enforces loan authorizations for each officer,
makes lending decisions on loans exceeding such limits, services all requests
for office credits to extent allowable under current laws and regulations,
administers all problem credits, and determines the allocation of funds for each
lending
19
22
division. Cornerstone's established maximum loan volume to assets is 80%. The
loan portfolio consists primarily of real estate, commercial and installment
loans.
GENERAL
At December 31, 1999, the Company's loan portfolio constituted
approximately 68.36% of the Company's total assets. The following table sets
forth the composition of the Company's loan portfolio at the indicated dates.
At December 31,
------------------------------------------------
(In thousands) 1999 1998
--------------------- ----------------------
Amount Percent Amount Percent
------ ------- ------ -------
Commercial, financial,
and agricultural................. 35,504 49.10% 36,678 49.64%
Real estate - construction........ 5,560 7.69% 5,456 7.38%
Real estate - mortgage............ 24,917 34.44% 24,067 32.57%
Consumer loans.................... 6,345 8.77% 7,692 10.41%
Total loans....................... 72,326 100.00% 73,893 100.00%
The following table sets forth the scheduled maturities of the loans in
the Company's loan portfolio as of December 31, 1999 based on their contractual
terms to maturity. Overdrafts are reported as due in less than one year. Loans
unpaid at maturity are renegotiated based on current market rates and terms.
Loans Maturing
----------------------------------------
Less Than One to Five More than
One Year Years Five Years Total
--------- ----------- ---------- -----
Commercial, financial
and agricultural............ 18,864 15,579 1,061 35,504
Real estate - construction..... 5,532 28 0 5,560
Real estate - mortgage......... 6,504 17,994 419 24,917
Consumer loans................. 2,207 4,043 95 6,345
------ ------ ----- ------
Total...................... 33,107 37,644 1,575 72,326
20
23
TYPES OF LOANS
Commercial Loans
Commercial, industrial, and non-farm non-residential loans, hereinafter
referred to as commercial loans (excluding commercial construction loans),
totaled $ 35.5 million or 49.10% of the Company's loan portfolio at December 31,
1999. Commercial loans consist of loans and lines of credit to individuals,
partnerships and corporations for a variety of business purposes, such as
accounts receivable and inventory financing, equipment financing, business
expansion and working capital. The terms of the Bank's commercial loans
generally range from 90 days to 5 year balloon and a 15 year amortization, and
the loans generally carry interest rates which adjust in accordance with changes
in the prime rate, but when appropriate will be fixed to match the borrower's
needs. Substantially all of the Bank's commercial loans are secured and
guaranteed by the principals of the borrower.
Loans secured by marketable equipment are required to be amortized over
a period not to exceed 60 months. Generally, loans secured by current assets
such as inventory or accounts receivable are revolving lines of credit with
annual maturities. Loans secured by chattel mortgages and accounts receivable
may not exceed 80% of their market value. Loans secured by listed stocks,
municipal bonds and mutual funds may not exceed 70% of their market value.
Unsecured short-term loans and lines of credit must meet criteria set by the
Bank's Loan Committee. Current financial statements support all commercial
loans, and such financial statements are updated annually. Commercial loans,
which are considered small business loans, are the core business of Cornerstone.
Most loans are made with a long-term relationship intended and Cornerstone also
seeks to obtain the borrower's business and personal depository accounts.
Real Estate - Construction Loans
As of December 31, 1999, Cornerstone had $5.6 million in construction
and development loans outstanding, which represented 7.69% of the loan
portfolio. All construction and development loans are held in the Bank's loan
portfolio. The Bank makes residential construction loans to owner-occupants and
to persons building residential properties for resale. The majority of the
Bank's construction loans are made to residential real estate developers for
speculative single-family residential properties. Construction loans are usually
variable rate loans made for terms of one year or less, but extensions are
permitted if construction has continued satisfactorily and if the loan is
current and other circumstances warrant the extension. Construction loans are
limited to 80% of the appraised value of the lot and the completed value of the
proposed structure.
Construction financing generally is considered to involve a higher
degree of credit risk than permanent mortgage financing of residential
properties, and this additional risk usually is reflected in higher interest
rates. The higher risk of loss on construction loans is attributable in large
part to the fact that loan funds are estimated and advanced upon the security of
the project under construction, which is of uncertain value prior to the
completion of construction.
21
24
Moreover, because of the uncertainties inherent in estimating construction
costs, delays arising from labor problems, material shortages and other
unpredictable contingencies, it is relatively difficult to accurately evaluate
the total loan funds required to complete a project and to accurately evaluate
the related loan-to-value ratios. If the estimates of construction costs and the
salability of the property upon completion of the project prove to be
inaccurate, the Bank may be required to advance funds beyond the amount
originally committed to permit completion of the project. If the estimate of
value proves to be inaccurate, the Bank may be confronted, at or prior to the
maturity of the loan, with a project with a value, which is insufficient to
assure full repayment.
The Bank's underwriting criteria are designed to evaluate and minimize
the risk of each construction loan. Among other items, the Bank considers
evidence of the availability of permanent financing or a take-out commitment to
the borrower, the financial strength and reputation of the borrower, an
independent appraisal and review of cost estimates, market conditions, and, if
applicable, the amount of the borrower's equity in the project, pre-construction
sale or leasing information and cash flow projections of the borrower.
Real Estate - Mortgage Loans
At December 31, 1999, real estate mortgage loans totaled $ 24.9 million
or 34.44% of the Company's loan portfolio. Real estate mortgage loans include
all loans secured by real estate for purposes other than construction or
acquisition and development and are hereinafter referred to as real estate
loans. All real estate loans are held in the Bank's loan portfolio. Of this
amount, $ 23.4 million or 32.45% of the Company's loan portfolio was comprised
of loans secured by one to four family residential properties, including home
equity loans (loans secured by the equity in the borrower's residence but not
necessarily for the purpose of home improvement). Most of these home equity
loans are made at fixed interest rates for terms of one to three years with
balloon payment provisions and amortized over a 10-15 year period. The Bank's
experience indicates that real estate loans normally remain outstanding for much
shorter periods (seven years on average) than their stated maturity because the
borrowers repay the loans in full either upon the sale of the secured property
or upon the refinancing of the original loan.
In the case of owner occupied single family residences, real estate
loans are made for up to 95% of the value of the property securing the loan,
based upon an appraisal if the loan amount is over $100,000. When the loan is
secured by real estate containing a non-owner occupied dwelling of one to four
family units, loans generally are made for up to 80% of the value, based upon an
appraisal if the loan amount is over $100,000. The Bank also requires title
insurance to insure the priority of the property lien on its real estate loans
over $50,000 and requires fire and casualty insurance on all of its loans.
The real estate loans originated by the Bank contain a "due-on-sale"
clause, which provides that the Bank may declare the unpaid balance of the loan
immediately due and payable upon the sale of the mortgaged property. Such
clauses are an important means of reducing the average loan life and increasing
the yield on existing fixed-rate real estate loans, and it is the Bank's policy
to enforce due-on-sale clauses.
22
25
At December 31, 1999, the remainder of the Company's real estate loans
totaled $ 1.5 million or 2.04% of the Company's loan portfolio. These loans were
comprised of multifamily residential properties.
Consumer Loans
At December 31, 1999, consumer loans totaled $ 6.3 million or 8.78% of
the Company's loan portfolio. These loans consist of consumer installment loans
and consumer credit card balances. As of December 31, 1999, the Bank had $ .9
million credit card balances outstanding
The Bank makes both secured and unsecured consumer loans for a variety
of personal and household purposes. Most of the Bank's consumer loans are
automobile loans, boat loans, property improvement loans and loans to depositors
on the security of their certificates of deposit. These loans are generally made
for terms of up to five years at fixed interest rates. The Bank considers
consumer loans to involve a relatively high credit risk compared to real estate
loans. Consumer loans, therefore, generally yield a relatively high return to
the Bank and provide a relatively short maturity. The Bank believes that the
generally higher yields and the shorter terms available on various types of
consumer loans tend to offset the relatively higher risk associated with such
loans, and contribute to a profitable spread between the Bank's average yield on
earning assets and the Bank's cost of funds.
ORIGINATION, PURCHASE AND SALE OF LOANS
The Bank originates loans primarily in Hamilton County, Tennessee. The
Bank also originates loans in Marion, Sequatchie, and Bradley Counties in
Tennessee, and Dade, Walker and Catoosa Counties in Georgia each of, which is
contiguous to Hamilton County. Loans are originated by eight loan officers who
operate from the Bank's offices in Chattanooga. These loan officers actively
solicit loan applications from existing customers, local manufacturers and
retailers, builders, real estate developers, real estate agents and others. The
Bank also receives numerous loan applications as a result of customer referrals
and walk-ins to its offices.
Upon receipt of a loan application and all required supporting
information from a prospective borrower, the Bank obtains a credit report and
verifies specific information relating to the loan applicant's employment,
income and creditworthiness. For significant extensions of credit in which real
estate will secure the proposed loan, a certified appraisal of the real estate
is undertaken by an independent appraiser approved by the Bank. The Bank's loan
officers then analyze the credit worthiness of the borrower and the value of any
collateral involved.
The Bank's loan approval process is intended to be conservative but
also responsive to customer needs. Loans are approved in accordance with the
Bank's written loan policy, which
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provides for several tiers of approval authority, based on a borrower's
aggregate debt with the Bank. Certain loan officers have the authority to
approve loans of up to $ 100,000. All other loan officers have the authority to
approve secured loans of up to at least $ 10,000. There is an Officers Loan
Committee comprised of the senior officers of the Bank which must approve any
loan that increases the borrower's aggregate indebtedness above an individual
officer's limit, but that is not more than $ 250,000. The Directors Loan
Committee mentioned above must approve all loans over $ 250,000 but that is not
more than $ 1,000,000. All loans above $1,000,000 up to the Bank's legal lending
limit must be approved by the Board of Directors of the Bank. The Bank's legal
lending limit is 25% of the Bank's qualifying equity for secured loans and 15%
for unsecured loans.
The Bank has in the past purchased and sold commercial loan
participations with correspondent banks and will continue the practice when
management feels the action would be in the best interest of stockholders. The
purchase of loan participations allows the Bank to expand its loan portfolio and
increase profitability while still maintaining the high credit standards, which
are applied to all extensions of credit made by the Bank. The sale of loan
participations allows the Bank to make larger loans which it otherwise would be
unable to make due to capital or other funding considerations. As of the end
December 31, 1999, the Bank had a purchased participation balance of $560
thousand and had sold participation balance of $2.9 million.
LOAN FEE INCOME
In addition to interest earned on loans, the Bank receives origination
fees for making loans, commitment fees for making certain loans, and other fees
for miscellaneous loan-related services. Such fee income varies with the volume
of loans made, prepaid or sold, and the rates of fees vary from time to time
depending on the supply of funds and competitive conditions.
Commitment fees are charged by the Bank to the borrower for certain
loans and are calculated as a percentage of the principal amount of the loan.
These fees normally are deducted from the proceeds of the loan and generally
range from 1/2% to 2% of the principal amount, depending on the type and volume
of loans made and market conditions such as the demand for loans, the
availability of money and general economic conditions. The Bank complies with
FASB 91 and amortizes all loan fees in excess of $5,000 over the life of the
loan.
The Bank also receives miscellaneous fee income from late payment
charges, overdraft fees, property inspection fees, and miscellaneous services
related to its existing loans. For the year ended December 31, 1999, the Bank
recognized origination, commitment and other loan fees totaling $ 327,639, which
equaled 4.26% of the Company's total interest income for the year.
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PROBLEM LOANS AND ALLOWANCE FOR LOAN LOSSES
Problem Loans
In originating loans, the Company recognizes that it will experience
credit losses and that the risk of loss will vary with, among other things, the
type of loan being made, the creditworthiness of the borrower over the term of
the loan and, in the case of a secured loan, the guaranty of the security for
the loan. The Company has instituted measures at the Bank which are designed to
reduce the risk of, and monitor exposure to, credit losses.
The Bank's loan portfolio is systematically (all loans over $100,000
secured and $50,000 unsecured will be reviewed and graded annually) reviewed by
the Bank's management and periodically by third party loan review consultants,
external auditors, and State and Federal regulators to identify deficiencies.
Input from all the above parties is used by the Bank to take corrective actions
as necessary. As discussed below, each of the Bank's loans is assigned a rating
in accordance with the Bank's internal loan rating system. All past due loans
are reviewed by the Bank's senior lending officers and monthly by the Loan
Committee of the Board of Directors, and all loans classified as substandard or
doubtful, as well as any "special mention" loans (defined in the following
paragraph), are placed on the Bank's watch list and reviewed at least monthly by
the Director's Loan Committee. In addition, all loans to a particular borrower
are reviewed, regardless of classification, each time such borrower requests a
renewal or extension of any loan or requests an additional loan. All lines of
credit are reviewed annually prior to renewal. Such reviews include, but are not
limited to, the ability of the borrower to repay the loan, a re-assessment of
the borrower's financial condition, the value of any collateral and the
estimated potential loss to the Bank, if any.
The Bank's internal problem loan rating system establishes three
classifications for problem assets substandard, doubtful and loss. Additionally,
in connection with regulatory examinations of the Bank, Federal and State
examiners have authority to identify problem assets and, if appropriate, require
the Bank to classify them. Substandard assets have one or more defined
weaknesses and are characterized by the distinct possibility that the Bank will
sustain some loss if the deficiencies are not corrected. Doubtful assets have
the weaknesses of substandard assets with the additional characteristic that the
weaknesses make collection or liquidation in full, on the basis of currently
existing facts, conditions and values, highly questionable and improbable. An
asset classified as loss is considered uncollectible and of such little value
that continuance as an asset of the Bank is not warranted. Consequently, such
assets are charged-off in the month they are classified as loss. Federal
regulations also designate a "special mention" category, described as assets
which do not currently expose the Bank to a sufficient degree of risk to warrant
classification but do possess credit deficiencies or potential weaknesses
deserving management's close attention.
Assets classified as substandard or doubtful require the Bank to
establish general allowances for loan losses. If an asset or portion thereof is
classified as loss, the Bank must either establish specific allowances for loan
losses in the amount of 100% of the portion of the asset classified as loss or
charge off such amount. General loss allowances established to cover
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possible losses related to assets classified as substandard or doubtful may be
included, up to certain limits, in determining the Bank's regulatory capital,
while specific valuation allowances for loan losses do not qualify as regulatory
capital.
The Bank's collection procedures provide that when a loan becomes 15
days and 30 days delinquent, the borrower is contacted by mail and payment is
requested. If the delinquency continues, subsequent efforts are made to contact
and request payment from the delinquent borrower. Most loan delinquencies are
cured within 60 days and no legal action is required. In certain circumstances,
the Bank, for a fee, may modify the loan, grant a limited moratorium on loan
payments or revise the payment schedule to enable the borrower to restructure
his or her financial affairs. Generally, the Bank stops accruing interest and
any accrued non collected interest will be reversed in accordance with GAAP on
delinquent loans when payment is in arrears for 90 days (unless the obligation
is both well secured and in the process of collection) or when collection
otherwise becomes doubtful. If the delinquency exceeds 120 days and is not cured
through the Bank's normal collection procedures or through a restructuring, the
Bank will institute measures to enforce its remedies resulting from the default,
including commencing a foreclosure, repossession or collection action. In
certain cases, the Bank will consider accepting a voluntary conveyance of
collateral in lieu of foreclosure or repossession. Real property acquired by the
Bank as a result of foreclosure or by deed in lieu of foreclosure is classified
as "real estate owned" until it is sold and is carried at the lower of cost
(defined as fair value at foreclosure) or fair value less estimated costs to
dispose. Accounting standards define fair value as the amount that is expected
to be received in a current sale between a willing buyer and seller other than
in a forced or liquidation sale. Fair values at foreclosure are based on
appraisals. Losses arising from the acquisition of foreclosed properties are
charged against the allowance for loan losses. Subsequent write-downs are
provided by a charge to income through losses on other real estate in the period
in which the need arises.
The Bank attempts to sell real estate owned promptly after foreclosure,
and it sold $153,251 of its real estate owned due to loan foreclosures during
the year ended December 31, 1999. The book value of real estate owned that was
sold by the Bank during the year ended December 31, 1999 totaled $202,907. As of
December 31, 1999, there was $393 thousand real estate owned as a result of
foreclosure.
The following table sets forth information regarding the Company's
delinquent and non-performing assets as of the dates indicated.
(In thousands) At December 31,
---------------
1999 1998
---- ----
Accruing loans which are contractually
past due 90 days or more:
Commercial, financial, and agricultural.................... 3 0
Real estate - construction................................. 0 114
Real estate - mortgage..................................... 0 0
Consumer................................................... 3 0
--------------------------------------
Total ................................................... 6 114
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Ratio of delinquent (30 days or more) but accruing loans to:
Total loans.............................................. 1.20% 2.16%
Total assets............................................. 0.82% 1.44%
Non-accruing loans:
Commercial, financial, and agricultural...................... 532 516
Real estate - construction................................... 0 0
Real estate - mortgage....................................... 318 13
Consumer loans............................................... 10 80
Total ................................................... 860 609
Real estate acquired through foreclosure....................... 393 0
Property acquired through repossession......................... 31 18
Total loans and real estate acquired
through foreclosure and repossessions....................... 424 18
Total assets................................................... 105,802 110,506
Ratio of non-performing assets total assets:................... 1.21% 0.57%
Allowance for Loan Losses
The allowance or reserve for possible loan losses is a means of
absorbing future losses, which could be incurred from the current loan
portfolio. The Bank maintains an allowance for possible loan losses, and
management adjusts the general allowances monthly by charges to income in
response to changes to outstanding loan balances.
The Bank maintains a general allowance equal to approximately 1.35% of
the total principal amount of loans outstanding and management adjusts the
general allowance monthly by charges or credits to income in response to changes
in the outstanding loan balance. Management also may establish specific loan
loss allowances for specific loans after considering such factors as past
delinquencies on the loan, the value of the underlying collateral and the size
of the loan. A loan or portion thereof is charged off against the general
allowance when management has determined that losses on such loans are probable.
Recoveries on any loans charged-off in prior fiscal periods are credited to the
allowance. It is the opinion of the Bank's management that the balance in the
general allowance for loan losses as of December 31, 1999 is adequate to absorb
possible losses from loans currently in the portfolio.
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The following table summarizes the Company's loan loss experience for
the periods indicated.
Years Ended December 31,
------------------------
(In thousands) 1999 1998
---- ----
Average loans........................................................ 69,643 69,356
Allowance for possible loan losses,
beginning of the period........................................... 1,400 915
Charge-offs for the period:
Commercial, financial, and agricultural.......................... 1,014 166
Real estate - construction....................................... 0 0
Real estate - mortgage........................................... 111 49
Consumer......................................................... 387 103
----------------------------------
Total charge-offs................................................ 1,512 318
Recoveries for the period:
Commercial, financial, and agricultural.......................... 131 45
Real estate - construction....................................... 0 0
Real estate - mortgage........................................... 13 13
Consumer......................................................... 115 30
----------------------------------
Total recoveries................................................. 259 88
Net charge-offs for the period................................... 1,253 230
Provision for loan losses............................................ 855 715
Allowance for possible loan losses,
end of the period................................................ 1,002 1,400
Ratio of allowance for loan losses to
total average loans outstanding.................................. 1.44% 2.02%
Ratio of net charge-offs during
the period to average loans
outstanding during the period.................................... 1.80% 0.33%
In addition to the Bank's loan rating system for problem assets
described above (see Problem Loans, above), the Bank has established a loan
rating system for all categories of loans which assists management and the Board
of Directors in determining the adequacy of the Bank's allowance for loan
losses. Each loan in the Bank's portfolio is assigned a rating which is reviewed
by management periodically to ensure its continued suitability. An exception is
made in the case of (i) monthly installment loans which are grouped together by
delinquency status such as over 10, 30, 60, or 90 days past due and (ii) problem
assets which are rated as
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substandard, doubtful, or loss as discussed above. All other loans are assigned
a rating of excellent, good, or moderate. The total amount of loans in each of
these loan rating categories is weighted by a factor that management believes
reasonably reflects losses that can be anticipated with respect to loans in each
of these categories. Based on these weightings, the Bank's management
establishes an allowance for loan losses that is reviewed by its Board of
Directors each month.
The following table sets forth the Company's allocation of the
allowance for loan losses as of December 31, 1999, and 1998.
At December 31, 1999 At December 31, 1998
-------------------------------- ----------------------------
(In thousands) Percent of loans Percent of loans
in each category in each category
Balance at end of period applicable to Amount to total loans Amount to total loans
- -------------------------------------- ------ -------------- ------ --------------
Commercial, financial, and agricultural... 492 49.09% 695 49.64%
Real estate - construction................ 77 7.69% 103 7.38%
Real estate - mortgage.................... 345 34.45% 456 32.57%
Consumer ................................. 88 8.77% 146 10.41%
------------------------------------------------------------
Total................................ 1,002 100.00% 1,400 100.00%
INVESTMENT ACTIVITIES
Investment Policy
The objective of Cornerstone's investment policy is to invest funds not
otherwise needed to meet the loan demand of Cornerstone's market area and to
meet the five following objectives: Gap Management, Liquidity, Pledging, Return,
and Local Community Support. In doing so, Cornerstone will use the portfolio to
provide structure and liquidity that the loan portfolio cannot. The management
investment committee will balance the market risk and credit risks against the
potential investment return, make investments compatible with the pledge
requirements of Cornerstone's deposit of public funds, maintain compliance with
regulatory investment requirements, and assists the various public entities with
their financing needs. The management investment committee is authorized to
execute security transactions for the investment portfolio based on the
decisions of the Board Asset Liability Committee (ALCO). All the investment
transactions occurring since the previous ALCO meeting are reviewed by the ALCO
at its next monthly meeting, in addition to the entire portfolio. The investment
policy allows portfolio holdings to include short-term securities purchased to
provide Cornerstone's needed liquidity and longer-term securities purchased to
generate stable income for Cornerstone during periods of interest rate
fluctuations.
The Company's investment portfolio totaled $ 19 million or 18.02% of
total assets at December 31, 1999.
The following table sets forth the carrying value of the Bank's
investments at the dates
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indicated. Securities held in both available for sale and held to maturity
status. Securites available for sale are carried at fair market value and
securities held to maturity are held at their book value.
At December 31,
------------------------------
(In thousands) 1999 1998
--------- ---------
Securities available for sale:
U.S. Government and agency
obligations................................................. 8,935 1,604
Mortgage-backed and other securities.......................... 4,404 7,676
States & political subdivisions tax-exempt.................... 0 0
------------------------------
Total...................................................... 13,339 9,280
Securities held to maturity:
U.S. Government and agency
obligations................................................. 198 352
Mortgage-backed and other securities.......................... 5,525 8,725
States & political subdivisions tax-exempt.................... 0 0
------------------------------
Total......................................................... 5,723 9,077
Total Securities.......................................... 19,063 18,357
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The following table sets forth the fair value of the Bank's investments
at December 31, 1999, the weighted average yields on the Bank's investments at
December 31, 1999 and the periods to maturity of the Bank's investments from
December 31, 1999.
Periods to Maturity from December 31, 1999
------------------------------------------------------------------------------------------
1 year or less 1 - 5 years 5 - 10 years Over 10 years
------------------ ------------------ ----------------- ---------------------
(In thousands)
Weighted Weighted Weighted Weighted
AVAILABLE FOR SALE: Average Average Average Average
Amount Yield (1) Amount Yield (1) Amount Yield (1) Amount Yield (1)
------ --------- ------ --------- ------ --------- ------ ----------
U. S. Treasuries..................... 0 0.00% 0 0.00% 0 0.00% 0 0.00%
U. S. Government
agencies.......................... 0 0.00% 8,937 6.31% 0 0.00% 0 0.00%
Mortgage backed Securities (2)....... 0 0.00% 203 6.68% 517 0.00% 3,682 6.49%
Tax-exempt
municipal bonds................... 0 0.00% 0 0.00% 0 0.00% 0 0.00%
Other bonds, notes, de-bentures,
and securities.................... 0 0.00% 0 0.00% 0 0.00% 0 0.00%
-----------------------------------------------------------------------------------------
Total............................. 0 0.00% 9,140 517 6.74% 3,682 6.49%
-----------------------------------------------------------------------------------------
Total Available for Sale:........ 13,339 6.38%
Periods to Maturity from December 31, 1999
------------------------------------------------------------------------------------------
1 year or less 1 - 5 years 5 - 10 years Over 10 years
------------------ ------------------ ----------------- ---------------------
(In thousands)
Weighted Weighted Weighted Weighted
AVAILABLE FOR SALE: Average Average Average Average
Amount Yield (1) Amount Yield (1) Amount Yield (1) Amount Yield (1)
------ --------- ------ --------- ------ --------- ------ ----------
U. S. Treasuries..................... 0 0.00% 0 0.00% 0 0.00% 0 0.00%
U. S. Government
agencies.......................... 0 0.00% 198 6.29% 0 0.00% 0 0.00%
Mortgage backed Securities (2)....... 10 6.00% 1,106 6.49% 509 6.94% 3,906 6.49%
Tax-exempt
municipal bonds................... 0 0.00% 0 0.00% 0 0.00% 0 0.00%
Other bonds, notes, de-bentures,
and securities.................... 0 0.00% 0 0.00% 0 0.00% 0 0.00%
-------------------------------------------------------------------------------------------
Total............................ 10 6.00% 1,304 6.46% 509 6.94% 3,848 6.49%
-------------------------------------------------------------------------------------------
Total Held to Maturity........... 5,671 6.50%
Total Securities................. 19,010 6.41%
- -------------
(1)The weighted average yields on tax-exempt securities have been computed on a
tax-equivalent basis.
(2) Mortgages are allocated by maturity and not amortized
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SOURCES OF FUNDS
GENERAL
Time, money market, savings and demand deposits are the major source of
the Company's funds for lending and other investment purposes. All deposits are
held by the Bank. In addition, the Company obtains funds from loan principal
repayments and proceeds from sales of loan participations and investment
securities. Loan repayments are a relatively stable source of funds, while
deposit inflows and outflows and sales of loan participations and investment
securities are significantly influenced by prevailing interest rates, economic
conditions and the Company's asset and liability management strategies.
Borrowings may be used on a short-term basis to compensate for reductions in the
availability of other sources of funds or on a longer term basis to support
expanded lending activities and for other general business purposes.
DEPOSITS
The Bank offers several types of deposit accounts, with the principal
differences relating to the minimum balances required, the time period the funds
must remain on deposit and the interest rate. Deposits are obtained primarily
from the Bank's Chattanooga Metropolitan Statistical Area (MSA). The Bank does
not advertise for deposits outside of this area. The Bank does not solicit funds
from brokers, nor does it rely upon any single person or group of related
persons for a material portion of its deposits.
A principal source of deposits for the Bank consists of short-term
money market and other accounts, which are highly responsive to changes in
market interest rates. Accordingly, the Bank, like all financial institutions,
is subject to short-term fluctuations in deposits in response to customer
actions due to changing short-term market interest rates. The ability of the
Bank to attract and maintain deposits and the Bank's cost of funds have been and
will continue to be significantly affected by money market conditions.
The following tables set forth the composition of deposits for the
Company, excluding accrued interest payable, by type for the years ended
December 31, 1999 and December 31, 1998.
1999 1998
(In thousands) --------------------
Demand Deposits .................................. 12,412 14,152
NOW accounts ..................................... 12,626 12,998
Savings & Money market deposits .................. 10,255 10,283
Time deposits less than $100,000 ................. 39,923 43,089
Time deposits $100,000 or more ................... 16,129 17,490
---------------------
Total deposits ......................... 91,346 98,012
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The following table presents a breakdown by category of the average
amount of deposits and the average rate paid on deposits for the periods
indicated:
(In thousands) 1999 1998
-----------------------------------------
Demand Deposits ....................... 11,042 10,490
NOW accounts .......................... 13,604 1.70% 12,287 2.12%
Savings & Money market deposits ....... 9,890 3.28% 10,195 3.67%
Time deposits less than $100,000 ...... 39,554 5.33% 60,234 5.82%
Time deposits $100,000 or more ........ 15,897 5.56%
-----------------------------
Total deposits .............. 89,987 93,206
BORROWINGS
The Company has paid off a holding company loan with First Tennessee
Bank, which began the year with a balance of $1.250 million. The company does
not anticipate borrowings in the future. The Bank has available several Federal
Funds lines of credit available with corespondent banks with a total
availability of $7 million as of the end of 1999. As of December 31, 1999, the
Bank had an outstanding balance of $1 million. In addition, the Bank has the
right to borrow from the Federal Reserve Bank if necessary to supplement its
supply of funds available for lending and to meet deposit withdrawal
requirements.
FINANCIAL CONDITION
Earning Assets. Average earning assets in 1999 decreased $1.1 million
or 1.2% over 1998 primarily due to the smaller security position the Bank held.
This was as a result of a decrease in certificates of deposit, which will be
discussed below.
Loan Portfolio. Cornerstone's average loans for 1998 were $70 million,
an increase of less than 1% over $69 million in average loans for 1998. Loan
growth for 1999 was funded through the reduction of securities. The actual
balance for the end of 1999, was $72.3 million a decrease of 1.0 million from
1998. During 1999, the portfolio fluctuated from the beginning of the year down
to a low balance in May of 1999 when the Bank's loan portfolio balance was $65
million back up to the yearend figure of $72.3 million.
Investment Portfolio. Cornerstone's average investment securities
portfolio decreased 8.2% or $1.66 million from 1998 to 1999. Cornerstone
maintains an investment strategy of seeking portfolio yields within acceptable
risk levels as well as providing liquidity, pledging requirements, and GAP
management. To assist in accomplishment of these missions the Bank materially
reduced its mortgage backed security exposure during 1999. The Bank ended the
year with less than 46% of the portfolio in mortgage backed securities. The Bank
replaced these securities with non-callable bullet U.S. Agency securities that
have a much lower interest rate risk. Cornerstone maintains two classifications
of investment securities. "Held to Maturity" and "Available for Sale." The
"Available for Sale" securities are carried at fair market value, where
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as "Held to Maturity" securities are carried at book value. At yearend 1999,
unrealized losses in the "Available for Sale" portfolio amounted to ($277,713).
Deposits. Cornerstone's average deposits decreased $3.7 million or 4.4%from 1998
to 1999. From yearend 1998 to yearend 1999, total deposits decreased $6.7
million or 6.8%. The Bank's strategy was to attact core transaction deposits and
be less aggressive on certificates of deposits as the Bank went through its
transition period when lenders were focusing on loan documentation rather than
attracting new loans in the spring of 1999. The strategy lead to a general
decrease in the most expensive deposits and therefore reduced the Bank's general
cost of funds and increased the net interest income for the Bank.
Capital Resources. Stockholders average equity increased $.9 million or 8.8%.
The Bank lost $413,123 in 1999, but raised approximately $2 million in the month
of July and August through a warrant sale approved by the shareholders. The
actual balance increased $1.6 million or 16.3% from $10 million as of the end of
1998 to $11.7 million.
BALANCE SHEET MANAGEMENT
Liquidity Management. Liquidity is the ability of a company to convert
assets into cash without significant loss and to raise funds by increasing
liabilities. Liquidity management involves having the ability to meet day-to-day
cash flow requirements of its customers, whether they are depositors wishing to
withdraw funds or borrowers requiring funds to meet their credit needs.
The primary function of asset / liability management is not only to
assure adequate liquidity in order for Cornerstone to meet the needs of its
customer base, but to maintain an appropriate balance between interest-sensitive
assets and interest-sensitive liabilities so that Cornerstone can profitably
deploy its assets and therefore optimize earning. Both assets and liabilities
are considered sources of liquidity funding and both are, therefore, monitored
on a daily basis.
The asset portion of the balance sheet provides liquidity primarily through loan
repayment and maturity of investment securities. Additional sources of liquidity
are the investment in Federal Funds sold and prepayments from the mortgage
backed securities from the investment portfolio.
The liability portion of the balance sheet provides liquidity through various
interest bearing and non-interest bearing deposit accounts. Other liabilities,
which do not qualify as a deposit, are Federal Funds purchased and securities
under agreement to repurchase (REPO's). Both are temporary solutions for
liquidity as Fed Funds must be paid off at least once every 30 days and REPO's
must be collateralized by investment securities. At year end December 31, 1999,
Cornerstone had $1 million in Federal Funds purchased and $1.2 million in
REPO's.
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RESULTS OF OPERATIONS
Year ended December 31, 1999 compared to year ended December 31, 1998
Net Interest Income. Net interest income is the principal component of
a financial institution's income stream and represents the spread between
interest and fee income generated from earning assets and the interest expense
paid on liabilities. The following discussion is on a fully taxable equivalent
basis.
Net interest income before the loan loss provision for 1999 increased
$63,408 or 1.6% over 1998. The increase in net interest income from 1998 to 1999
is due to active management of the asset and liability mix while the bank went
through its reorganization. This was done by monitoring the balance sheet daily
and allowing the most expensive deposits to run off when the demand for loans
slowed during the spring of 1999.
Interest income decreased $524,497 or 6.4% in 1999 from 1998. Interest
income produced by the loan portfolio decreased $337,500 or 5.6% from 1998 to
1999. Interest income on investment securities and Federal Funds sold decreased
$146,997 or 10% from 1998 to 1999. The decrease in interest income was due to
the Banks reorganization of the Bank's lending function which lowered loan
balanced as mentioned above and a generally unfavorable interest rate
environment to invest in marketable securities. To compound this situation a
large portion of the securities portfolio, which was purchased at a premium,
prepaid early and reduced securities interest income by the amount of premium
prepaid.
Total interest expense decreased $587,905 or 13.9% in 1999 from 1998.
The interest expense decrease from 1998 to 1999, is a direct response from
management of the bank to maintain it interest rate spread by the adjusting of
the deposit mix and make it less dependent on certificates of deposit.
One of the most useful tools for measuring the ability of a small
community bank to make money is its ability to make money to maximize net
interest margin and the interest rate spread. The net interest margin, or the
net yield on earning assets, is computed by dividing fully taxable equivalent
net interest income by average-earning assets. This ratio represents the
difference between the average yield on average-earning assets and the average
rate paid for all funds used to support those earning assets. The net interest
margin increased 12 basis points in 1999 to 4.4%. The net costs of funds,
defined as interest expense divided by average-earning assets, decreased 58
basis points from 4.55% in 1998 to 3.97% in 1999. The yield on earning assets
decreased 47 basis points to 8.37% in 1999 from 8.84% in 1998.
Allowance for Loan Loss. The allowance for possible loan loss
represents management's assessment of the risks associated with extending credit
and its evaluation of the quality of the loan portfolio. Management analyzes the
loan portfolio to determine the adequacy of the allowance for possible loan
losses and the appropriate provisions required to maintain a level
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38
considered adequate to absorb anticipated loan losses. Management believes that
the $1,001,809 as of December 31, 1999, in the allowance for possible loan loss
account is sufficient to absorb known credit risks in the portfolio. No
assurance can be given, however, that adverse economic circumstances will not
result in increased losses in the loan portfolio and require greater provisions
for possible loan losses in the future.
Non-performing Assets. Non-performing assets include non-performing
loans and foreclosed real estate held for sale. Non-performing loans include
loans classified as non-accrual or renegotiated. Cornerstone's policy is to
place a loan on non-accrual status when it is contractually past due 90 days or
more as to payment of principal or interest. At the time a loan is placed on
non-accrual status, interest previously accrued but not collected may be
reversed and charged against current earnings. Recognition of any interest after
a loan has been placed on non-accrual is accounted for on a cash basis. As of
December 31, 1999, Cornerstone had $1,003,765 of non-performing assets.
Non-interest Income. Non-interest income consists of revenues generated
from a broad range of financial services and activities including fee-based
services and profits and commissions earned through credit life insurance sales
and other activities. In addition, gains or losses realized from the sale of
investment portfolio securities are included in non-interest income. Total
non-interest income decreased by $101,398 or 14.8% from 1998 to 1999. Fee income
from service charges on deposit accounts increased $19,180 or 4.1% in 1999 which
offset a large decrease in other non-interest income.
Non-interest Expense. Non-interest expense for 1999 increased by
$896,043 or 25.2% from 1998. Salaries and employee benefits increased by
$445,068 or 26.7% from 1998 for $2,114,951. This increase was a result of
salaries increasing as new management was brought in to reorganize the Bank
coupled with double-digit increases in benefit costs. Occupancy expense
increased by less than 1% as the bank found ways to reduce expenses while the
operations of the Bank moved to a new operations center to reduce congestion in
the branches and to make the operation personnel more productive. All other
non-interest expense increased $450,257 or 27.2% in 1999, primarily due to
expense incurred to legal fees, professional fees, and reconcilement
charge-offs.
Capital Resources / Liquidity
Liquidity. Of primary importance to depositors, creditors and
regulators is the ability to have readily available funds sufficient to repay
fully maturing liabilities. Cornerstone's liquidity, represented by cash and
cash from banks, is a result of its operating, investing and financing
activities. In order to insure funds are available at all times, Cornerstone
devotes resources to projecting on a monthly basis the amount of funds
accessible. Liquidity requirements can also be met through short term borrowing
or the disposition of short-term assets which are generally matched to
correspond to the maturity of liabilities.
Cornerstone's liquidity target is measured by adding all the Bank's net
cash, short term and marketable securities and dividing this number by total
deposits and short term liabilities not secured by assets pledged the approved
policy liquidity is target 15% and currently the Bank's liquidity ratio is
19.9%.Cornerstone is not subject to any specific regulatory liquidity
36
39
requirements imposed by regulatory orders. Cornerstone is subject to general
FDIC guidelines which do not require a minimum level of liquidity. Management
believes its liquidity ratios meet or exceed these guidelines. Management does
no know if any trends or demands which are reasonably likely to result in
liquidity increasing or decreasing in any material manner.
The following table sets forth liquidity ratios for periods indicated:
December 31, 1999 December 31, 1998
--------------------------------------------
Average loans to average deposits 77.4% 74.4%
Impact of Inflation and Changing Prices. The financial statements and
related financial data presented herein have been prepared in accordance with
generally accepted accounting principles, which require the measurement of the
financial position and operating results in terms of historical dollars without
considering the changes in the relative purchasing power of money over time and
due to inflation. Management is concerned with two inflationary factors; the
most common is the general impact of inflation on operations of Cornerstone and
is reflected in increased operating costs. The other and most dangerous to the
Bank's profitability is interest rate adjustments by the Federal Reserve and the
general fixed income market in reaction to inflation. In other words interest
rate risk, unlike most industrial companies virtually all of the assets and
liabilities of Cornerstone are monetary in nature. As a result, interest rates
may have a more significant impact on Cornerstone's performance than the effects
of general levels of inflation. Interest rates do not necessarily move in the
same direction or in the same magnitude as the price of goods and services and
each issue must be dealt with independently.
CAPITAL ADEQUACY
Capital adequacy refers to the level of capital required to sustain
asset growth and to absorb losses. The objective of Cornerstone's management is
to maintain a level of capitalization that is sufficient to take advantage of
profitable growth opportunities while meeting regulatory requirements. This is
achieved by improving profitability through effectively allocating resources to
more profitable business, improving asset quality, strengthening service
quality, and streamlining costs. The primary measures used by management to
monitor the results of these efforts are the ratios of average equity to average
assets, average tangible assets, and average equity to net loans.
The FDIC has adopted capital guidelines governing the activities of
banks. These guidelines require the maintenance of an amount of capital based on
risk-adjusted assets so that categories of assets with potential higher credit
risk will require more capital backing than assets with lower risk. In addition,
banks are required to maintain capital to support, on a risk-adjusted basis,
certain off-balance sheet activities such as loan commitments. The capital
guidelines classify capital into two tiers, referred to as Tier I and Tier II.
Under risk-based capital requirements, total capital consists of Tier I capital
which is generally common shareholder's equity less goodwill and Tier II which
is primarily Tier I capital plus a portion of the loan loss allowance. In
determining risk-based capital requirements, assets are assigned risk-weights of
0% to 100%, depending primarily on the regulatory assigned levels of credit risk
associated with such assets. Off-balance sheet items are considered in the
calculation of risk-adjusted assets
37
40
through conversion factors established by the regulators. The framework for
calculating risk-based capital requires banks to meet the regulatory minimums of
4% Tier I and 8% total risk based capital. In 1990 regulators added a leverage
computation to the capital requirements, comparing Tier I capital to total
average assets less goodwill.
(In thousands) December 31, 1999 December 31, 1998
--------------------------------------
CAPITAL: Amount Amount
Tier I Capital:
Stockholders' equity 11,657 10,024
Less disallowed intangibles (2,723) (2,834)
-------- --------
Total Tier I capital 8,934 7,190
Tier II capital:
Qualifying debt -- --
AFS Security(after tax losses) 183 --
Qualifying allowance for loan losses 1,002 1,400
-------- --------
Total Tier II capital 10,119 8,590
Total capital 10,119 8,590
Risk-adjusted assets 73,294 79,598
Average assets 100,167 102,929
RATIOS:
Tier I capital to risk-adjusted assets 12.19% 9.03%
Tier II capital to risk-adjusted assets 13.81% 10.79%
Leverage - Tier I capital to average assets
Less disallowed intangibles 8.92% 6.99%
The Federal Deposit Insurance Corporation Improvement Act of 1991
("FDICIA") established five capital categories for banks. Under the regulation
defining these five capital categories, each bank is classified into one of the
five categories based on its level of risk-based capital as measured by Tier I
capital, total risk-based capital, and Tier I leverage ratios and its
supervisory ratings. The following table lists the five categories of capital
and each of the minimum requirements for the three risk-based ratios.
Total Risk-Based Tier I Risk-Based Leverage
Capital Ratio Capital Ratio Ratio
Well-capitalized 10%or above 6% or above 5% or above
Adequately capitalized 8% or above 4% or above 4% or above
Under capitalized Less than 8% Less than 4% Less than 4%
Significantly undercapitalized Less than 6% Less than 3% Less than 3%
Critically undercapitalized -- -- 2% or less
On December 31, 1999, Cornerstone exceeded the regulatory minimums and qualified
as a well-capitalized institution under the regulations.
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ITEM 8. FINANCIAL STATEMENTS
The following consolidated financial statements of the Company and its
subsidiary, together with the Report of Independent Certified Public Accountants
thereon, are included on page F-1 through F-33 of this Annual Report on Form
10-K:
Consolidated Balance Sheets as of December 31, 1999 and 1998
Consolidated Statements of Operations for the years ended
December 31, 1999, 1998 and 1997
Consolidated Statements of Changes in Stockholders' Equity for
the years ended December 31, 1999, 1998 and 1997
Consolidated Statements of Cash Flows for the years ended
December 31, 1999, 1998 and 1997
Notes to Consolidated Financial Statements
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
Neither the Company nor the Bank had any change in accountants or
disagreements with accountants on accounting and financial disclosure during the
two most recent fiscal years or subsequently.
39
42
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS
Following is certain information regarding the directors and executive
officers of the Company.
DIRECTORS AND EXECUTIVE OFFICERS
The following table provides certain information regarding directors
and executive officers as of March 25, 1999.
PRINCIPAL
OCCUPATIONS
NAME AGE POSITIONS FOR PREVIOUS 5 YEARS
---- ----------- --------------------
Ramesh V. Amin 53 Director President, American
Plastics, Inc.
Randy Brooks 47 Director President, R. K. Haskew &
Company, Inc.
B. Kenneth Driver 64 Director President and Chief
Operating Officer,
Fillauer, Inc.
Karl Fillauer 52 Director Chairman, Fillauer, Inc.
Gregory B. Jones 47 Chief Executive Officer, Banker
President, Director
James H. Large 56 Director President, Key James Brick
& Supply Company, Inc.
Lawrence D. Levine. 70 Director President, Financial
Management Corp.
Russell W. Lloyd 59 Director President, MPL Construction
Co., Inc.
Earl A. Marler, Jr. 63 Chairman of the Board, Banker
Director
Doyce G. Payne, M.D. 49 Director Physician
Turner Smith 59 Director Director, Southeast Energy
Services, Inc.
Billy O. Wiggins 57 Director President, Checks, Inc.
Marsha Yessick 52 Director Owner, Yessick's Design
Center
Nathaniel F. Hughes 41 Executive Vice President and Banker
Chief Financial Officer
Jerry D. Lee 39 Executive Vice President and Banker
Senior Loan Administrator
40
43
No director of Cornerstone is related to any other director, except
Messrs. Brooks and Fillauer who are brothers-in-law. No director of Cornerstone
is a director or executive officer of another bank holding company, bank,
savings and loan association, or credit union. The following is a brief
description of the business experience of the executive officers of Cornerstone:
GREGORY B. JONES, Chief Executive Officer and President, was employed
at Pioneer Bancshares as the Chief Financial Officer from 1994 - 1998. From 1978
to 1994 Mr. Jones served as the Comptroller of the Pioneer Bank. His duties
consisted of primarily administrative responsibilities for the holding company
and the 3 subsidiary banks and direct managerial responsibilities for 2
affiliate companies he created; Pioneer Securities and Center Finance. Prior to
Pioneer Mr. Jones worked at Compass Bank in Huntsville in an Accounting Officer
role. He received his B.S. in Business Administration from the University of
Alabama and his MBA from The University of Tennessee at Chattanooga. He is a
graduate of numerous Banking schools and serves as an instructor for the
Tennessee Bankers Association.
NATHANIEL F. HUGHES, Executive Vice President and Chief Financial
Officer, was employed at Pioneer Bancshares as the Chief Investment Officer from
1994-1998. His duties were primarily administrative and concentrated in Asset
Liability Management, Portfolio Management, Budgeting and Cash Management. From
1983 to 1991 Mr. Hughes worked at SunTrust Bank as an Investment Officer. From
1980 to 1983 he served as a Platoon Commander in the United States Marine Corps.
He received his BBA from the University of Kentucky and MBA from Vanderbilt
University. He holds a Certified Financial Analyst (CFA) designation. Currently
serves as a Commander of an Artillery Battalion in the United States Marine
Corps Reserve.
JERRY D. LEE, Executive Vice President and Senior Loan Administrator,
was employed from 1996 to 1999 with Northwest Georgia Bank as Senior Loan
Officer and Manager of the Investor Mortgage Lending. In that position, his
primary responsibilities included management of credit underwriting, commercial
and consumer production and oversight of Investor Mortgage Lending. From 1990 to
1996, Mr. Lee was employed by AmSouth Bank, where he managed various commercial
and consumer lending departments. From 1983 to 1990, he was employed by SunTrust
Bank, where he managed credit administration and had commercial loan production
responsibilities. He received his B.S. in Finance from University of Tennessee
at Chattanooga.
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44
THE CORNERSTONE BOARD AND ITS COMMITTEES
Directors are elected annually and each director holds office until his
successor is elected and qualified. The Company has five standing committees:
the Executive and Strategic Planning Committee, the Audit Committee, the
Asset/Liability Management Committee, the Human Resource Committee and the
Nominating Committee. These committees advise on policy origination and revision
plan administrative strategy and assure policy compliance through management
reporting from areas under their supervision. These same five committees also
serve the Bank. In addition, the Bank has a Directors Loan Committee and a
Compliance/Community Reinvestment Act ("CRA") Committee.
No director of Cornerstone is a director or executive officer of
another bank holding company, bank, savings and loan association, or credit
union.
During the last fiscal year, the Board of Directors of Cornerstone held
twelve meetings. The Directors of Cornerstone also serve as directors of the
Bank. The Board of Directors of the Bank held twelve (12) meetings in 1999.
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45
ITEM 11. EXECUTIVE COMPENSATION
EXECUTIVE COMPENSATION
COMPENSATION TABLE
The table below sets forth certain elements of compensation for the
named executive officer of the Company and the Bank for the periods indicated.
SUMMARY COMPENSATION TABLE
LONG TERM (1) COMPENSATION
--------------------------------------------
Restricted Securities
ANNUAL COMPENSATION Stock Underlying All Other
------------------------------
Name and Salary Bonus Awards Options/SAR's Compensation
Principal Position Year ( $ ) ( $ ) ( $ ) ( # ) (2) ( $ ) (3)
- -----------------------------------------------------------------------------------------------------------------------
Gregory B. Jones 1999 $120,000 $ 0 0 5,500 $7,125
President & CEO 1998 0 0 0 0 0
Company and Bank 1997 0 0 0 0 0
- --------------------------------
(1) The Company maintains a "1996 Cornerstone Statutory and Nonstatutory
Stock Option Plan" which was approved by the shareholders in 1996.
There were no shares of restricted stock held by any executive officers
on December 31, 1999.
(2) Options acquired pursuant to option grants must generally be held at
least two years before partial vesting is possible. The Company does
not grant SAR's.
(3) Includes the Company's 1999 match for 401(K), and $5,400 in Bank Board
directors fees.
OPTIONS/SAR GRANTS IN LAST FISCAL YEAR
The following table contains information about option awards made to
the named executive officer during the Company's fiscal year ended December 31,
1999.
STOCK OPTION GRANTS IN 1999
POTENTIAL REALIZABLE VALUE AT
ASSUMED ANNUAL RATES OF
STOCK PRICE APPRECIATION FOR
Individual Grants THE OPTION TERM (4)
- --------------------------------------------------------------------------------------------------------------------
( a ) ( b ) ( c ) ( d ) ( e ) ( f ) ( g )
Number of % of Total
Securities Options/SAR's
Underlying Granted to Exercise or
Options/SAR's Employees in Base Price Expiration
Name Granted (#)(1) Fiscal Year ($/share)(2) Date (3) 5% ($) 10% ($)
- --------------------------------------------------------------------------------------------------------------------
Gregory B. Jones 5,500 25.58% $ 15.00 03/01/09 $ 51,884 $131,484
43
46
- ---------------------------
(1) These options are granted under the "1996 Cornerstone Statutory and
Nonstatutory Stock Option Plan".
(2) These options were granted at fair market value at the time of the
grant, are generally 100% exercisable after five years of the grant,
with a vesting schedule of 30% the third year, 60% the fourth year and
100% the fifth year.
(3) These options could expire earlier in certain situations.
(4) The potential realizable value of the options granted in 1999 to the
executive officer named above was calculated by multiplying those
options by the excess of (a) the assumed market value at March 1, 2009
of common stock if the estimated market value of common stock were to
increase 5% or 10% in each year of the option's 10-year term over (b)
the base price shown. This calculation does not take into account any
taxes or other expenses, which might be owed. The 5% and 10%
appreciation rates are set forth in the SEC rules and no representation
is of course, made that the common stock will appreciate at those
assumed rates or at all.
AGGREGATED OPTION EXERCISES IN 1999
AND DECEMBER 31, 1999 OPTION VALUES
Number of Securities Number of Securities Underlying
Underlying Options Value Unexercised Options as of Value of Unexercisable, In-the
Exercised Realized 12/31/99 ( # ) Money Options at 12/31/99 ( $ )
-----------------------------------------------------------------
Name ( # ) ( $ ) Exercisable Unexercisable Exercisable Unexercisable
- -------------------------------------------------------------------------------------------------------------------------
Gregory B. Jones 0 $ 0 0 5,500 $ 0 $ 0
- ---------------------------------
(1) Shares acquired pursuant to option grant must generally be held five
years for 100% vestment, with a vesting schedule of 30% the third year,
60% the fourth year and 100% the fifth year.
(2) Value is calculated as the difference between the estimated closing
price of a share of common stock on December 31, 1999 ($13.00 per
share) and the exercise price of the options. No value is reported if
the exercise price of the options exceeded the estimated market price
of a share of common stock on December 31, 1999.
401(K) PLAN
The Company has a 401(k) plan covering employees meeting certain age
requirements. The plan is structured such that employees can contribute to the
plan on a tax-deductible basis and have their contributions invested in various
investment funds offered under the plan. The plan permits, but does not require,
the Company to make an employer matching contribution during the plan year.
Employer contributions, which represent 25% of the first 6% of an employee's
salary contributed to the plan, totaled $13,863 in 1999.
1996 CORNERSTONE STATUTORY AND NONSTATUTORY STOCK OPTION PLAN
The Company established the 1996 Cornerstone Statutory and Nonstatutory
Stock Option Plan (the "Plan") during 1996 as a long-term incentive for eligible
employees and directors. The total number of shares that may be issued under the
plan may not exceed 205,000. Of such shares, 55,000 may be incentive stock
options and the remaining 150,000 shares of stock may be nonqualified stock
options. The persons eligible to receive incentive stock options under the plan
are key Company employees and officers selected by the Human Resource Committee
of the Board. Persons designated by the Committee who are eligible to receive
nonqualified options need not be employees of the Company and generally will be
non-employee directors of the Company. The options are issued at the market
value of the Company's stock and are
44
47
exercisable upon issue. The term of all options issued under the Plan are for 10
years.
COMPENSATION OF DIRECTORS
The Directors of the Company are not compensated for their attendance
at Company Board meetings or Company committee meetings. Each Director received
$450 for each Bank Board meeting. Each non-employee Director also received $75
for each Bank committee meeting attended. Total Director fees paid by the Bank
for services rendered on behalf of the Bank in 1999 was $98,125.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
OWNERSHIP OF CORNERSTONE COMMON STOCK
As of March 25, 1999, Cornerstone's records indicated the following
number of shares were beneficially owned by, (i) each person who is a director
or a named executive officer of Cornerstone and (ii) all directors and executive
officers as a group.
Amount and Nature
Name of of Beneficial Ownership Percent
Beneficial Owner (Number of Shares)(2) Of Class(1)
---------------- ----------------------- -----------
(i) Ramesh V. Amin* 70,001 (2) 5.40%
Randy Brooks 29,746 (2) 2.29%
B. Kenneth Driver 25,186 (2) (3) 1.86%
Karl Fillauer 33,190 (2) (4) 2.56%
Gregory B. Jones 21,186 (5) 1.68%
James H. Large 39,690 (2) (6) 3.06%
Lawrence D. Levine 17,500 (2) 1.35%
Russell W. Lloyd 33,290 (2) (7) 2.57%
Earl A. Marler, Jr. 37,065 (2) (8) 2.86%
Doyce G. Payne, M.D. 41,315 (2) (9) 3.19%
Turner Smith 30,000 (2) 2.31%
Billy O. Wiggins 48,044 (2) (10) 3.71%
Marsha Yessick 26,000 (2) 2.01%
Nathaniel F. Hughes 17,500 1.35%
Jerry D. Lee 20,500 (11) 1.56%
(ii) Directors and executive officers as a group
(15 persons) 490,551 37.83%
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Footnotes to the Directors Table:
(1) Unless otherwise indicated, beneficial ownership consists of sole
voting and investing power based on 1,166,629 shares issued and
outstanding on December 31, 1999. Options to purchase 130,000 shares
are exercisable or become exercisable within 60 days of December 31,
1999. Such shares are deemed to be outstanding for the purpose of
computing the percentage of outstanding shares owned by each person to
whom a portion of such options relate, but are not deemed to be
outstanding for the purpose of computing the percentage owned by any
other person.
(2) Includes 10,000 shares issuable within the next 60 days upon exercise
of options issued pursuant to the 1996 Cornerstone
Statutory-Nonstatutory Stock Option Plan.
(3) Includes 15,186 shares held jointly with Mr. Driver's spouse.
(4) Includes 23,190 shares held jointly with Mr. Fillauer's spouse.
(5) Includes 4,194 shares held jointly with Mr. Jones' spouse, and 1,400
shares held in an IRA account by Mr. Jones' spouse.
(6) Includes 4,300 shares held jointly with Mr. Large's spouse, 1,600
shares held by Mr. Large's spouse and 22, 170 shares held by Key James
Brick Company trust PSP.
(7) Includes 20,000 shares held jointly with Mr. Lloyd's spouse and 100
shares held as custodian for a grandchild.
(8) Includes 27,065 shares held jointly with Mr. Marler's spouse.
(9) Includes 10,690 shares held jointly with Dr. Payne's spouse and 2,625
shares held as custodian for a child.
(10) Includes 6,190 shares held jointly with Mr. Wiggins' spouse, 7,500
shares jointly held with Mr. Wiggins' spouse and mother and 3,000
shares held as custodian for a child
(11) Includes 8,000 shares held jointly with Mr. Lee spouse, 8,500 shares
held Mr. Lee's spouse's IRA and 200 shares held as custodian for a
child
* Mr. Amin's address is 3155 Cypress Pond Pass, Duluth, GA 30097.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Various Company directors, executive officers and their affiliates,
including corporations and firms of which they are officers or in which they
and/or their families have an ownership interest, are customers of the Company
and its subsidiary. These persons, corporations and firms have had transactions
in the ordinary course of business with the Company and its subsidiary,
including borrowings, all of which, in the opinion of management, were on
substantially the same terms including interest rates and collateral as those
prevailing at the time for comparable transactions with unaffiliated persons and
did not involve more than the normal risk of collectibility or present other
unfavorable features. The Company and its subsidiary expect to have such
transactions on similar terms with its directors, executive officers and their
affiliates in the future. The aggregate amount of loans outstanding by
Cornerstone Community Bank to directors, executive officers and related parties
as of December 31, 1999 was approximately $1,711,000 which represented 14.68% of
the Company's consolidated shareholders' equity on that date.
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49
ITEM 14. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
The following exhibits are filed as a part of or incorporated by
reference in this report: [may incorporate by reference to S-1]
Exhibit No. Description
3.1* Articles of Incorporation of the Company
3.2* Bylaws of the Company, as amended (see attached amendment)
4. The right of securities holders are defined in the
Articles of Incorporation and By laws provided in
exhibits 3.1 and 3.2 respectively.
10.1** Cornerstone Statutory-Nonstatutory Stock Option Plan
10.2** Employment Agreement between Cornerstone Bancshares, Inc. and
Gregory B. Jones, dated March 1, 1999.
10.3** Employment Agreement between Cornerstone Bancshares, Inc. and
Nathaniel F. Hughes, dated March 1, 1999. 10.4 ** Employment
Agreement between Cornerstone Bancshares, Inc. and Jerry D.
Lee, dated March 1, 1999.
21.+ The sole subsidiary of Cornerstone Bancshares, Inc. is Cornerstone
Community Bank, Chattanooga, Tennessee.
27.+ Financial Data Schedule(FOR SEC USE ONLY)
- ----------
*Incorporated herein by reference to the exhibit of the same number in the
Company's Registration Statement on Form S-4, as amended (No. 333-26699).
**Incorporated herein by reference to the exhibit of the same number in the
Company's Registration Statement on Form S-1, as amended (No. 333-96185).
+ Filed herewith.
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50
SIGNATURES
In accordance with Section 13 or 15(d) of the Securities Exchange Act
of 1934, the Registrant has caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
CORNERSTONE BANCSHARES, INC.
(Registrant)
Date: March 29, 2000 By: /s/ Gregory B. Jones
-------------------------------
Gregory B. Jones
President and Chief
Executive Officer
By: /s/ Nathaniel F. Hughes
-------------------------------
Nathaniel F. Hughes
EVP & Chief Financial Officer
In accordance with the Securities Exchange Act of 1934, this report has
been signed below by the following persons on behalf of the Registrant and in
the capacities indicated on March 29, 2000.
Signature Title
------
/s/ Earl A. Marler, Jr. Chairman of the Board
- -----------------------------
Earl A. Marler, Jr.
/s/ Gregory B. Jones President, Chief Executive Officer and
- -----------------------------
Gregory B. Jones Director (principal executive officer and
principal financial officer)
/s/ Ramesh V. Amin Director
- -----------------------------
Ramesh V. Amin
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51
/s/ B. Kenneth Driver Director
- ---------------------------------
B. Kenneth Driver
/s/ Karl Fillauer Director
- ---------------------------------
Karl Fillauer
/s/ James H. Large Director
- ---------------------------------
James H. Large
/s/ Lawrence D. Levine Director
- ---------------------------------
Lawrence D. Levine
/s/ Russell W. Lloyd Director
- ---------------------------------
Russell W. Lloyd
/s/ Doyce G. Payne Director
- ---------------------------------
Doyce G. Payne
/s/ Turner Smith Director
- ---------------------------------
Turner Smith
/s/ Billy O. Wiggens Director
- ---------------------------------
Billy O. Wiggens
/s/ Marsha Yessick Director
- ---------------------------------
Marsha Yessick
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52
INDEX OF EXHIBITS
Exhibit No. Description
-----------
3.1* Articles of Incorporation of the Company
3.2* Bylaws of the Company, as amended (see attached)
4. The right of securities holders are defined in the
Articles of Incorporation and By laws provided in
exhibits 3.1 and 3.2 respectively.
10.1** Cornerstone Statutory-Nonstatutory Stock Option Plan
10.5** Employment Agreement between Cornerstone Bancshares,
Inc. and Gregory B. Jones, dated March 1, 1999.
10.6** Employment Agreement between Cornerstone Bancshares,
Inc. and Nathaniel F. Hughes, dated March 1, 1999.
10.7** Employment Agreement between Cornerstone Bancshares,
Inc. and Jerry D. Lee, dated March 1, 1999.
21.+ The sole subsidiary of Cornerstone Bancshares, Inc.
is Cornerstone Community Bank, Chattanooga, Tennessee.
27.+ Financial Data Schedule
- ----------
*Incorporated herein by reference to the exhibit of the same number in the
Company's Registration Statement on Form S-4, as amended (No. 333-26699).
**Incorporated herein by reference to the exhibit of the same number in the
Company's Registration Statement on Form S-1, as amended (No. 333-96185).
+ Filed herewith.
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53
Report of Independent Certified Public Accountants
on the Financial Statements
To the Stockholders and
Board of Directors
Cornerstone Bancshares, Inc.
Chattanooga, Tennessee
We have audited the accompanying consolidated balance sheets of
Cornerstone Bancshares, Inc. and subsidiary as of December 31, 1999 and 1998,
and the related consolidated statements of operations, changes in stockholders'
equity, and cash flows for each of the three years in the period ended December
31, 1999. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Cornerstone
Bancshares, Inc. and subsidiary as of December 31, 1999 and 1998, and the
results of their operations and their cash flows for each of the three years in
the period ended December 31, 1999, in conformity with generally accepted
accounting principles.
HAZLETT, LEWIS & BIETER, PLLC
Chattanooga, Tennessee
January 28, 2000
F-1
54
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
December 31, 1999 and 1998
1999 1998
-------------- --------------
ASSETS
Cash and due from banks $ 7,721,701 $ 4,268,967
Federal funds sold -- 8,425,000
Securities available for sale 13,339,306 9,280,116
Securities held to maturity (fair value approximates $5,670,719
at December 31, 1999) 5,723,320 9,077,465
Loans, net of allowance for loan losses of $1,001,809 in 1999
and $1,400,000 in 1998 71,323,878 72,492,549
Bank premises and equipment, net 2,231,179 1,967,329
Accrued interest receivable 656,159 638,441
Excess cost over fair value of net assets acquired 2,722,651 2,834,124
Other assets 2,084,033 1,522,143
-------------- --------------
Total assets $ 105,802,227 $ 110,506,134
============== ==============
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits:
Noninterest-bearing demand deposits $ 12,411,939 $ 14,151,526
Interest-bearing demand deposits 12,626,200 12,998,223
Savings deposits and money market accounts 10,254,825 10,283,103
Time deposits of $100,000 or more 16,129,350 17,489,618
Time deposits under $100,000 39,923,313 43,089,138
-------------- --------------
Total deposits 91,345,627 98,011,608
Accrued interest payable 189,870 270,634
Federal funds purchased and securities sold under
agreements to repurchase 2,179,363 --
Other liabilities 193,108 470,861
Notes payable -- 1,250,000
-------------- --------------
Total liabilities 93,907,968 100,003,103
-------------- --------------
Commitments and contingencies
Redeemable common stock 237,504 478,744
-------------- --------------
Stockholders' equity:
Preferred stock - no par value; 2,000,000 shares
authorized; no shares issued -- --
Common stock - $1.00 par value; 2,000,000 shares
authorized; 1,166,629 and 1,009,461 shares issued
and outstanding in 1999 and 1998, respectively 1,166,629 1,009,461
Additional paid-in capital 11,128,234 9,017,430
Retained earnings (deficit) (454,818) (41,695)
Accumulated other comprehensive income (183,290) 39,091
-------------- --------------
Total stockholders' equity 11,656,755 10,024,287
-------------- --------------
Total liabilities and stockholders' equity $ 105,802,227 $ 110,506,134
============== ==============
The Notes to Consolidated Financial Statements are an integral part of these
statements.
F-2
55
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS
Years Ended December 31, 1999, 1998 and 1997
1999 1998 1997
------------ ------------ ------------
INTEREST INCOME
Loans $ 6,361,554 $ 6,739,054 $ 3,408,638
Securities 1,146,591 1,296,613 647,430
Federal funds sold 179,324 176,299 135,476
------------ ------------ ------------
Total interest income 7,687,469 8,211,966 4,191,544
------------ ------------ ------------
INTEREST EXPENSE
Time deposits of $100,000 or more 884,435 988,663 589,085
Other deposits 2,662,507 3,152,473 1,552,016
Federal funds purchased and securities
sold under agreements to repurchase 22,500 8,518 318
Other 74,043 81,736 12,038
------------ ------------ ------------
Total interest expense 3,643,485 4,231,390 2,153,457
------------ ------------ ------------
Net interest income before provision for loan losses 4,043,984 3,980,576 2,038,087
Provision for loan losses 855,000 715,343 273,277
------------ ------------ ------------
Net interest income after provision for loan losses 3,188,984 3,265,233 1,764,810
------------ ------------ ------------
NONINTEREST INCOME
Service charges 486,898 467,718 197,414
Other noninterest income 47,324 108,304 24,957
Net gains from sale of loans and securities 50,620 110,218 103,394
------------ ------------ ------------
Total noninterest income 584,842 686,240 325,765
------------ ------------ ------------
NONINTEREST EXPENSES
Salaries and employee benefits 2,114,951 1,669,883 928,270
Net occupancy and equipment expense 225,435 224,717 108,614
Other operating expenses 2,106,842 1,656,585 685,257
------------ ------------ ------------
Total noninterest expenses 4,447,228 3,551,185 1,722,141
------------ ------------ ------------
Income (loss) before income tax expense (benefit) (673,402) 400,288 368,434
Income tax expense (benefit) (260,279) 151,956 144,334
------------ ------------ ------------
Net income (loss) $ (413,123) $ 248,332 $ 224,100
============ ============ ============
EARNINGS (LOSS) PER SHARE
Basic $ (0.39) $ .25 $ .35
Diluted (0.39) .24 .33
============ ============ ============
The Notes to Consolidated Financial Statements are an integral part of these
statements.
F-3
56
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
Years Ended December 31, 1999, 1998 and 1997
Accumulated
Total Additional Retained Other
Comprehensive Stockholders' Common Paid-in Earnings Comprehensive
Income Equity Stock Capital (Deficit) Income
------------- ----------- ------- ---------- --------- -------------
BALANCE, December 31, 1996 $ 3,047,276 $1,100,200 $ 34,500 $1,903,145 $ 9,431
Bank combination 4,232,940 (356,934) 6,961,166 (2,417,272) 45,980
Issuance of common stock 1,580,260 131,688 1,448,572 -- --
Redeemable common stock (856,797) -- (856,797) -- --
Comprehensive income:
Net income $224,100 224,100 -- -- 224,100 --
Other comprehensive income, net of tax:
Unrealized holding gains (losses) on securities
available for sale, net of reclassification
adjustment (12,694) (12,694) -- -- -- (12,694)
-------- ----------- --------- --------- -------- -------
Total comprehensive income $211,406
=======
BALANCE, December 31, 1997 8,215,085 874,954 7,587,441 (290,027) 42,717
Redemption of common stock (350,107) (27,897) (322,210) -- --
Issuance of common stock 1,964,187 162,404 1,801,783 -- --
Increase in redeemable common stock (49,584) -- (49,584) -- --
Comprehensive income:
Net income $248,332 248,332 -- -- 248,332 --
Other comprehensive income, net of tax:
Unrealized holding gains (losses) on securities
available for sale, net of reclassification
adjustment (3,626) (3,626) -- -- -- (3,626)
-------- ----------- --------- --------- -------- -------
Total comprehensive income $244,706
=======
BALANCE, December 31, 1998 $10,024,287 $1,009,461 $9,017,430 $(41,695) $39,091
=========== ========= ========= ======== =======
F-4
57
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
Years Ended December 31, 1999, 1998 and 1997
Accumulated
Total Additional Retained Other
Comprehensive Stockholders' Common Paid-in Earnings Comprehensive
Income Equity Stock Capital (Deficit) Income
------------- ----------- ------- ---------- --------- -------------
BALANCE, December 31, 1998 $10,024,287 $1,009,461 $9,017,430 $(41,695) $39,091
Redemption of common stock (270,928) (19,352) (251,576) -- --
Issuance of common stock 2,568,588 176,520 2,392,068 -- --
Increase in redeemable common stock (29,688) -- (29,688) -- --
Comprehensive income:
Net loss $(413,123) (413,123) -- -- (413,123) --
Other comprehensive income, net of tax:
Unrealized holding gains (losses) on securities
available for sale, net of reclassification
adjustment (222,381) (222,381) -- -- -- (222,381)
-------- ----------- ---------- ----------- ---------- --------
Total comprehensive income (loss) $(635,504)
--=======
BALANCE, December 31, 1999 $11,656,755 $1,166,629 $11,128,234 $(454,818) $(183,290)
=========== --======== --========= --======== ----=====
The Notes to Consolidated Financial Statements are an integral part of these
statements.
F-5
58
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS Years Ended December
31, 1999, 1998 and 1997
1999 1998 1997
------------ ------------ ------------
CASH FLOWS FROM OPERATING ACTIVITIES
Net income (loss) $ (413,123) $ 248,332 $ 224,100
Adjustments to reconcile net income (loss) to net cash
provided by operating activities:
Depreciation and amortization 309,842 421,406 108,251
Provision for loan losses 855,000 715,343 273,277
Gains on sales of loans (60,386) (110,218) --
Deferred income taxes 119,294 (248,610) (38,314)
Proceeds from sales of loans held for sale 4,270,574 6,969,087 --
Originations of loans held for sale (4,216,713) (6,858,869) --
Changes in other operating assets and liabilities:
Accrued interest receivable (17,718) (53,995) (162,195)
Accrued interest payable (80,764) (54,917) 125,432
Other assets and liabilities (292,119) (144,068) (541,628)
------------ ------------ ------------
Net cash provided by operating activities 473,887 883,491 (11,077)
------------ ------------ ------------
CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from security transactions:
Securities available for sale 4,904,263 6,318,245 2,076,069
Securities held to maturity 3,323,155 8,736,045 4,177,498
Purchase of securities available for sale (9,246,955) (8,139,733) (6,347,646)
Purchase of securities held to maturity -- (7,101,585) --
Net increase in loans (771,662) (12,796,580) (20,261,850)
Purchase of bank premises and equipment (369,322) (223,054) (332,638)
Proceeds from sale of other real estate 153,326 -- --
Payments related to bank combination -- (457,637) (3,829,731)
Cash and cash equivalents acquired in bank combination -- -- 5,050,906
------------ ------------ ------------
Net cash used in investing activities (2,007,195) (13,664,299) (19,467,392)
------------ ------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES
Net (decrease) increase in deposits (6,665,981) 16,161,803 19,889,783
Increase in federal funds purchased and securities
sold under repurchase agreements 2,179,363 -- --
Proceeds from borrowings on debt -- 395,000 500,000
Principal paid on notes payable (1,250,000) -- --
Redemption of common stock (270,928) (350,107) --
Issuance of common stock 2,568,588 1,964,187 1,580,260
------------ ------------ ------------
Net cash provided by (used in) financing activities (3,438,958) 18,170,883 21,970,043
------------ ------------ ------------
NET INCREASE (DECREASE) IN CASH AND
CASH EQUIVALENTS (4,972,266) 5,390,075 2,491,574
CASH AND CASH EQUIVALENTS, beginning of year 12,693,967 7,303,892 4,812,318
------------ ------------ ------------
CASH AND CASH EQUIVALENTS, end of year $ 7,721,701 $ 12,693,967 $ 7,303,892
============ ============ ============
SUPPLEMENTAL DISCLOSURES OF CASH
FLOW INFORMATION
Cash paid during the period for interest $ 3,724,249 $ 4,215,080 $ 2,028,025
Cash paid during the period for taxes 44,403 425,171 199,859
============ ============ ============
NONCASH INVESTING AND FINANCING ACTIVITIES
Acquisition of real estate through foreclosure $ 545,929 $ -- $ --
Increase in redeemable common stock 29,688 49,584 779,267
Common stock issued in bank combination -- -- 1,921,856
============ ============ ============
The Notes to Consolidated Financial Statements are an integral part of these
statements.
F-6
59
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1999 and 1998
Note 1. Summary of Significant Accounting Policies
The accounting and reporting policies of Cornerstone Bancshares, Inc.
and subsidiary (Company) conform with generally accepted accounting
principles and practices within the banking industry. The policies
that materially affect financial position and results of operations
are summarized as follows:
Nature of operations:
The Company is a bank-holding company which owns all of the
outstanding common stock of Cornerstone Community Bank (the Bank).
The Bank provides a variety of financial services through 5 locations
in Chattanooga, Tennessee. The Bank's primary deposit products are
demand deposits, savings accounts, and certificates of deposit. Its
primary lending products are commercial loans, real estate loans, and
installment loans.
Principles of consolidation:
The consolidated financial statements include the accounts of the
Company and its subsidiary. All material intercompany accounts and
transactions have been eliminated in consolidation.
Excess cost over fair value of net assets acquired:
The excess cost over fair value of net assets acquired represents the
excess of the cost of the investment over the underlying net assets
of the subsidiary bank at the date of acquisition. Certain amounts
have been allocated to specific tangible assets in the accompanying
financial statements. The excess cost over fair value of net assets
acquired is being amortized over 25 years using the straight-line
method.
Use of estimates:
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements and the reported amounts of
revenues and expenses during the reporting period. Actual results
could differ from those estimates.
Material estimates that are particularly susceptible to significant
change in the near term relate to the determination of the allowance
for losses on loans, the allowance for losses on foreclosed assets,
and deferred income taxes. In connection with the determination of
the allowances for losses on loans and foreclosed assets, management
obtains independent appraisals for significant properties and other
assets.
F-7
60
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1999 and 1998
Note 1. Summary of Significant Accounting Policies (continued)
Use of estimates: (continued)
While management uses available information to recognize losses on
loans, future additions to the allowance may be necessary based on
changes in local economic conditions. In addition, regulatory
agencies, as an integral part of their examination process,
periodically review the Bank's allowances for losses on loans and
foreclosed assets. Such agencies may require the Bank to recognize
additions to the allowances based on their judgments about
information available to them at the time of their examination.
Because of these factors, it is reasonably possible that the
allowances for losses on loans and foreclosed assets may change
materially in the near term.
Cash and cash equivalents:
For purposes of reporting cash flows, cash and cash equivalents
include cash on hand, amounts due from banks, and federal funds sold.
Securities held to maturity:
Bonds, notes, and debentures for which the Bank has the positive
intent and ability to hold to maturity are reported at cost, adjusted
for premiums and discounts that are recognized in interest income
using the interest method over the period to maturity.
Securities available for sale:
Securities available for sale consist of bonds, notes, debentures and
certain equity securities not classified as securities held to
maturity. Unrealized holding gains and losses, net of tax, on
securities available for sale are reported as a net amount in a
separate component of stockholders' equity until realized. Gains and
losses on the sale of securities available for sale are determined
using the specific-identification method. Premiums and discounts are
recognized in interest income over the period to maturity.
Securities sold under agreements to repurchase:
Securities sold under agreements to repurchase, which are classified
as secured borrowings, generally are repurchased within one to four
days from the transaction date. Securities sold under agreements to
repurchase are reflected at the amount of cash received in connection
with the transaction. The Company may be required to provide
additional collateral based on the fair value of the underlying
securities.
F-8
61
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1999 and 1998
Note 1. Summary of Significant Accounting Policies (continued)
Loans:
Loans are stated at unpaid principal balances less the allowance for
loan losses.
Loans are placed on nonaccrual when a loan is specifically determined
to be impaired or when, in the opinion of management, there is an
indication that the borrower may be unable to meet payments as they
become due. Any unpaid interest previously accrued on those loans is
reversed from income. Interest income generally is not recognized on
specific impaired loans unless the likelihood of further loss is
remote. Interest payments received on such loans are applied as a
reduction of the loan principal balance. Interest income on other
nonaccrual loans is recognized only to the extent of interest
payments received.
The allowance for loan losses is maintained at a level which, in
management's judgment, is adequate to absorb credit losses inherent
in the loan portfolio. The amount of the allowance is based on
management's evaluation of the collectibility of the loan portfolio,
including the nature of the portfolio, credit concentrations, trends
in historical loss experience, specific impaired loans, and economic
conditions. Allowances for impaired loans are generally determined
based on collateral values or the present value of estimated cash
flows. The allowance is increased by a provision for loan losses,
which is charged to expense, and reduced by charge-offs, net of
recoveries.
Foreclosed assets:
Assets acquired through, or in lieu of, loan foreclosure are held for
sale and are initially recorded at fair value at the date of
foreclosure, establishing a new cost basis. Subsequent to
foreclosure, valuations are periodically performed by management and
the assets are carried at the lower of carrying amount or fair value
less cost to sell. Revenue and expenses from operations and changes
in the valuation allowance are included in net expenses on foreclosed
assets.
Bank premises and equipment:
Bank premises and equipment are stated at cost, less accumulated
depreciation. Depreciation is computed using the straight-line
depreciation method and accelerated depreciation methods for both
financial statement purposes and income tax purposes. Bank premises
are depreciated over 30 years, and furniture, fixtures and equipment
are depreciated over 5 to 12 years. Additions and major renewals and
betterments are capitalized and depreciated over their estimated
useful lives. Repairs, maintenance, and minor renewals are charged to
operating expense as incurred. When property is replaced or otherwise
disposed of, the cost of such assets and the related accumulated
depreciation are removed from the accounts. The gain or loss, if any,
is recorded in the statement of income.
F-9
62
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1999 and 1998
Note 1. Summary of Significant Accounting Policies (continued)
Deferred income taxes:
Deferred income tax assets and liabilities are determined using the
liability (or balance sheet) method. Under this method, the net
deferred tax asset or liability is determined based on the tax
effects of the temporary differences between the book and tax bases
of the various balance sheet assets and liabilities and gives current
recognition to changes in tax rates and laws.
Reclassifications:
Certain amounts in the 1998 and 1997 financial statements have been
reclassified to conform with the 1999 presentation.
Note 2. Securities
Securities have been classified in the balance sheet according to
management's intent as either securities held to maturity or
securities available for sale.
The amortized cost and approximate market value of securities at
December 31, 1999 and 1998, is as follows:
1999
---------------------------------------------------------------
Gross Gross
Amortized Unrealized Unrealized Market
Cost Gains Losses Value
----------- --------- ------------ -----------
Securities available for sale:
Securities of U.S. Government
agencies and corporations $ 9,141,183 $ -- $ (206,480) $ 8,934,703
Mortgage-backed and
other securities 4,475,836 6,757 (77,990) 4,404,603
----------- --------- ------------ -----------
$13,617,019 $ 6,757 $ (284,470) $13,339,306
=========== ========= ============ ===========
Securities held to maturity:
Securities of U.S. Government
agencies and corporations $ 198,436 $ -- $ (401) $ 198,035
Mortgage-backed and
other securities 5,524,884 5,559 (57,759) 5,472,684
----------- --------- ------------ -----------
$ 5,723,320 $ 5,559 $ (58,160) $ 5,670,719
=========== ========= ============ ===========
F-10
63
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1999 and 1998
Note 2. Securities (continued)
1998
-----------------------------------------------------------
Gross Gross
Amortized Unrealized Unrealized Market
Cost Gains Losses Value
------------ ---------- ----------- ----------
Securities available for sale:
U.S. Government
securities $ 400,000 $ 2,644 $ -- $ 402,644
Securities of U.S.
Government agencies 1,179,857 21,607 -- 1,201,464
Mortgage-backed and
other securities 7,637,209 47,801 (9,002) 7,676,008
---------- -------- ----------- ----------
$9,217,066 $ 72,052 $ (9,002) $9,280,116
========== ======== =========== ==========
Securities held to maturity:
U.S. Government
securities $ 352,082 $ 3,613 $ -- $ 355,695
Mortgage-backed and
other securities 8,725,383 47,002 (25,394) 8,746,991
---------- -------- ----------- ----------
$9,077,465 $ 50,615 $ (25,394) $9,102,686
========== ======== =========== ==========
At December 31, 1999 and 1998, securities with a carrying value of
approximately $8,745,000 and $5,116,000, respectively, were pledged
to secure public deposits and for other purposes required or
permitted by law. At December 31, 1999, the carrying amount of
securities pledged to secure repurchase agreements was $3,628,000. At
December 31, 1998, there were no securities pledged to secure
repurchase agreements.
F-11
64
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1999 and 1998
Note 2. Securities (continued)
The amortized cost and estimated market value of securities at
December 31, 1999, by contractual maturity, are shown below. Expected
maturities will differ from contractual maturities because borrowers
may have the right to call or prepay obligations with or without call
or prepayment penalties.
Securities Available for Sale Securities Held to Maturity
------------------------------ -----------------------------
Amortized Fair Amortized Fair
Cost Value Cost Value
----------- ----------- ------------ ------------
Due in one year or less $ 9,141,183 $ 8,937,054 $ 10,306 $ 10,293
Due from one year to
five years 205,591 203,825 1,320,446 1,304,282
Due from five years to
ten years 522,151 516,926 515,982 509,308
Due after ten years 3,748,094 3,681,501 3,876,586 3,846,836
----------- ----------- ------------ ------------
$13,617,019 $13,339,306 $ 5,723,320 $ 5,670,719
=========== =========== ============ ============
There were no sales of securities available for sale in 1999 and
1998. For the year ended December 31, 1997, proceeds from sales of
securities available for sale amounted to $2,572,054. The Bank had
gross realized gains of $103,394 in 1997. There were no gross
realized losses in 1997. The tax provision applicable to these net
realized gains amounted to $39,300 in 1997.
Note 3. Loans and Allowance for Loan Losses
At December 31, 1999 and 1998, the Bank's loans consist of the
following (in thousands):
1999 1998
------- -------
Mortgage loans on real estate:
Residential 1-4 family $17,063 $15,953
Residential multifamily (5 or more) 1,475 1,429
Commercial 21,843 22,828
Construction 5,560 5,456
Second mortgages 4,090 4,133
Equity lines of credit 2,289 2,552
------- -------
52,320 52,351
------- -------
Commercial loans 13,661 13,164
------- -------
F-12
65
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1999 and 1998
Note 3. Loans and Allowance for Loan Losses (continued)
1999 1998
------------ ------------
Consumer installment loans:
Personal $ 5,427 $ 7,694
Credit cards 918 684
------------ ------------
6,345 8,378
------------ ------------
72,326 73,893
Less: Allowance for loan losses (1,002) (1,400)
------------ ------------
Loans, net $ 71,324 $ 72,493
============ ============
A summary of transactions in the allowance for loan losses for the
years ended December 31, 1999, 1998 and 1997, is as follows:
1999 1998 1997
--------- --------- ---------
Balance, beginning of year $1,400,000 $ 915,005 $ 201,422
Provision for loan losses 855,000 715,343 273,277
Bank combination -- -- 456,960
Loans charged-off (1,512,047) (318,041) (16,654)
Recoveries of loans
previously charged-off 258,856 87,693 --
---------- --------- ---------
Balance, end of year $1,001,809 $1,400,000 $ 915,005
========== ========== =========
The Bank's only significant concentration of credit at December 31,
1999, occurred in real estate loans which totaled approximately
$52,320,000. While real estate loans accounted for 72 percent of
total loans, these loans were primarily residential development and
construction loans, residential mortgage loans, commercial loans
secured by commercial properties, and consumer loans. Substantially
all real estate loans are secured by properties located in Tennessee.
In the normal course of business, the Bank makes loans to executive
officers and directors and their affiliates of the Bank on
substantially the same terms, including interest rates and
collateral, as those prevailing at the time for comparable
transactions with other borrowers. Loans to executive officers,
principal shareholders, and directors and their affiliates were
approximately $1,711,000 and $2,987,000 at December 31, 1999 and
1998, respectively.
F-13
66
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1999 and 1998
Note 3. Loans and Allowance for Loan Losses (continued)
The following is a summary of information pertaining to impaired
loans at December 31, 1999 and 1998 (in thousands):
December 31,
-------------------------------
1999 1998
------------ ------------
Total impaired loans $ 860 $ 609
============ ============
Valuation allowance related to impaired loans $ 169 $ 203
============ ============
Years ended December 31,
-------------------------------
1999 1998
------------ ------------
Average investment in impaired loans $ 904 $ 145
============ ============
Impaired loans without a valuation allowance were insignificant in
relation to the Bank's loan portfolio at December 31, 1999 and 1998.
Interest income recognized on impaired loans was insignificant to
total interest income on loans for each of the years ending December
31, 1999, 1998 and 1997.
Note 4. Bank Premises and Equipment
A summary of bank premises and equipment at December 31, 1999 and
1998, is as follows:
1999 1998
------------ ------------
Land $ 463,278 $ 463,278
Buildings and improvements 1,249,851 1,091,255
Furniture, fixtures and equipment 1,016,765 1,419,645
Work in progress 136,217 --
------------ ------------
2,866,111 2,974,178
Accumulated depreciation (634,932) (1,006,849)
------------ ------------
$ 2,231,179 $ 1,967,329
============ ============
Depreciation expense for the years ended December 31, 1999, 1998 and
1997, amounted to $161,589, $199,944, and $108,251, respectively.
F-14
67
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1999 and 1998
Note 4. Bank Premises and Equipment (continued)
Certain bank facilities and equipment are leased under various
operating leases. Total rent expense for the years ended December 31,
1999, 1998 and 1997, was $108,863, $89,657, and $28,324,
respectively.
Future minimum rental commitments under noncancelable leases are as
follows:
2000 $140,905
2001 140,905
2002 111,111
2003 48,010
2004 39,000
--------
Total $479,931
========
Note 5. Time Deposits
At December 31, 1999, the scheduled maturities of time deposits are
as follows:
2000 $42,754,104
2001 10,926,410
2002 1,786,342
2003 418,026
Thereafter 167,781
-----------
Total $56,052,663
===========
Note 6. Income Taxes
The Company files a consolidated federal income tax return with its
subsidiary. Under the terms of a tax-sharing agreement, the
subsidiary's allocated portion of the consolidated tax liability is
computed as if it was reporting income and expenses to the Internal
Revenue Service as a separate entity.
Income tax expense (benefit) in the statement of operations for the
years ended December 31, 1999, 1998 and 1997, consists of the
following:
1999 1998 1997
----------- ---------- --------
Current tax expense (benefit) $ (379,573) $ 400,566 $182,648
Deferred tax expense (benefit) related to:
Provision for loan losses 235,688 (199,449) (24,700)
Net operating loss carryforward (125,504) (11,121) (8,000)
Other 9,110 (38,040) (5,614)
----------- ---------- --------
Income tax expense (benefit) $ (260,279) $ 151,956 $144,334
=========== ========== ========
F-15
68
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1999 and 1998
Note 6. Income Taxes (continued)
The income tax benefit is different from the expected tax benefit
computed by multiplying income before income tax benefit by the
statutory federal income tax rates. The reasons for this difference
are as follows:
1999 1998 1997
----------- ---------- --------
Expected tax at statutory rates $ (228,956) $ 136,097 $125,268
Increase (decrease) resulting tax effect of:
State income taxes, net of federal
tax benefit (26,667) 16,013 14,737
Other (4,656) (154) 4,329
----------- ---------- --------
Income tax expense (benefit) $ (260,279) $ 151,956 $144,334
=========== ========== ========
At December 31, 1999, the Bank had net operating loss carryforwards
for federal tax purposes of approximately $332,000 and for state tax
purposes of approximately $1,356,000. Such net operating loss
carryforwards expire in 2014.
As of December 31, 1999, deferred tax assets recognized for
deductible temporary differences totaled approximately $1,210,000 and
deferred tax liabilities for taxable temporary differences totaled
approximately $412,000.
Note 7. Notes Payable
The Company had borrowings under a $1,000,000 revolving line of
credit and a promissory note dated September 30, 1998, with First
Tennessee Bank. Borrowings were collateralized by all of the
outstanding stock of the Bank. Interest was payable annually based on
First Tennessee Bank's base commercial rate. The line of credit
agreement expired and the promissory note matured during 1999 and
were paid in full.
Note 8. Employee Benefit Plan
The Bank has a 401(k) employee benefit plan covering substantially
all employees who have completed at least one year of service and met
minimum age requirements. The amount of employer contribution is
computed annually under a defined formula based primarily on the
employees' salaries. The maximum employer required contribution to
the plan is 3 percent of the employees' annual salaries. Any
additional contribution to the plan is determined at the discretion
of the Board of Directors. For the years ended December 31, 1999,
1998 and 1997, total contributions to the plan were $13,863, $10,850,
and $7,491, respectively.
F-16
69
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1999 and 1998
Note 9. Financial Instruments With Off-Balance-Sheet Risk
The Bank 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 various
commitments to extend credit and standby letters of credit. These
instruments expose the Bank to varying degrees of credit and interest
rate risk in excess of the amount recognized in the accompanying
balance sheet. To manage this risk, the Bank uses the same management
policies and procedures for financial instruments with
off-balance-sheet risk as it does for financial instruments whose
risk is reflected on the balance sheet.
The credit risk of all financial instruments varies based on many
factors, including the value of collateral held and other security
arrangements. To mitigate credit risk, the Bank generally determines
the need for specific covenant, guarantee, and collateral
requirements on a case-by-case basis, depending on the customer's
creditworthiness. The amount and type of collateral held to reduce
credit risk vary, but may include real estate, machinery, equipment,
inventory, and accounts receivable as well as cash on deposit,
stocks, bonds, and other marketable securities that are generally
held in the Bank's possession. This collateral is valued and
inspected to ensure both its existence and adequacy. The Bank
requests additional collateral when appropriate.
At December 31, 1999, commitments under standby letters of credit and
undisbursed loan commitments aggregated $9,585,000. The Bank's credit
exposure for these financial instruments is represented by their
contractual amounts. The Bank does not anticipate any material losses
as a result of the commitments under standby letters of credit and
undisbursed loan commitments.
Note 10. Fair Value of Financial Instruments
Fair value estimates are made at a specific point in time, based on
relevant market information about the financial instrument. These
estimates do not reflect any premium or discount that could result
from offering for sale at one time the Company's entire holdings of a
particular financial instrument. Because no market exists for a
significant portion of the Company's financial instruments, fair
value estimates are based on judgments regarding future expected loss
experience, current economic conditions, risk characteristics of
various financial instruments, and other factors. These estimates are
subjective in nature; involve uncertainties and matters of judgment;
and, therefore, cannot be determined with precision. Changes in
assumptions could significantly affect the estimates.
Fair value estimates are based on existing financial instruments
without attempting to estimate the value of anticipated future
business and the value of assets and liabilities that are not
considered financial instruments. The following methods and
assumptions were used to estimate the fair value of each class of
financial instruments:
F-17
70
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1999 and 1998
Note 10. Fair Value of Financial Instruments (continued)
Cash and cash equivalents:
For cash and cash equivalents, the carrying amount is a reasonable
estimate of fair value.
Securities:
The fair value of securities is estimated based on bid prices
published in financial newspapers or bid quotations received from
securities dealers.
Loans:
The fair value of loans is calculated by discounting scheduled cash
flows through the estimated maturity using estimated market discount
rates, adjusted for credit risk and servicing costs. The estimate of
maturity is based on historical experience with repayments for each
loan classification, modified, as required, by an estimate of the
effect of current economic and lending conditions.
Deposits:
The fair value of deposits with no stated maturity, such as demand
deposits, money market accounts, and savings accounts, is equal to
the amount payable on demand. The fair value of time deposits is
based on the discounted value of contractual cash flows. The discount
rate is estimated using the rates currently offered for deposits of
similar remaining maturities.
Federal funds purchased and securities sold under agreements to
repurchase:
The estimated value of these liabilities, which are extremely short
term, approximates their carrying value.
The carrying amount and estimated fair value of the Company's
financial instruments at December 31, 1999 and 1998, are as follows
(in thousands):
1999 1998
----------------------- -----------------------
Carrying Estimated Carrying Estimated
Amount Fair Value Amount Fair Value
-------- --------- -------- ---------
Assets:
Cash and due from banks $ 7,722 $ 7,722 $ 4,269 $ 4,269
Federal funds sold -- -- 8,425 8,425
Securities 19,063 19,010 18,357 18,383
Net loans 71,324 71,600 72,492 72,480
F-18
71
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1999 and 1998
Note 10. Fair Value of Financial Instruments (continued)
1999 1998
---------------------- ----------------------
Carrying Estimated Carrying Estimated
Amount Fair Value Amount Fair Value
-------- ---------- -------- ---------
Liabilities:
Noninterest-bearing
demand deposits $12,412 $12,412 $14,152 $14,152
Interest-bearing
demand deposits 12,626 12,626 12,998 12,998
Savings deposits and money
market accounts 10,255 10,255 10,283 10,283
Time deposits 56,053 55,883 60,579 60,606
Notes payable -- -- 1,250 1,250
Federal funds purchased and
securities sold under
agreements to repurchase 2,179 2,179 -- --
Note 11. Contingencies
During 1999, a third party complaint was filed against the Bank
alleging that checks amounting to $661,500 were deposited into
accounts at the Bank under forged endorsements and the third party
plaintiff seeks recovery of the funds. The Bank has filed a claim
under its forgery bond insurance policy and the insurance company is
aggressively defending the Bank against the allegations. Management
has reviewed the matter with its general counsel and the insurance
company's legal counsel. Management believes that the complaint is
without merit and that any loss to the Bank would not have a
materially adverse effect on the financial condition of the Bank or
the consolidated financial condition of the Company. Accordingly, no
provision for this matter has been made in the Company's consolidated
financial statements.
During 1999, the Bank was one of six defendants named in a lawsuit
seeking $3,000,000 in compensatory damages and $5,000,000 in punitive
damages. With respect to the Bank, the lawsuit alleges (1) that the
Bank and a Bank employee violated banking obligations to the
plaintiffs, who are partners in a limited partnership, by allowing
the limited partnership to run large overdrafts in partial
consideration for improper benefits given to the Bank employee by the
manager of the limited partnership; (2) that the Bank employee
influenced another bank to loan funds to the limited partnership at a
time that the Bank employee knew of large overdrafts at the Bank; (3)
that the Bank carried an overdraft with the limited partnership
without notifying the plaintiffs; and (4) that the Bank breached
duties owed to the plaintiffs under state common law and state and
federal banking laws. The Bank has reviewed the matter with its
general counsel and is vigorously defending the lawsuit. Although no
assurance can be given with respect to the ultimate outcome of the
lawsuit, management believes that the allegations against the Bank
are without merit and should not have a material adverse effect on
the consolidated financial condition of the Company or the financial
condition of the Bank. Accordingly, no provision for this matter has
been made in the Company's consolidated financial statements.
F-19
72
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1999 and 1998
Note 11. Contingencies (continued)
The Bank is involved in certain other claims arising from normal
business activities. Management believes that those claims are
without merit or that the ultimate liability, if any, resulting from
them will not materially affect the Bank's financial condition or the
Company's consolidated financial position.
Note 12. Liquidity and Capital Resources
The Company's primary source of funds is the receipt of dividends
from its subsidiary bank. Banking regulators limit the amount of
dividends that the Bank may pay without prior approval of the Bank's
regulatory agency. As discussed in Note 14, the Bank cannot pay
dividends without specific regulatory approval.
Note 13. Stock Options and Warrants
The Company has a stock option plan under which members of the Board
of Directors, at the formation of the Bank, were granted options to
purchase a total of 140,000 shares of the Bank's common stock. These
options were granted for the specific purpose of raising capital. The
option price was $10.00 per share which was the estimated fair value
of the stock at the June 30, 1996, grant date. The options expire ten
years from the date of grant and were fully vested at the grant date.
On October 15, 1997, the Bank stock options were converted to Company
stock options. No options have been exercised since the original
grant date. During 1999, 10,000 stock options were forfeited. At
December 31, 1999, the remaining contractual life of outstanding
options was 6.5 years.
The Company also has a stock option plan under which officers and
employees can be granted options to purchase shares of the Company's
common stock. There were no shares allocated under this plan during
1998 and 1997. On March 2, 1999, the Company granted options to
purchase 21,500 shares of the Company's common stock to certain
officers of the Bank. The grant price was $15.00 per share. The
options vest at 30% on March 2, 2001; 30% on March 2, 2002; and 40%
on March 2, 2003. On December 31, 1999, 5,000 shares were forfeited
leaving 16,500 shares outstanding.
The Company applies APB Opinion 25, Accounting for Stock Issued to
Employees, and related Interpretations in accounting for its stock
option plan for officers and employees. Accordingly, no compensation
cost has been recognized for its fixed price stock option plan.
Compensation cost for the Company's stock option plan for officers
and employees based on the fair value at the grant dates for awards
under that plan consistent with the method of FASB Statement 123,
Accounting for Stock-Based Compensation, was insignificant for the
year ended December 31, 1999.
F-20
73
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1999 and 1998
Note 13. Stock Options and Warrants (continued)
A stock warrant was issued with each of the 590,130 original shares
of the Company's common stock which entitles each stockholder to
purchase an additional share of the Company's common stock at a
specified price. At December 31, 1999 and 1998, warrants for the
purchase of 166,767 and 323,935 shares, respectively, were
outstanding. The exercise price was $12.00 per share until February
1999 and is $15.00 per share thereafter. During a certain period of
1999, the Company offered warrants at $13.00. If not exercised, such
warrants will expire five years after issuance. In connection with
the acquisition of the Bank of East Ridge 157,168 and 134,507
warrants were exercised in 1999 and 1998, respectively.
Note 14. Regulatory Matters
The Bank is subject to various regulatory capital requirements
administered by the Tennessee Department of Financial Institutions
and the federal banking agencies. Failure to meet minimum capital
requirements can initiate certain mandatory--and possibly additional
discretionary--actions by regulators that, if undertaken, could have
a direct material effect on the Bank's financial statements. Under
capital adequacy guidelines and the regulatory framework for prompt
corrective action, the Bank must meet specific capital guidelines
that involve quantitative measures of the Bank's assets, liabilities,
and certain off-balance-sheet items as calculated under regulatory
accounting practices. The Bank's capital amounts and classification
are also subject to qualitative judgments by the regulators about
components, risk weightings, and other factors.
Quantitative measures established by regulation to ensure capital
adequacy require the Bank to maintain minimum amounts and ratios (set
forth in the table below) of total and Tier I capital (as defined in
the regulations) to risk-weighted assets (as defined), and of Tier I
capital (as defined) to average assets (as defined). Management
believes, as of December 31, 1999, that the Bank meets all capital
adequacy requirements to which it is subject.
As of December 31, 1999, the most recent notification from the
Federal Deposit Insurance Corporation categorized the Bank as well
capitalized under the regulatory framework for prompt corrective
action. There are no conditions or events since that notification
that management believes have changed the institution's prompt
corrective action category for bank capital.
F-21
74
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1999 and 1998
Note 14. Regulatory Matters (continued)
The Bank's actual capital amounts and ratios are also presented in
the table. Dollar amounts are presented in thousands.
For Capital
Actual Adequacy Purposes
--------------------- -----------------------
Amount Ratio Amount Ratio
------ ----- -------- -------
As of December 31, 1999:
Total capital
(to risk-weighted assets) $ 9,604 12.8% $ 6,015 8.0%
Tier I capital
(to risk-weighted assets) 8,663 11.5% 3,008 4.0%
Tier I capital
(to average assets) 8,663 8.6% 8,105 8.0%
As of December 31, 1998:
Total capital
(to risk-weighted assets) $ 9,808 12.8% $ 6,136 8.0%
Tier I capital
(to risk-weighted assets) 8,844 11.5% 3,068 4.0%
Tier I capital
(to average assets) 8,844 8.4% 8,407 8.0%
The Bank is operating under a Memorandum of Understanding
(Memorandum) dated November 24, 1998, between the Board of Directors,
the Tennessee Department of Financial Institutions, and the Federal
Deposit Insurance Corporation. Among other things, the Memorandum
provides the following:
- The Board of Directors was required to develop a
written management plan that addresses the Bank's
plans for size, structure, growth, earnings,
services, information systems, personnel, accounting,
financial reporting and operating matters.
- The Bank shall maintain a Tier I capital ratio of
equal to or greater than 8%.
- The Bank shall not pay dividends without the prior
approval of the FDIC.
- The Bank shall report its progress on the actions
required by the Memorandum to the FDIC on specific
dates.
At December 31, 1999, the Bank continues to operate under the
Memorandum and management of the Bank believes that they are
conforming to all provisions of the Memorandum.
F-22
75
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1999 and 1998
Note 15. Other Comprehensive Income
Other comprehensive income consists of unrealized holding gains and
losses on securities available for sale. A summary of other
comprehensive income and the related tax effects for the years ended
December 31, 1999, 1998, and 1997, is as follows:
Tax
Before-Tax (Expense) Net-of-Tax
Amount Benefit Amount
--------- --------- ----------
Year ended December 31, 1999:
Unrealized holding gains and losses
arising during the period $(358,679) $ 136,298 $(222,381)
Less reclassification adjustment for
gains realized in net income -- -- --
--------- --------- ---------
$(358,679) $ 136,298 $(222,381)
========= ========= =========
Year ended December 31, 1998:
Unrealized holding gains and losses
arising during the period $ (5,848) $ 2,222 $ (3,626)
Less reclassification adjustment for
gains realized in net income -- -- --
--------- --------- ---------
$ (5,848) $ 2,222 $ (3,626)
========= ========= =========
Year ended December 31, 1997:
Unrealized holding gains and losses
arising during the period $ 82,920 $ (31,520) $ 51,400
Less reclassification adjustment for
gains realized in net income 103,394 (39,300) 64,094
--------- --------- ---------
$ (20,474) $ 7,780 $ (12,694)
========= ========= =========
Note 16. Bank Combination
On October 15, 1997, the Company completed a combination of the Bank
of East Ridge (East Ridge) with Cornerstone Community Bank
(Cornerstone). The surviving bank operates as Cornerstone Community
Bank. All of East Ridge's outstanding common stock owned by the
Company was redeemed in the combination and all of the Company's
outstanding common stock of record on October 15, 1997, was retired
with stockholders of that date receiving cash and/or newly issued
shares of common stock of the Company. The combination resulted in a
change in control of ownership and management of the Company as the
officers and directors of Cornerstone Community Bank replaced all of
the officers and directors of the Company. The Company changed its
name from East Ridge Bancshares, Inc. to Cornerstone Bancshares, Inc.
concurrent with the combination.
F-23
76
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1999 and 1998
Note 16. Bank Combination (continued)
The purchase price totaled $6,125,000 comprised of $4,287,368 cash
and 153,136 shares of newly issued common stock. The purchase price
exceeded the fair value of net assets acquired by approximately
$2,900,000, which is being amortized on the straight-line basis over
25 years. The combination has been accounted for as a purchase
accounting transaction and, accordingly, the operating results of
East Ridge are included in the accompanying financial statements from
the date of combination.
The following unaudited pro forma consolidated results of operations
for the year ended December 31, 1997, assumes the Cornerstone and
East Ridge combination occurred as of January 1, 1997 (in thousands):
Interest income $ 7,012
Interest expense 3,387
-------
Net interest income 3,625
Provision for loan losses 463
-------
Net interest income after provision for loan losses 3,162
Non-interest income 579
Non-interest expense 3,375
-------
Income before income taxes 366
Income taxes 97
-------
Net income $ 269
=======
Note 17. Earnings Per Common Share
Basic earnings per share represents income available to common
stockholders divided by the weighted-average number of common shares
outstanding during the period. Diluted earnings per share reflects
additional common shares that would have been outstanding if dilutive
potential common shares had been issued, as well as any adjustment to
income that would result from the assumed issuance. Potential common
shares that may be issued by the Company relate to outstanding stock
options and warrants, determined using the treasury stock method, and
redeemable common stock, determined using the reverse treasury stock
method.
F-24
77
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1999 and 1998
Note 17. Earnings Per Common Share (continued)
Earnings per common share have been computed based on the following:
1999 1998 1997
----------- ---------- --------
Net income (loss) $ (413,123) $ 248,332 $224,100
Less: Preferred stock dividends -- -- --
----------- ---------- --------
Net income (loss) applicable to
common stock $ (413,123) $ 248,332 $224,100
=========== ========== ========
Average number of common shares
outstanding 1,069,411 987,043 649,468
Effect of dilutive options -- 30,000 30,000
----------- ---------- --------
Average number of common shares
outstanding used to calculate diluted
earnings per common share 1,069,411 1,017,043 679,468
=========== ========== ========
Note 18. Redeemable Common Stock
At December 31, 1999 and 1998, the Company was obligated to redeem
certain shares of common stock issued in connection with the bank
combination described in Note 16. Such obligation includes the right
of a certain shareholder to sell certain shares of common stock to
the Company over a three-year period at $12.55, $14.00, and $16.00
per share in years 1998, 1999, and 2000, respectively. The Company
has the option to redeem such shares during the same period at the
same prices. During 1999 and 1998, the Company redeemed 19,756 and
27,897 shares, respectively, under this obligation.
F-25
78
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1999 and 1998
Note 19. Condensed Parent Company Financial Statements
Condensed financial statements of Cornerstone Bancshares, Inc. are
summarized as follows:
Condensed Balance Sheets
1999 1998
------------ ------------
ASSETS
Cash $ 475,506 $ 2,934
Excess cost over fair value of net assets acquired 2,722,651 2,834,124
Other assets 196,044 51,376
Investment in subsidiary 8,480,172 8,883,624
------------ ------------
Total assets $ 11,874,373 $ 11,772,058
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Accrued interest payable $ -- $ 19,027
Other liabilities (19,886) --
Notes payable -- 1,250,000
------------ ------------
Total liabilities (19,886) 1,269,027
------------ ------------
Redeemable common stock 237,504 478,744
------------ ------------
Stockholders' equity:
Preferred stock; no par value; 2,000,000 shares
authorized; no shares issued -- --
Common stock, $1.00 par value; 2,000,000 shares
authorized; 1,166,629 and 1,009,461 shares issued
and outstanding in 1999 and 1998, respectively 1,166,629 1,009,461
Additional paid-in capital 11,128,234 9,017,430
Retained earnings (deficit) (454,818) (41,695)
Accumulated other comprehensive income (183,290) 39,091
------------ ------------
Total stockholders' equity 11,656,755 10,024,287
------------ ------------
Total liabilities and stockholders' equity $ 11,874,373 $ 11,772,058
============ ============
F-26
79
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1999 and 1998
Note 19. Condensed Parent Company Financial Statements (continued)
Condensed Statements of Operations and Retained Earnings
1999 1998
--------- ---------
INCOME
Net loss from sale of assets $ -- $(112,155)
Equity in subsidiary's earnings (141,071) 547,672
--------- ---------
Total income (141,071) 435,517
--------- ---------
EXPENSES
Interest expense 74,043 122,567
Other operating expenses 363,914 111,194
--------- ---------
Total expenses 437,957 233,761
--------- ---------
Income (loss) before income tax benefit (579,028) 201,756
Income tax benefit (165,905) (46,576)
--------- ---------
NET INCOME (LOSS) (413,123) 248,332
RETAINED EARNINGS (DEFICIT), beginning of year (41,695) (290,027)
--------- ---------
RETAINED EARNINGS (DEFICIT), end of year $(454,818) $ (41,695)
========= =========
F-27
80
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1999 and 1998
Note 19. Condensed Parent Company Financial Statements (continued)
Condensed Statements of Cash Flows
1999 1998
----------- -----------
CASH FLOWS FROM OPERATING ACTIVITIES
Net income (loss) $ (413,123) $ 248,332
Adjustments to reconcile net income (loss) to net cash
used in operating activities:
Amortization 111,473 111,170
Equity in earnings of subsidiary 141,071 (547,672)
Changes in other operating assets and liabilities:
Increase (decrease) in accrued interest payable (19,027) 19,027
Increase in other assets and liabilities (395,482) (743,465)
----------- -----------
Net cash used in operating activities (575,088) (912,608)
----------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES
Additional capitalization of subsidiary -- (1,575,394)
Payments related to bank combination -- (457,637)
----------- -----------
Net cash used in investing activities -- (2,033,031)
----------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from borrowings on line of credit -- 145,000
Proceeds from notes payable -- 250,000
Principal paid on notes payable (1,250,000) --
Redemption of common stock (270,928) (350,107)
Issuance of common stock 2,568,588 1,964,187
----------- -----------
Net cash provided by financing activities 1,047,660 2,009,080
----------- -----------
NET INCREASE (DECREASE) IN CASH AND
CASH EQUIVALENTS 472,572 (936,559)
CASH AND CASH EQUIVALENTS, beginning of year 2,934 939,493
----------- -----------
CASH AND CASH EQUIVALENTS, end of year $ 475,506 $ 2,934
=========== ===========
SUPPLEMENTAL DISCLOSURES OF CASH
FLOW INFORMATION
Cash paid during the period for interest $ 93,070 $ 103,540
Cash paid during the period for taxes -- 425,171
=========== ===========
F-28
81
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1999 AND 1998
NOTE 20. QUARTERLY DATA (UNAUDITED)
YEARS ENDED DECEMBER 31,
-----------------------------------------------------------------------------------------------------
1999 1998
------------------------------------------------- -------------------------------------------------
FOURTH THIRD SECOND FIRST FOURTH THIRD SECOND FIRST
QUARTER QUARTER QUARTER QUARTER QUARTER QUARTER QUARTER QUARTER
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
Interest income $2,002,689 $1,968,741 $1,824,432 $1,891,607 $2,121,181 $2,109,078 $1,940,703 $1,937,610
Interest expense 902,511 879,658 901,369 959,947 1,056,092 1,101,132 1,089,324 984,842
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
Net interest income 1,100,178 1,089,083 923,063 931,660 1,065,089 1,007,946 851,379 952,768
Provision for loan losses 95,000 105,000 605,000 50,000 408,673 183,478 76,147 47,018
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
Net interest income, after
provision for loan
losses 1,005,178 984,083 318,063 881,660 656,416 824,468 775,205 905,750
Noninterest income 146,486 151,581 158,566 128,209 25,175 161,234 450,480 152,745
Noninterest expenses 1,156,306 1,090,420 1,209,219 991,283 959,544 905,484 856,208 829,949
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
Income (loss) before
income taxes (4,642) 45,244 (732,590) 18,586 (277,953) 80,218 369,477 228,546
Provision for income taxes (109,715) (58,957) (113,475) 21,868 37,881 (47,683) 33,662 128,096
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
Net income (loss) $ 105,073 $ 104,201 $ (619,115) $ (3,282) $ (315,834) $ 127,901 $ 335,815 $ 100,450
========== ========== ========== ========== ========== ========== ========== ==========
Earnings per common share:
Basic $ 0.14 $ 0.09 $ (0.61) $ (0.01) $ (0.31) $ 0.13 $ 0.33 $ 0.10
========== ========== ========== ========== ========== ========== ========== ==========
Diluted $ 0.12 $ 0.08 $ (0.61) $ (0.01) $ (0.31) $ 0.11 $ 0.29 $ 0.09
========== ========== ========== ========== ========== ========== ========== ==========
F-29
82
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1999 and 1998
Note 21. Subsequent Event
During the first quarter of year 2000, the Company intends to
register 150,000 shares of its common stock with the Securities and
Exchange Commission. After such registration, management will offer
such shares at $13 per share to the public and expects to sell all
such shares by the end of year 2000.
F-30
83
Report of Independent Certified Public Accountants
on Accompanying Information
To the Stockholders and
Board of Directors
Cornerstone Bancshares, Inc.
Chattanooga, Tennessee
Our report on our audits of the basic financial statements of
Cornerstone Bancshares, Inc. and subsidiary for 1999, 1998 and 1997 appears on
page 1. Those audits were made for the purpose of forming an opinion on the
consolidated financial statements taken as a whole. The consolidating
information shown on pages 32 and 33 is presented for purposes of additional
analysis of the consolidated financial statements rather than to present the
financial position, results of operations, and cash flows of the individual
companies. The consolidating information has been subjected to the auditing
procedures applied in the audits of the consolidated financial statements and,
in our opinion, is fairly stated in all material respects in relation to the
consolidated financial statements taken as a whole.
HAZLETT, LEWIS & BIETER, PLLC
Chattanooga, Tennessee
January 28, 2000
84
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATING BALANCE SHEET
December 31, 1999
Cornerstone Cornerstone
Community Bancshares,
ASSETS Bank Inc. Eliminations Consolidated
------------- ------------ ----------- ------------
Cash and due from banks $ 7,721,701 $ 475,506 $ 475,506 $ 7,721,701
Securities available for sale 13,339,306 -- -- 13,339,306
Securities held to maturity 5,723,320 -- -- 5,723,320
Loans, net of allowance for loan losses 71,323,878 -- -- 71,323,878
Bank premises and equipment, net 2,231,179 -- -- 2,231,179
Accrued interest receivable 656,159 -- -- 656,159
Excess cost over fair value of net assets acquired -- 2,722,651 -- 2,722,651
Other assets 1,887,989 196,044 -- 2,084,033
Investment in subsidiary -- 8,480,172 8,480,172 --
------------- ------------ ----------- -------------
Total assets $ 102,883,532 $ 11,874,373 $ 8,955,678 $ 105,802,227
============= ============ =========== =============
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits:
Noninterest-bearing demand deposits $ 12,887,445 $ -- $ 475,506 $ 12,411,939
Interest-bearing demand deposits 12,626,200 -- -- 12,626,200
Savings deposits and money market accounts 10,254,825 -- -- 10,254,825
Time deposits of $100,000 or more 16,129,350 -- -- 16,129,350
Time deposits under $100,000 39,923,313 -- -- 39,923,313
------------- ------------ ----------- ------------
Total deposits 91,821,133 -- 475,506 91,345,627
Accrued interest payable 189,870 -- -- 189,870
Federal funds purchased and securities sold under
agreements to repurchase 2,179,363 -- -- 2,179,363
Other liabilities 212,994 (19,886) -- 193,108
------------- ------------ ----------- ------------
Total liabilities 94,403,360 (19,886) 475,506 93,907,968
------------- ------------ ----------- ------------
Redeemable common stock -- 237,504 -- 237,504
------------- ------------ ----------- ------------
Stockholders' equity:
Preferred stock
Common stock 590,130 1,166,629 590,130 1,166,629
Additional paid-in capital -- 11,128,234 -- 11,128,234
Surplus 7,862,448 -- 7,862,448 --
Retained earnings (deficit) 210,884 (454,818) 210,884 (454,818)
Accumulated other comprehensive income (183,290) (183,290) (183,290) (183,290)
------------- ------------ ----------- ------------
Total stockholders' equity 8,480,172 11,656,755 8,480,172 11,656,755
------------- ------------ ----------- ------------
Total liabilities and stockholders' equity $ 102,883,532 $ 11,874,373 $ 8,955,678 $ 105,802,227
============= ============ =========== =============
F-32
85
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATING STATEMENT OF OPERATIONS
Year Ended December 31, 1999
Cornerstone Cornerstone
Community Bancshares,
Bank Inc. Eliminations Consolidated
----------- ---------- ------------ ------------
INTEREST INCOME
Loans $ 6,361,554 $ -- $ -- $ 6,361,554
Securities 1,146,591 -- -- 1,146,591
Federal funds sold 179,324 -- -- 179,324
----------- --------- -------- -----------
Total interest income 7,687,469 -- -- 7,687,469
----------- --------- -------- -----------
INTEREST EXPENSE
Time deposits of $100,000 or more 884,435 -- -- 884,435
Other deposits 2,662,507 -- -- 2,662,507
Federal funds purchased and securities
sold under agreements to repurchase 22,500 -- -- 22,500
Other -- 74,043 -- 74,043
----------- --------- -------- -----------
Total interest expense 3,569,442 74,043 -- 3,643,485
----------- --------- -------- -----------
Net interest income (expense) before
provision for loan losses 4,118,027 (74,043) -- 4,043,984
Provision for loan losses 855,000 -- -- 855,000
----------- --------- -------- -----------
Net interest income (expense) after
provision for loan losses 3,263,027 (74,043) -- 3,188,984
----------- --------- -------- -----------
NONINTEREST INCOME
Service charges 486,898 -- -- 486,898
Other noninterest income 47,324 -- -- 47,324
Net gains from sale of loans 50,620 -- -- 50,620
Equity in subsidiary's earnings -- (141,071) 141,071 --
----------- --------- -------- -----------
Total noninterest income 584,842 (141,071) 141,071 584,842
----------- --------- -------- -----------
NONINTEREST EXPENSES
Salaries and employee benefits 2,114,951 -- -- 2,114,951
Net occupancy and equipment expense 225,435 -- -- 225,435
Other operating expenses 1,742,928 363,914 -- 2,106,842
----------- --------- -------- -----------
Total noninterest expenses 4,083,314 363,914 -- 4,447,228
----------- --------- -------- -----------
Income (loss) before income tax benefit (235,445) (579,028) 141,071 (673,402)
Income tax benefit (94,374) (165,905) -- (260,279)
----------- --------- -------- -----------
Net income (loss) $ (141,071) $(413,123) $141,071 $ (413,123)
=========== ========= ======== ===========