UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2008 Commission File Number 000-22787 FOUR OAKS FINCORP, INC. (Exact name of registrant as specified in its charter) North Carolina 56-2028446 -------------- ---------- (State or other jurisdiction of (IRS Employer Identification incorporation or organization) Number) 6114 U.S. 301 South Four Oaks, North Carolina 27524 ------------------------- ----- (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (919) 963-2177 -------------- Securities registered under Section 12(b) of the Act: NONE Securities registered under Section 12(g) of the Act: Common Stock, par value $1.00 per share --------------------------------------- (Title of Class) Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. YES | | NO |X| Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. YES | | NO |X| Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days: |X| YES | | NO Indicate by check mark whether disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. | | Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of "large accelerated filer", "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act: Large accelerated filer | | Accelerated filer |X| Non-accelerated filer | | Smaller reporting company | | (Do not check if a smaller reporting company) Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act): | | YES |X| NO $84,360,731 ----------- (Aggregate market value of voting and non-voting common equity held by non-affiliates of the registrant based on the price at which the registrant's Common Stock, par value $1.00 per share was sold on June 30, 2008) 6,207,191 --------- (Number of shares of Common Stock, par value $1.00 per share, outstanding as of March 6, 2009) Documents Incorporated by Reference Where Incorporated - ----------------------------------- ------------------ (1) Proxy Statement for the 2009 Annual Part III Meeting of Shareholders to be held May 11, 2009 - 1 - Forward Looking Information Information set forth in this Annual Report on Form 10-K under the caption "Business" and "Management's Discussion and Analysis of Financial Condition and Results of Operations" contains various "forward looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, which statements represent our judgment concerning the future and are subject to business, economic and other risks and uncertainties, both known and unknown, that could cause our actual operating results and financial position to differ materially. Such forward looking statements can be identified by the use of forward looking terminology, such as "may," "will," "expect," "anticipate," "estimate," or "continue" or the negative thereof or other variations thereof or comparable terminology. We caution that any such forward looking statements are further qualified by important factors that could cause our actual operating results to differ materially from those in the forward looking statements, including, without limitation, the effects of future economic conditions, governmental fiscal and monetary policies, legislative and regulatory changes, the risks of changes in interest rates on the level and composition of deposits, the effects of competition from other financial institutions, the failure of assumptions underlying the establishment of the allowance for possible loan losses and the low trading volume of our common stock and the risks discussed in Item 1A. Risk Factors below. Any forward looking statements contained in this Annual Report on Form 10-K are as of the date hereof and we undertake no duty to update them if our view changes later. These forward looking statements should not be relied upon as representing our view as of any date subsequent to the date hereof. PART I Item 1 - Business. Four Oaks Bank & Trust Company (referred to herein as the "bank") was incorporated under the laws of the State of North Carolina in 1912. On February 5, 1997, the bank formed Four Oaks Fincorp, Inc. (referred to herein as the "Company"; references herein to "we," "us" and "our" refer to the Company and its consolidated subsidiaries, unless the context otherwise requires) for the purpose of serving as a holding company for the bank. Our corporate offices and banking offices are located in eastern and central North Carolina. We have no significant assets other than cash, the capital stock of the bank and its membership interest in Four Oaks Mortgage Services, L.L.C., as well as $3,189,000 in securities available for sale. In addition, we have an interest in Four Oaks Statutory Trust I, a wholly owned Delaware statutory business trust (the "Trust"), for the sole purpose of issuing trust preferred securities. The Trust is not consolidated with our financial statements of the Company pursuant to the provisions of Financial Accounting Standards Board ("FASB") Interpretation No. 46, "Consolidation of Variable Interest Entities (revised December 2003) - an interpretation of ARB No. 51" ("FIN 46R"). We formed the Trust for the sole purpose of issuing $12.0 million of trust preferred securities (the "Trust Preferred Securities"). The Trust has invested the net proceeds from the sale of the Trust Preferred Securities in Junior Subordinated Deferrable Interest Debentures (the "Debentures") issued by us and recorded in borrowings on the accompanying consolidated balance sheet. The Trust Preferred Securities pay cumulative cash distributions quarterly at an annual rate, reset quarterly, equal to three month LIBOR plus 1.35%. The dividends paid to holders of the Trust Preferred Securities, which are recorded as interest expense, are deductible for income tax purposes. As of December 31, 2008, we had assets of $924.8 million, net loans outstanding of $672.0 million and deposits of $722.7 million. We have enjoyed considerable growth over the past five (5) years as evidenced by a 170.6% increase in assets, a 150.0% increase in net loans outstanding, and a 164.8% increase in deposits since December 31, 2003. We had net income of $4.2 million and $5.7 million and basic earnings per share of $.65 and $.92 for the years ended December 31, 2008 and 2007, respectively. Net income of $7.0 million and basic earnings per share of $1.15 were recorded for the year ended December 31, 2006. The bank continues to remain a community-focused bank engaging in general commercial banking business to the communities we serve. The bank provides a full range of banking services, including such services as: o checking accounts; o savings accounts; o individual retirement accounts; - 2 - o NOW accounts; o money market accounts; o certificates of deposit; o a student checking and savings program; o e-statements; o loans for businesses, agriculture, real estate, personal uses, home improvement and automobiles; o mortgage loans; o equity lines of credit; o credit cards; o safe deposit boxes; o electronic funds transfer services, including wire transfers; o internet banking, bill pay services and mobile banking; o telephone banking; o gift cards; o cashier's checks; o traveler's check cards; and o free notary services to all bank customers. The bank also provides its customers access to automated teller machines ("ATMs") through its own ATMs throughout its communities served as well as access to worldwide ATMs for cash withdrawals through the services of the Star, Cirrus, or Visa networks by using ATM or Visa check cards. The Visa check cards may also be used at merchant locations worldwide through the Star, Cirrus, or Visa networks. Through an arrangement with Lincoln Financial Securities Corporation acting as a registered broker-dealer performing the brokerage services, the bank also makes available a complete line of insurance and investment services, including financial strategies, mutual funds, annuities, insurance, stock brokerage, IRA's, discount brokerage services, employee benefit plans, 401(k)'s and simplified employee pension plans. The securities involved in these services are not deposits or other obligations of the bank, and are not insured by the Federal Deposit Insurance Corporation (the "FDIC"). At present, the bank does not provide the services of a trust department. We maintain a website at www.fouroaksbank.com where our periodic reports on Form 10-Q and 10-K and our current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act are available under "Investor Relations." We are registered as a financial holding company with the Federal Reserve System. We are a state-chartered member of the Federal Reserve System and the FDIC insures the bank's deposits up to applicable limits. Our corporate offices are located at 6114 US 301 South, Four Oaks, North Carolina, 27524. Our common stock is traded on the OTC Bulletin Board under the symbol "FOFN". Our market area is concentrated in eastern and central North Carolina. From its headquarters located in Four Oaks and its seventeen locations in Four Oaks, Clayton, Smithfield, Garner, Benson, Fuquay-Varina, Wallace, Holly Springs, Harrells, Sanford, Zebulon, Dunn, Rockingham and Southern Pines, the bank serves a major portion of Johnston County, and parts of Wake, Harnett, Duplin, Sampson, Lee, Moore and Richmond counties. Johnston County is contiguous to Wake, Wayne, Wilson, Harnett, Sampson, and Nash counties. Wake County is contiguous to Johnston, Durham, Harnett, Nash, Franklin, Granville and Chatham counties. Sampson County is contiguous to Duplin, Pender, Bladen, Harnett, Cumberland, Johnston, and Wayne counties. Lee County is contiguous to Chatham, Moore and Harnett counties. Duplin County is contiguous to Pender, Sampson, Wayne, Lenoir, Jones and Onslow counties. Harnett County is contiguous to Cumberland, Moore, Lee, Chatham, Wake, Johnston and Sampson counties. Moore County is contiguous to Harnett, Lee, Chatham, Randolph, Montgomery, Richmond, Hoke, Cumberland and Scotland counties. Richmond County is contiguous to Anson, Stanley, Montgomery, Moore, Hoke and Scotland counties. Johnston County has a diverse economy and is not dependent on any one particular industry. The leading industries in the area include retail trade, manufacturing, pharmaceuticals, government, services, construction, wholesale trade and agriculture. The population for Johnston County in 2007 was estimated in excess of 157,000. As of June 2008, the bank ranked first in deposit market share for Johnston County at 30.2%. In Four Oaks, the main office is located at 6144 US 301 South and an additional branch is located at 111 North Main Street. The bank also operates a branch office in Clayton at 102 East Main Street, two in Smithfield at 128 North Second Street, and 403 South Brightleaf Boulevard, two in Garner at 200 Glen Road and 574 Village Court, one in Benson at 200 East Church Street, one in Fuquay-Varina at 325 North Judd Parkway Northeast, one in Wallace at 406 East Main Street, one in Holly Springs at 101 West Center Street, one in Harrells at 590 Tomahawk Highway, one in Sanford at 830 Spring Lane, one in Zebulon at 130 North Arendell Avenue, one in Dunn at 604-A Erwin Road, one in Rockingham at 1401 Fayetteville Road and one in Southern Pines at 105 Commerce Avenue. - 3 - The majority of the bank's customers are individuals and small to medium-size businesses. The deposits and loans are well diversified with no material concentration in a single industry or group of related industries. There are no seasonal factors that would have any material adverse effect on the bank's business, and the bank does not rely on foreign sources of funds or income. In an effort to offer a more diversified and competitive product line to better serve our customers and community, in 2003 we discontinued our provision of secondary market-type mortgages through the bank and, through a joint venture with Centex Corporation, formed Four Oaks Mortgage Company, L.P. From 2003 until August 2008, Four Oaks Mortgage Company, L.P. provided secondary market-type mortgages and was the vehicle through which all of our mortgage business was run. Four Oaks Mortgage Company, L.P. was owned 49.99% by our wholly-owned subsidiary, Four Oaks Mortgage Services, L.L.C., and 50.01% by its general partner, CTX Mortgage Ventures, LLC ("CTX"), a wholly-owned indirect subsidiary of Centex Corporation. In August 2008, CTX terminated this partnership. On September 1, 2008, we entered into a six-month marketing agreement with PrimeLending to provide mortgage lending services. Amounts spent on research activities relating to the development or improvement of services has been immaterial over the past two years. At December 31, 2008, the bank employed 208 full time equivalent employees. Our employees are extremely important to our continued success and the bank considers its relationship with its employees to be good. Management continually seeks ways to improve upon their benefits and well being. The following table sets forth certain of our financial data and ratios for the years ended December 31, 2008, 2007 and 2006 derived from our audited financial statements and notes. This information should be read in conjunction with and is qualified in its entirety by reference to the more detailed audited financial statements and notes thereto included in this report: 2008 2007 2006 ------------- ------------- ------------ (In thousands, except ratios) Net income $ 4,231 $ 5,652 $ 7,017 Average equity capital accounts $ 66,066 $ 52,246 $ 45,541 Ratio of net income to average equity capital accounts 6.40% 10.82% 15.41% Average daily total deposits $ 631,809 $ 505,494 $ 435,991 Ratio of net income to average daily total deposits 0.67% 1.12% 1.61% Average daily loans (gross) $ 628,507 $ 494,426 $ 426,768 Ratio of average daily loans to average daily total deposits 99.48% 97.81% 97.88% MERGER WITH LONGLEAF COMMUNITY BANK On April 17, 2008, the Company completed the merger with LongLeaf Community Bank ("LongLeaf"), headquartered in Rockingham, North Carolina. Under the terms of the merger agreement, each share of LongLeaf common stock was converted into the right to receive either (i) $16.50 in cash, without interest, (ii) 1.0 share of the Company's common stock multiplied by an exchange ratio of 1.1542825 or (iii) 0.60 shares of the Company's common stock multiplied by an exchange ratio of 1.1542825 plus an amount equal to $6.60 in cash. As a result of the acquisition, the Company paid $4.9 million in cash and issued 609,770 additional shares of common stock. The acquisition was accounted for using the purchase method of accounting, with the operating results of LongLeaf subsequent to April 17, 2008 included in the Company's financial statements. A summary of the total purchase price of the transaction is as follows: (In thousands) Fair value of common stock issued $ 7,554 Fair value of common stock options issued 390 Cash paid for shares 4,265 Transaction costs paid in cash 606 ---------------- Total purchase price $ 12,815 ================ - 4 - A summary of the fair value of the assets acquired and liabilities assumed is as follows: (In thousands) Cash and due from banks $ 1,690 Interest-earning deposits 1,763 Federal funds sold 4,585 Investment securities available for sale 4,212 Loans, net 47,248 Accrued interest receivable 242 FHLB stock 279 Bank premises and equipment 3,678 Deferred tax assets, net 886 Core deposit intangible 470 Goodwill 6,083 Other assets 139 Deposits (54,514) FHLB Advances (2,586) Accrued interest payable (105) Other liabilities (1,255) ------------------ Net assets acquired $ 12,815 ================== Competition Commercial banking in North Carolina is extremely competitive due in large part to North Carolina's early adoption of statewide branching. As a result, many commercial banks have branches located in several communities. The bank competes in its market area with some of the largest banking organizations in the state and the country and other financial institutions, such as federally and state-chartered savings and loan institutions. At June 2008, we operated branches in Johnston, Wake, Sampson, Duplin, Lee, Harnett, Moore and Richmond counties, North Carolina. At that time in Johnston County, North Carolina, the bank's primary market, there were a total of approximately $1.4 billion in deposits and 41 branches represented by the top twelve financial institutions in the county based on deposit share, all commercial banks. The bank operated seven of the 41 branches with deposits of $420.7 million, placing the bank first in the top twelve based on deposit share. Many of the bank's competitors have broader geographic markets and higher lending limits than those of the bank and are also able to provide more services and make greater use of media advertising. Therefore, in our market area, the bank has significant competition for deposits and loans from other depository institutions. Other financial institutions such as credit unions, as well as consumer finance companies, mortgage companies and other lenders engaged in the business of extending credit with varying degrees of regulatory restrictions also compete in our market area. Additionally, credit unions have been permitted to expand their membership criteria and expand their loan services to include traditional bank services such as commercial lending creating a greater competitive disadvantage to tax-paying financial institutions. The enactment of legislation authorizing interstate banking has caused great increases in the size and financial resources of some of the bank's competitors. See "Holding Company Regulation" below for a description of this legislation. In addition, as a result of interstate banking, out-of-state commercial banks may acquire North Carolina banks and heighten the competition among banks in North Carolina. Although the competition in its market areas is expected to continue to be significant, the bank believes that it has certain competitive advantages that distinguish it from its competition. The bank believes that its primary competitive advantages are its strong local identity, its affiliation with the community and its emphasis on providing specialized services to small and medium-sized business enterprises, as well as professional and upper-income individuals. The bank offers customers modern, high-tech banking without forsaking community values such as prompt, personal service and friendliness. The bank offers many personalized services and attracts and retains customers by being responsive and sensitive to their individualized needs. The bank also relies on goodwill and referrals from our shareholders and the bank's satisfied customers, as well as traditional media, to attract new customers. To enhance a positive image in the community, the bank supports and participates in local events and its officers and directors serve on boards of local civic and charitable organizations. - 5 - Governmental Regulation Holding companies, banks and many of their non-bank affiliates are extensively regulated under both federal and state law. The following is a brief summary of certain statutes, rules and regulations affecting us and the bank. This summary is qualified in its entirety by reference to the particular statutory and regulatory provisions referred to below and are not intended to be an exhaustive description of the statutes or regulations applicable to the business of the Company or bank. Supervision, regulation and examination of the company and the bank by bank regulatory agencies is intended primarily for the protection of the bank's depositors rather than the Company's shareholders. Holding Company Regulation General. Four Oaks Fincorp, Inc. is a holding company registered with the Board of Governors of the Federal Reserve System under the Bank Holding Company Act of 1956 (the "BHCA"). As such, we are subject to the supervision, examination and reporting requirements contained in the BHCA and the regulation of the Federal Reserve. The bank is also subject to the BHCA. The BHCA requires that a bank holding company obtain the prior approval of the Federal Reserve before (i) acquiring direct or indirect ownership or control of more than five percent of the voting shares of any bank, (ii) taking any action that causes a bank to become a subsidiary of the bank holding company, (iii) acquiring all or substantially all of the assets of any bank or (iv) merging or consolidating with any other bank holding company. The BHCA generally prohibits a bank holding company, with certain exceptions, from engaging in activities other than banking, or managing or controlling banks or other permissible subsidiaries, and from acquiring or retaining direct or indirect control of any company engaged in any activities other than those activities determined by the Federal Reserve to be closely related to banking, or managing or controlling banks, as to be a proper incident thereto. In determining whether a particular activity is permissible, the Federal Reserve must consider whether the performance of such an activity can reasonably be expected to produce benefits to the public, such as greater convenience, increased competition or gains in efficiency, that outweigh possible adverse effects, such as undue concentration of resources, decreased or unfair competition, conflicts of interest or unsound banking practices. For example, banking, operating a thrift institution, extending credit or servicing loans, leasing real or personal property, providing securities brokerage services, providing certain data processing services, acting as agent or broker in selling credit life insurance and certain other types of insurance underwriting activities have all been determined by regulations of the Federal Reserve to be permissible activities. Pursuant to delegated authority, the Federal Reserve Bank of Richmond has authority to approve certain activities of holding companies within its district, including us, provided the nature of the activity has been approved by the Federal Reserve. Despite prior approval, the Federal Reserve has the power to order a holding company or its subsidiaries to terminate any activity or to terminate its ownership or control of any subsidiary when it believes that continuation of such activity or such ownership or control constitutes a serious risk to the financial safety, soundness or stability of any bank subsidiary of that bank holding company. Financial Holding Companies. The Gramm-Leach-Bliley Modernization Act of 1999 (the "GLBA"), which was enacted on November 12, 1999, allows bank holding companies that meet certain new regulatory standards regarding management, capital and the Community Reinvestment Act of 1997 (the "CRA"), to engage in a broader range of non-banking activities than previously permissible, including insurance underwriting and making merchant banking investments in commercial and financial companies; allows insurers and other financial services companies to acquire banks; removes various restrictions that applied to bank holding company ownership of securities firms and mutual fund advisory companies; and establishes the overall regulatory structure applicable to bank holding companies that also engage in insurance and securities operations. Effective as of February 23, 2009, we have elected to become a financial holding company, and therefore we are subject to the regulatory framework under the GLBA. In addition to creating the more flexible financial holding company structure, the GLBA introduced several additional customer privacy protections that apply to us and the bank. The GLBA's privacy provisions require financial institutions to, among other things: (i) establish and annually disclose a privacy policy, (ii) give consumers the right to opt out of disclosures to nonaffiliated third parties, with certain exceptions, (iii) refuse to disclose consumer account information to third-party marketers and (iv) follow regulatory standards to protect the security and confidentiality of consumer information. Pursuant to the GLBA's rulemaking provisions, the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation and the Office of Thrift Supervision adopted regulations, establishing standards for safeguarding customer information. Such regulations provide financial institutions guidance in establishing and implementing administrative, technical and physical safeguards to protect the security, confidentiality and integrity of customer information. - 6 - Mergers and Acquisitions. The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the "IBBEA") permits interstate acquisitions of banks and bank holding companies without geographic limitation, subject to any state requirement that the bank has been organized for a minimum period of time, not to exceed five (5) years, and the requirement that the bank holding company, prior to or following the proposed acquisition, controls no more than ten percent (10%) of the total amount of deposits of insured depository institutions in the U.S. and no more than thirty percent (30%) of such deposits in any state (or such lesser or greater amount set by state law). In addition, the IBBEA permits a bank to merge with a bank in another state as long as neither of the states has opted out of the IBBEA prior to May 31, 1997. In 1995, the state of North Carolina "opted in" to such legislation. In addition, a bank may establish and operate a de novo branch in a state in which the bank does not maintain a branch if that state expressly permits de novo interstate branching. As a result of North Carolina having opted-in, unrestricted interstate de novo branching is permitted in North Carolina. Additional Restrictions and Oversight. Subsidiary banks of a bank holding company are subject to certain restrictions imposed by the Federal Reserve on any extensions of credit to the bank holding company or any of its subsidiaries, investments in the stock or securities thereof and the acceptance of such stock or securities as collateral for loans to any borrower. A bank holding company and its subsidiaries are also prevented from engaging in certain tie-in arrangements in connection with any extension of credit, lease or sale of property or furnishing of services. An example of a prohibited tie-in would be any arrangement that would condition the provision or cost of services on a customer obtaining additional services from the bank holding company or any of its other subsidiaries. The Federal Reserve may issue cease and desist orders against bank holding companies and non-bank subsidiaries to stop actions believed to present a serious threat to a subsidiary bank. The Federal Reserve also regulates certain debt obligations, changes in control of bank holding companies and capital requirements. Under the provisions of the North Carolina law, we are registered with and subject to supervision by the North Carolina Commissioner of Banks. Capital Requirements. The Federal Reserve has established risk-based capital guidelines for bank holding companies and state member banks. The minimum standard for the ratio of capital to risk-weighted assets (including certain off balance sheet obligations, such as standby letters of credit) is eight percent (8%). At least half of this capital must consist of common equity, retained earnings and a limited amount of perpetual preferred stock and minority interests in the equity accounts of consolidated subsidiaries, less goodwill items and certain other items ("Tier 1 capital"). The remainder ("Tier 2 capital") may consist of mandatory convertible debt securities and a limited amount of other preferred stock, subordinated debt and loan loss reserves. In addition, the Federal Reserve has established minimum leverage ratio guidelines for bank holding companies. These guidelines provide for a minimum leverage ratio of Tier 1 capital to adjusted average quarterly assets less certain amounts ("Leverage Ratio") equal to three percent for bank holding companies that meet certain specified criteria, including having the highest regulatory rating. All other bank holding companies will generally be required to maintain a Leverage Ratio of between four percent and five percent. The guidelines also provide that bank holding companies experiencing significant growth, whether through internal expansion or acquisitions, will be expected to maintain strong capital ratios well above the minimum supervisory levels without significant reliance on intangible assets. The same heightened requirements apply to bank holding companies with supervisory, financial, operational or managerial weaknesses, as well as to other banking institutions if warranted by particular circumstances or the institution's risk profile. Furthermore, the guidelines indicate that the Federal Reserve will continue to consider a "tangible Tier 1 Leverage Ratio" (deducting all intangibles) in evaluating proposals for expansion or new activity. The Federal Reserve has not advised us of any specific minimum Leverage Ratio or tangible Tier 1 Leverage Ratio applicable to us. As of December 31, 2008, we had Tier 1 risk-adjusted, total regulatory capital and leverage capital of approximately 10.12%, 11.46% and 7.99%, respectively, all in excess of the minimum requirements to be considered well-capitalized under prompt corrective action provisions. Dividends. During 2008, we paid cash dividends of $.325 per share on our common stock, a 12.1% increase over 2007. North Carolina banking law requires that dividends be paid out of retained earnings as determined pursuant to North Carolina General Statues Section 53-87. At present, the Company has sufficient cash from its operations to pay cash dividends on its common stock. In the past, we have received cash dividends from our bank and may continue to do so from time to time in the future as necessary for cash flow purposes. Also, applicable federal banking law contains additional limitations and restrictions on the payment of dividends by a bank holding company. Accordingly, shareholders receive dividends from us only to the extent that funds are available from our operations or the bank. In addition, the Federal Reserve generally prohibits bank holding companies from paying dividends except out of operating earnings, and the prospective rate of earnings retention appears consistent with the bank holding company's capital needs, asset quality and overall financial condition. - 7 - USA Patriot Act of 2001. Title III of the USA Patriot Act of 2001 contains the International Money Laundering Abatement and Financial Anti-Terrorism Act of 2001 (the "IMLAFA"). The anti-money laundering provisions of IMLAFA impose affirmative obligations on a broad range of financial institutions, including banks, brokers, and dealers. Among other requirements, IMLAFA requires all financial institutions to establish anti-money laundering programs that include, at minimum, internal policies, procedures, and controls; specific designation of an anti-money laundering compliance officer; ongoing employee training programs; and an independent audit function to test the anti-money laundering program. IMLAFA requires financial institutions that establish, maintain, administer, or manage private banking accounts for non-United States persons or their representatives to establish appropriate, specific, and, where necessary, enhanced due diligence policies, procedures, and controls designed to detect and report money laundering. Additionally, IMLAFA provides for the Department of Treasury to issue minimum standards with respect to customer identification at the time new accounts are opened. As of the date of this filing, we believe that IMLAFA has not had a material impact on the bank's operations. The bank has established policies and procedures to ensure compliance with the IMLAFA, which are overseen by an Anti-Money Laundering Officer who was appointed by our Board of Directors. Bank Regulation The bank is subject to numerous state and federal statutes and regulations that affect its business, activities, and operations, and is supervised and examined by the North Carolina Commissioner of Banks and the Federal Reserve. The Federal Reserve and the North Carolina Commissioner of Banks regularly examine the operations of banks over which they exercise jurisdiction. They have the authority to approve or disapprove the establishment of branches, mergers, consolidations, and other similar corporate actions, and to prevent the continuance or development of unsafe or unsound banking practices and other violations of law. The Federal Reserve and the North Carolina Commissioner of Banks regulate and monitor all areas of the operations of banks and their subsidiaries, including loans, mortgages, issuances of securities, capital adequacy, loss reserves, and compliance with the CRA, as well as other laws and regulations. Interest and certain other charges collected and contracted for by banks are also subject to state usury laws and certain federal laws concerning interest rates. The deposit accounts of the bank are insured by the Deposit Insurance Fund (the "DIF") of the Federal Deposit Insurance Corporation (the "FDIC") up to a maximum of two hundred fifty thousand dollars ($250,000) per insured depositor, with the exception of non-interest bearing accounts and NOW accounts paying .5% or less, which are 100% FDIC insured. These increased insurance limits are in effect through December 31, 2009. Any insured bank that is not operated in accordance with or does not conform to FDIC regulations, policies, and directives may be sanctioned for noncompliance. Civil and criminal proceedings may be instituted against any insured bank or any director, officer or employee of such bank for the violation of applicable laws and regulations, breaches of fiduciary duties or engaging in any unsafe or unsound practice. The FDIC has the authority to terminate insurance of accounts pursuant to procedures established for that purpose. Under the North Carolina Business Corporation Act, we may not pay a dividend or distribution, if after giving it effect we would not be able to pay our debts as they become due in the usual course of business or our total assets would be less than our liabilities. All dividends paid by the bank are paid to us, the sole shareholder of the bank. In general, our ability to pay cash dividends is dependent in part upon the amount of dividends paid to us by the bank. The ability of the bank to pay dividends to us is subject to statutory and regulatory restrictions on the payment of cash dividends, including the requirement under the North Carolina banking laws that cash dividends be paid only out of undivided profits and only if the bank has surplus of a specified level. The Federal Reserve also imposes limits on the bank's payment of dividends. The amount of future dividends paid to us by the bank will in general be a function of the profitability of the bank, which cannot be accurately estimated or assured. We expect the bank will continue to pay us dividends in the foreseeable future from time to time as needed to pay cash dividends to our shareholders. Like us, the bank is required by federal regulations to maintain certain minimum capital levels. The levels required of the bank are the same as those required of us. At December 31, 2008, the bank had Tier 1 risk-adjusted, total regulatory capital and leverage capital of approximately 9.44%, 10.69% and 7.43%, respectively, in excess of the minimum requirements to be considered well-capitalized under prompt corrective action provisions. - 8 - The bank is subject to insurance assessments imposed by the FDIC, including a risk-based assessment schedule providing for annual assessment rates ranging from 5 to 43 cents per $100 in assessable deposits, applicable to institutions insured by the DIF. The FDIC may change the assessment schedule quarterly. The actual assessment to be paid by each insured institution is based on the institution's assessment risk classification, which focuses on whether the institution is considered "well capitalized," "adequately capitalized" or "under capitalized," as such terms are defined in the applicable federal regulations. Within each of these three risk classifications, each institution will be assigned to one of three subgroups based on supervisory risk factors. In particular, regulators will assess supervisory risk based on whether the institution is financially sound with only a few minor weaknesses (Subgroup A), whether it has weaknesses which, if not corrected, could result in an increased risk of loss to the DIF (Subgroup B) or whether such weaknesses pose a substantial probability of loss to the DIF unless effective corrective action is taken (Subgroup C). The FDIC also is authorized to impose one or more special assessments in an amount deemed necessary to enable repayment of amounts borrowed by the FDIC from the United States Treasury Department and, beginning in 1997, all banks are required to pay additional annual assessments as set by the Financing Corporation, which was established by the Competitive Equality Banking Act of 1987. The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") provides for, among other things, (i) publicly available annual financial condition and management reports for certain financial institutions, including audits by independent accountants, (ii) the establishment of uniform accounting standards by federal banking agencies, (iii) the establishment of a "prompt corrective action" system of regulatory supervision and intervention, based on capitalization levels, with greater scrutiny and restrictions placed on depository institutions with lower levels of capital, (iv) additional grounds for the appointment of a conservator or receiver and (v) restrictions or prohibitions on accepting brokered deposits, except for institutions which significantly exceed minimum capital requirements. FDICIA also provides for increased funding of the FDIC insurance funds and the implementation of risk-based premiums. A central feature of FDICIA is the requirement that the federal banking agencies take "prompt corrective action" with respect to depository institutions that do not meet minimum capital requirements. Pursuant to FDICIA, the federal bank regulatory authorities have adopted regulations setting forth a five-tiered system for measuring the capital adequacy of the depository institutions that they supervise. Under these regulations, a depository institution is classified in one of the following capital categories: "well capitalized," "adequately capitalized," "under capitalized," "significantly undercapitalized," or "critically undercapitalized." An institution may be deemed by the regulators to be in a capitalization category that is lower than is indicated by its actual capital position if, among other things, it receives an unsatisfactory examination rating with respect to asset quality, management, earnings or liquidity. FDICIA provides the federal banking agencies with significantly expanded powers to take enforcement action against institutions which fail to comply with capital or other standards. Such action may include the termination of deposit insurance by the FDIC or the appointment of a receiver or conservator for the institution. Banks are also subject to the CRA, which requires the appropriate federal bank regulatory agency, in connection with its examination of a bank, to assess such bank's record in meeting the credit needs of the community served by that bank, including low and moderate-income neighborhoods. Each institution is assigned one of the following four ratings of its record in meeting community credit needs: "outstanding," "satisfactory," "needs to improve" or "substantial noncompliance." The regulatory agency's assessment of the bank's record is made available to the public. Further, such assessment is required of any bank which has applied to (i) charter a national bank, (ii) obtain deposit insurance coverage for a newly chartered institution, (iii) establish a new branch office that will accept deposits, (iv) relocate an office or (v) merge or consolidate with, or acquire the assets or assume the liabilities of, a federally regulated financial institution. In the case of a bank holding company applying for approval to acquire a bank or other bank holding company, the Federal Reserve will assess the record of each subsidiary bank of the applicant bank holding company, and such records may be the basis for denying the application. In addition, the GLBA's "CRA Sunshine Requirements" call for financial institutions to disclose publicly certain written agreements made in fulfillment of the CRA. Banks that are parties to such agreements also must report to federal regulators the amount and use of any funds expended under such agreements on an annual basis, along with such other information as regulators may require. This annual reporting requirement is effective for any agreements made after May 12, 2000. - 9 - Monetary Policy and Economic Controls Both the Company and the bank are directly affected by governmental policies and regulatory measures affecting the banking industry in general. Of primary importance is the Federal Reserve Board, whose actions directly affect the money supply which, in turn, affects banks' lending abilities by increasing or decreasing the cost and availability of funds to banks. The Federal Reserve Board regulates the availability of bank credit in order to combat recession and curb inflationary pressures in the economy by open market operations in United States government securities, changes in the discount rate on member bank borrowings, changes in reserve requirements against bank deposits, and limitations on interest rates that banks may pay on time and savings deposits. Deregulation of interest rates paid by banks on deposits and the types of deposits that may be offered by banks have eliminated minimum balance requirements and rate ceilings on various types of time deposit accounts. The effect of these specific actions and, in general, the deregulation of deposit interest rates has generally increased banks' cost of funds and made them more sensitive to fluctuations in money market rates. In view of the changing conditions in the national economy and money markets, as well as the effect of actions by monetary and fiscal authorities, no prediction can be made as to possible future changes in interest rates, deposit levels, or loan demand on our business and earnings or those of the bank. As a result, banks, including the bank, face a significant challenge to maintain acceptable net interest margins. (the rest of this page left intentionally blank) - 10 - Executive Officers of the Registrant The following table sets forth certain information with respect to our executive officers: Positions and offices with Four Oaks Fincorp, Inc. Year first and Four Oaks Bank & Trust Company and Name Age employed business experience during past five (5) years - -------------------------------------------------------------------------------------------------------- Ayden R. Lee, Jr. 60 1980 Chief Executive Officer, President and Chairman of the Board of Directors of Four Oaks Fincorp, Inc. and Four Oaks Bank & Trust Company. Previously Director of Four Oaks Fincorp, Inc. and Four Oaks Bank & Trust Company. Clifton L. Painter 59 1986 Senior Executive Vice President, Chief Operating Officer of Four Oaks Fincorp, Inc. and Four Oaks Bank & Trust Company. Nancy S. Wise 53 1991 Executive Vice President, Chief Financial Officer of Four Oaks Fincorp, Inc. and Four Oaks Bank & Trust Company. Previously, Senior Vice President, Chief Financial Officer of Four Oaks Fincorp, Inc. and Four Oaks Bank & Trust Company. W. Leon Hiatt, III 41 1994 Executive Vice President of Four Oaks Fincorp, Inc. and Four Oaks Bank & Trust Company, Chief Administrative Officer of Four Oaks Bank & Trust Company. Previously, Senior Vice President Four Oaks Fincorp, Inc. and Four Oaks Bank & Trust Company, Loan Administrator of Four Oaks Bank & Trust Company. Jeff D. Pope 52 1991 Executive Vice President of Four Oaks Fincorp, Inc. and Four Oaks Bank & Trust Company, Chief Banking Officer of Four Oaks Bank & Trust Company. Previously, Branch Administrator, Senior Vice President, Loan Officer and Regional Branch Administrator of Four Oaks Bank and Trust Company. - 11 - Item 1A. Risk Factors Our Results Are Impacted by the Economic Conditions of Our Principal Operating Regions The majority of our customers are individuals and small to medium-size businesses located in North Carolina's Johnston, Wake, Duplin, Sampson, Harnett, Lee, Moore and Richmond counties and surrounding areas. As a result of this geographic concentration, our results may correlate to the economic conditions in these areas. Declines in these markets' economic conditions may adversely affect the quality of our loan portfolio and the demand for our products and services, and accordingly, our results of operations. We Are Exposed to Risks in Connection with the Loans We Make A significant source of risk for us arises from the possibility that loan losses will be sustained because borrowers, guarantors, and related parties fail to perform in accordance with the terms of their loans. Our policy dictates that we maintain an allowance for loan losses. The amount of the allowance is based on management's evaluation of our loan portfolio, the financial condition of the borrowers, current economic conditions, past and expected loan loss experience, and other factors management deems appropriate. Such policies and procedures, however, may not prevent unexpected losses that could adversely affect our results of operations. If the value of real estate in our core market areas were to decline materially, a significant portion of our loan portfolio could become undercollateralized, which could have a material adverse effect on us. With most of our loans concentrated in the Coastal Plain region of North Carolina, a decline in local economic conditions could adversely affect the values of our real estate collateral. Consequently, a decline in local economic conditions may have a greater effect on our earnings and capital than on the earnings and capital of larger financial institutions whose real estate loan portfolios are geographically diverse. In addition to the financial strength and cash flow characteristics of the borrower in each case, the Bank often secures loans with real estate collateral. At December 31, 2008, approximately 88% of the Bank's loans had real estate as a primary or secondary component of collateral. The real estate collateral in each case provides an alternate source of repayment in the event of default by the borrower and may deteriorate in value during the time the credit is extended. If we are required to liquidate the collateral securing a loan to satisfy the debt during a period of reduced real estate values, our earnings and capital could be adversely affected. We Compete with Larger Companies for Business Commercial banking in North Carolina is extremely competitive due in large part to North Carolina's early adoption of statewide branching. The bank competes in the North Carolina market area with some of the largest banking organizations in the state and the country and other financial institutions, such as federally and state-chartered savings and loan institutions and credit unions, as well as consumer finance companies, mortgage companies and other lenders engaged in the business of extending credit. Many of these competitors have broader geographic markets, higher lending limits, more services, and more media advertising. We may not be able to compete effectively in our markets, and our results of operations could be adversely affected by the nature or pace of change in competition. We Are Exposed to Certain Market Risks Like most financial institutions, our most significant market risk exposure is the risk of economic loss resulting from adverse changes in market prices and interest rates. Our market risk stems primarily from interest rate risk inherent in our lending and deposit-taking activities. Our policy allows that we may maintain derivative financial instruments, such as interest rate swap agreements, to manage such risk. To manage the risk of potentially decreasing interest rates for our variable rate loan portfolio, from time to time we may use an interest rate swap agreement whereby we contract to receive fixed rate payments and in turn, we agree to make variable interest payments for a defined time period. In addition, we use fixed rate time deposits, such as certificates of deposit, for use in our lending and investment activities. If the interest rates decline, we face the risk of being committed to pay a fixed rate that is higher than the fair value rate of such deposits. To manage this risk, we may use interest rate swaps whereby we contract to make a series of floating rate payments in exchange for receiving a series of fixed rate payments. Because the value of derivative contracts is tied to an independent instrument, index or reference rate, the contracts are written in abstract amounts that only provide the basis for calculating payments between counterparties, i.e., notional amounts. Credit risk arises when amounts receivable from the counterparty exceed amounts payable, or when the counterparty fails to pay. The counterparties to these contracts are primarily large commercial banks and investment banks. We control our risk of loss on derivative contracts by subjecting each contracting counterparty to credit reviews and approvals similar to those used in making loans and other extensions of credit, and we continuously monitor these agreements. Other risks include the effect on fixed rate positions during periods of changing interest rates, e.g., when interest rates fall, the notional amounts decrease more rapidly, whereas when interest rates rise, the notional amounts decrease more slowly. - 12 - U.S. and International Credit Markets and Economic Conditions Could Affect the Company's Liquidity and Financial Condition As described in Part I, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations--Impact of Recent Developments on the Banking Industry," global market and economic conditions continue to be disruptive and volatile and the disruption has particularly had a negative impact on the financial sector. The possible duration and severity of this adverse economic cycle is unknown. Although the Company remains well-capitalized and has not suffered any liquidity issues as a result of these recent events, the cost and availability of funds may be adversely affected by illiquid credit markets. Continued turbulence in U.S. and international markets and economies may adversely affect the Company's liquidity, financial condition, and profitability. While the U.S. and foreign governments have instituted programs to address economic stabilization, the efficacy of these programs in stabilizing the economy and the banking system at large are uncertain. Details as to the Company's ultimate participation in the U.S. Treasury's Capital Purchase Program and its subsequent impact on the Company also remain uncertain. Although the final terms of the program have not been decided, the U.S. Treasury's program could reduce investment returns to participating banks' shareholders by restricting dividends to common shareholders, diluting existing shareholders interests and restricting capital management practices. In addition, federal and state governments could pass additional legislation responsive to current credit conditions. The Company could experience higher credit losses because of legislation or regulatory action that reduces the amounts borrowers are contractually required to pay under existing loan contracts or that limits its ability to foreclose on property or other collateral or makes foreclosure less economically feasible. Technological Advances The banking industry undergoes frequent technological changes with introductions of new technology-driven products and services. In addition to improving customer services, the effective use of technology increases efficiency and enables financial institutions to reduce costs. Our future success will depend, in part, on our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands for convenience as well as to create additional efficiencies in our operations. Many of our competitors, however, have substantially greater resources to invest in technological improvements. Compliance with Changing Laws, Regulations and Standards May Result in Additional Risks and Expenses We are subject to changing laws, regulations and standards, including the BHCA, the GLBA, the IBBEA, the USA Patriot Act of 2001, the FDIC, the CRA, the North Carolina Business Corporation Act, the Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley"), and new SEC regulations to name a few. Sarbanes-Oxley and new SEC regulations, in particular, are creating uncertainty for companies such as ours because they are subject to varying interpretations in many cases. As a result, their application in practice may evolve over time as new guidance is provided by regulatory and governing bodies, which could result in continuing uncertainty regarding compliance matters and higher costs necessitated by ongoing revisions to disclosure and governance practices. We are committed to maintaining high standards of corporate governance and public disclosure. As a result, our efforts to comply with evolving laws, regulations, and standards have resulted in, and are likely to continue to result in, increased expenses and a diversion of management time and attention. Specifically, our efforts to comply with Section 404 of Sarbanes-Oxley and the related regulations regarding management's required assessment of our internal control over financial reporting and our external auditors' audit of that assessment have required the commitment of significant financial and managerial resources. We expect these efforts to require the continued commitment of significant resources. Further, the members of our board of directors, members of the audit or compensation committees, our chief executive officer, our chief financial officer, and certain other of our executive officers could face an increased risk of personal liability in connection with the performance of their duties. In addition, it may become more difficult and more expensive to obtain director and officer liability insurance. As a result, our ability to attract and retain executive officers and qualified board and committee members could be more difficult. - 13 - Government Regulations May Prevent or Impair Our Ability to Pay Dividends, Engage in Acquisitions or Operate in Other Ways Current and future legislation and the policies established by federal and state regulatory authorities will affect our operations. We are subject to supervision and a periodic examination by the Federal Reserve Bank and the North Carolina State Banking Commission. Banking regulations, designed primarily for the protection of depositors, may limit our growth and the return to you, our investors, by restricting certain of our activities, such as: o payment of dividends to our shareholders; o possible mergers with or acquisitions of or by other institutions; o our desired investments; o loans and interest rates on loans; o payment of interest, interest rates on deposits; o the possible expansion of branch offices; and/or o our ability to make other financial services available. We also are subject to capitalization guidelines set forth in federal regulations, and could be subject to enforcement actions to the extent that we are found by regulatory examiners to be undercapitalized. We cannot predict what changes, if any, will be made to existing federal and state legislation and regulations or the effect that such changes may have on our future business and earnings prospects. The cost of compliance with regulatory requirements including those imposed by the SEC may adversely affect our ability to operate profitably. We Depend Heavily on our Key Management Personnel Our success depends in part on our ability to retain key executives and to attract and retain additional qualified management personnel who have experience both in sophisticated banking matters and in operating a small to mid-size bank. Competition for such personnel is strong in the banking industry and we may not be successful in attracting or retaining the personnel we require. We expect to compete effectively in this area by offering competitive financial packages that include incentive-based compensation. We Have a High Concentration of Loans Secured by Real Estate A significant portion of our loan portfolio is dependent on real estate. In addition to the financial strength and cash flow characteristics of the borrower in each case, often loans are secured with real estate collateral. At December 31, 2008, approximately 88.2% of our loans have real estate as a primary or secondary component of collateral. The real estate in each case provides an alternate source of repayment in the event of default by the borrower and may deteriorate in value during the time the credit is extended. An adverse change in the economy affecting values of real estate generally or in our primary markets specifically could significantly impair the value of collateral and our ability to sell the collateral upon foreclosure. Furthermore, it is likely that, in a decreasing real estate market, we would be required to increase our allowance for loan losses. If we are required to liquidate the collateral securing a loan to satisfy the debt during a period of reduced real estate values or to increase our allowance for loan losses, our profitability and financial condition could be adversely impacted. Our Allowance for Probable Loan Losses May Be Insufficient We maintain an allowance for probable loan losses, which is a reserve established through a provision for probable loan losses charged to expense. This allowance represents management's best estimate of probable losses that have been incurred within the existing portfolio of loans. The allowance, in the judgment of management, is necessary to reserve for estimated loan losses and risks inherent in the loan portfolio. The level of the allowance reflects management's continuing evaluation of industry concentrations; specific credit risks; loan loss experience; current loan portfolio quality; present economic, political, and regulatory conditions and unidentified losses inherent in the current loan portfolio. The determination of the appropriate level of the allowance for probable loan losses inherently involves a high degree of subjectivity and requires us to make significant estimates and assumptions regarding current credit risks and future trends, all of which may undergo material changes. Changes in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside our control, may require an increase in the allowance for probable loan losses. In addition, bank regulatory agencies periodically review our allowance for loan losses and may require an increase in the provision for probable loan losses or the recognition of further loan charge-offs, based on judgments different than those of management. In addition, if charge-offs in future periods exceed the allowance for probable loan losses; we will need additional provisions to increase the allowance for probable loan losses. Any increases in the allowance for probable loan losses will result in a decrease in net income and, possibly, capital, and may have a material adverse effect on our financial condition and results of operations. See Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations for further discussion related to our process for determining the appropriate level of the allowance for probable loan losses. - 14 - We May Experience Goodwill Impairment In light of the overall instability of the economy, the continued volatility in the financial markets, the downward pressure on bank stock prices, and expectations of financial performance for the banking industry, including the Company, our estimates of goodwill fair value may be subject to change or adjustment and we may determine that additional impairment charges are necessary. No assurance can be given that goodwill will not be written down in future periods. We Are Subject To Environmental Liability Risk Associated With Lending Activities A significant portion of our loan portfolio is secured by real property. During the ordinary course of business, we may foreclose on and take title to properties securing certain loans. In doing so, there is a risk that hazardous or toxic substances could be found on these properties. If hazardous or toxic substances are found, we may be liable for remediation costs, as well as for personal injury and property damage. Environmental laws may require us to incur substantial expenses and may materially reduce the affected property's value or limit our ability to use or sell the affected property. In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase our exposure to environmental liability. Although we have policies and procedures to perform an environmental review before initiating any foreclosure action on nonresidential real property, these reviews may not be sufficient to detect all potential environmental hazards. The remediation costs and any other financial liabilities associated with an environmental hazard could have a material adverse effect on our financial condition and results of operations. Our Controls and Procedures May Fail or Be Circumvented Management regularly reviews and updates our internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of our controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on our business, results of operations and financial condition. The Holders of Our Subordinated Debentures Have Rights That Are Senior to Those of Our Shareholders As described below, we have issued $12.0 million of subordinated debentures in connection with a trust preferred securities issuance by our subsidiary, the Trust. We unconditionally guarantee payments of the principal and interest on the trust preferred securities. Our subordinated debentures are senior to our shares of common stock. As a result, we must make payments on the subordinated debentures (and the related trust preferred securities) before any dividends can be paid on our common stock and, in the event of bankruptcy, dissolution or liquidation, the holders of the debentures must be satisfied before any distributions can be made to the holders of common stock. Our Information Systems May Experience an Interruption or Breach in Security We rely heavily on communications and information systems to conduct our business. Any failure, interruption, or breach in security of these systems could result in failures or disruptions in our customer relationship management, general ledger, deposit, loan, and other systems. While we have policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of our information systems, there can be no assurance that we can prevent any such failures, interruptions or security breaches or, if they do occur, that they will be adequately addressed. The occurrence of any failures, interruptions, or security breaches of our information systems could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our financial condition and results of operations. - 15 - An Investment in Our Common Stock Is Not an Insured Deposit Our common stock is not a bank deposit and, therefore, is not insured against loss by the FDIC, any other deposit insurance fund or by any other public or private entity. Investment in our common stock is inherently risky for the reasons described in this "Risk Factors" section and elsewhere in this report and is subject to the same market forces that affect the price of common stock in any company. As a result, if you acquire our common stock, you may lose some or all of your investment. Consumers May Decide Not To Use Banks to Complete Their Financial Transactions Technology and other changes are allowing parties to complete financial transactions that historically have involved banks through alternative methods. For example, consumers can now maintain funds that historically would have been held as bank deposits in brokerage accounts or mutual funds. Consumers can also complete transactions such as paying bills and/or transferring funds directly without the assistance of banks. The process of eliminating banks as intermediaries could result in the loss of fee income, as well as the loss of customer deposits and the related income generated from those deposits. The loss of these revenue streams and the lower cost deposits as a source of funds could have a material adverse effect on our financial condition and results of operations. Item 1B - Unresolved Staff Comments. Not applicable. Item 2 - Properties. The bank owns its main office, which is located at 6144 US 301 South, Four Oaks, North Carolina. The main office, which was constructed by the bank in 1985, is a 12,000 square foot facility on 1.64 acres of land. The bank leases a limited-service facility in downtown Four Oaks located at 111 North Main Street from M.S. Canaday, who is a former director of the company as well as a former director of the bank. Under the terms of the lease, which the bank believes to be arms-length, the bank paid $1,036 per month in rent in 2008. The lease is month-to-month and we review its terms on an annual basis. The bank also leases a branch office located at 101 West Center Street, Holly Springs, North Carolina. Under the terms of the lease, the bank will pay $2,575 per month for a period of five years ending April 1, 2009, with a 3% increase per year for the next 5 years until March 31, 2013. The bank's Harrells office located at 590 Tomahawk Highway, Harrells, North Carolina is under a lease with terms specifying the bank will pay $600 each month for a period of four years ending December 31, 2009. In addition, the bank has entered into a ten-year lease on its Sanford office located at 830 Spring Lane Sanford, North Carolina. Under the terms of the lease, the bank will pay $7,600 each month with an annual rate increase not to exceed 2.5% over a 10 year period. On September 17, 2007, the bank entered into a two year lease on its Dunn office located at 604-A Erwin Road, Dunn, North Carolina. Under the terms of the lease, the bank will pay $1,500 each month for the period beginning September 17, 2007 and ending August 31, 2009. In addition, the bank has leased additional space for its Dunn location for a one year term beginning September 8, 2008 at $400 per month. On February 25, 2008, the bank entered into a five year lease on its Garner Village office, located at 504-574 Village Court, Garner, North Carolina. Under the terms of the lease, the bank will pay $3,000 each month with an annual rate increase not to exceed 3% over a 5 year period. The bank owns a 5,000 square foot facility renovated in 1992 on 1.15 acres of land located at 5987 US 301 South, Four Oaks, North Carolina which houses its training center. The bank also owns a 15,000 square foot facility built in 2000 located at 6114 US 301 South, Four Oaks, North Carolina, which houses its administrative offices, data operations, loan operations, and wide area network central link. In addition, the bank owns the following: - 16 - Location Year Built Present Function Square Feet - -------- ---------- ---------------- ----------- 102 East Main Street Clayton, North Carolina 1986 Branch Office 4,900 200 East Church Street Benson, North Carolina 1987 Branch Office 2,300 128 North Second Street Smithfield, North Carolina 1991 Branch Office 5,500 403 South Brightleaf Boulevard Limited-Service Smithfield, North Carolina 1995 Facility 860 200 Glen Road Garner, North Carolina 1996 Branch Office 3,500 325 North Judd Parkway Northeast Fuquay-Varina, North Carolina 2002 Branch Office 8,900 406 East Main Street Wallace, North Carolina 2006 Branch Office 9,300 805 N. Arendell Avenue Zebulon, North Carolina 2007 Branch Office 6,100 1401 Fayetteville Road Rockingham, North Carolina 2005 Branch Office 10,200 105 Commerce Avenue Southern Pines, North Carolina 2005 Branch Office 4,100 On September 1, 2008, the bank leased three offices of its Fuquay-Varina branch office to PrimeLending under a six-month lease. Under the terms of the lease, the bank receives $1,000 per month in rent from PrimeLending. Management believes each of the properties referenced above is adequately covered by insurance. In addition to the above locations, we have one ATM located inside Blackmon's Country store in Four Oaks and 15 ATMs in Food Lion grocery stores in the cities and towns of Clayton, Benson, Sanford, Wallace, Fuquay-Varina, Holly Springs, Garner, Zebulon, and Wendell, North Carolina. The net book value for our properties, including land, buildings, and furniture and equipment was $17.2 million at December 31, 2008. Additional information is disclosed in Note D "Bank Premises and Equipment" to our consolidated financial statements presented under Item 8 of Part II of this Form 10-K. Item 3 - Legal Proceedings. We are not involved in any material legal proceedings at the present time. - 17 - Item 4 - Submission of Matters to a Vote of Security Holders. A Special Meeting of Shareholders was held on Monday, December 22, 2008. The following matters were submitted to a vote of the shareholders with the results shown below: (a) Approval of amendment to the Articles of Incorporation to authorize 50,000 shares of preferred stock, no par value per share, which may be issued by the Company in the future with such rights, preferences and designations as determined by our board of directors without further shareholder action Votes For Votes Against Abstained - ----------------------- ------------------------- ----------------------- 4,171,852 411,411 14,189 (b) Approval of proposal to adjourn, postpone or continue the Special Meeting in order to enable our board of directors to continue to solicit additional proxies in favor of the proposal to amend our articles of incorporation Votes For Votes Against Abstained - ----------------------- ------------------------- ----------------------- 4,147,470 330,948 119,494 The matters listed above are described in detail in our definitive proxy statement dated December 4, 2008 for the Special Meeting of Shareholders held on December 22, 2008. (the rest of this page intentionally blank) - 18 - PART II Item 5 - Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities. Our common stock trades on the OTC Bulletin Board under the symbol "FOFN." The range of high and low bid prices of our common stock for each quarter during the two most recent fiscal years, as published by the OTC Bulletin Board, adjusted for stock splits, is as follows (prices reflect inter-dealer prices, without retail mark-up, mark-down or commissions and may not necessarily represent actual transactions): Fiscal Year Ended December 31, ------------------------------ 2007 2008 ------------------- ---------------------- High Low High Low --------- --------- ------------ --------- First quarter $ 24.77 $ 23.64 $ 17.00 $ 14.75 Second quarter 23.64 20.00 16.25 11.00 Third quarter 20.00 18.82 14.50 10.50 Fourth quarter 19.09 15.50 11.00 6.50 As of March 5, 2009, the approximate number of holders of record of our common stock was 2,100. We have no other class of equity securities. The bank's ability to declare a dividend to us and the company's ability to pay dividends are subject to the restrictions of the North Carolina Business Corporation Act. There also are state banking laws that require a surplus of at least 50% of paid-in capital stock be maintained in order for the bank to declare a dividend to the company. Subject to the legal availability of funds to pay dividends, cash dividends paid by us in 2008 and 2007, after giving effect to the 10% stock dividend in 2007 were $0.325 and $0.29 per share, respectively. We did not sell any securities in 2008 that were not registered under the Securities Act of 1933 as amended. During 2008, we repurchased 6,020 shares of our equity securities registered pursuant to Section 12 of the Securities Exchange Act of 1934, as amended. We made no purchases on behalf of the Company or any "affiliated purchaser" (as defined in Rule 10b-18(a)(3) under the Exchange Act) of the Company's common stock during the three months ended December 31, 2008. Item 6 - Selected Financial Data The following table sets forth certain historical consolidated financial data for the periods indicated. The selected historical annual consolidated statement of operations and balance sheet data as of each of the fiscal years ended December 31, 2008 and 2007 and are derived from, and are qualified in their entirety by, our audited consolidated financial statements included elsewhere in this report. The selected historical annual consolidated statement of operations data for each of the years ended December 31, 2006, 2005 and 2004 and balance sheet data as of each of the years ended December 31, 2006, 2005 and 2004 are derived from audited consolidated financial statements not included herein. Historical results are not necessarily indicative of the results to be expected in the future. You should read the following data together with "Item 1. Business," "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations," and our audited consolidated financial statements and the related notes appearing in "Item 8. Financial Statements." (dollars in thousands, except per share data). - 19 - As of and for the Year Ended December 31, --------------------------------------------------------- 2008 2007 2006 2005 2004 ---------- ---------- ---------- ------------ ----------- Operating Data: Total interest income $ 49,041 $ 47,513 $ 40,556 $ 29,404 $ 21,748 Total interest expense 23,363 23,699 17,817 9,983 5,811 ---------- ---------- ---------- ------------ ---------- Net interest income 25,678 23,814 22,739 19,421 15,937 Provision for loan losses 3,336 1,362 873 1,403 1,596 ---------- ---------- ---------- ------------ ---------- Net interest income after provision 22,342 22,452 21,866 18,018 14,341 Noninterest income 5,530 4,071 4,337 3,077 3,849 Noninterest expense 21,992 17,684 15,559 13,354 11,507 ---------- ---------- ---------- ------------ ---------- Income before income taxes 5,880 8,839 10,644 7,741 6,683 Provision for income taxes 1,649 3,187 3,627 2,738 2,308 ---------- ---------- ---------- ------------ ---------- Net income $ 4,231 $ 5,652 $ 7,017 $ 5,003 $ 4,375 ========== ========== ========== ============ =========== Per Share Data: (Note A) Earnings per share - basic $ 0.65 $ 0.92 $ 1.15 $ 0.84 $ 0.75 Earnings per share - diluted 0.65 0.91 1.14 0.83 0.75 Cash dividends declared 0.33 0.29 0.24 0.22 0.19 Market price High 17.00 24.77 28.00 25.00 20.00 Low 6.50 15.50 17.40 17.60 13.44 Close 6.90 15.75 26.75 22.61 17.60 Book value 9.63 8.86 8.04 6.91 6.31 Weighted average shares outstanding Basic 6,554,450 6,170,140 6,080,778 5,972,073 5,839,186 Diluted 6,556,767 6,192,559 6,137,222 6,016,319 5,872,418 Selected Year-End Balance Sheet Data: Total assets $ 924,783 $ 708,303 $ 608,137 $ 522,872 $ 398,500 Loans 681,500 545,270 461,763 397,094 312,815 Allowance for loan losses 9,542 6,653 5,566 4,965 4,055 Deposits 722,694 537,763 466,868 398,341 315,307 Short-term borrowings 114,314 97,000 73,400 74,140 43,160 Subordinated Debentures 12,372 12,372 12,372 - - Shareholders' equity 66,650 54,630 49,323 41,612 37,295 Selected Average Balances: Total assets $ 832,979 $ 655,157 $ 560,689 $ 449,462 $ 376,422 Loans 628,507 494,426 426,768 351,103 298,783 Total interest-earning assets 782,435 619,340 528,056 419,307 349,596 Deposits 631,809 505,494 435,991 355,214 295,524 Total interest-bearing liabilities 683,619 521,957 435,131 340,798 282,743 Shareholders' Equity 66,066 52,246 45,541 39,613 35,135 - 20 - As of and for the Year Ended December 31, --------------------------------------------------------- 2008 2007 2006 2005 2004 ---------- ---------- ---------- ------------ ----------- Selected Performance Ratios: Return on average assets 0.51% 0.86% 1.25% 1.11% 1.16% Return on average equity 6.40% 10.82% 15.41% 12.63% 12.45% Net interest spread 2.85% 3.13% 3.59% 4.08% 4.16% Net interest margin (yield) 3.28% 3.84% 4.31% 4.63% 4.56% Net Income to average daily deposits 0.67% 1.12% 1.61% 1.41% 1.48% Noninterest income to total revenue 10.13% 7.89% 9.66% 9.47% 15.04% Noninterest income to average assets 0.66% 0.62% 0.77% 0.68% 1.02% Noninterest expense to average assets 2.64% 2.70% 2.77% 2.97% 3.06% Efficiency ratio 71.90% 63.49% 57.43% 58.51% 58.58% Dividend payout ratio 50.35% 31.66% 20.80% 26.26% 25.36% Asset Quality Ratios: Nonperforming loans to period-end loans 3.05% 0.23% 0.18% 0.25% 0.30% Allowance for loan losses to period-end loans 1.40% 1.22% 1.21% 1.25% 1.30% Allowance for loan losses to nonperforming loans 45.86% 530.54% 663.41% 497.99% 429.56% Nonperforming assets to total assets 2.49% 0.42% 0.20% 0.25% 0.39% Net loan charge-offs to average loans 0.29% 0.06% 0.06% 0.14% 0.32% Capital Ratios: Total risk-based capital - Bank 10.69% 11.88% 12.79% 10.40% 11.80% Tier 1 risk-based capital - Bank 9.44% 10.71% 11.63% 9.19% 10.60% Leverage ratio - Bank 7.43% 8.85% 9.31% 7.66% 8.60% Equity to assets ratio 7.21% 7.71% 8.11% 7.96% 9.36% Equity to assets ratio (averages) 7.93% 7.97% 8.12% 8.81% 9.33% Average interest earning assets to average total assets 93.93% 94.53% 94.18% 93.29% 92.87% Average loans to average total deposits 99.48% 97.81% 97.88% 98.84% 101.10% Average interest bearing liabilities to average interest earning assets 87.37% 84.28% 82.40% 81.28% 80.88% Other Data: Number of banking offices 17 14 13 12 10 Number of full time equivalent employees 208 177 156 135 131 Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations. The following discussion and analysis provides information about the major components of our results of operations and financial condition, liquidity and capital resources and should be read in conjunction with our audited consolidated financial statements and notes thereto which are contained in this report. Additional discussion and analysis related to fiscal year 2008 is contained in our Quarterly Reports on Form 10-Q for the fiscal quarters ended March 31, 2008, June 30, 2008 and September 30, 2008, respectively. Impact of Recent Developments on the Banking Industry ----------------------------------------------------- The banking industry, including the Company, is operating in a challenging and volatile economic environment. The effects of the downturn in the housing market have adversely impacted credit markets, consumer confidence, and the broader economy. Along with other financial institutions, the Company's stock price has suffered as a result. Management cannot predict when these market difficulties will subside. While the current economic downturn and the difficulties it presents for the Company and others in the banking industry are unprecedented, management believes that the business is cyclical and must be viewed and measured over time. The Company's primary focus at this time is to manage the business safely during the economic downturn and be poised to take advantage of any market opportunities that may arise. Because of the current economic situation, U.S. and foreign governments have acted in attempts to stabilize the financial system. For example, the U.S. government has adopted the Emergency Economic Stabilization Act, which, among other things, authorized the U.S. Treasury to establish the Capital Purchase Program under which certain United States financial institutions may sell senior preferred stock and issue warrants to purchase an institution's common stock to the Treasury in exchange for a capital infusion. See "Liquidity and Capital Resources" below for a more detailed discussion of the Company's potential participation in this program. It is not clear at this time what impact these measures will have on the Company or the financial markets as a whole. Management will continue to monitor the effects of these programs as they related to the Company and its financial operations. - 21 - On February 27, 2009, the FDIC proposed amendments to the restoration plan for the Deposit Insurance Fund. This amendment proposes the imposition of a 20 basis point emergency special assessment on insured depository institutions as of June 30, 2009. The assessment is proposed to be collected on September 30, 2009. The interim rule would also permit the FDIC to impose an emergency special assessment after June 30, 2009, of up to 10 basis points if necessary to maintain public confidence in federal deposit insurance. Based on average deposits for the fourth quarter, this special assessment, if implemented as proposed, would equal approximately $1.5 million for the additional 20 basis points, and a maximum of approximately $727,000 for the possible additional assessment of up to 10 basis points. This special assessment if implemented as proposed will have a significant impact on the results of operations of the Company for fiscal 2009. On March 5, 2009, the FDIC Chairman announced that the FDIC intends to lower the special assessment from 20 basis points to 10 basis points. The approval of the cutback is contingent on whether Congress passes legislation that would expand the FDIC's line of credit with the U.S. Treasury to $100 billion. The assessment rates, including the special assessment, are subject to change at the discretion of the Board of Directors of the FDIC. Overview As a community-focused commercial bank, our primary business consists of providing a full range of banking services to our customers with an emphasis on quality personal service. Our core products consist of loans secured by real estate and commercial and consumer loans as well as various deposit products to meet our customers' needs. Our primary source of income is generated from net interest income, the difference between interest income received on our loans and securities and interest expense paid on deposits and borrowings. Our income is also affected by our ability to price our products competitively and maximize the interest rate spread between the interest yield on loans and securities and the interest rate paid on deposits and borrowings. Our products also generate other income through product related fees and commissions. We incur operating expenses consisting primarily of salaries and benefits, occupancy and equipment and other professional and miscellaneous expenses. Our assets have increased from $522.9 million at December 31, 2005 to $924.8 million at December 31, 2008, primarily due to increased loan demand, while our total deposits have increased from $398.3 million to $722.7 million over that same period. In addition, for 72 consecutive years, we have paid dividends (prior to 1997 when we reorganized into a holding company, it was our wholly owned subsidiary, Four Oaks Bank & Trust Company, which paid dividends). For the past five years, dividends have averaged 29.4% of our average net income. Return on average equity and return on average assets for 2008 were 6.40% and .51%, respectively, decreasing from returns of 10.82% and .86%, respectively, for 2007. We set interest rates on deposits and loans at competitive rates. We have maintained spreads of 2.85% and 3.13% in 2008 and 2007, respectively, between interest earned on average loans and investments and interest paid on average interest-bearing deposits and borrowings. Our gross loans have increased from $397.1 million at December 31, 2005 to $681.5 million at December 31, 2008; while our average net annual charge-offs over the same period were approximately $770,000. The sustained growth provided by operations resulted in increases in total assets of 30.6%, 16.5%, and 16.3% for 2008, 2007 and 2006, respectively. Our gross loans grew 25.0% and 18.1% in 2008 and 2007, respectively. Our total investments (including interest-earning deposits and FHLB stock) increased 50.5% and 12.7% in 2008 and 2007, respectively, due to the decision to build the portfolio as yields have continued to improve throughout 2007 and 2008. We closely monitor changes in the financial markets in order to maximize the yield on our assets. The growth in loans for 2008 and 2007 was funded by deposit growth of 34.4% and 15.2%, respectively. Earnings decreased in 2008, ending the year with net income of $4.2 million, a decrease of 25.1% over 2007's net income of $5.7 million, as a result of a challenging economic environment. During 2008 and 2007, Four Oaks Mortgage Company, L.P. provided secondary market-type mortgages which contributed $75,000 and $112,000 to our revenue for the years 2008 and 2007, respectively. Four Oaks Mortgage Company, L.P. was owned 49.99% by our wholly owned subsidiary, Four Oaks Mortgage Services, L.L.C., and 50.01% by its general partner, CTX Mortgage Ventures, LLC, a wholly owned indirect subsidiary of Centex Corporation. In August 2008, CTX terminated this partnership. On September 1, 2008, we entered into a six-month marketing agreement with PrimeLending to provide mortgage lending services. - 22 - In December 2004, we added the Retail Real Estate Lending division, which works with individuals, developers, and contractors involved in real estate acquisition and development. Management historically has attempted to monitor and control increases in overhead expenses while being committed to developing the skills and enhancing the professionalism of our employees. Employee turnover has been minimal historically, while the number of our full-time equivalent employees has increased from 135 at December 31, 2005 to 208 at December 31, 2008. Results of Operations Comparison of Financial Condition at December 31, 2008 and 2007 During 2008, our total assets increased by $216.5 million, or 30.6%, from $708.3 million at December 31, 2007 to $924.8 million at December 31, 2008. This increase in our total assets resulted primarily from growth in our net loans, which increased from $538.6 million at December 31, 2007 to $672.0 million at December 31, 2008, an increase of $133.4 million, or 24.8%. The acquisition of LongLeaf Community Bank ("LongLeaf") on April 17, 2008 contributed $47.2 million of the total loan growth. The sustained growth in our loan portfolio continued to reflect a trend towards growth in commercial real estate lending primarily in real estate construction as a result of a continued shift in our markets from an agricultural focus to a suburban focus. Loans secured by real estate at December 31, 2008 grew $118.7 million over 2007 of which $22.2 million of the increase was related to construction and land development loans. In addition to loan growth, our securities portfolio increased $57.7 million to $172.0 million at December 31, 2008 from $114.3 million at December 31, 2007. Our loan growth and increases in our securities portfolio were primarily funded by deposit growth of $184.9 million, or 34.4%, during 2008 to $722.7 million at December 31, 2008 compared with $537.8 million at December 31, 2007. Our local market customers continue to be our primary source for deposit growth, funding deposit growth predominantly in savings and time deposits. Deposits from our local market customers provided $77.0 million of the December 31, 2008 increase in deposits over December 31, 2007, and with the remaining $107.9 million increase coming from deposits outside our local customer base. The LongLeaf acquisition accounted for $54.5 million of the total deposit growth. We believe the growth in deposits was encouraged by targeted deposit campaigns and branch calling efforts within our competitive market, in spite of the national prime decrease from 7.25% at January 1, 2008 to 3.25% at December 31, 2008. Shareholders' equity increased by $12.00 million as of December 31, 2008 as compared to December 31, 2007. This increase in shareholders' equity resulted principally from shares of common stock valued at $7.6 million issued and stock options valued at $389,000 in connection with the merger with LongLeaf, net income of $4.2 million, dividend reinvestment plan proceeds of $1.2 million, proceeds from the exercise of stock options of $502,000 and employee stock purchase plan proceeds of $149,000, net of dividends paid of $2.2 million, stock repurchase expenses of $75,000 and other comprehensive loss of $33,000 comprised of unrealized losses on securities available for sale. Net Income During 2008, we earned net income of $4.2 million, or $.65 basic net income per share, which was a 25.1% decrease from 2007 net income of $5.7 million, or $.92 basic net income per share. Strong competition for deposits in our local markets prevented deposit rates from lowering at the same pace as loan rates, causing a decline in our net interest margin. The resulting $1.5 million, or 3.2%, increase in interest income failed to absorb a 24.4% increase in non-interest expense for 2008 over 2007. Opening and operating two new full-service offices during 2008 and the addition of the two offices acquired from the merger with LongLeaf contributed to increased salaries and benefits, occupancy and equipment and other operating costs, along with the upfitting of the new Garner Village location. In addition to the new offices, rising costs in employee salaries contributed to increased personnel expense in 2008. Net Interest Income Like most financial institutions, the primary component of earnings for the bank is net interest income. Net interest income is the difference between interest income, principally from loan and investment securities, and interest expense, principally on customer deposits and borrowings. Changes in net interest income result from changes in volume, spread and margin. For this purpose, volume refers to the average dollar level of interest-earning assets and interest-bearing liabilities, spread refers to the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities, and margin refers to net interest income divided by average interest-earning assets. Margin is influenced by the level and relative mix of interest-earning assets and interest-bearing liabilities, as well as by levels of non-interest-bearing liabilities and capital. - 23 - Net interest income increased by $1.9 million to $25.7 million in 2008, with a net yield of 3.28% compared to $23.8 million and a net yield of 3.84% in 2007. The yield for 2008 decreased an overall 56 basis points from 2007 due to the decreasing rates on variable rate loans. The increase in net interest income primarily was generated by an increased volume of $9.9 million in average net interest-earning assets, which produced $1.9 million in net interest income. The additional interest income over interest expense was driven by steady loan growth, acquisition of higher yielding investments as well as an increase of $1.6 million in average non-interest-bearing demand deposits. The rates earned on a substantial portion of our loans reprice to correspond with each prime rate decrease. Most of our interest-bearing liabilities, however, have fixed interest rates until maturity and as a result do not reprice as quickly or in the same increments as our loan portfolio. The national prime decreased 400 basis points during 2008 to 3.25% at December 31, 2008 from 7.25% at January 1, 2008. Prime rate decreased seven times in late 2008, which accounts for the decrease in net interest margin for 2008. On average, our interest-earning assets grew $163.1 million during 2008 over 2007. A substantial portion of the increase in interest-earning assets was achieved through increased loan demand. Average loans increased by $134.1 million during 2008 over 2007 to $628.5 million. Average available-for-sale investments increased $21.6 million generating additional interest income of $1.2 million. Although the volume of interest-bearing liabilities increased $161.7 million in 2008, a slight decrease in interest expense resulted from the rapidly falling interest rates in the second half of 2008. Provision for Loan Losses and Asset Quality Our provision for loan losses was $3.3 million during 2008 and $1.4 million during 2007. Net charge-offs in 2008 increased to $1.8 million compared to $275,000 in 2007. As a percent of average loans, net charge-offs were 0.29%, the highest level in the past five years, an increase of 0.23% from 2007. The higher level of net charge-offs and nonperforming assets is attributable to the challenging economic environment especially in the real estate and commercial construction sectors caused by recessionary conditions such as increased unemployment and declines in asset values. The provision for loan losses is charged to bring the allowance for loan losses to the level deemed appropriate by management after adjusting for recoveries of amounts previously charged off. Loans are charged against the allowance for loan losses when management believes that the uncollectibility of a loan balance is confirmed. The allowance for loan losses is maintained at a level deemed adequate to absorb probable losses inherent in the loan portfolio and results from management's consideration of such factors as the financial condition of borrowers, past and expected loss experience, current economic conditions, and other factors management feels deserve recognition in establishing an appropriate reserve. Although management attempts to maintain the allowance at a level deemed adequate, future additions to the allowance may be necessary based upon changes in market conditions or the status of the loans included in the loan portfolio. In addition, various regulatory agencies periodically review our allowance for loan losses. These agencies may require us to make adjustments based upon their judgments about information available to them at the time of their examination. See "Allowance for Loan Losses and Summary of Loan Loss Experience" below. We evaluate our loan portfolio in accordance with Statement of Financial Accounting Standards ("SFAS") No. 114, Accounting by Creditors for Impairment of a Loan, as amended by SFAS No. 118, Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosures. Under these standards, a loan is considered impaired, based on current information and events, if it is probable that we will be unable to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan agreement. Uncollateralized loans are measured for impairment based on the present value of expected future cash flows discounted at the historical effective interest rate or the loan's observable market price, while all collateral-dependent loans are measured for impairment based on the fair value of the collateral. If the recorded investment in the loan exceeds the measure of fair value, a valuation allowance is established as a component of the allowance for loan losses. This evaluation is inherently subjective, as it requires material estimates that may be susceptible to significant change. Our non-performing assets, which consist of loans past due 90 days or more, real estate acquired in the settlement of loans, and loans in nonaccrual status, increased to $23.0 million at December 31, 2008 from $3.0 million at December 31, 2007. This increase was primarily due to the contraction of the housing market and subsequent slowdown of real estate construction, resulting from the current economic environment. Our allowance for loan losses, expressed as a percentage of gross loans, was 1.40% and 1.22% at December 31, 2008 and 2007, respectively. At December 31, 2008, the allowance for loan losses amounted to $9.5 million, which management believes is adequate to absorb losses inherent in our loan portfolio. - 24 - Non-interest Income Non-interest income before gains and losses on sales of securities, hedging activity and loans increased $900,000, or 24.2%, from $3.9 million during 2007 to $4.8 million in 2008. Our non-interest income is comprised primarily of service charges on deposit accounts, financial services commissions, merchant fees, changes in the value of bank-owned life insurance and various other sources of miscellaneous operating income. Net gains of $673,000 on sales of investment securities and interest rate hedging activity were recognized in 2008. The primary component of the increase in non-interest income is income on the cash surrender value of the bank-owned life insurance policy, resulting in income of $525,000 for the year ended December 31, 2008, as compared to a net loss of $205,000 in 2007. Non-interest Expense Our non-interest expense increased from $17.7 million in 2007 to $22.0 million in 2008, an increase of $4.3 million. Although our non-interest expense has continued to increase, our non-interest expense as a percent of our average assets has declined over the last five years, down to 2.64% for 2008, our lowest level in the last five years. Approximately 46.2% of the $4.3 million increase in non-interest expense over 2007 was due to increases in salaries and benefits. Salaries increased 21.4% while employee benefits increased 24.9%, primarily due to a 17.5% increase in the number of employees in 2008 over 2007. In addition to normal salary increases and increased costs for employee benefits overall, personnel costs grew due to additional staffing needs throughout the bank. In total, our number of full time equivalent employees grew from 177 employees for the year 2007 to 208 employees for the year 2008. The increased personnel costs reflect the costs of additional personnel for the new Garner Village, Rockingham, and Southern Pines offices as well as increased staffing for the administration and operations departments. The primary increases in other non-interest expense for 2008 over 2007 included advertising expense, up $157,000, printing and office supplies, up $72,000, ATM expense, up $130,000, FDIC insurance premium, up $293,000, and expenses relating to the collection of non-performing loans and sale of repossessed assets, up $233,000. There were no other significant increases in the remaining other non-interest expense categories. Income Taxes Income taxes, as a percentage of income before income taxes, for 2008 and 2007 were 28.04% and 36.06%, respectively. The decrease resulted because non-taxable income from investment securities and bank-owned life insurance comprised a larger portion of income before taxes in the current year. Results of Operations Comparison of Financial Condition at December 31, 2007 and 2006 During 2007, our total assets increased by $100.2 million, or 16.5%, from $608.1 million at December 31, 2006 to $708.3 million at December 31, 2007. This increase in our total assets resulted primarily from growth in our net loans, which increased from $456.2 million at December 31, 2006 to $538.6 million at December 31, 2007, an increase of $82.4 million, or 18.1%. The sustained growth in our loan portfolio continues to reflect a trend towards growth in commercial real estate lending primarily in real estate construction as a result of a continued shift in our markets from an agricultural focus to a suburban focus. Loans secured by real estate at December 31, 2007 of which $58.0 million was related to construction and land development loans, grew $78.4 million over 2006. In addition to loan growth, our securities portfolio increased $12.9 million to $114.3 million at December 31, 2007 from $101.4 million at December 31, 2006. Our loan growth and increases in our securities portfolio were primarily funded by deposit growth of $70.9 million, or 15.2%, during 2007 to $537.8 million at December 31, 2007 compared with $466.9 million at December 31, 2006. Our local market customers continue to be our primary source for deposit growth, funding deposit growth predominantly in savings and time deposits. Deposits from our local market customers provided $65.6 million of the December 31, 2007 increase in deposits over December 31, 2006, and with the remaining $5.3 million increase coming from deposits outside our local customer base. We believe the growth in deposits was encouraged by targeted deposit campaigns and branch calling efforts within our competitive market, in spite of the national prime decrease from 8.25% at January 1, 2007 to 7.25% at December 31, 2007. - 25 - Shareholders' equity increased by $5.3 million as of December 31, 2007 as compared to December 31, 2006. This increase resulted from our net income of $5.7 million, dividend reinvestment plan proceeds of $1.3 million, proceeds from the exercise of stock options of $362,000 and employee stock purchase plan proceeds of $141,000, net of dividends paid of $1.8 million, stock repurchase expenses of $1.5 million and other comprehensive gain of $855,000 comprised of unrealized gains on securities available for sale of $613,000, net of tax and unrealized gains on cash flow hedging activities of $242,000 net of tax. Net Income During 2007, we earned net income of $5.7 million, or $.92 basic net income per share, which was a 19.5% decrease over 2006 net income of $7.0 million, or $1.15 basic net income per share. Increased competition for deposits in our local markets caused interest expense to increase, causing a decline in our net interest margin. The resulting $1.1 million, or 4.7%, increase in interest income failed to absorb a 13.7% increase in non-interest expense for 2007 over 2006. A full year of opening and operating two new full-service offices during 2007 contributed to increased salaries and benefits, occupancy and equipment and other operating costs, along with costs associated with the completion of the new building for Zebulon and the upfitting of the new Dunn location. In addition to the new offices, rising costs in employee salaries contributed to increased personnel expense in 2007. Compliance costs related to the Sarbanes-Oxley Act of 2002 increased costs for outside professional services for 2007. Net Interest Income Like most financial institutions, the primary component of earnings for the bank is net interest income. Net interest income is the difference between interest income, principally from loan and investment securities, and interest expense, principally on customer deposits and borrowings. Changes in net interest income result from changes in volume, spread and margin. For this purpose, volume refers to the average dollar level of interest-earning assets and interest-bearing liabilities, spread refers to the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities, and margin refers to net interest income divided by average interest-earning assets. Margin is influenced by the level and relative mix of interest-earning assets and interest-bearing liabilities, as well as by levels of non-interest-bearing liabilities and capital. Net interest income increased by $1.1 million to $23.8 million in 2007, with a net yield of 3.84% compared to $22.7 million and a net yield of 4.31% in 2006. However, the yield for 2007 decreased overall 47 basis points from 2006 due to the increasing costs of deposits and borrowings. The increase in net interest income primarily was generated by an increased volume of $5.4 million in average net interest-earning assets, which produced $1.1 million in net interest income. The additional interest income over interest expense was driven by steady loan growth, acquisition of higher yielding investments as well as an increase of $2.1 million in average non-interest-bearing demand deposits. The rates earned on a substantial portion of our loans reprice to correspond with each prime rate increase. Most of our interest-bearing liabilities, however, have fixed interest rates until maturity and as a result do not reprice as quickly or in the same increments as our loan portfolio. The national prime decreased 100 basis points during 2007 to 7.25% at December 31, 2007 from 8.25% at January 1, 2007. Prime rate decreased three times in late 2007, which accounts for the decrease in net interest margin for 2007. On average, our interest-earning assets grew $91.3 million during 2007 over 2006. A substantial portion of the increase in interest-earning assets was achieved through increased loan demand. Average loans increased by $67.7 million during 2007 over 2006 to $494.4 million, generating additional interest income of $5.5 million. An increase in volume of interest-bearing liabilities of $85.8 million in 2007 resulted in additional interest expense of $3.7 million, while increased competition for deposits in our local markets resulted in increased interest expense of $2.2 million. The increase in interest expense in 2007 primarily resulted from a $27.0 million increase in more expensive other time deposits at an average rate paid on these deposits of 5.02%, which was an increase of 77 basis points over 2006. However, an increase of $36.7 million in less expensive NOW and money market deposits at an average rate paid of 3.59% and an increase of $2.1 million in interest free demand deposits in 2007 partially offset the increased cost of other time deposits. Interest expense on subordinated debt associated with our Trust Preferred Securities increased from $626,000 in 2006 to $850,000 in 2007. The average outstanding balance of subordinated debt increased from $9.4 million in 2006 to $12.4 million in 2007, as we completed a $12 million offering of Trust Preferred Securities in late March 2006. The Trust Preferred Securities pay cumulative cash distributions quarterly at an annual rate, reset quarterly, equal to three month LIBOR plus 1.35%. Provision for Loan Losses and Asset Quality Our provision for loan losses was $1.4 million during 2007 and $873,000 million during 2006. Net charge-offs in 2007 increased to $275,000 compared to $272,000 in 2006. As a percent of average loans, net charge-offs were 0.06%, the lowest level in the past five years and unchanged from 2006. The lower level of net charge-offs and nonperforming assets is attributable to continued efforts to improve asset quality, including improved underwriting. - 26 - The provision for loan losses is charged to bring the allowance for loan losses to the level deemed appropriate by management after adjusting for recoveries of amounts previously charged off. Loans are charged against the allowance for loan losses when management believes that the uncollectibility of a loan balance is confirmed. The allowance for loan losses is maintained at a level deemed adequate to absorb probable losses inherent in the loan portfolio and results from management's consideration of such factors as the financial condition of borrowers, past and expected loss experience, current economic conditions, and other factors management feels deserve recognition in establishing an appropriate reserve. Although management attempts to maintain the allowance at a level deemed adequate, future additions to the allowance may be necessary based upon changes in market conditions or the status of the loans included in the loan portfolio. In addition, various regulatory agencies periodically review our allowance for loan losses. These agencies may require us to make adjustments based upon their judgments about information available to them at the time of their examination. See "Allowance for Loan Losses and Summary of Loan Loss Experience" below. We evaluate our loan portfolio in accordance with Statement of Financial Accounting Standards ("SFAS") No. 114, Accounting by Creditors for Impairment of a Loan, as amended by SFAS No. 118, Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosures. Under these standards, a loan is considered impaired, based on current information and events, if it is probable that we will be unable to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan agreement. Uncollateralized loans are measured for impairment based on the present value of expected future cash flows discounted at the historical effective interest rate or the loan's observable market price, while all collateral-dependent loans are measured for impairment based on the fair value of the collateral. If the recorded investment in the loan exceeds the measure of fair value, a valuation allowance is established as a component of the allowance for loan losses. This evaluation is inherently subjective as it requires material estimates that may be susceptible to significant change. Our non-performing assets, which consist of loans past due 90 days or more, real estate acquired in the settlement of loans, and loans in nonaccrual status, increased to $3.0 million at December 31, 2007 from $1.3 million at December 31, 2006. This increase was primarily due to properties valued at approximately $2.6 million being added to other real estate owned during 2007, and to a lesser degree, the contraction of the housing market and subsequent slowdown of real estate construction. Our allowance for loan losses, expressed as a percentage of gross loans, was 1.22% and 1.21% at December 31, 2007 and 2006, respectively. At December 31, 2007, the allowance for loan losses amounted to $6.7 million, which management believes is adequate to absorb losses inherent in our loan portfolio. Non-interest Income Non-interest income before gains and losses on sales of securities, hedging activity and loans decreased $744,000, or 16.1%, from $4.6 million during 2006 to $3.9 million in 2007. Our non-interest income is comprised primarily of service charges on deposit accounts, financial services commissions, merchant fees, changes in the value of bank-owned life insurance and various other sources of miscellaneous operating income. Net gains of $512,000 on sales of investment securities and interest rate hedging activity were recognized in 2007. The primary component of the decrease in non-interest income is a loss on the surrender of the previous bank-owned life insurance policy and the subsequent purchase of a new policy, resulting in a net loss of $205,000 for the year ended December 31, 2007, as compared to a net gain of $549,000 in 2006. Non-interest Expense Our non-interest expense increased from $15.5 million in 2006 to $17.7 million in 2007, an increase of $2.2 million. Although our non-interest expense has continued to increase, our non-interest expense as a percent of our average assets has declined over the last five years, down to 2.70% for 2007, our lowest level in the last five years. Approximately 70.3% of the $2.2 million increase in non-interest expense over 2006 was due to increases in salaries and benefits. Salaries increased 17.9% while employee benefits increased 14.4%, primarily due a 13.5% increase in the number of employees in 2007 over 2006. In addition to normal salary increases and increased costs for employee benefits overall, personnel costs grew due to additional staffing needs throughout the bank. In total, our number of full time equivalent employees grew from 156 employees for the year 2006 to 177 employees for the year 2007. The increased personnel costs reflect the costs of additional personnel for the new Dunn loan production office as well as increased staffing for the administration and operations departments. In addition to personnel costs, additional costs during 2007 were incurred for occupancy expense. For 2007, occupancy expense increased $118,000 over 2006. Additional testing and documentation required for compliance with the Sarbanes-Oxley Act of 2002 continued to increase our fees paid for outside professional services in 2007, contributing to an increase of $80,000 over 2006. The primary increases in other non-interest expense for 2007 over 2006 included advertising expense, up $28,000, printing and office supplies, up $21,000, auto expense, up $17,000, meals, entertainment and travel, up $30,000, donations and charities expense, up $58,000, ATM expense, up $77,000, postage, up $32,000, and expenses relating to the collection of non-performing loans and sale of repossessed assets, up $34,000. There were no other significant increases in the remaining other non-interest expense categories. - 27 - Income Taxes Income taxes, as a percentage of income before income taxes, for 2007 and 2006 were 36.06% and 34.08%, respectively. The increase was the result of management's redirection of funds between loans and different types of taxable and tax-exempt interest-bearing assets in response to economic conditions and the bank's liquidity requirements. Liquidity and Capital Resources The United States Department of the Treasury ("Treasury") has announced that it will make funds available to certain banks under the Troubled Asset Relief Program's Capital Purchase Program (the "Program"). The Emergency Economic Stabilization Act of 2008 authorized the Treasury to establish the Program under which certain United States financial institutions may sell senior preferred stock and issue warrants to purchase an institution's common stock to the Treasury in exchange for a capital infusion. Under the Program, eligible institutions can generally apply to issue preferred stock to the Treasury in aggregate amounts between 1% and 3% of the institution's risk-weighted assets. On November 5, 2008, the Company's board of directors (the "Board") authorized and approved the Company's participation in the Program, and the Company filed its application with the Treasury in November, 2008 to participate in the Program. In order to participate in the Program, the Company's shareholders approved an amendment to the Company's Articles of Incorporation to authorize preferred stock, and the Board authorized the Company to sell up to 20,000 shares of senior preferred stock ("Senior Preferred") to the Treasury for $1,000 per share. As of the filing date of this report, we are currently waiting to hear about the status of our application. Accordingly, there is no binding agreement or commitment with respect to the Company's participation in the Program. The Company and the Treasury must still negotiate the terms and conditions of the Company's participation in the Program, which means that closing of the transaction is not guaranteed. Although the Company has no reason to believe that the Company will not be able to ultimately participate in the Program, no assurances can be given that the Company will be able to ultimately participate in the Program, the approximate number of shares of preferred stock that the Company may issue pursuant to the Program or the approximate amount of consideration the Company will receive as compensation from the Treasury for any such shares that may be issued by the Company under the Program. Market and public confidence in our financial strength and in the strength of financial institutions in general will largely determine our access to appropriate levels of liquidity. This confidence is significantly dependent on our ability to maintain sound asset quality and appropriate levels of capital resources. The term "liquidity" refers to our ability to generate adequate amounts of cash to meet our needs for funding loan originations, deposit withdrawals, maturities of borrowings and operating expenses. Management measures our liquidity position by giving consideration to both on and off-balance sheet sources of, and demands for, funds on a daily and weekly basis. Sources of liquidity include cash and cash equivalents, (net of federal requirements to maintain reserves against deposit liabilities), investment securities eligible for pledging to secure borrowings, investments available for sale, loan repayments, loan sales, deposits and borrowings from the Federal Home Loan Bank secured with pledged loans and securities, and from correspondent banks under overnight federal funds credit lines. In addition to interest rate sensitive deposits, the Company's primary demand for liquidity is anticipated funding under credit commitments to customers. We have maintained a sufficient level of liquidity in the form of cash, federal funds sold, and investment securities. These aggregated $200.9 million at December 31, 2008, compared to $132.6 million and $119.1 million at December 31, 2007 and 2006, respectively. The increase in 2008 primarily resulted from a $216.5 million increase in total assets. - 28 - Supplementing customer deposits as a source of funding, we have available lines of credit from various correspondent banks to purchase federal funds on a short-term basis of approximately $38.2 million. As of December 31, 2008, the Bank has the credit capacity to borrow up to $185.0 million, from the Federal Home Loan Bank of Atlanta ("FHLB"), with $114.3 million outstanding as of that date. At December 31, 2007 we had FHLB borrowings outstanding of $97.0 million. At December 31, 2008, our outstanding commitments to extend credit consisted of loan commitments of $98.5 million, undisbursed lines of credit of $21.5 million, financial stand-by letters of credit of $874,000 and performance stand-by letters of credit of $2.1 million. We believe that our combined aggregate liquidity position from all sources is sufficient to meet the funding requirements of loan demand and deposit maturities and withdrawals in the near term. In recent years, we have relied heavily on certificates of deposits as a source of funds. While the majority of these funds are from our local market area, the Bank has utilized brokered and out-of-market certificates of deposits to diversify and supplement our deposit base. In late 2008, we began to shift our focus from certificates of deposits to expanding our nonmaturity deposit base. Certificates of deposits represented 64% of our total deposits at December 31, 2008, an increase from 57% at December 31, 2007. Brokered and out-of-market certificates of deposit totaled $144.3 million at year-end 2008 and $47.0 million at year-end 2007, which comprised 20.0% and 8.7% of total deposits, respectively. Certificates of deposit of $100,000 or more, inclusive of brokered and out-of-market certificates, represented 38.5% of our total deposits at December 31, 2008 and 32.1% at December 31, 2007. Large certificates of deposits are generally considered rate sensitive. While we will need to pay competitive rates to retain these deposits at their maturities, there are other subjective factors that will determine their continued retention. Off-Balance Sheet Arrangements As part of its normal course of business to meet the financing needs of its customers, the bank is at times a party to financial instruments with off-balance sheet credit risk. Such instruments include commitments to extend credit and standby letters of credit. At December 31, 2008, the bank's outstanding commitments to extend credit consisted of undisbursed lines of credit, other commitments to extend, undisbursed portion of construction loans and stand-by letters of credit of $122.9 million. Additional detail regarding the bank's off-balance sheet risk exposure is presented in Notes K and L to the accompanying consolidated financial statements. Interest Rate Sensitivity Analysis As a part of our interest rate risk management policy, we periodically perform an interest rate sensitivity analysis. Interest rate sensitivity analysis is a common, though imperfect, measure of interest rate risk, which measures the relative dollar amounts of interest-earning assets and interest-bearing liabilities that reprice within a specific time period, either through maturity or rate adjustment. Any resulting interest rate "gap" is the difference between the amounts of such assets and liabilities that are subject to repricing. A positive gap for a given period means that the amount of interest-earning assets maturing or otherwise repricing within that period exceeds the amount of interest-bearing liabilities maturing or otherwise repricing within the same period. Accordingly, in a declining interest rate environment, an institution with a positive gap would generally be expected, absent the effects of other factors, to experience a decrease in the yield on its assets greater than the decrease in the cost of its liabilities, and its net interest income should be negatively affected. Conversely, the yield on its assets for an institution with a positive gap would generally be expected to increase more quickly than the cost of funds in a rising interest rate environment, and such institution's net interest income generally would be expected to be positively affected by rising interest rates. Changes in interest rates generally have the opposite effect on an institution with a negative gap. The table below sets forth the amounts of our interest-earning assets and interest-bearing liabilities outstanding as of December 31, 2008 that are projected to reprice or mature in each of the future time periods shown. Except as stated below, the amounts of assets and liabilities shown that reprice or mature within a particular period were determined in accordance with the contractual terms of the assets or liabilities. Loans with adjustable rates are shown as being due at the end of the next upcoming adjustment period. Money market deposit accounts and negotiable order of withdrawal or other transaction accounts are assumed to be subject to immediate repricing and depositor availability and have been placed in the shortest period. In making the gap computations, none of the traditional assumptions regarding prepayment rates and deposit decay rates have been used for any interest-earning assets or interest-bearing liabilities. In addition, the table does not reflect scheduled principal payments that will be received throughout the lives of the loans or investments. The interest rate sensitivity of our assets and liabilities illustrated in the following table would vary substantially if different assumptions were used or if actual experience differs from that indicated by such assumptions. (dollars in thousands). - 29 - Interest Rate Sensitivity as of December 31, 2008 ---------------------------------------------------------------------- 3 Months Over 3 Months Total Within Over 12 or Less to 12 Months 12 Months Months Total -------------- -------------- ------------ -------------- ----------- Interest-earning assets: Loans $ 328,387 $ 58,365 $ 386,752 $ 294,748 $ 681,500 Securities available for sale - 569 569 171,422 171,991 Other earning assets 9,303 - 9,303 6,529 15,832 -------------- -------------- ------------ -------------- ----------- Total interest-earning assets $ 337,690 $ 58,934 $ 396,624 $ 472,699 $ 869,323 ============== ============== ============ ============== =========== Percent of total interest- earning assets 38.85% 6.78% 45.62% 54.38% 100.00% Cumulative percent of total interest-earning assets 38.85% 45.62% 45.62% 100.00% 100.00% Interest-bearing liabilities Fixed maturity deposits $ 190,471 $ 222,985 $ 413,456 $ 51,118 $ 464,574 All other deposits 184,148 - 184,148 - 184,148 Borrowings 1,500 - 1,500 112,814 114,314 -------------- -------------- ------------ -------------- ----------- Total interest-bearing liabilities $ 376,119 $ 222,985 $ 599,104 $ 163,932 $ 763,036 ============== ============== ============ ============== =========== Percent of total interest-bearing liabilities 49.29% 29.22% 78.52% 21.48% 100.00% Cumulative percent of total interest-bearing liabilities 49.29% 78.52% 78.52% 100.00% 100.00% Interest sensitivity gap $ (38,429) $ (164,051) $ (202,480) $ 308,766 $ 106,286 Cumulative interest sensitivity gap (38,429) (202,480) (202,480) 106,286 106,286 Cumulative interest sensitivity gap as a percent of total interest- earning assets -4.42% -23.29% -23.29% 12.23% 12.23% Cumulative ratio of interest- sensitive assets to interest-sensitive liabilities 89.78% 66.20% 66.20% 113.93% 113.93% Contractual Obligations and Commitments In the normal course of business there are various outstanding contractual obligations that require future cash outflows. The following table shows our expected contractual obligations and future operating lease commitments as of December 31, 2008 (in thousands): Payments Due by Period --------------------------------------------------------- Less than More than Total 1 year 1-2 years 3-5 years 5 years ----------- ----------------------- ---------- ---------- Borrowings $ 114,314 $ 1,500 $ - $ 814 $ 112,000 Subordinated debentures 12,372 - - - 12,372 Operating leases 1,089 187 169 476 257 Deposits 464,574 413,456 42,300 8,718 100 ----------- ------------ ---------- ---------- ---------- Total $ 592,349 $ 415,143 $ 42,469 $ 10,008 $ 124,729 =========== ============ ========== ========== ========== - 30 - The following table shows our undisbursed lines of credit, other commitments to extend, undisbursed portion of construction loans and stand-by letters of credit as of December 31, 2008 (in thousands): Amount of Commitment Expiration Per Period ------------------------------------------------------------ Less than More than Total 1 year 1-2 years 3-5 years 5 years ----------- ----------------------- ------------- ---------- Undisbursed lines of credit $ 39,450 $ 3,312 $ 11,363 $ 1,974 $ 22,802 Other commitments to extend 27,836 18,570 9,247 14 4 Undisbursed portion of construction loans 52,672 41,380 11,101 58 132 Stand-by letters of credit 2,940 2,628 34 278 - ----------- ----------- ---------- ------------- ---------- Total $ 122,898 $ 65,891 $ 31,745 $ 2,324 $ 22,938 =========== =========== ========== ============= ========== Inflation The effect of inflation on financial institutions differs somewhat from the effect it has on other businesses. The performances of banks, with assets and liabilities that are primarily monetary in nature, are affected more by changes in interest rates than by inflation. Interest rates generally increase as the rate of inflation increases, but the magnitude of the change in rates may not be the same. During periods of high inflation, there are normally corresponding increases in the money supply, and banks will normally experience above average growth in assets, loans, and deposits. Also, general increases in the price of goods and services will generally result in increased operating expenses. Distribution of Assets, Liabilities, and Shareholders' Equity; Interest Rates and Interest Differential The following schedule presents average balance sheet information for the years 2008, 2007 and 2006, along with related interest earned and average yields for interest-earning assets and the interest paid and average rates for interest-bearing liabilities. Nonaccrual notes are included in loan amounts. - 31 - Average Daily Balances, Interest Income/Expense, Average Yield/Rate For the Years Ended December 31, ----------------------------------------------------------------------------------------- 2008 2007 2006 ----------------------------- ----------------------------- ----------------------------- Average Average Average Average Average Average Balance Interest Rate Balance Interest Rate Balance Interest Rate ---------- --------- -------- ---------- --------- -------- ---------- --------- -------- (dollars in thousands) Interest-earning assets: Loans $ 628,507 $ 41,182 6.55% $ 494,426 $ 40,967 8.29% $ 426,768 $ 35,457 8.31% Investment securities - taxable 123,452 6,646 5.38% 111,837 5,873 5.25% 89,195 4,503 5.05% Investment securities - tax exempt 14,783 627 4.24% 4,846 178 3.68% 4,123 152 3.69% Other interest-earning assets 15,693 586 3.73% 8,231 495 6.01% 7,970 444 5.57% --------- --------- --------- --------- --------- --------- Total interest-earning assets 782,435 49,041 6.27% 619,340 47,513 7.67% 528,056 40,556 7.68% --------- -------- --------- -------- --------- -------- Other assets 50,544 35,817 32,633 --------- --------- --------- Total assets $ 832,979 $ 655,157 $ 560,689 ========= ========= ========= Interest-bearing liabilities: Deposits: NOW and money market deposits $ 129,411 $ 2,655 2.05% $ 107,520 $ 3,860 3.59% $ 71,981 $ 2,079 2.89% Savings deposits 28,878 448 1.55% 30,068 800 2.66% 37,304 1,079 2.89% Time deposits, $100,000 and over 219,589 8,747 3.98% 166,744 8,164 4.90% 157,497 6,961 4.42% Other time deposits 176,979 6,528 3.69% 125,875 6,317 5.02% 96,058 4,083 4.25% Borrowed funds 116,390 4,411 3.79% 79,378 3,708 4.67% 63,885 2,989 4.68% Subordinated debentures 12,372 575 4.65% 12,372 850 6.87% 9,389 626 6.67% --------- --------- --------- --------- --------- --------- Total interest-bearing liabilities 683,619 23,363 3.42% 521,958 23,699 4.54% 436,114 17,817 4.09% --------- -------- --------- -------- --------- -------- Noninterest-bearing deposits 76,951 75,286 73,151 Other liabilities 6,343 5,668 5,883 Stockholders' equity 66,066 52,246 45,541 --------- --------- --------- Total liabilities and stockholders' equity $ 832,979 $ 655,157 $ 560,689 ========= ========= ========= Net interest income and interest rate spread $ 25,678 2.85% $ 23,814 3.13% $ 22,739 3.59% ========= ======== ========= ======== ========= ======== Net yield on average interest-earning assets 3.28% 3.84% 4.31% ======== ======== ======== Ratio of average interest-earning assets to average interest-bearing liabilities 114.45% 118.66% 121.08% ========== ========== ========== - 32 - The following table shows changes in interest income and expense by category and rate/volume variances for the years ended December 31, 2008 and 2007. The changes due to rate and volume were allocated on their absolute values: Year Ended Year Ended December 31, 2008 vs. 2007 December 31, 2007 vs. 2006 ------------------------------------- ----------------------------------- Increase (Decrease) Due to Increase (Decrease) Due to ------------------------------------- ----------------------------------- Volume Rate Total Volume Rate Total ------------- ---------- ------------ ------------ ---------- ----------- (In thousands) Interest income: Loans $ 9,948 $ (9,733) $ 215 $ 5,614 $ (103) $ 5,511 Investment securities - taxable 618 156 774 1,166 204 1,370 Investment securities - tax exempt 394 55 449 26 - 26 Other interest-earning assets 322 (232) 90 17 34 51 ------------- ---------- ------------ ------------ ---------- ----------- Total interest income 11,282 (9,754) 1,528 6,823 135 6,958 ------------- ---------- ------------ ------------ ---------- ----------- Interest expense: Deposits NOW and money market deposits 618 (1,822) (1,204) 1,151 630 1,781 Savings deposits (25) (328) (353) (202) (77) (279) Time deposits over $100,000 2,346 (1,763) 583 431 772 1,203 Other time deposits 2,224 (2,014) 210 1,383 851 2,234 Borrowed funds 1,565 (862) 703 725 (6) 719 Subordinated Debentures - (275) (275) 202 22 224 ------------- ---------- ------------ ------------ ---------- ----------- Total interest expense 6,728 (7,064) (336) 3,690 2,192 5,882 ------------- ---------- ------------ ------------ ---------- ----------- Net interest income increase (decrease) $ 4,554 $ (2,690) $ 1,864 $ 3,133 $ (2,057) $ 1,076 ============= ========== ============ ============ ========== =========== Market Risk Like most financial institutions, our most significant market risk exposure is the risk of economic loss resulting from adverse changes in market price and interest rates. This risk of loss can be reflected in diminished current market values and/or reduced potential net interest income in future periods. Our market risk arises primarily from interest rate risk inherent in our lending and deposit-taking activities. The structure of our loan and deposit portfolios is such that a significant decline in interest rates may adversely impact net market values and net interest income. We do not maintain a trading account nor are we subject to currency exchange risk or commodity price risk. Interest rate risk is monitored as part of the bank's asset/liability management function. The following table presents information about the contractual maturities, average interest rates and estimated fair values of our financial instruments we considered market risk sensitive as of December 31, 2008. Loans include nonaccrual loans but not the allowance for loan losses. (dollars in thousands). - 33 - Average Beyond Interest Estimated 2009 2010 2011 2012 2013 Five Years Total Rate Fair Value --------- -------- -------- -------- -------- ---------- --------- ---------- ---------- Financial Assets Loans: Fixed rate $ 102,064 $ 56,278 $ 79,954 $ 56,470 $ 86,336 $ 30,260 $ 411,362 6.90% $ 412,167 Variable Rate 186,287 $ 24,628 $ 10,590 $ 6,155 $ 8,643 $ 33,835 270,138 4.80% 270,666 Securities available for sale - 280 519 - 1,886 169,306 171,991 4.97% 171,991 Other earning assets 9,303 - - - - - 9,303 3.73% 9,303 --------- -------- -------- -------- -------- ---------- --------- ---------- ---------- Total $ 297,654 $ 81,186 $ 91,063 $ 62,625 $ 96,865 $ 233,401 $ 862,794 5.82% $ 864,127 ========= ======== ======== ======== ======== ========== ========= ========== Financial Liabilities Money market, NOW and savings deposits $ 184,148 - - - - - $ 184,148 1.08% $ 213,557 Time deposits 413,456 42,300 3,498 3,445 1,775 100 464,574 3.85% 434,034 Borrowings 1,500 - 814 - - 112,000 114,314 4.07% 117,042 Subordinated debentures - - 12,372 - - - 12,372 4.65% 11,773 --------- -------- -------- -------- -------- ---------- --------- ---------- ---------- Total $ 599,104 $ 42,300 $ 16,684 $ 3,445 $ 1,775 $ 112,100 $ 775,408 3.24% $ 776,406 ========= ======== ======== ======== ======== ========== ========= ========== Derivative Financial Instruments A derivative is a financial instrument that derives its cash flows, and therefore its value, by reference to an underlying instrument, index, or reference rate. These instruments primarily consist of interest rate swaps, caps, floors, financial forward and futures contracts and options written or purchased. Derivative contracts are written in amounts referred to as notional amounts. Notional amounts only provide the basis for calculating payments between counterparties and do not represent amounts to be exchanged between parties and are not a measure of financial risk. Credit risk arises when amounts receivable from a counterparty exceed amounts payable. We control our risk of loss on derivative contracts by subjecting counterparties to credit reviews and approvals similar to those used in making loans and other extensions of credit. We have used interest rate swaps in the management of interest rate risk. Interest rate swaps are contractual agreements between two parties to exchange a series of cash flows representing interest payments. A swap allows both parties to alter the repricing characteristics of assets or liabilities without affecting the underlying principal positions. Through the use of a swap, assets and liabilities may be transformed from fixed to floating rates, from floating rates to fixed rates, or from one type of floating rate to another. At December 31, 2008, there were no derivative financial instruments outstanding. Although off-balance sheet derivative financial instruments do not expose us to credit risk equal to the notional amount, such agreements generate credit risk to the extent of the fair value gain in an off-balance sheet derivative financial instrument if the counterparty fails to perform. We minimize such risk by evaluating the creditworthiness of the counterparties and consistently monitoring these agreements. The counterparties to these arrangements are primarily large commercial banks and investment banks. Where appropriate, master netting agreements are arranged or collateral is obtained in the form of rights to securities. Other risks associated with interest-sensitive derivatives include the effect on fixed rate positions during periods of changing interest rates. Indexed amortizing swaps' notional amounts and maturities change based on certain interest rate indices. Generally, as rates fall the notional amounts decline more rapidly, and as rates increase notional amounts decline more slowly. As of December 31, 2008, we had no indexed amortizing swaps outstanding. Under unusual circumstances, financial derivatives also increase liquidity risk, which could result from an environment of rising interest rates in which derivatives produce negative cash flows while being offset by increased cash flows from variable rate loans. We consider such risk to be insignificant due to the relatively small derivative positions we hold. A discussion of derivatives is presented in Note K to our consolidated financial statements, which are presented under Item 8 of Part II in this Form 10-K. - 34 - Quarterly Financial Information The following table sets forth, for the periods indicated, certain of our consolidated quarterly financial information. This information is derived from our unaudited financial statements, which include, in the opinion of management, all normal recurring adjustments that management considers necessary for a fair presentation of the results for such periods. This information should be read in conjunction with our consolidated financial statements included under Item 8 of Part II in this Form 10-K. The results for any quarter are not necessarily indicative of results for any future period. (dollars in thousands, except per share data). Year Ended December 31, 2008 Year Ended December 31, 2007 --------------------------------------- -------------------------------------- Fourth Third Second First Fourth Third Second First Quarter Quarter Quarter Quarter Quarter Quarter Quarter Quarter ----------- -------- -------- --------- ---------- -------- -------- --------- Operating Data: Total interest income $ 12,274 $ 12,397 $ 12,240 $ 12,131 $ 12,480 $ 12,310 $ 11,594 $ 11,128 Total interest expense 5,804 5,641 5,953 5,965 6,203 6,134 5,891 5,471 ----------- -------- -------- --------- ---------- -------- -------- --------- Net interest income 6,469 6,756 6,287 6,166 6,277 6,176 5,703 5,657 Provision for loan losses 1,747 347 954 288 587 280 232 262 ----------- -------- -------- --------- ---------- -------- -------- --------- Net interest income after provision 4,722 6,409 5,332 5,878 5,690 5,896 5,471 5,395 Noninterest income 1,339 1,313 1,489 1,389 1,037 1,218 750 1,067 Noninterest expense 5,844 5,626 5,556 4,966 4,510 4,306 4,607 4,262 ----------- -------- -------- --------- ---------- -------- -------- --------- Income before income taxes 217 2,097 1,265 2,301 2,218 2,808 1,614 2,200 Provision for income taxes (129) 672 302 804 876 996 565 750 ----------- -------- -------- --------- ---------- -------- -------- --------- Net income $ 346 $ 1,425 $ 964 $ 1,497 $ 1,341 $ 1,812 $ 1,050 $ 1,450 =========== ======== ======== ========= ========== ======== ======== ========= Per Share Data: Net income: Basic $ 0.05 $ 0.21 $ 0.15 $ 0.24 $ 0.22 $ 0.27 $ 0.17 $ 0.24 Diluted 0.05 0.21 0.15 0.24 0.22 0.27 0.17 0.24 Cash dividends declared 0.085 0.08 0.08 0.08 0.08 0.08 0.07 0.06 Investment Portfolio The valuations of investment securities at December 31, 2008, 2007 and 2006, respectively, were as follows (in thousands): Available for Sale ---------------------------------------------------------------------------- 2008 2007 2006 ------------------------ ------------------------ ------------------------ Amortized Estimated Amortized Estimated Amortized Estimated cost fair value cost fair value cost fair value ----------- ----------- ----------- ----------- ----------- ----------- U.S. Government and agency securities $ 65,590 $ 65,748 $ 92,651 $ 93,208 $ 85,730 $ 85,247 State and municipal securities 46,852 46,975 6,136 6,148 4,623 4,609 Mortgage-backed securities 53,899 55,013 12,985 13,087 9,882 9,860 Other 4,982 4,255 1,789 1,858 1,441 1,677 ---------- ----------- ----------- ----------- ----------- ----------- Total securities $ 171,323 $ 171,991 $ 113,561 $ 114,301 $ 101,676 $ 101,393 ========== =========== =========== =========== =========== =========== Pledged securities $ 120,880 $ 98,540 $ 69,239 =========== =========== =========== - 35 - The following table sets forth the carrying value of our available for sale investment portfolio at December 31, 2008 (in thousands): Carrying Value --------------------------------------------------------- After 1 After 5 year years through 5 through 10 After 10 1 year years years years Total ---------- ----------- ---------- ---------- ---------- U.S. Government and agency securities - $ - $ 47,745 $ 18,003 $ 65,748 State and municipal securities - 2,729 5,281 38,965 46,975 Mortgage-backed securities - - - 55,013 55,013 Other - - - 4,255 4,255 ---------- ----------- ---------- ---------- ---------- Total $ - $ 2,729 $ 53,026 $ 116,235 $ 171,991 ========== =========== ========== ========== ========== The following table sets forth the weighted average yield by maturity of our available for sale investment portfolio at December 31, 2008 amortized cost: Weighted Average Yields ------------------------------------------------------------- After 1 After 5 year years through 5 through 10 After 10 1 year years years years Total ---------- ------------ ----------- ----------- ----------- U.S. Government and agency securities - - 5.49% 5.34% 5.45% State and municipal securities - 5.43% 4.98% 4.30% 4.45% Mortgage-backed securities - - - 5.69% 5.69% Other - - - 2.80% 2.80% ---------- ------------ ----------- ----------- ----------- Total weighted average yields - 5.43% 5.44% 4.77% 4.97% ========== ============ =========== =========== =========== - 36 - Loan Portfolio Loans consisted of the following, as extracted from the Call Reports of December 31, 2008, 2007, 2006, 2005 and 2004 (in thousands): 2008 2007 2006 2005 2004 ----------- ----------- ----------- ----------- ----------- Loans receivable: Loans secured by real estate: Construction and land development $ 274,687 $ 252,449 $ 194,460 $ 142,592 $ 90,742 Secured by farmland 15,683 12,700 12,326 11,650 15,203 Secured by 1-4 family residential properties: Revolving open-end loans & lines of credit 37,078 24,579 22,868 23,581 23,295 All other 114,619 76,776 68,196 66,140 58,158 Secured by multifamily residential properties 8,033 5,123 3,913 4,085 5,088 Secured by nonfarm nonresidential properties 151,043 110,769 102,217 84,189 72,611 Loans to finance agricultural production and other loans to farmers 3,060 3,119 2,724 3,729 4,020 Commercial and industrial loans 51,663 45,653 37,622 34,166 26,005 Loans to individuals for household, family and other personal expenditures Credit cards and related plans 4,689 4,331 4,778 3,933 3,807 Other 10,804 8,235 11,840 22,438 13,400 Obligations of states and political subdivisions in the U.S.: Tax exempt obligations 7,130 744 199 113 225 All other loans 3,195 1,030 897 787 628 Lease financing receivables 4 5 5 9 12 Deferred cost (unearned income) and fees (189) (243) (283) (318) (379) ----------- ----------- ----------- ----------- ----------- Total loans 681,500 545,270 461,763 397,094 312,815 Allowance for loan losses (9,542) (6,653) (5,566) (4,965) (4,055) ----------- ----------- ----------- ----------- ----------- Net loans $ 671,958 $ 538,617 $ 456,197 $ 392,129 $ 308,760 =========== =========== =========== =========== =========== Commitments and contingencies: Commitments to make loans 119,958 141,511 140,539 97,183 89,377 Standby letters of credit 2,940 2,611 4,711 4,796 1,726 - 37 - Certain Loan Maturities The maturities and carrying amounts of certain loans as of December 31, 2008 are summarized as follows (in thousands): Real Estate Commerical Construction Financial and and Land Agricultural Development Total -------------- ------------- -------------- Due within one year $ 62,897 $ 183,029 $ 245,926 Due after one year through five years: Fixed rate 120,487 73,093 193,580 Variable rate 23,344 16,303 39,647 Due after five years: Fixed rate 10,520 2,574 13,094 Variable rate 6,035 183 6,218 -------------- ------------- ------------- Total $ 223,283 $ 275,182 $ 498,465 ============== ============= ============= Risk Elements Past due and nonaccrual loans, as extracted from the Call Reports of December 31, 2008, 2007, 2006, 2005, and 2004 were as follows (in thousands): 2008 2007 2006 2005 2004 --------- --------- ---------- ---------- ---------- Nonaccrual loans: Real estate loans $20,164 $1,038 $ 859 $ 535 $ 614 Installment loans 33 40 58 114 80 Commercial and all other loans 607 176 50 348 250 --------- --------- ---------- ---------- ---------- Total $20,804 $1,254 $ 967 $ 997 $ 944 ========= ========= ========== ===================== Agricultural loans included above $ 167 $ 164 $ - $ 252 $ 197 ========= ========= ========== ========== ========== Past due 90 days or more and still accruing: Real estate loans $ 968 $ 30 $ 33 $ 64 $ 188 Installment loans - - - - 1 Credit cards and related plans 60 22 - 10 11 Commercial and all other loans 18 - - - 26 --------- --------- ---------- ---------- ---------- Total $ 1,046 $ 52 $ 33 $ 74 $ 226 ========= ========= ========== ========== ========== Agricultural loans included above $ - $ - $ - $ - $ 26 ========= ========= ========== ========== ========== Loans, including impaired loans, are generally classified as nonaccrual if they are past due as to maturity or payment of principal or interest for a period of more than 90 days, unless such loans are well-secured and in the process of collection. The gross interest income that would have been recorded for loans accounted for on a nonaccrual basis at December 31, 2008 was approximately $646,000. This amount represents interest income that would have been recorded if the loans had been current in accordance with their original terms and had been outstanding throughout the period or since origination, if held for part of the period. - 38 - Foreclosed assets (included in other assets) were $1.2 million, $1.7 million, $327,000, $247,000, and $404,000, at December 31, 2008, 2007, 2006, 2005, and 2004, respectively. The amount of interest recognized on impaired loans during the portion of 2008 that they were impaired was not material. Allowance for Loan Losses and Summary of Loan Loss Experience As a matter of policy, the bank maintains an allowance for loan losses. The allowance for loan losses is created by direct charges to income and by recoveries of amounts previously charged off. The allowance is reduced as losses on loans are charged against the allowance when realized. We evaluate our loan portfolio in accordance with SFAS No. 114, Accounting by Creditors for Impairment of a Loan, as amended by SFAS No. 118, Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosure. Under these standards, a loan is considered impaired, based on current information and events, if it is probable that the company will be unable to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan agreement. Uncollateralized loans are measured for impairment based on the present value of expected future cash flows discounted at the historical effective interest rate or the loan's observable market price, while all collateral-dependent loans are measured for impairment based on the fair value of the collateral. If the recorded investment in the loan exceeds the measure of fair value, a valuation allowance is established as a component of the allowance for loan losses. This evaluation is inherently subjective, as it requires material estimates that may be susceptible to significant change. The loan portfolio and the adequacy of the allowance are evaluated by management at least quarterly. In addition, our Loan Committee reviews our loan portfolio and credit quality quarterly. The amount of the allowance is based on management's evaluation of the loan portfolio including trends in composition, growth, and terms, historical and expected loan loss experience, economic conditions and conditions that may affect the borrowers' ability to pay, and other factors management deems appropriate. In addition, regulatory examiners may require the bank to recognize changes to the allowance for loan losses based on their judgments about information available to them at the time of their examination. The bank's management believes its allowance for loan losses is adequate under existing economic conditions to absorb loan losses inherent in its loan portfolio. Although management attempts to maintain the allowance at a level deemed adequate, future additions to the allowance may be necessary based upon changes in market conditions or the status of the loans included in the loan portfolio. The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loans are charged against the allowance for loan losses when management believes that the uncollectibility of a loan balance is confirmed. In addition to the review of loans considered impaired as discussed above, the allowance for loan losses is also based upon such factors as changes in the trends in volumes and terms of loans, levels and trends of charge-offs and recoveries, national and local economic trends and conditions that may affect the borrowers' ability to pay, effects of changes in risk selection and underwriting standards as well as overall portfolio quality. If conditions change substantially from the assumptions used to evaluate the allowance for loan losses, it is possible that management's assessment of the allowance may change. - 39 - The following table summarizes the bank's loan loss experience for the years ending December 31, 2008, 2007, 2006, 2005, and 2004 (in thousands, except ratios): 2008 2007 2006 2005 2004 ------------ ------------ ------------ ------------ ------------ Balance at beginning of period $ 6,653 $ 5,566 $ 4,965 $ 4,055 $ 3,430 Charge-offs: Commercial and other 260 104 135 245 417 Real estate 1,267 144 87 158 395 Installment loans to individuals 309 217 178 198 237 Credit cards and related plans 159 39 58 95 297 ------------ ------------ ------------ ------------ ------------ 1,995 504 458 696 1,346 ------------ ------------ ------------ ------------ ------------ Recoveries: Commercial and other 51 26 49 49 206 Real estate 19 71 32 19 27 Installment loans 78 88 65 69 56 Credit cards and related plans 10 44 40 66 86 ------------ ------------ ------------ ------------ ------------ 158 229 186 203 375 ------------ ------------ ------------ ------------ ------------ Net charge-offs 1,837 275 272 493 971 ------------ ------------ ------------ ------------ ------------ Additions charged to operations 3,336 1,362 873 1,403 1,596 ------------ ------------ ------------ ------------ ------------ Adjustments due to Merger with Longleaf Community Bank 1,390 - - - - ------------ ------------ ------------ ------------ ------------ Balance at end of year $ 9,542 $ 6,653 $ 5,566 $ 4,965 $ 4,055 ============ ============ ============ ============ ============ Ratio of net charge-offs during the year to average gross loans outstanding during the year 0.29% 0.06% 0.06% 0.14% 0.32% The following table summarizes the bank's allocation of allowance for loan losses at December 31, 2008, 2007, 2006, 2005 and 2004 (in thousands, except ratios): At December 31, ----------------------------------------------------------- 2008 2007 2006 --------------------- ------------------ ------------------ % of Total % of Total % of Total Amount Loans (1) Amount Loans (1) Amount Loans (1) --------- ----------- ------- ---------- ------- ---------- Real estate loans $ 8,414 88% $ 5,883 88% $ 4,866 87% Commercial and industrial loans 766 8% 595 9% 486 9% Installment loans 217 2% 153 2% 200 4% Unallocated 145 2% 22 - 14 - --------- ----------- ------- ---------- ------- ---------- Total $ 9,542 100% $ 6,653 100% $ 5,566 100% ========= =========== ======= ========== ======= ========== - 40 - At December 31, ----------------------------------------- 2005 2004 -------------------- -------------------- % of Total % of Total Amount Loans (1) Amount Loans (1) --------- ---------- -------- ----------- Real estate loans $ 4,150 84% $ 3,432 85% Commercial and industrial loans 474 10% 389 10% Installment loans 330 7% 223 6% Unallocated 11 0% 11 0% --------- ---------- -------- ----------- Total $ 4,965 100% $ 4,055 100% ========= ========== ======== =========== - ------------------------------------ (1) Represents total of all outstanding loans in each category as a percentage of total loans outstanding. Deposits Time certificates in amounts of $100,000 or more outstanding at December 31, 2008 by maturity were as follows (in thousands): Three months or less $ 126,259 Over three months through six months 73,743 Over six months through twelve months 54,065 Over twelve months through three years 21,645 Over three years 2,823 ----------------------- Total $ 278,535 ======================= Borrowings The bank borrows funds principally from the FHLB. Information regarding such borrowings is as follows (in thousands, except rates): 2008 2007 2006 ------------ ----------- ------------- Balance outstanding at December 31 $ 114,314 $ 97,000 $ 70,000 Weighted average rate at December 31 3.60% 4.44% 4.65% Maximum borrowings during the year $ 147,994 $ 97,000 $ 70,000 Average amounts outstanding during year $ 108,321 $ 78,405 $ 62,103 Weighted average rate during year 4.07% 4.73% 4.65% There were no short-term advances outstanding from the FHLB at December 31, 2008 and 2007. For 2008 and 2007, average outstanding short-term balances were $1,144,000 and $973,000, respectively. In addition, the bank may purchase federal funds through unsecured federal funds lines of credit with various banks aggregating $38.2 million. These lines are intended for short-term borrowings and are payable on demand and bear interest based upon the daily federal funds rate. For 2008 and 2007, average federal funds purchased were $6.9 million and $3.6 million, respectively. At December 31, 2008 the bank had no federal funds borrowings outstanding under these lines. At December 31, 2007, there were $10.0 million federal funds borrowings outstanding. The Company completed a $12 million offering of Trust Preferred Securities on March 30, 2006. Net proceeds from the sale of the Trust Preferred Securities were invested in Junior Subordinated Deferrable Interest Debentures issued by the Company. - 41 - Critical Accounting Estimates and Policies We prepare our consolidated financial statements in conformity with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amount of revenues and expenses during the reporting period. Actual results could differ from those estimates. Critical accounting estimates and policies are those we believe are both most important to the portrayal of our financial condition and results, and require our most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. Judgments and uncertainties affecting the application of those policies may result in materially different amounts being reported under different conditions or using different assumptions. We believe that the allowance for loan losses represents a particularly sensitive accounting estimate. The amount of the allowance is based on management's evaluation of the collectibility of the loan portfolio, including the maturity of the loan portfolio, credit concentration, trends in historical loss experience, specific impaired loans and general economic conditions. See Note A to the consolidated financial statements for a comprehensive discussion of our accounting policy for the allowance for loan losses. Additionally, we believe that intangible assets represent a sensitive accounting estimate. Intangible assets include goodwill and other identifiable assets, such as core deposit premiums, resulting from acquisitions. Core deposit premiums are amortized primarily on a straight-line basis over a ten-year life based upon historical studies of core deposits. Goodwill is not amortized but is tested annually for impairment or at any time an event occurs or circumstances change that may trigger a decline in the value of the reporting unit. Examples of such events or circumstances include adverse changes in legal factors, business climate, unanticipated competition, change in regulatory environment, or loss of key personnel. The Company tests for impairment in accordance with SFAS No. 142. Potential impairment of goodwill exists when the carrying amount of a reporting unit exceeds its fair value. In testing for impairment, an estimate of the fair value of the reporting unit under a business combination is done using one of two approaches. The Comparable Transaction Approach utilizes a regional transaction group and a national transaction group. For each group, average and median pricing ratios were applied to provide a range of values along with several qualitative factors being considered. The Discounted Cash Flow Approach is derived from the present value of future dividends over a five year time horizon and the projected terminal value at the end of the fifth year. The goodwill that would arise from this estimate is compared to the carrying value of the goodwill currently on the books to determine impairment. To the extent a reporting unit's carrying amount exceeds its fair value, an indication exists that the reporting unit's goodwill may be impaired, and a second step of impairment test will be performed. In the second step, the implied fair value of the reporting unit's goodwill, determined by allocating the reporting unit's fair value to all of its assets (recognized and unrecognized) and liabilities as if the reporting unit had been acquired in a business combination at the date of the impairment test. If the implied fair value of reporting unit goodwill is lower than its carrying amount, goodwill is impaired and is written down to its implied fair value. The loss recognized is limited to the carrying amount of goodwill. Once an impairment loss is recognized, future increases in fair value will not result in the reversal of previously recognized losses. New Accounting Standards SFAS No. 157, Fair Value Measurements, was issued in September 2006. In defining fair value, SFAS No. 157 retains the exchange price notion in earlier definitions of fair value. However, the definition of fair value under SFAS No. 157 focuses on the price that would be received to sell an asset or paid to transfer a liability (an exit price), not the price that would be paid to acquire the asset or received to assume the liability (an entry price). SFAS No. 157 applies whenever other accounting pronouncements require or permit assets or liabilities to be measured at fair value. Accordingly, SFAS No. 157 does not expand the use of fair value in any new circumstances. SFAS No. 157 also establishes a fair value hierarchy that prioritizes the information used to develop assumptions used to determine the exit price. Under this standard, fair value measurements would be disclosed separately by level within the fair value hierarchy. The Company adopted SFAS No. 157 effective January 1, 2008. The adoption of SFAS No. 157 had no effect on the Company's financial condition or results of operations. For additional information on the fair value of certain financial assets and liabilities, see Note M to the consolidated financial statements. - 42 - In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities. SFAS No. 159 creates a fair value option allowing an entity irrevocably to elect fair value as the initial and subsequent measurement attribute for certain financial assets and financial liabilities, with changes in fair value recognized in earnings as they occur. SFAS No. 159 requires an entity to report those financial assets and financial liabilities measured at fair value in a manner that separates those reported fair values from the carrying amounts of assets and liabilities measured using another measurement attribute on the face of the statement of financial position. SFAS No. 159 also requires an entity to provide information that would allow users to understand the effect on earnings of changes in the fair value on those instruments selected for the fair value election. The Company adopted SFAS No. 159 effective January 1, 2008. There was no initial effect of adoption since the Company did not elect the fair value option for any existing asset or liability. In addition, the Company did not elect the fair value option for any financial assets originated or purchased, or for liabilities issued, through December 31, 2008. In December 2007, the FASB issued SFAS No. 141(revised 2007), Business Combinations ("SFAS No. 141(R)"), which replaces SFAS No. 141. SFAS No. 141(R) establishes principles and requirements for recognition and measurement of assets, liabilities and any noncontrolling interest acquired due to a business combination. SFAS No. 141(R) expands the definitions of a business and a business combination, resulting in an increased number of transactions or other events that will qualify as business combinations. Under SFAS No. 141(R) the entity that acquires the business (the "acquirer") will record 100 percent of all assets and liabilities of the acquired business, including goodwill, generally at their fair values. As such, an acquirer will not be permitted to recognize the allowance for loan losses of the acquiree. SFAS No. 141(R) requires the acquirer to recognize goodwill as of the acquisition date, measured as a residual. In most business combinations, goodwill will be recognized to the extent that the consideration transferred plus the fair value of any noncontrolling interests in the acquiree at the acquisition date exceeds the fair value of the identifiable net assets acquired. Under SFAS No. 141(R), acquisition-related transaction and restructuring costs will be expensed as incurred rather than treated as part of the cost of the acquisition and included in the amount recorded for assets acquired. SFAS No. 141(R) is effective for fiscal years beginning after December 15, 2008. Accordingly, for acquisitions completed after December 31, 2008, the Company will apply the provisions of SFAS No. 141(R). In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB 51, which defines noncontrolling interest as the portion of equity in a subsidiary not attributable, directly or indirectly, to the parent. SFAS No. 160 requires the ownership interests in subsidiaries held by parties other than the parent (previously referred to as minority interest) to be clearly presented in the consolidated statement of financial position within equity, but separate from the parent's equity. The amount of consolidated net income attributable to the parent and to any noncontrolling interest must be clearly presented on the face of the consolidated statement of income. Changes in the parent's ownership interest while the parent retains its controlling financial interest (greater than 50 percent ownership) are to be accounted for as equity transactions. Upon a loss of control, any gain or loss on the interest sold will be recognized in earnings. Additionally, any ownership interest retained will be remeasured at fair value on the date control is lost, with any gain or loss recognized in earnings. SFAS No. 160 is effective for fiscal years beginning after December 15, 2008. Accordingly, the Company will adopt the provisions of SFAS No. 160 in the first quarter 2009. The Company does not expect the adoption of the provisions of SFAS No. 160 to have a material effect on its financial condition and results of operations. SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities, an amendment of FASB Statement No. 133, issued in March 2008, requires enhanced disclosures about an entity's derivative and hedging activities. These enhanced disclosures will discuss (a) how and why an entity uses derivative instruments; (b) how derivative instruments and related hedged items are accounted for under SFAS No. 133, and its related interpretations; and (c) how derivative instruments and related hedged items affect an entity's financial position, financial performance, and cash flows. SFAS No. 161 is effective for financial statements issued for fiscal years beginning after November 15, 2008 with earlier adoption allowed. The Company does not believe that the adoption of SFAS No. 161 will have a material effect on its financial condition or results of operations. FSP No. FAS 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active ("FSP FAS 157-3"), issued in October 2008, clarifies the application of SFAS No. 157 in a market that is not active and provides an example to illustrate key considerations in determining the fair value of a financial asset when the market for that financial asset is not active. FSP FAS 157-3 was effective upon issuance, including prior periods for which financial statements have not been issued. Revisions resulting from a change in the valuation technique or its application should be accounted for as a change in accounting estimate following the guidance in SFAS No. 154, Accounting Changes and Error Corrections. However, the disclosure provisions in SFAS No. 154 for a change in accounting estimate are not required for revisions resulting from a change in valuation technique or its application. As FSP FAS 157-3 clarified but did not change the application of SFAS No. 157, the adoption of FSP FAS 157-3 had no effect on the Company's financial condition or results of operations. - 43 - Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies are not expected to have a material impact on the Company's financial position, results of operations and cash flows. From time to time the FASB issues exposure drafts for proposed statements of financial accounting standards. Such exposure drafts are subject to comment from the public, to revisions by the FASB and to final issuance by the FASB as statements of financial accounting standards. Management considers the effect of the proposed statements on the consolidated financial statements of the Company and monitors the status of changes to and proposed effective dates of exposure drafts. Item 7A - Quantitative and Qualitative Disclosures About Market Risk. This information is included under Item 7 of this report under the captions "Interest Rate Sensitivity Analysis," "Market Risk," and "Derivative Financial Instruments." Item 8 - Financial Statements and Supplementary Data. - 44 - REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Shareholders Four Oaks Fincorp, Inc. Four Oaks, North Carolina We have audited the accompanying consolidated balance sheets of Four Oaks Fincorp, Inc. and Subsidiaries as of December 31, 2008 and 2007 and the related consolidated statements of operations, comprehensive income, shareholders' equity and cash flows for each of the years in the three-year period ended December 31, 2008. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Four Oaks Fincorp, Inc. and Subsidiaries as of December 31, 2008 and 2007, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2008 in conformity with accounting principles generally accepted in the United States of America. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness Four Oaks Fincorp, Inc.'s internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated March 12, 2009 expressed an unqualified opinion on the effectiveness of the Company's internal control over financial reporting. /s/ Dixon Hughes PLLC - --------------------- Raleigh, North Carolina March 12, 2009 - -------------------------------------------------------------------------------- - 45 - Four Oaks Fincorp, Inc. Consolidated Balance Sheets December 31, 2008 and 2007 - ---------------------------------------------------------------------------------------------------------------------------------- 2008 2007 ------------------------------- -------------------------- (Amounts in thousands, except share data) ASSETS Cash and due from banks $ 19,449 $ 14,394 Interest-earning deposits 9,303 3,881 Federal funds sold 123 - Investment securities available for sale, at fair value 171,991 114,301 Loans 681,500 545,270 Allowance for loan losses (9,542) (6,653) ------------------------------- -------------------------- Net loans 671,958 538,617 Accrued interest receivable 4,216 3,564 Bank premises and equipment, net 17,156 12,627 FHLB stock 6,529 5,010 Investment in life insurance 10,566 10,041 Goodwill 6,083 - Other assets 7,409 5,868 ------------------------------- -------------------------- Total assets $ 924,783 $ 708,303 =============================== ========================== LIABILITIES AND SHAREHOLDERS' EQUITY Deposits: Noninterest-bearing demand $ 73,971 $ 74,687 Money market and NOW accounts 155,737 126,300 Savings 28,412 28,041 Time deposits, $100,000 and over 278,535 172,513 Other time deposits 186,039 136,222 ------------------------------- -------------------------- Total deposits 722,694 537,763 Borrowings 114,314 97,000 Subordinated debentures 12,372 12,372 Accrued interest payable 3,282 4,055 Other liabilities 5,471 2,483 ------------------------------- -------------------------- Total liabilities 858,133 653,673 ------------------------------- -------------------------- Commitments and Contingencies (Notes C, L, N, and P) Shareholders' equity: Common stock, $ 1.00 par value, 20,000,000 shares authorized; 6,921,909 and 6,165,197 shares issued and outstanding at December 31, 2008 and 2007, respectively 6,922 6,165 Additional paid-in capital 30,862 21,545 Retained earnings 28,456 26,477 Accumulated other comprehensive income 410 443 ------------------------------- -------------------------- Total shareholders' equity 66,650 54,630 ------------------------------- -------------------------- Total liabilities and shareholders' equity $ 924,783 $ 708,303 =============================== ========================== - ---------------------------------------------------------------------------------------------------------------------------------- The accompanying notes are an integral part of these consolidated financial statements. - 46 - Four Oaks Fincorp, Inc. Consolidated Statements of Operations For the Years Ended December 31, 2008, 2007 and 2006 - ---------------------------------------------------------------------------------------------------------------------------------- 2008 2007 2006 ------------------- ----------------- ----------------- (Amounts in thousands, except per share data) Interest and dividend income: Loans, including fees $ 41,182 $ 40,967 $ 35,457 Investment securities: Taxable 6,646 5,873 4,503 Tax-exempt 627 178 152 Dividends 505 390 287 Interest-earning deposits 81 105 157 ------------------- ----------------- ----------------- Total interest and dividend income 49,041 47,513 40,556 ------------------- ----------------- ----------------- Interest expense: Deposits 18,379 19,142 14,202 Borrowings 4,984 4,557 3,615 ------------------- ----------------- ----------------- Total interest expense 23,363 23,699 17,817 ------------------- ----------------- ----------------- Net interest income 25,678 23,814 22,739 Provision for loan losses 3,336 1,362 873 ------------------- ----------------- ----------------- Net interest income after provision for loan losses 22,342 22,452 21,866 ------------------- ----------------- ----------------- Non-interest income: Service charges on deposit accounts 2,291 2,098 2,053 Other service charges, commissions and fees 1,522 1,544 1,613 Gains (losses) on sale of investment securities 576 (36) (121) Gains (losses) on hedges, net 97 165 (262) Gains on sale of loans 47 69 103 Merchant fees 472 436 402 Income (loss) from investment in life insurance 525 (205) 549 ------------------- ----------------- ----------------- Total non-interest income 5,530 4,071 4,337 ------------------- ----------------- ----------------- Non-interest expenses: Salaries 10,250 8,444 7,163 Employee benefits 2,110 1,690 1,477 Occupancy expenses 1,026 799 681 Equipment expenses 1,543 1,409 1,438 Professional and consulting fees 1,617 1,263 1,183 Other taxes and licenses 456 275 271 Merchant processing expenses 410 370 355 Other operating expenses 4,580 3,434 2,991 ------------------- ----------------- ----------------- Total non-interest expenses 21,992 17,684 15,559 ------------------- ----------------- ----------------- Income before income taxes 5,880 8,839 10,644 Provision for income taxes 1,649 3,187 3,627 ------------------- ----------------- ----------------- Net income $ 4,231 $ 5,652 $ 7,017 =================== ================= ================= Basic net income per common share $ 0.65 $ 0.92 $ 1.15 =================== ================= ================= Diluted net income per common share $ 0.65 $ 0.91 $ 1.14 =================== ================= ================= - ---------------------------------------------------------------------------------------------------------------------------------- The accompanying notes are an integral part of these consolidated financial statements. - 47 - Four Oaks Fincorp, Inc. Consolidated Statements of Comprehensive Income For the Years Ended December 31, 2008, 2007 and 2006 - ---------------------------------------------------------------------------------------------------------------------------------- 2008 2007 2006 ------------------ ------------------- --------------- (Amounts in thousands) Net income $ 4,231 $ 5,652 $ 7,017 ------------------ ------------------- --------------- Other comprehensive income (loss): Securities available for sale: Unrealized holding gains on available for sale securities 504 987 145 Tax effect (189) (395) (57) Reclassification of (gains) losses recognized in net income (576) 36 121 Tax effect 228 (14) (48) ------------------ ------------------- --------------- Net of tax amount (33) 613 161 ------------------ ------------------- --------------- Cash flow hedging activities: Unrealized holding gains on cash flow hedging activities - 402 314 Tax effect - (160) (127) ------------------ ------------------- --------------- Net of tax amount - 242 187 ------------------ ------------------- --------------- Total other comprehensive income (loss) (33) 855 348 ------------------ ------------------- --------------- Comprehensive income $ 4,198 $ 6,507 $ 7,365 ================== =================== =============== - ---------------------------------------------------------------------------------------------------------------------------------- The accompanying notes are an integral part of these consolidated financial statements. - 48 - Four Oaks Fincorp, Inc. Consolidated Statements of Shareholders' Equity For the Years Ended December 31, 2008, 2007 and 2006 - ---------------------------------------------------------------------------------------------------------------------------------- Accumulated Common stock Additional other Total ----------------------- paid-in Retained comprehensive shareholders' Shares Amount capital earnings income (loss) equity ------------ --------- ------------ ---------- -------------- --------------- (Amounts in thousands, except share data) BALANCE, DECEMBER 31, 2005 4,379,258 $4,379 $ 9,178 $ 28,815 $ (760) $ 41,612 Net income - - - 7,017 - 7,017 Other comprehensive income - - - - 348 348 Effect of 5-for-4 stock split 1,109,543 1,110 (1,110) - - - Issuance of common stock 98,896 98 1,511 - - 1,609 Current income tax benefit - - 293 - - 293 Stock based compensation - - 144 - - 144 Purchases and retirement of common stock (9,835) (9) - (243) - (252) Cash dividends of $.24 per share - - - (1,448) - (1,448) ------------ --------- ------------ ---------- -------------- --------------- BALANCE, DECEMBER 31, 2006 5,577,862 $5,578 $ 10,016 $ 34,141 $ (412) $ 49,323 Net income - - - 5,652 - 5,652 Other comprehensive income - - - - 855 855 Effect of 10% stock dividend 562,345 562 9,532 (10,094) - - Issuance of common stock 100,797 100 1,565 - - 1,665 Current income tax benefit - - 203 - - 203 Stock based compensation - - 229 - - 229 Purchases and retirement of common stock (75,807) (75) - (1,437) - (1,513) Cash dividends of $.29 per share - - - (1,784) - (1,784) ------------ --------- ------------ ---------- -------------- --------------- BALANCE, DECEMBER 31, 2007 6,165,197 $6,165 $ 21,545 $ 26,477 $ 443 $ 54,630 Net income - - - 4,231 - 4,231 Other comprehensive income (loss) - - - - (33) (33) Effect of merger with LongLeaf Community Bank 609,770 610 7,335 - - 7,945 Issuance of common stock 152,962 153 1,706 - - 1,859 Current income tax benefit - - 102 - - 102 Stock based compensation - - 174 - - 174 Purchases and retirement of common stock (6,020) (6) - (69) - (75) Cash dividends of $ .325 per share YTD - - - (2,183) - (2,183) ------------ --------- ------------ ---------- -------------- --------------- BALANCE AT DECEMBER 31, 2008 6,921,909 $6,922 $ 30,862 $ 28,456 $ 410 $ 66,650 ============ ========= ============ ========== ============== =============== - ---------------------------------------------------------------------------------------------------------------------------------- The accompanying notes are an integral part of these consolidated financial statements. - 49 - Four Oaks Fincorp, Inc. Consolidated Statements of Cash Flows For the Years Ended December 31, 2008, 2007 and 2006 - ---------------------------------------------------------------------------------------------------------------------------------- 2008 2007 2006 ----------------- -------------------- ------------------- (Amounts in thousands) Cash flows from operating activities: Net income $ 4,231 $ 5,652 $ 7,017 Adjustments to reconcile net income to net cash provided by operations: Provision for loan losses 3,336 1,362 873 Provision for depreciation and amortization 1,116 1,009 1,022 Deferred income tax benefit - (523) (319) Net amortization of bond premiums and discounts 19 32 (28) Stock based compensation 174 229 144 Gain on sale of loans (47) (69) (103) (Gain) loss on sale of investment securities (576) 36 121 (Gain) loss on sale of foreclosed assets 197 20 (2) Loss on disposition of premises and equipment 4 77 73 (Income) loss from investment in life insurance (525) 205 (549) Changes in hedge activity (97) (165) 262 Changes in assets and liabilities: Other assets (578) 407 (1,365) Interest receivable (410) 50 (664) Other liabilities 1,830 134 (3,556) Interest payable (878) 797 1,003 ----------------- -------------------- ------------------- Net cash provided by operating activities 7,796 9,253 3,929 ----------------- -------------------- ------------------- Cash flows from investing activities: Proceeds from sales and calls of investment securities available for sale 152,498 78,027 36,759 Proceeds from maturities of investment securities available for sale - 2,000 275 Purchase of investment securities available for sale (205,491) (91,980) (58,045) Purchase of FHLB stock (3,802) (1,320) (1,825) Redemption of FHLB stock 2,562 504 1,286 Net increase in loans (89,655) (86,283) (65,107) Purchases of bank premises and equipment (1,999) (2,070) (3,028) Purchases of bank-owned life insurance - (1,822) - Proceeds from sale of foreclosed assets 736 1,299 193 Expenditures on foreclosed assets (61) (110) (1) Net cash provided by business combination 3,167 - - ----------------- -------------------- ------------------- Net cash used by investing activities (142,045) (101,755) (89,493) ----------------- -------------------- ------------------- Cash flows from financing activities: Net proceeds from borrowings 14,728 23,600 (740) Net increase in deposit accounts 130,418 70,895 68,526 Proceeds from subordinated debentures - - 12,372 Proceeds from issuance of common stock 1,859 1,665 1,609 Excess tax benefits from stock options 102 203 293 Purchases and retirement of common stock (75) (1,513) (252) Cash dividends paid (2,183) (1,784) (1,448) ----------------- -------------------- ------------------- Net cash provided by financing activities 144,849 93,066 80,360 ----------------- -------------------- ------------------- Net increase (decrease) in cash and cash equivalents 10,600 564 (5,204) Cash and cash equivalents at beginning of year 18,275 17,711 22,915 ----------------- -------------------- ------------------- Cash and cash equivalents at end of year $ 28,875 $ 18,275 $ 17,711 ================= ==================== =================== - ---------------------------------------------------------------------------------------------------------------------------------- The accompanying notes are an integral part of these consolidated financial statements. - 50 - Four Oaks Fincorp, Inc. Notes to Consolidated Financial Statements December 31, 2008, 2007 and 2006 - -------------------------------------------------------------------------------- NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation The consolidated financial statements include the accounts and transactions of Four Oaks Fincorp, Inc. (the "Company"), a bank holding company incorporated under the laws of the State of North Carolina, and its wholly owned subsidiaries, Four Oaks Bank & Trust Company, Inc. (the "Bank") and Four Oaks Mortgage Services, LLC, the Company's mortgage origination subsidiary. All significant intercompany transactions have been eliminated. In March 2006, the Company formed Four Oaks Statutory Trust I, a wholly owned Delaware statutory business trust (the "Trust"), for the sole purpose of issuing Trust Preferred Securities (as defined in Note H below). The Trust is not included in the consolidated financial statements of the Company, in accordance with Financial Accounting Standards Board ("FASB") Interpretation No. 46, "Consolidation of Variable Interest Entities (revised December 2003) - an interpretation of ARB No. 51" ("FIN 46R"). Nature of Operations The Company was incorporated under the laws of the State of North Carolina on February 5, 1997. The Company's primary function is to serve as the holding company for its wholly owned subsidiaries, the bank and Four Oaks Mortgage Services, LLC. The bank operates seventeen offices in eastern and central North Carolina, and its primary source of revenue is derived from loans to customers and from its securities portfolio. The loan portfolio is comprised mainly of real estate, commercial, and consumer loans. These loans are primarily collateralized by residential and commercial properties, commercial equipment, and personal property. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Use of Estimates Preparing consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan losses. Cash and Cash Equivalents For the purpose of presentation in the consolidated statements of cash flows, cash and cash equivalents are defined as those amounts included in the balance sheet captions cash and due from banks and interest-earning deposits. Federal regulations require institutions to set aside specified amounts of cash as reserves against transactions and time deposits. As of December 31, 2008, the daily average gross reserve requirement was $3.5 million. Investment Securities Investment securities are classified into three categories: (1) Held to Maturity - Debt securities that the Company has the positive intent and the ability to hold to maturity are classified as held to maturity and reported at amortized cost; (2) Trading - Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and reported at fair value, with unrealized gains and losses included in earnings; and - -------------------------------------------------------------------------------- - 51 - Four Oaks Fincorp, Inc. Notes to Consolidated Financial Statements December 31, 2008, 2007 and 2006 - -------------------------------------------------------------------------------- NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) (3) Available for Sale - Debt and equity securities not classified as either securities held to maturity or trading securities are reported at fair value, with unrealized gains and losses excluded from earnings and reported, net of income taxes, as other comprehensive income, a separate component of shareholders' equity. The Company has historically classified all securities as available for sale. Gains and losses on sales of securities, computed based on specific identification of adjusted cost of each security, are included in income at the time of the sale. Premiums and discounts are amortized into interest income using a method that approximates the interest method over the period to maturity. Loans and Allowance for Loan Losses Loans are stated at the amount of unpaid principal, reduced by an allowance for loan losses. Interest on loans is calculated by using the simple interest method on daily balances of the principal amount outstanding. Loan origination fees are deferred, as well as certain direct loan origination costs. Such costs and fees are recognized as an adjustment to yield over the contractual lives of the related loans utilizing the interest method. The Company evaluates its loan portfolio in accordance with Statement of Financial Accounting Standards ("SFAS") No. 114, Accounting by Creditors for Impairment of a Loan, as amended by SFAS No. 118, Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosure. Under these standards, a loan is considered impaired, based on current information and events, if it is probable that the Company will be unable to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan agreement. Uncollateralized loans are measured for impairment based on the present value of expected future cash flows discounted at the historical effective interest rate or the loan's observable market price, while all collateral-dependent loans are measured for impairment based on the fair value of the collateral. If the recorded investment in the loan exceeds the measure of fair value, a valuation allowance is established as a component of the allowance for loan losses. The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loans are charged against the allowance for loan losses when management believes that the uncollectibility of a loan balance is confirmed. In addition to the review of loans considered impaired as discussed above, the allowance for loan losses is also based upon such factors as changes in the trends in volumes and terms of loans, levels and trends of charge-offs and recoveries, national and local economic trends and conditions that may affect the borrowers' ability to pay, effects of changes in risk selection and underwriting standards as well as overall portfolio quality. If conditions change substantially from the assumptions used to evaluate the allowance for loan losses, it is possible that management's assessment of the allowance may change. In addition, regulatory examiners may require the bank to recognize changes to the allowance for loan losses based on their judgments about information available to them at the time of their examination. Income Recognition on Impaired and Nonaccrual Loans Loans, including impaired loans, are generally classified as nonaccrual if they are past due as to maturity or payment of principal or interest for a period of more than 90 days, unless such loans are well-secured and in the process of collection. If a loan or a portion of a loan is classified as doubtful or is partially charged-off, the loan is generally classified as nonaccrual. Loans that are on a current payment status or past due less than 90 days may also be classified as nonaccrual if repayment in full of principal and/or interest is in doubt. Loans may be returned to accrual status when all principal and interest amounts contractually due (including arrearages) are reasonably assured of repayment within an acceptable period of time and there is a sustained period of repayment performance (generally a minimum of six months) by the borrower, in accordance with the contractual terms. - -------------------------------------------------------------------------------- - 52 - Four Oaks Fincorp, Inc. Notes to Consolidated Financial Statements December 31, 2008, 2007 and 2006 - -------------------------------------------------------------------------------- NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) While a loan is classified as nonaccrual and the future collectibility of the recorded loan balance is doubtful, collections of interest and principal are generally applied as a reduction to the principal outstanding, except in the case of loans with scheduled amortizations where the payment is generally applied to the oldest payment due. When the future collectibility of the recorded loan balance is expected, interest income may be recognized on a cash basis. In the case where a nonaccrual loan had been partially charged-off, recognition of interest on a cash basis is limited to that which would have been recognized on the recorded loan balance at the contractual interest rate. Receipts in excess of that amount are recorded as recoveries to the allowance for loan losses until prior charge-offs have been fully recovered. Foreclosed Assets Assets acquired as a result of foreclosure are valued at fair value at the date of foreclosure establishing a new cost basis. After foreclosure, valuations of the property are periodically performed by management and the assets are carried at the lower of cost or fair value minus estimated costs to sell. Losses from the acquisition of property in full or partial satisfaction of debt are treated as credit losses. Routine holding costs, subsequent declines in value, and gains or losses on disposition are included in other income and expense. Bank Premises and Equipment Land is carried at cost. Buildings, furniture, and equipment are stated at cost less accumulated depreciation. Depreciation is computed using the straight-line method based on the estimated useful lives of assets. Useful lives range from 5 to 10 years for furniture and equipment and 40 years for buildings. Expenditures for repairs and maintenance are charged to expense as incurred. Goodwill and Other Intangibles In July 2001, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 142, Goodwill and Other Intangible Assets. SFAS No. 142 required companies to cease amortizing goodwill and established a new method for testing goodwill for impairment on an annual basis. In accordance with provisions of SFAS No. 142, all goodwill resulting from business combinations is not being amortized. Other intangible assets, consisting of premiums on purchased core deposits, are being amortized over ten years principally using the straight-line method. The carrying amount of goodwill and other intangible assets at December 31, 2008 amounted to $6.1 million and $449,000, respectively. Income Taxes Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the tax bases of assets and liabilities and their carrying amounts for financial reporting purposes. Deferred tax assets are also recognized for operating loss carry-forwards. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which the temporary differences are expected to be recovered or settled. Deferred tax assets are reduced by a valuation allowance if it is more likely than not that the tax benefits will not be realized. The Company adopted the provisions of FIN 48, Accounting for Uncertainty in Income Taxes, on January 1, 2007 with no impact on the consolidated financial statements. The Company did not recognize any interest or penalties related to income tax during the years ended December 31, 2007 and 2008, and did not accrue any interest or penalties as of December 31, 2008 or 2007. The Company did not have an accrual for uncertain tax positions as deductions taken and benefits accrued are based on widely understood administrative practices and procedures, and are based on clear and unambiguous tax law. Tax returns for all years 2005 and thereafter are subject to possible future examinations by tax authorities. - -------------------------------------------------------------------------------- - 53 - Four Oaks Fincorp, Inc. Notes to Consolidated Financial Statements December 31, 2008, 2007 and 2006 - -------------------------------------------------------------------------------- NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Stock in Federal Home Loan Bank of Atlanta As a requirement for membership, the Company invests in stock of the FHLB of Atlanta. This investment is carried at cost. Due to the redemptive provisions of the FHLB, the Company estimated that fair value equals cost and that this investment was not impaired as of December 31, 2008. Comprehensive Income Comprehensive income is defined as the change in equity during a period for non-owner transactions and is divided into net income and other comprehensive income. Other comprehensive income includes revenues, expenses, gains, and losses that are excluded from earnings under current accounting standards. Components of other comprehensive income for the Company consist of the unrealized gains and losses, net of taxes, in the Company's available for sale securities portfolio and unrealized gains and losses, net of taxes, in the Company's cash flow hedge instruments. Accumulated other comprehensive income at December 31, 2008 and 2007 consists of the following: 2008 2007 --------------- ------------------ (Amounts in thousands) Unrealized holding gains (losses) - investment securities available for sale $ 668 $ 740 Deferred income taxes (258) (297) --------------- ------------------ Net unrealized holding gains (losses) - investment securities available for sale 410 443 --------------- ------------------ Total accumulated other comprehensive income (loss) $ 410 $ 443 =============== ================== Stock Compensation Plans Effective January 1, 2006, the Company adopted SFAS No. 123 (revised 2004), Share-Based Payment ("SFAS No. 123R"), which was issued by the FASB in December 2004. SFAS No. 123R revises SFAS No. 123 Accounting for Stock-Based Compensation, and supersedes Accounting Principles Board Opinion ("APB") No. 25, Accounting for Stock Issued to Employees, and its related interpretations. SFAS No. 123R requires recognition of the cost of employee services received in exchange for an award of equity instruments in the financial statements over the period the employee is required to perform the services in exchange for the award (usually the vesting period). SFAS No. 123R also requires measurement of the cost of employee services received in exchange for an award based on the grant-date fair value of the award. SFAS No. 123R also amends SFAS No. 95, Statement of Cash Flows, to require that excess tax benefits be reported as financing cash inflows, rather than as a reduction of taxes paid, which is included within operating cash flows. The Company adopted SFAS No. 123R using the modified prospective application as permitted under SFAS No. 123R. Accordingly, prior period amounts have not been restated. Under this application, the Company is required to record compensation expense for all awards granted after the date of adoption and for the unvested portion of previously granted awards that remain outstanding at the date of adoption. Prior to the adoption of SFAS No. 123R, the Company used the intrinsic value method as prescribed by APB No. 25 and thus recognized no compensation expense for options granted with exercise prices equal to the fair market value of the Company's common stock on the date of grant. - -------------------------------------------------------------------------------- - 54 - Four Oaks Fincorp, Inc. Notes to Consolidated Financial Statements December 31, 2008, 2007 and 2006 - -------------------------------------------------------------------------------- NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Net Income Per Common Share and Common Shares Outstanding Basic earnings per share represents income available to common shareholders divided by the weighted average number of common shares outstanding during the period. Diluted earnings per share reflect additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income that would result from the assumed issuance. All references to net income per share, weighted average shares outstanding, and dividends per share have been retroactively adjusted for a 10% stock dividend issued on October 3, 2007 and a five for four stock split distributed in the form of 25% stock dividend on November 10, 2006. Potential common shares that may be issued by the Company relate solely to outstanding stock options. Basic and diluted net income per common share have been computed based upon net income as presented in the accompanying consolidated statements of operations divided by the weighted average number of common shares outstanding or assumed to be outstanding as summarized below: 2008 2007 2006 ----------- ----------- ----------- Weighted average number of common shares used in computing basic net income per share 6,554,450 6,170,140 6,080,778 Effect of dilutive stock options 2,317 22,419 56,444 ----------- ----------- ----------- Weighted average number of commons shares and dilutive potential common shares used in computing diluted net income per share 6,556,767 6,192,559 6,137,222 =========== =========== =========== There were 165,605 antidilutive shares outstanding for the year ended December 31, 2008. As of December 31, 2007 and 2006, there were no antidilutive shares outstanding. Derivative Instruments The Company utilizes interest rate swaps in the management of interest rate risk. Interest rate swaps are contractual agreements between two parties to exchange a series of cash flows representing interest payments. A swap allows both parties to alter the repricing characteristics of assets or liabilities without affecting the underlying principal positions. Through the use of a swap, assets and liabilities may be transformed from fixed to floating rates, from floating rates to fixed rates, or from one type of floating rate to another. Swap terms generally range from one year to ten years depending on the need. The net interest payable or receivable on interest rate swaps that are designated as hedges is accrued and recognized as an adjustment to the interest income or expense of the related asset or liability. Gains and losses from early terminations of derivatives are deferred and amortized as yield adjustments over the shorter of the remaining term of the hedged asset or liability or the remaining term of the derivative instrument. Upon disposition or settlement of the asset or liability being hedged, deferral accounting is discontinued and any gains or losses are recognized in income. Unrealized holding gains and losses on derivatives designated as cash flow hedges are reported, net of applicable income tax effect, in accumulated other comprehensive income. Derivative financial instruments that fail to qualify as a hedge are carried at fair value with gains and losses recognized in current earnings. - -------------------------------------------------------------------------------- - 55 - Four Oaks Fincorp, Inc. Notes to Consolidated Financial Statements December 31, 2008, 2007 and 2006 - -------------------------------------------------------------------------------- NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) New Accounting Standards SFAS No. 157, Fair Value Measurements, was issued in September 2006. In defining fair value, SFAS No. 157 retains the exchange price notion in earlier definitions of fair value. However, the definition of fair value under SFAS No. 157 focuses on the price that would be received to sell an asset or paid to transfer a liability (an exit price), not the price that would be paid to acquire the asset or received to assume the liability (an entry price). SFAS No. 157 applies whenever other accounting pronouncements require or permit assets or liabilities to be measured at fair value. Accordingly, SFAS No. 157 does not expand the use of fair value in any new circumstances. SFAS No. 157 also establishes a fair value hierarchy that prioritizes the information used to develop assumptions used to determine the exit price. Under this standard, fair value measurements would be disclosed separately by level within the fair value hierarchy. The Company adopted SFAS No. 157 effective January 1, 2008. The adoption of SFAS No. 157 had no effect on the Company's financial condition or results of operations. For additional information on the fair value of certain financial assets and liabilities, see Note M to the consolidated financial statements. In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities. SFAS No. 159 creates a fair value option allowing an entity irrevocably to elect fair value as the initial and subsequent measurement attribute for certain financial assets and financial liabilities, with changes in fair value recognized in earnings as they occur. SFAS No. 159 requires an entity to report those financial assets and financial liabilities measured at fair value in a manner that separates those reported fair values from the carrying amounts of assets and liabilities measured using another measurement attribute on the face of the statement of financial position. SFAS No. 159 also requires an entity to provide information that would allow users to understand the effect on earnings of changes in the fair value on those instruments selected for the fair value election. The Company adopted SFAS No. 159 effective January 1, 2008. There was no initial effect of adoption since the Company did not elect the fair value option for any existing asset or liability. In addition, the Company did not elect the fair value option for any financial assets originated or purchased, or for liabilities issued, through December 31, 2008. In December 2007, the FASB issued SFAS No. 141(revised 2007), Business Combinations ("SFAS No. 141(R)"), which replaces SFAS No. 141. SFAS No. 141(R) establishes principles and requirements for recognition and measurement of assets, liabilities and any noncontrolling interest acquired due to a business combination. SFAS No. 141(R) expands the definitions of a business and a business combination, resulting in an increased number of transactions or other events that will qualify as business combinations. Under SFAS No. 141(R) the entity that acquires the business (the "acquirer") will record 100 percent of all assets and liabilities of the acquired business, including goodwill, generally at their fair values. As such, an acquirer will not be permitted to recognize the allowance for loan losses of the acquiree. SFAS No. 141(R) requires the acquirer to recognize goodwill as of the acquisition date, measured as a residual. In most business combinations, goodwill will be recognized to the extent that the consideration transferred plus the fair value of any noncontrolling interests in the acquiree at the acquisition date exceeds the fair values of the identifiable net assets acquired. Under SFAS No. 141(R), acquisition-related transaction and restructuring costs will be expensed as incurred rather than treated as part of the cost of the acquisition and included in the amount recorded for assets acquired. SFAS No. 141(R) is effective for fiscal years beginning after December 15, 2008. Accordingly, for acquisitions completed after December 31, 2008, the Company will apply the provisions of SFAS No. 141(R). In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB No. 51, which defines noncontrolling interest as the portion of equity in a subsidiary not attributable, directly or indirectly, to the parent. SFAS No. 160 requires the ownership interests in subsidiaries held by parties other than the parent (previously referred to as minority interest) to be clearly presented in the consolidated statement of financial position within equity, but separate from the parent's equity. The amount of consolidated net income attributable to the parent and to any noncontrolling interest must be clearly presented on the face of the consolidated statement of income. Changes in the parent's ownership interest while the parent retains its controlling financial interest (greater than 50 percent ownership) are to be accounted for as equity transactions. Upon a loss of control, any gain or loss on the interest sold will be recognized in earnings. Additionally, any ownership interest retained will be remeasured at fair value on the date control is lost, with any gain or loss recognized in earnings. SFAS No. 160 is effective for fiscal years beginning after December 15, 2008. Accordingly, the Company will adopt the provisions of SFAS No. 160 in the first quarter 2009. The Company does not expect the adoption of the provisions of SFAS No. 160 to have a material effect on its financial condition and results of operations. - -------------------------------------------------------------------------------- - 56 - Four Oaks Fincorp, Inc. Notes to Consolidated Financial Statements December 31, 2008, 2007 and 2006 - -------------------------------------------------------------------------------- NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities, an amendment of FASB Statement No. 133, issued in March 2008, requires enhanced disclosures about an entity's derivative and hedging activities. These enhanced disclosures will discuss (a) how and why an entity uses derivative instruments; (b) how derivative instruments and related hedged items are accounted for under SFAS No. 133, and its related interpretations; and (c) how derivative instruments and related hedged items affect an entity's financial position, financial performance, and cash flows. SFAS No. 161 is effective for financial statements issued for fiscal years beginning after November 15, 2008 with earlier adoption allowed. The Company does not believe that the adoption of SFAS No. 161 will have a material effect on its financial condition or results of operations. FSP No. FAS 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active ("FSP FAS 157-3"), issued in October 2008, clarifies the application of SFAS No. 157 in a market that is not active and provides an example to illustrate key considerations in determining the fair value of a financial asset when the market for that financial asset is not active. FSP FAS 157-3 was effective upon issuance, including prior periods for which financial statements have not been issued. Revisions resulting from a change in the valuation technique or its application should be accounted for as a change in accounting estimate following the guidance in SFAS No. 154, Accounting Changes and Error Corrections. However, the disclosure provisions in SFAS No. 154 for a change in accounting estimate are not required for revisions resulting from a change in valuation technique or its application. As FSP FAS 157-3 clarified but did not change the application of SFAS No. 157, the adoption of FSP FAS 157-3 had no effect on the Company's financial condition or results of operations. Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies are not expected to have a material impact on the Company's financial position, results of operations and cash flows. From time to time the FASB issues exposure drafts for proposed statements of financial accounting standards. Such exposure drafts are subject to comment from the public, to revisions by the FASB and to final issuance by the FASB as statements of financial accounting standards. Management considers the effect of the proposed statements on the consolidated financial statements of the Company and monitors the status of changes to and proposed effective dates of exposure drafts. Reclassifications Certain items included in the 2007 and 2006 consolidated financial statements have been reclassified to conform to the 2008 presentation. These reclassifications have no effect on the net income or shareholders' equity previously reported. - -------------------------------------------------------------------------------- - 57 - Four Oaks Fincorp, Inc. Notes to Consolidated Financial Statements December 31, 2008, 2007 and 2006 - -------------------------------------------------------------------------------- NOTE B - INVESTMENT SECURITIES The amortized cost, gross unrealized gains, gross unrealized losses and fair values of securities available for sale as of December 31, 2008 and 2007 are as follows: Gross Gross Amortized Unrealized Unrealized Cost Gains Losses Fair Value ----------- ------------ ------------ ------------ (Amounts in thousands) 2008: U.S. government and agency securities $ 65,590 $ 161 $ 3 $ 65,748 State and municipal securities 46,852 301 178 46,975 Mortgage-backed securities 53,899 1,171 57 55,013 Other 4,982 - 727 4,255 ----------- ------------ ------------ ------------ $ 171,323 $ 1,633 $ 965 $ 171,991 =========== ============ ============ ============ Gross Gross Amortized Unrealized Unrealized Cost Gains Losses Fair Value ----------- ------------ ------------ ------------ (Amounts in thousands) 2007: U.S. government and agency securities $ 92,651 $ 559 $ 2 $ 93,208 State and municipal securities 6,136 17 5 6,148 Mortgage-backed securities 12,985 122 20 13,087 Other 1,789 69 - 1,858 ----------- ------------ ------------ ------------ $ 113,561 $ 767 $ 27 $ 114,301 =========== ============ ============ ============ The following table shows gross unrealized losses and fair values of investment securities, aggregated by investment category and length of time that the individual securities have been in a continuous unrealized loss position, at December 31, 2008 and 2007. As of December 31, 2008, the unrealized losses relate to two U.S. government agency securities, four mortgage-backed securities, thirty-five municipal securities and fifteen other securities. None of the securities had continuous unrealized losses for more than twelve months. The unrealized losses relate to debt securities that have incurred fair value reductions due to higher market interest rates since the securities were purchased. The unrealized losses are not likely to reverse unless and until market interest rates decline to the levels that existed when the securities were purchased. Since none of the unrealized losses relate to the marketability of the securities or the issuer's ability to honor redemption obligations, none of the securities are deemed to be other than temporarily impaired. - -------------------------------------------------------------------------------- - 58 - Four Oaks Fincorp, Inc. Notes to Consolidated Financial Statements December 31, 2008, 2007 and 2006 - -------------------------------------------------------------------------------- NOTE B - INVESTMENT SECURITIES (Continued) 2008 ---------------------------------------------------------------- Less Than 12 Months 12 Months or More Total ---------------------- -------------------- -------------------- Fair Unrealized Fair Unrealized Fair Unrealized value losses value losses value losses ----------- ---------- --------- ---------- --------- ---------- (Amounts in thousands) Securities available for sale: U.S. government and agency securities $ 3,992 $ 3 $ - $ - $ 3,992 $ 3 State and municipal securities 14,097 178 - - 14,097 178 Mortgage-backed securities 4,253 57 - - 4,253 57 Other 96 47 930 680 1,025 727 ----------- ---------- --------- ---------- --------- ---------- Total temporarily impaired securities $ 22,438 $ 285 $ 930 $ 680 $ 23,367 $ 965 =========== ========== ========= ========== ========= ========== 2007 ---------------------------------------------------------------- Less Than 12 Months 12 Months or More Total ---------------------- -------------------- -------------------- Fair Unrealized Fair Unrealized Fair Unrealized value losses value losses value losses ----------- ---------- --------- ---------- --------- ---------- (Amounts in thousands) Securities available for sale: U.S. government and agency securities $ 14,983 $ 2 $ - $ - $ 14,983 $ 2 State and municipal securities 139 - 1,519 5 1,658 5 Mortgage-backed securities - - 2,439 20 2,439 20 ----------- ---------- --------- ---------- --------- ---------- Total temporarily impaired securities $ 15,122 $ 2 $ 3,958 $ 25 $ 19,080 $ 27 =========== ========== ========= ========== ========= ========== The amortized cost and fair value of available for sale securities at December 31, 2008 by contractual maturities are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. - -------------------------------------------------------------------------------- - 59 - Four Oaks Fincorp, Inc. Notes to Consolidated Financial Statements December 31, 2008, 2007 and 2006 - -------------------------------------------------------------------------------- NOTE B - INVESTMENT SECURITIES (Continued) Amortized Cost Fair Value ------------- -------------- (Amounts in thousands) Due within one year $ - $ - Due after one year through five years 2,685 2,729 Due after five years through ten years 52,866 53,026 Due after ten years 115,772 116,235 ------------- -------------- $ 171,323 $ 171,991 ============= ============== Securities with a carrying value of approximately $120.9 million and $98.5 million at December 31, 2008 and 2007, respectively, were pledged to secure public deposits and for other purposes required or permitted by law. Sales and calls of securities available for sale during 2008, 2007 and 2006 generated gross realized gains of $635,000, $82,000, and $15,000, respectively and gross realized losses of $59,000, $118,000, and $136,000, respectively. NOTE C - LOANS AND ALLOWANCE FOR LOAN LOSSES Major classifications of loans as of December 31, 2008 and 2007 are summarized as follows: 2008 2007 ----------- ------------ (Amounts in thousands) Real estate - residential and other $ 310,773 $ 217,247 Real estate - agricultural 15,683 12,700 Construction and land development 274,687 252,449 Other agricultural 3,060 3,119 Consumer loans 15,494 12,566 Commercial loans 51,663 45,653 Other loans 10,329 1,779 ----------- ------------ 681,689 545,512 Less: Net deferred loan fees and costs (189) (243) Allowance for loan losses (9,542) (6,653) ----------- ------------ $ 671,958 $ 538,617 =========== ============ Nonperforming assets at December 31, 2008 and 2007 consist of the following: - -------------------------------------------------------------------------------- - 60 - Four Oaks Fincorp, Inc. Notes to Consolidated Financial Statements December 31, 2008, 2007 and 2006 - -------------------------------------------------------------------------------- NOTE C - LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued) 2008 2007 ----------- ---------- (Amounts in thousands) Loans past due ninety days or more and still accruing $ 1,046 $ 52 Nonaccrual loans 20,804 1,254 Foreclosed assets (included in other assets) 1,191 1,688 ----------- ---------- $ 23,041 $ 2,994 =========== ========== At December 31, 2008, the recorded investment in loans considered impaired in accordance with SFAS No. 114 totaled $20.8 million. This amount consisted entirely of nonaccrual loans. At December 31, 2007, the investment in loans considered impaired consisted of both accrual and nonaccrual loans in the amount of $5.6 million and $1.2 million, respectively. Impaired loans of $17.0 million and $4.4 million had related allowances for loan losses of $2.9 million and $2.2 million at December 31, 2008 and 2007, respectively. For the years ended December 31, 2008 and 2007, the average recorded investment in impaired loans was approximately $9.9 million and $5.0 million, respectively. The amount of interest recognized on impaired loans during the portion of the year that they were impaired was not material. A summary of the allowance for loan losses for the years ended December 31, 2008, 2007 and 2006 is as follows: 2008 2007 2006 ---------- --------- --------- (Amounts in thousands) Balance, beginning $ 6,653 $ 5,566 $ 4,965 Provision for loan losses 3,336 1,362 873 Loans charged-off (1,995) (504) (458) Recoveries of loans previously charged-off 158 229 186 Merger with Longleaf Community Bank 1,390 - - ---------- --------- --------- Balance, ending $ 9,542 $ 6,653 $ 5,566 ========== ========= ========= The Company had loan and deposit relationships with most of its directors and executive officers and with companies with which certain directors and executive officers are associated. The following is a reconciliation of loans directly outstanding to executive officers, directors, and their affiliates (amounts in thousands): Balance at December 31, 2007 $ 6,941 New loans - Principal repayments (2,474) --------------- Balance at December 31, 2008 $ 4,467 =============== As a matter of policy, these loans and credit lines are approved by the Company's Board of Directors and are made with interest rates, terms, and collateral requirements comparable to those required of other borrowers. In the opinion of management, these loans do not involve more than the normal risk of collectibility. At December 31, 2008, the Company had pre-approved but unused lines of credit totaling $434,000 to executive officers, directors and their affiliates. - -------------------------------------------------------------------------------- - 61 - Four Oaks Fincorp, Inc. Notes to Consolidated Financial Statements December 31, 2008, 2007 and 2006 - -------------------------------------------------------------------------------- NOTE D - BANK PREMISES AND EQUIPMENT Company premises and equipment at December 31, 2008 and 2007 are as follows: 2008 2007 --------------- -------------- (Amounts in thousands) Land $ 4,482 $ 2,815 Buildings 12,468 9,501 Furniture and equipment 10,162 9,159 --------------- -------------- 27,112 21,475 Less accumulated depreciation (9,956) (8,848) --------------- -------------- $ 17,156 $ 12,627 =============== ============== Depreciation expense for the year ended December 31, 2008, was $1.1 million. For the years ended December 31, 2007 and 2006 depreciation expenses amounted to $1.0 million for each year. NOTE E - GOODWILL AND OTHER INTANGIBLES The following is a summary of goodwill and other intangible assets at December 31, 2008 and 2007: 2008 2007 -------------------- ---------------------- (Amounts in thousands) Goodwill, beginning of year - - Goodwill acquired during the year 6,083 - -------------------- ---------------------- Goodwill, end of year $ 6,083 $ - ==================== ====================== Other intangibles - gross 686 216 Less accumulated amortization 236 191 -------------------- ---------------------- Other intangibles - net $ 449 $ 25 ==================== ====================== Other intangibles amortization expense for the years ended December 31, 2008, 2007 and 2006 amounted to $46,000, $14,000, and $14,000, respectively. Estimated amortization expense for other intangibles for future years are as follows (amounts in thousands): 2009 $ 58 2010 47 2011 47 2012 47 2013 47 2014 and beyond 203 ---------------- $ 449 ================ - -------------------------------------------------------------------------------- - 62 - Four Oaks Fincorp, Inc. Notes to Consolidated Financial Statements December 31, 2008, 2007 and 2006 - -------------------------------------------------------------------------------- NOTE F - DEPOSITS At December 31, 2008, the scheduled maturities of time deposits are as follows (amounts in thousands): Less than $100,000 or $100,000 more Total ------------- ----------- --------------- Within one year $ 159,389 $ 254,067 $ 413,456 Over one year through three years 24,154 21,645 45,799 Over three years 2,496 2,823 5,320 ------------- ----------- --------------- $ 186,039 $ 278,535 $ 464,574 ============= =========== =============== NOTE G - BORROWINGS At December 31, 2008 and 2007, borrowed funds included the following FHLB advances (amounts in thousands): Maturity Interest Rate 2008 2007 - --------------------------- -------------------- ------------------- ------------------ May 25, 2016 4.46% Fixed $ 5,000 $ 5,000 November 17, 2016 4.11% Fixed 5,000 5,000 November 30, 2016 4.09% Fixed 7,000 7,000 June 5, 2017 4.35% Fixed 10,000 10,000 July 3, 2017 4.36% Fixed 13,000 13,000 July 24, 2017 4.34% Fixed 5,000 5,000 July 31, 2017 4.35% Fixed 5,000 5,000 August 14, 2017 4.08% Fixed 5,000 5,000 August 14, 2017 3.94% Fixed 5,000 5,000 October 4, 2017 3.95% Fixed 7,000 7,000 February 5, 2018 2.06% Fixed 10,000 - June 5, 2018 2.25% Fixed 5,000 - June 5, 2018 2.55% Fixed 5,000 - June 5, 2018 3.03% Fixed 5,000 - September 10, 2018 3.14% Fixed 10,000 - September 18, 2018 2.71% Fixed 10,000 - November 17, 2011 4.15% Fixed 814 - February 17, 2009 5.10% Fixed 1,500 - Advances repaid in 2008 - 20,000 ------------------- ------------------ $ 114,314 $ 87,000 =================== ================== The above advances are secured by a floating lien covering the Company's loan portfolio of qualifying residential (1-4 units) first mortgage loans. At December 31, 2008, the Company has available lines of credit totalling $70.6 million with the FHLB for borrowing dependent on adequate collateralization. The weighted average rates for the above borrowings at December 31, 2008 and 2007 were 4.07% and 4.73%, respectively. In addition to the above advances, the Company has lines of credit of $38.2 million from various financial institutions to purchase federal funds on a short-term basis. The Company has no federal fund purchases outstanding as of December 31, 2008. The Company had $10.0 million outstanding as of December 31, 2007. - -------------------------------------------------------------------------------- - 63 - Four Oaks Fincorp, Inc. Notes to Consolidated Financial Statements December 31, 2008, 2007 and 2006 - -------------------------------------------------------------------------------- NOTE H - TRUST PREFERRED SECURITIES On March 30, 2006, $12.0 million of trust preferred securities ("Trust Preferred Securities") were placed through the Trust. The Trust has invested the net proceeds from the sale of the Trust Preferred Securities in Junior Subordinated Deferrable Interest Debentures (the "Debentures") issued by the Company and recorded in borrowings on the accompanying consolidated balance sheet. The Trust Preferred Securities pay cumulative cash distributions quarterly at an annual rate, reset quarterly, equal to three month LIBOR plus 1.35%. The dividends paid to holders of the Trust Preferred Securities, which will be recorded as interest expense, are deductible for income tax purposes. The Trust Preferred Securities are redeemable on June 15, 2011 or afterwards in whole or in part, on any June 15, September 15, December 15, or March 15. Redemption is mandatory by June 15, 2036. The Company has fully and unconditionally guaranteed the Trust Preferred Securities through the combined operation of the Debentures and other related documents. The Company's obligation under the guarantee is unsecured and subordinate to senior and subordinated indebtedness of the Company. The Trust Preferred Securities qualify as Tier I capital for regulatory capital purposes subject to certain limitations. NOTE I - INCOME TAXES Allocation of income tax expense between current and deferred portions is as follows: Years Ended December 31, ------------------------------------------------- 2008 2007 2006 ----------------- --------------- ------------ (Amounts in thousands) Current tax expense: Federal $ 1,586 $ 3,384 $ 3,513 State 66 326 433 ----------------- --------------- ------------ 1,652 3,710 3,946 ----------------- --------------- ------------ Deferred tax expense: Federal (38) (426) (269) State 35 (97) (50) ----------------- --------------- ------------ (3) (523) (319) ----------------- --------------- ------------ $ 1,649 $ 3,187 $ 3,627 ================= =============== ============ The reconciliation of expected income tax at the statutory federal rate of 34% with income tax expense is as follows: Years Ended December 31, -------------------------------------------------------- 2008 2007 2006 ------------------ ------------------ ------------------ (Amounts in thousands) Expense computed at statutory rate of 34% $ 1,999 $ 3,005 $ 3,619 Effect of state income taxes, net of federal benefit 66 151 253 Tax exempt income (232) (59) (51) (Income) loss from investment in life insurance (178) 70 (187) Other, net (6) 20 (7) ------------------ ------------------ ------------------ $ 1,649 $ 3,187 $ 3,627 ================== ================== ================== - -------------------------------------------------------------------------------- - 64 - Four Oaks Fincorp, Inc. Notes to Consolidated Financial Statements December 31, 2008, 2007 and 2006 - -------------------------------------------------------------------------------- NOTE I - INCOME TAXES (Continued) Deferred income taxes consist of the following: Years Ended December 31, ---------------------------- 2008 2007 ------------ ------------ (Amounts in thousands) Deferred tax assets: Allowance for loan losses $ 3,589 $ 2,520 Non-qualified stock options 231 148 Unamortized investment premiums (3) 15 Net deferred loan fees 73 94 Deductible merger expenses 164 - SERP accrual 80 68 Other 108 29 ------------ ------------ Total deferred tax assets 4,242 2,874 ------------ ------------ Deferred tax liabilities: Property and equipment $ 748 640 Unrealized gain on securities 258 297 Prepaid expense 151 132 Fair market value adjustment on purchased assets 306 - Other 4 16 ------------ ------------ Total deferred tax liabilities 1,467 1,085 ------------ ------------ Net deferred tax asset included in other assets $ 2,775 $ 1,789 ============ ============ When tax returns are filed, it is highly certain that some positions taken would be sustained upon examination by the taxing authorities, while others are subject to uncertainty about the merits of the position taken or the amount of the position that would be ultimately sustained. The benefit of a tax position is recognized in the financial statements in the period during which, based on all available evidence, management believes it is more likely than not that the position will be sustained upon examination, including the resolution of appeals or litigation processes, if any. Tax positions taken are not offset or aggregated with other positions. Tax positions that meet the more-likely-than-not recognition threshold are measured as the largest amount of tax benefit that is more than 50 percent likely of being realized upon settlement with the applicable taxing authority. The portion of the benefits associated with tax positions taken that exceeds the amount measured as described above is reflected as a liability for unrecognized tax benefits in the accompanying consolidated balance sheet along with any associated interest and penalties that would be payable to the taxing authorities upon examination. NOTE J - REGULATORY RESTRICTIONS The bank, as a North Carolina banking corporation, may pay dividends to the Company only out of undivided profits as determined pursuant to North Carolina General Statutes Section 53-87. However, regulatory authorities may limit payment of dividends by any bank when it is determined that such a limitation is in the public interest and is necessary to ensure the financial soundness of the bank. Current Federal regulations require that the Bank maintain a minimum ratio of total capital to risk weighted assets of 8%, with at least 4% being in the form of Tier 1 capital, as defined in the regulations. In addition, the Bank must maintain a leverage ratio of 4%. As of December 31, 2008, the Bank's capital exceeded the current capital requirements. The Bank currently expects to continue to exceed these minimums without altering current operations or strategy. - -------------------------------------------------------------------------------- - 65 - Four Oaks Fincorp, Inc. Notes to Consolidated Financial Statements December 31, 2008, 2007 and 2006 - -------------------------------------------------------------------------------- NOTE J - REGULATORY RESTRICTIONS (Continued) The Bank is subject to various regulatory capital requirements administered by the federal and state banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Bank's financial statements. Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios, as set forth in the table below. Management believes, as of December 31, 2008, that the Bank meets all capital adequacy requirements to which it is subject. As of December 31, 2008, the most recent notification from the FDIC categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Bank must maintain minimum amounts and ratios as set forth in the table below. There are no conditions or events since that notification that management believes have changed the Bank's category. The Bank's actual capital amounts and ratios are also presented in the table below (dollars in thousands): Minimum To Be Well Capitalized Under Prompt Minimum for Capital Corrective Action Actual Adequacy Purposes Provisions ------------------------ ------------------------------------------- Amount Ratio Amount Ratio Amount Ratio ------------- ---------- ---------- ---------- ---------- ---------- As of December 31, 2008: - ------------------------ Total Capital (to Risk Weighted Assets) $ 75,330 10.7% $ 56,376 8.0% $ 70,470 10.0% Tier I Capital (to Risk Weighted Assets) 66,512 9.4% 28,188 4.0% 42,282 6.0% Tier I Capital (to Average Assets) 66,512 7.4% 35,783 4.0% 44,729 5.0% As of December 31, 2007: - ------------------------ Total Capital (to Risk Weighted Assets) $ 67,505 11.9% $ 45,458 8.0% $ 56,822 10.0% Tier I Capital (to Risk Weighted Assets) 60,852 10.7% 22,729 4.0% 34,093 6.0% Tier I Capital (to Average Assets) 60,852 8.9% 27,501 4.0% 34,378 5.0% The Company is also subject to these capital requirements. At December 31, 2008 and 2007, the Company's total capital to risk weighted assets, Tier 1 capital to risk weighted assets and Tier 1 capital to average assets were 11.5%, 10.1%, and 8.0%, and 12.9%, 11.7%, and 10.2%, respectively. NOTE K - DERIVATIVES Derivative Financial Instruments From time to time, the Company has stand-alone derivative financial instruments in the form of interest rate swap agreements, which derive their value from underlying interest rates. These transactions involve both credit and market risk. The notional amounts are amounts on which calculations, payments, and the value of the derivative are based. Notional amounts do not represent direct credit exposures. Direct credit exposure is limited to the net difference between the calculated amounts to be received and paid, if any. Such difference, which represents the fair value of the derivative instruments, is reflected on the Company's consolidated balance sheets as derivative assets and derivative liabilities. - -------------------------------------------------------------------------------- - 66 - Four Oaks Fincorp, Inc. Notes to Consolidated Financial Statements December 31, 2008, 2007 and 2006 - -------------------------------------------------------------------------------- NOTE K - DERIVATIVES (Continued) The Company is exposed to credit-related losses in the event of nonperformance by the counterparties to these agreements. The Company controls the credit risk of its financial contracts through credit approvals, limits and monitoring procedures, and does not expect any counterparties to fail their obligations. The Company deals only with primary dealers. Derivative instruments are generally either negotiated over-the-counter ("OTC") contracts or standardized contracts executed on a recognized exchange. Negotiated OTC derivative contracts are generally entered into between two counterparties that negotiate specific agreements terms, including the underlying instruments, amount, exercise prices and maturity. Risk Management Policies - Hedging Instruments The primary focus of the Company's asset/liability management program is to monitor the sensitivity of the Company's net portfolio value and net income under varying interest rate scenarios to take steps to control its risks. On a quarterly basis, the Company simulates the net portfolio value and net income expected to be earned over a twelve-month period following the date of simulation. The simulation is based on a projection of market interest rates at varying levels and estimates the impact of such market rates on the levels of interest-earning assets and interest-bearing liabilities during the measurement period. Based upon the outcome of the simulation analysis, the Company considers the use of derivatives as a means of reducing the volatility of net portfolio value and projected net income within certain ranges of projected changes in interest rates. The Company evaluates the effectiveness of entering into any derivative instrument agreement by measuring the cost of such an agreement in relation to the reduction in net portfolio value and net income volatility within an assumed range of interest rates. Interest Rate Risk Management - Cash Flow Hedging Instruments The Company originates variable rate loans for its loan portfolio. These loans expose the Company to variability in cash flows, primarily from interest receipts due to changes to interest rates. If interest rates increase, interest income increases. Conversely, if interest rates decrease, interest income decreases. Management believes it is prudent to limit the variability of a portion of its cash flows on variable rate loans therefore, generally hedges a portion of its variable-rate receipts. To meet this objective, management enters into interest rate swap agreements whereby the Company receives fixed rate payments and makes variable rate payments during the contract period. At December 31, 2008 and 2007 there were no outstanding interest rate swap agreements used to hedge variable rate loans. Interest Rate Risk Management - Fair Value Hedging Instruments The Company uses funds from fixed rate time deposits in its lending and investment activities and for other general purposes. These debt obligations expose the Company to variability in their fair value due to changes in the level of interest rates. Management believes that it is prudent to limit the variability in the fair value of a portion of its fixed-rate funding. It is the Company's objective to hedge the change in fair value of fixed-rate funding coverage levels that are appropriate, given anticipated or existing interest rate levels and other market considerations, as well as the relationship of change in this liability to other liabilities of the Company. To meet this objective, the Company utilized interest rate swaps as an asset/liability management strategy to hedge the change in value of the funding due to changes in expected interest rate assumptions. These interest rate swap agreements are contracts to make a series of floating rate payments in exchange for receiving a series of fixed rate payments. - -------------------------------------------------------------------------------- - 67 - Four Oaks Fincorp, Inc. Notes to Consolidated Financial Statements December 31, 2008, 2007 and 2006 - -------------------------------------------------------------------------------- NOTE K - DERIVATIVES (Continued) All interest rate swap agreements were terminated during 2008. At December 31, 2007, the information pertaining to outstanding interest rate swap agreements used to hedge fixed-rate funding is as follows (dollars in thousands): 2007 ------------ Notional amount $ 33,301 Weighted average pay rate 4.93% Weighted average receive rate 4.25% Weighted average maturity in years 2.2 Unrealized gain (loss) relating to interest rate swaps $ (16) These agreements required the Company to make payments at variable-rate determined by a specified index (LIBOR) in exchange for receiving payments at a fixed-rate. The interest rate swap agreement used to hedge variable rate loans expired July 30, 2008. No other interest rate swaps were terminated during 2008 or 2007. At December 31, 2007, the Company's interest rate swaps used to hedge fixed-rate funding reflected an unrealized loss of $16,000. NOTE L - COMMITMENTS AND CONTINGENCIES The Company is a party to financial instruments with off-balance sheet credit risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheet. The contract or notional amounts of those instruments reflect the extent of involvement the Bank has in particular classes of financial instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of conditions established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since some of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company, upon extension of credit is based on management's credit evaluation of the borrower. Collateral obtained varies but may include real estate, stocks, bonds, and certificates of deposit. Unfunded commitments under lines of credit are commitments for possible future extensions of credit to existing customers. These lines of credit usually do not contain a specified maturity date and may not be drawn upon to the total extent to which the Bank is committed. Stand-by letters of credit are conditional lending commitments issued by the Bank to guarantee the performance of a customer to a third party. Those letters of credit are primarily issued to support public and private borrowing arrangements. Essentially all letters of credit issued have expiration dates within one year. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. - -------------------------------------------------------------------------------- - 68 - Four Oaks Fincorp, Inc. Notes to Consolidated Financial Statements December 31, 2008, 2007 and 2006 - -------------------------------------------------------------------------------- NOTE L - COMMITMENTS AND CONTINGENCIES (Continued) A summary of the contract amount of the Bank's exposure to off-balance sheet credit risk as of December 31, 2008 is as follows (dollars in thousands): Financial instruments whose contract amounts represent credit risk: Commitments to extend credit $ 98,463 Undisbursed lines of credit 21,495 Financial stand-by letters of credit 874 Performance stand-by letters of credit 2,066 NOTE M - FAIR VALUE MEASUREMENTS As discussed in Note A to the consolidated financial statements, the Company adopted SFAS No. 157 and SFAS No. 159 on January 1, 2008. SFAS No. 157 defines fair value, establishes a framework for measuring fair value under GAAP and expands disclosures about fair value measurements. SFAS No. 157 applies whenever other accounting pronouncements require or permit assets or liabilities to be measured at fair value. Accordingly, SFAS No. 157 does not expand the use of fair value in any new circumstances. SFAS No. 159 provides companies with an option to report selected financial assets and liabilities at fair value. As of December 31, 2008, the Company had not elected to measure any financial assets or liabilities using the fair value option under SFAS No. 159; therefore the adoption of SFAS No. 159 had no effect on the Company's financial condition or results of operations. The Company records securities available for sale and derivative assets at fair value on a recurring basis. Fair value is a market-based measurement and is defined as the price that would be received to sell an asset, or paid to transfer a liability, in an orderly transaction between market participants at the measurement date. The transaction to sell the asset or transfer the liability is a hypothetical transaction at the measurement date, considered from the perspective of a market participant that holds the assets or owes the liability. In general, the transaction price will equal the exit price and, therefore, represent the fair value of the asset or liability at initial recognition. In determining whether a transaction price represents the fair value of the asset or liability at initial recognition, each reporting entity is required to consider factors specific to the transaction and the asset or liability, the principal or most advantageous market for the asset or liability, and market participants with whom the entity would transact in the market. SFAS No. 157 establishes a fair value hierarchy to prioritize the inputs of valuation techniques used to measure fair value. The inputs are evaluated and an overall level for the fair value measurement is determined. This overall level is an indication of how market-observable the fair value measurement is and defines the level of disclosure. SFAS No. 157 clarifies fair value in terms of the price in an orderly transaction between market participants to sell an asset or transfer a liability in the principal (or most advantageous) market for the asset or liability at the measurement date (an exit price). In order to determine the fair value or the exit price, entities must determine the unit of account, highest and best use, principal market, and market participants. These determinations allow the reporting entity to define the inputs for fair value and level of hierarchy. Outlined below is the application of the fair value hierarchy established by SFAS No. 157 to the Company's financial assets that are carried at fair value. Level 1 - inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets. An active market for the asset or liability is a market in which the transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis. As of December 31, 2008, the Company did not carry any financial assets and liabilities at fair value hierarchy Level 1. Level 2 - inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument. As of December 31, 2008, the types of financial assets and liabilities the Company carried at fair value hierarchy Level 2 included securities available for sale and derivatives. - -------------------------------------------------------------------------------- - 69 - Four Oaks Fincorp, Inc. Notes to Consolidated Financial Statements December 31, 2008, 2007 and 2006 - -------------------------------------------------------------------------------- NOTE M - FAIR VALUE MEASUREMENTS (Continued) Level 3 - inputs to the valuation methodology are unobservable and significant to the fair value measurement. Unobservable inputs are supported by little or no market activity or by the entity's own assumptions. As of December 31, 2008, while the Company did not carry any financial assets or liabilities, measured on a recurring basis, at fair value hierarchy Level 3, the Company did value certain financial assets, measured on a non-recurring basis, at fair value hierarchy Level 3. Fair Value on a Recurring Basis. The Company measures certain assets at fair value on a recurring basis, as described below. Investment Securities Available for Sale Investment securities available-for-sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security's credit rating, prepayment assumptions and other factors such as credit loss assumptions. Level 1 securities include those traded on an active exchange, such as the New York Stock Exchange, U.S. Treasury securities that are traded by dealers or brokers in active over-the-counter markets and money market funds. Level 2 securities include mortgage-backed securities issued by government sponsored entities, municipal bonds and corporate debt securities. Securities classified as Level 3 include asset-backed securities in less liquid markets. Derivative Assets and Liabilities Derivative instruments held or issued by the Company for risk management purposes are traded in over-the-counter markets where quoted market prices are not readily available. For those derivatives, the Company measures fair value using models that use primarily market observable inputs, such as yield curves and option volatilities, and include the value associated with counterparty credit risk. The Company classifies derivatives instruments held or issued for risk management purposes as Level 2. As of December 31, 2008 the Company had no derivative assets or liabilities. The Company utilizes valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs. Fair Value on a Recurring Basis. Below is a table that presents information about assets measured at fair value on a recurring basis at December 31, 2008: Fair Value Measurements at December 31, 2008, Using ---------------------------------------------------- Total Carrying Quoted Prices Significant Amount in The Assets in Active Other Significant Consolidated Measured at Fair Markets for Observable Unobservable Balance Sheet Value Identical Assets Inputs Inputs Description 12/31/2008 12/31/2008 (Level 1) (Level 2) (Level 3) - ------------------------------------- ---------------- ----------------- ---------------- --------------- Available-for-sale securities $ 171,991 $ 171,991 $ 4,256 $ 167,735 $ - - -------------------------------------------------------------------------------- Fair Value on a Nonrecurring Basis. The Company measures certain assets at fair value on a nonrecurring basis, as described below. - 70 - Four Oaks Fincorp, Inc. Notes to Consolidated Financial Statements December 31, 2008, 2007 and 2006 - -------------------------------------------------------------------------------- NOTE M - FAIR VALUE MEASUREMENTS (Continued) Loans Held for Sale Loans held for sale are carried at the lower of cost or market value. The fair value of loans held for sale is based on what secondary markets are currently offering for portfolios with similar characteristics. As such, the Company classifies loans subjected to nonrecurring fair value adjustments as Level 2. There were no loans held for sale at December 31, 2008 and no fair value adjustments related to loans held for sale at as of or for the year ended December 31, 2008. Loans The Company does not record loans at fair value on a recurring basis. However, from time to time, a loan is considered impaired and an allowance for loan losses is established. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Once a loan is identified as individually impaired, management measures impairment in accordance with SFAS No. 114, "Accounting by Creditors for Impairment of a Loan." The fair value of impaired loans is estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. At December 31, 2008, substantially all of the total impaired loans were evaluated based on the fair value of the collateral. In accordance with SFAS No. 157, impaired loans where an allowance is established based on the fair value of collateral require classification in the fair value hierarchy. When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the impaired loan as nonrecurring Level 2. When current appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the impaired loan as nonrecurring Level 3. Impaired loans totaled $20.8 million at December 31, 2008. Of such loans, $17.0 million had specific loss allowances aggregating $2.9 million at that date. Of those specific allowances, all were determined using Level 3 inputs. Goodwill and Other Intangible Assets Goodwill and identified intangible assets are subject to impairment testing. When appropriate, a projected cash flow valuation method is used in the completion of impairment testing. This valuation method requires a significant degree of management judgment. In the event the projected undiscounted net operating cash flows are less than the carrying value, the asset is recorded at fair value as determined by the valuation model. As such, the Company classifies goodwill and other intangible assets subjected to nonrecurring fair value adjustments as Level 3. At December 31, 2008 there were no fair value adjustments related to goodwill of $6.1 million and other intangible assets of $449,000. Foreclosed Assets Foreclosed assets are adjusted to fair value upon transfer of the loans to foreclosed assets. Subsequently, foreclosed assets are carried at the lower of carrying value or fair value. Fair value is based upon independent market prices, appraised values of the collateral or management's estimation of the value of the collateral. When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the foreclosed asset as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the foreclosed asset as nonrecurring Level 3. At December 31, 2008 there were no fair value adjustments related to foreclosed real estate of $1.6 million. - -------------------------------------------------------------------------------- - 71 - Four Oaks Fincorp, Inc. Notes to Consolidated Financial Statements December 31, 2008, 2007 and 2006 - -------------------------------------------------------------------------------- NOTE N - STOCK OPTION PLAN The Company has a non-qualified stock option plan for certain key employees under which it is authorized to issue options for up to 1,342,773 shares of common stock. Options are granted at the discretion of the Company's Board of Directors at an exercise price approximating market value, as determined by a committee of Board members. All options granted subsequent to a 1997 amendment will be 100% vested one year from the grant date and will expire after such a period as is determined by the Board at the time of grant. Options granted prior to the amendment have ten year lives and a five year level vesting provision. A summary of option activity under the Plan for the year ended December 31, 2008, is presented below: Weighted- Average Option Remaining Aggregate Price Per Contractual Intrinsic Shares Share Term Value ------------ ----------- ------------ ---------- Outstanding at January 1, 2008 166,028 $ 16.20 Granted 175,944 12.30 Exercised (50,470) 10.44 Forfeited (1,376) 16.73 Expired (657) 10.24 ------------ Balance December 31, 2008 289,469 $ 14.84 2.93 $ - ============ =========== ============ ========== Excercisable at December 31, 2008 237,144 $ 14.69 2.27 $ - ============ =========== ============ ========== The weighted average exercise price of all exercisable options at December 31, 2008 is $14.69. There were 366,946 shares reserved for future issuance at December 31, 2008. As of December 31, 2008, there was $14,000 of unrecognized compensation cost related to non-vested share-based compensation arrangements. - -------------------------------------------------------------------------------- - 72 - Four Oaks Fincorp, Inc. Notes to Consolidated Financial Statements December 31, 2008, 2007 and 2006 - -------------------------------------------------------------------------------- NOTE N - STOCK OPTION PLAN (Continued) Additional information concerning the Company's stock options at December 31, 2008 is as follows: Remaining Exercise Number Contractual Number Price Outstanding Life Exercisable - -------- ----------- ------------ ------------- $10.92 116,001 4.64 116,001 $13.24 36,141 0.15 36,141 $15.55 52,325 3.15 - $16.73 43,863 1.14 43,863 $24.41 41,140 2.16 41,140 ----------- ------------ ------------- 289,469 2.93 237,144 =========== ============= The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions used for grants in 2008, 2007, and 2006: 2008 2007 2006 ---------- ---------- ----------- Dividend yield 1.80% 1.20% 1.53% Expected volatility 28.21% 23.76% 20.72% Risk free interest rate 2.82% 4.65% 4.73% Expected life 5 years 4 years 4 years The weighted average fair value of options granted during 2008, 2007 and 2006 was $2.97, $5.76, and $3.84, respectively. NOTE O - OTHER EMPLOYEE BENEFITS Supplemental Retirement In 1998, the Company's subsidiary, Four Oaks Bank & Trust Company, adopted a Supplemental Executive Retirement Plan ("SERP") for its president. The Company has purchased life insurance policies in order to provide future funding of benefit payments. SERP benefits will accrue and vest during the period of employment and will be paid in annual benefit payments over the officer's remaining life commencing with the officer's retirement. The liability accrued under the SERP plan amounts to $207,000 and $175,000 at December 31, 2008 and 2007, respectively. During 2008, 2007, and 2006, the expense attributable to the SERP amounted to $32,000, $28,000, and $25,000, respectively. Employment Agreements The Company has entered into employment agreements with certain of its executive officers to ensure a stable and competent management base. The agreements provide for benefits as spelled out in the contracts and cannot be terminated by the Company's Board of Directors, except for cause, without prejudicing the officers' rights to receive certain vested rights, including compensation. In addition, the Company has entered into severance compensation agreements with certain of its executive officers and key employees to provide them with severance pay benefits in the event of a change in control of the Company, as outlined in the agreements; the acquirer will be bound to the terms of the contracts. - -------------------------------------------------------------------------------- - 73 - Four Oaks Fincorp, Inc. Notes to Consolidated Financial Statements December 31, 2008, 2007 and 2006 - -------------------------------------------------------------------------------- NOTE O - OTHER EMPLOYEE BENEFITS (Continued) Defined Contribution Plan The Company sponsors a contributory profit-sharing plan in effect for substantially all employees. Participants may make voluntary contributions resulting in salary deferrals in accordance with Section 401(k) of the Internal Revenue Code. The plans provide for employee contributions up to $15,500 of the participant's annual salary and an employer contribution of 25% matching of the first 6% of pre-tax salary contributed by each participant. Expenses related to these plans for the years ended December 31, 2008, 2007 and 2006 were $149,000, $97,000, and $66,000, respectively. Contributions under the plan are made at the discretion of the Company's Board of Directors. Employee Stock Ownership Plan The Company sponsors an employee stock ownership plan (ESOP) which makes the employees of the Company, owners of stock in the Company. The Four Oaks Bank & Trust Company's Employee Stock Ownership Trust is available to full-time employees at least 21 years of age after six months of service. Contributions are voluntary by the Company and employees cannot contribute. Stock issued is purchased on the open market and the Company does not issue new shares in conjunction with this plan. Voluntary contributions are determined by the Company's Board of Directors annually based on Company performance and are allocated to employees based on annual compensation. Contribution expenses for this plan for the years ended 2008, 2007, and 2006 were $331,000, $300,000, and $249,000, respectively. Employee Stock Purchase and Bonus Plan The Employee Stock Purchase and Bonus Plan (the "Purchase Plan") is a voluntary plan that enables full-time employees of the Company and its subsidiaries to purchase shares of the Company's common stock. The Purchase Plan is administered by a committee of the Board of Directors, which has broad discretionary authority to administer the Purchase Plan. The Company's Board of Directors may amend or terminate the Purchase Plan at any time. The Purchase Plan is not intended to be qualified as an employee stock purchase plan under Section 423 of the Internal Revenue Code of 1986, as amended. Once a year, participants in the Purchase Plan purchase the Company's common stock at fair market value. Participants are permitted to purchase shares under the Purchase Plan up to (5%) of their compensation, with a maximum purchase amount of $1,000 per year. The Company matches, in cash, fifty percent (50%) of the amount of each participant's purchase, up to $500. After withholding for income and employment taxes, participants use the balance of the Company's matching grant to purchase shares of the Company's common stock. As of December 31, 2008, 268,544 shares of the Company's common stock had been reserved for issuance under the Purchase Plan, and 180,016 shares had been purchased. During the years ended December 31, 2008 and 2007, 9,628 and 5,785 shares, respectively, were purchased under the Purchase Plan. - -------------------------------------------------------------------------------- - 74 - Four Oaks Fincorp, Inc. Notes to Consolidated Financial Statements December 31, 2008, 2007 and 2006 - -------------------------------------------------------------------------------- NOTE P - LEASES The Company has entered into non-cancelable operating leases for four branch facilities. Future minimum lease payments under the leases for future years are as follows (amounts in thousands): 2009 $ 187 2010 169 2011 173 2012 178 2013 125 2014 and beyond 257 ---------- $ 1,089 ========== In addition, the Company has leased a building from one of its former directors for approximately $1,000 per month in 2008 and 2007, under an operating lease on a month-to-month basis. Total rental expense under operating leases for the years ended December 31, 2008, 2007 and 2006 amounted to $192,000, $152,000, and $116,000 respectively. NOTE Q- PARENT COMPANY FINANCIAL INFORMATION Condensed financial information of Four Oaks Fincorp, Inc. at December 31, 2008 and 2007 and for the years ended December 31, 2008, 2007 and 2006 is presented below: 2008 2007 -------------- -------------- (Amounts in thousands) Condensed Balance Sheets Assets: Cash and cash equivalents $ 993 $ 3,686 Equity investment in subsidiaries 74,687 62,187 Securities available for sale 3,189 1,153 Other assets 183 33 -------------- -------------- Total assets $ 79,052 $ 67,059 ============== ============== Liabilities and Shareholders' Equity: Other liabilities $ 30 $ 57 Subordinated debentures 12,372 12,372 Shareholders' equity 66,650 54,630 -------------- -------------- Total liabilities and shareholders' equity $ 79,052 $ 67,059 ============== ============== For the Years Ended December 31, -------------------------------- 2008 2007 2006 --------- ---------- --------- (Amounts in thousands) Condensed Statements of Operations Dividends received from bank subsidiary $ 2,183 $ 1,784 $ 1,448 Equity in undistributed earnings of subsidiaries 2,514 4,464 6,021 Interest income 113 228 187 Other income 105 83 65 Other expenses (684) (907) (704) --------- ---------- --------- Net income $ 4,231 $ 5,652 $ 7,017 - -------------------------------------------------------------------------------- - 75 - Four Oaks Fincorp, Inc. Notes to Consolidated Financial Statements December 31, 2008, 2007 and 2006 - -------------------------------------------------------------------------------- NOTE Q - PARENT COMPANY FINANCIAL INFORMATION (Continued) 2008 2007 2006 ------------ ------------ ----------- (Amounts in thousands) Condensed Statements of Cash Flows Operating activities: Net income $ 4,231 $ 5,652 $ 7,017 Equity in undistributed earnings of subsidiaries (2,514) (4,464) (6,021) Decrease (increase) in other assets (150) 43 (76) (Decrease) increase in other liabilities (27) (72) 17 ------------ ------------ ----------- Net cash provided by operating activities 1,540 1,159 937 ------------ ------------ ----------- Investing activities: Investment in subsidiaries (9,845) (315) (12,695) Purchase of securities available for sale (2,036) (138) (347) Proceeds from reclamation of equity in FOMC Partnership - - - ------------ ------------ ----------- Net cash used by investing activities (11,881) (453) (13,042) ------------ ------------ ----------- Financing activities: Proceeds from issuance of common stock 1,859 1,665 1,609 Effect of merger with LongLeaf Community Bank 7,945 - - Excess tax benefits from stock options 102 203 293 Proceeds from issuance of subordinated debentures - 12,372 Purchases and retirements of common stock (75) (1,513) (252) Dividends paid to shareholders (2,183) (1,784) (1,448) ------------ ------------ ----------- Net cash (used) provided by financing activities 7,648 (1,429) 12,574 ------------ ------------ ----------- Net (decrease) increase in cash and cash equivalents (2,693) (723) 469 Cash and cash equivalents, beginning of year 3,686 4,409 3,940 ------------ ------------ ----------- Cash and cash equivalents, end of year $ 993 $ 3,686 $ 4,409 ============ ============ =========== NOTE R - FAIR VALUE OF FINANCIAL INSTRUMENTS SFAS No. 107, Disclosures about Fair Value of Financial Instruments, requires the disclosure of estimated fair values for financial instruments. Quoted market prices, if available, are utilized as an estimate of the fair value of financial instruments. Because no quoted market prices exist for a significant part of the Company's financial instruments, the fair value of such instruments has been derived based on management's assumptions with respect to future economic conditions, the amount and timing of future cash flows and estimated discount rates. Different assumptions could significantly affect these estimates. Accordingly, the net realizable value could be materially different from the estimates presented below. In addition, the estimates are only indicative of individual financial instruments' values and should not be considered an indication of the fair value of the Company taken as a whole. The following methods and assumptions were used to estimate the fair value of each class of financial instrument. - -------------------------------------------------------------------------------- - 76 - Four Oaks Fincorp, Inc. Notes to Consolidated Financial Statements December 31, 2008, 2007 and 2006 - -------------------------------------------------------------------------------- NOTE R - FAIR VALUE OF FINANCIAL INSTRUMENTS (Continued) Cash and Cash Equivalents The carrying amounts of cash and cash equivalents are equal to the fair value due to the liquid nature of the financial instruments. Investment Securities Available for Sale Fair values of investment securities available for sale are based on quoted market prices. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities. Loans Fair values have been estimated by type of loan: residential real estate loans, consumer loans, and commercial and other loans. For variable-rate loans that reprice frequently and with no significant credit risk, fair values are based on carrying values. The fair values of fixed rate loans are estimated by discounting the future cash flows using the current rates at which loans with similar terms would be made to borrowers with similar credit ratings and for the same remaining maturities, adjusted for current liquidity and market conditions. The Company has assigned no fair value to off-balance sheet financial instruments since they are either short term in nature or subject to immediate repricing. FHLB Stock The carrying amount of FHLB stock approximates fair value. Investment in Life Insurance The carrying value of life insurance approximates fair value because this investment is carried at cash surrender value, as determined by the insurer. Deposits The fair value of demand deposits, savings accounts, and money market deposits is the amount payable on demand at year-end. Fair value of time deposits is estimated by discounting the future cash flows using the current rate offered for similar deposits with the same maturities. Borrowings and Subordinated Debentures The fair values are based on discounting expected cash flows at the interest rate for debt with the same or similar remaining maturities and collection requirements. Accrued Interest Receivable and Payable The carrying amounts of accrued interest approximate fair value. - -------------------------------------------------------------------------------- - 77 - Four Oaks Fincorp, Inc. Notes to Consolidated Financial Statements December 31, 2008, 2007 and 2006 - -------------------------------------------------------------------------------- NOTE R - FAIR VALUE OF FINANCIAL INSTRUMENTS (Continued) Derivative Financial Instruments Fair values for interest rate swap agreements are based upon the amounts required to settle the contracts. The following table presents information for financial assets and liabilities as of December 31, 2008 and 2007: 2008 2007 ----------------------- ----------------------- Carrying Estimated Carrying Estimated Value Fair Value Value Fair Value ---------- ----------- ----------- ---------- Financial assets: Cash and cash equivalents $ 28,875 $ 28,875 $ 18,275 $ 18,275 Securities available for sale 171,991 171,991 114,301 114,301 Loans, net 671,958 666,558 538,617 537,831 FHLB stock 6,529 6,529 5,010 5,010 Investment in life insurance 10,566 10,566 10,041 10,041 Accrued interest receivable 4,216 4,216 3,564 3,564 Financial liabilities: Deposits $ 722,693 $ 715,581 $ 537,763 $ 522,212 Subordinated debentures 12,372 11,773 12,372 12,381 Borrowings 114,314 117,042 97,000 99,905 Accrued interest payable 3,282 3,282 4,055 4,055 Derivative financial instruments: Interest rate swap agreements: Liabilities, net loss - - 80 80 NOTE S - CASH FLOW SUPPLEMENTAL DISCLOSURES The following information is supplemental information regarding the cash flows for the years ended December 31, 2008, 2007 and 2006: 2008 2007 2006 --------------- ------------ ------------- (Amounts in thousands) Cash paid for: Interest on deposits and borrowings $ 19,152 $ 22,902 $ 16,814 Income taxes 2,188 2,981 4,057 Summary of noncash investing and financing activities: Transfer from loans to foreclosed assets 273 2,570 269 Increase (decrease) in fair value of securities available for sale, net of tax (33) 613 161 Increase (decrease) in fair value of cash flow hedge, net of tax - 242 187 NOTE T - STOCK PURCHASE PLAN On November 26, 2007 the Board of Directors increased the purchase authorization to 500,000 shares and on December 22, 2008 authorized the extension of the Company's Stock Purchase Program through December 31, 2009. During 2008, the Company purchased 6,020 shares at an average cost of $12.49. At December 31, 2008, there were 344,949 shares available for repurchase. - -------------------------------------------------------------------------------- - 78 - Four Oaks Fincorp, Inc. Notes to Consolidated Financial Statements December 31, 2008, 2007 and 2006 - -------------------------------------------------------------------------------- NOTE U - MERGER WITH LONGLEAF COMMUNITY BANK On April 17, 2008, the Company completed the merger with LongLeaf Community Bank ("LongLeaf"), headquartered in Rockingham, North Carolina. Under the terms of the merger agreement, each share of LongLeaf common stock was converted into the right to receive either (i) $16.50 in cash, without interest, (ii) 1.0 share of the Company's common stock multiplied by an exchange ratio of 1.1542825 or (iii) 0.60 shares of the Company's common stock multiplied by an exchange ratio of 1.1542825 plus an amount equal to $6.60 in cash. As a result of the acquisition, the Company paid $4.9 million in cash and issued 609,770 additional shares of common stock. The acquisition was accounted for using the purchase method of accounting, with the operating results of LongLeaf subsequent to April 17, 2008 included in the Company's financial statements. A summary of the total purchase price of the transaction is as follows: (In thousands) Fair value of common stock issued $ 7,554 Fair value of common stock options issued 390 Cash paid for shares 4,265 Transaction costs paid in cash 606 ----------------- Total purchase price $ 12,815 ================= A summary of the fair value of the assets acquired and liabilities assumed is as follows: (In thousands) Cash and due from banks $ 1,690 Interest-earning deposits 1,763 Federal funds sold 4,585 Investment securities available for sale 4,212 Loans, net 47,248 Accrued interest receivable 242 FHLB stock 279 Bank premises and equipment 3,678 Deferred tax assets, net 886 Core deposit intangible 470 Goodwill 6,083 Other assets 139 Deposits (54,514) FHLB Advances (2,586) Accrued interest payable (105) Other liabilities (1,255) ----------------- Net assets acquired $ 12,815 ================= - -------------------------------------------------------------------------------- - 79 - Four Oaks Fincorp, Inc. Notes to Consolidated Financial Statements December 31, 2008, 2007 and 2006 - -------------------------------------------------------------------------------- NOTE V - RECENT DEVELOPMENTS WITH THE U.S. TREASURY The U.S. Treasury has announced that it will make funds available to certain banks under the Capital Purchase Program (the "Program"). The Emergency Economic Stabilization Act of 2008 authorized the Treasury to establish the Program under which certain United States financial institutions may sell senior preferred stock and issue warrants to purchase an institution's common stock to the Treasury in exchange for a capital infusion. Under the Program, eligible institutions can generally apply to issue preferred stock to the Treasury in aggregate amounts between 1% and 3% of the institution's risk-weighted assets, along with warrants covering shares of common stock. On November 5, 2008, the Company's board of directors (the "Board") authorized and approved the Company's participation in the Program, and the Company filed its application with the Treasury in November 2008 to participate in the Program. In order to participate in the Program, the Company's shareholders approved an amendment to the Compan's Articles of Incorporation to authorize preferred stock, and the Board authorized the Company to sell up to 20,000 shares of senior preferred stock ("Senior Preferred") to the Treasury for $1,000 per share. As of the filing date of this report, we are currently waiting to hear about the status of our application. Accordingly, there is no binding agreement or commitment with respect to the Company's participation in the Program. The Company and the Treasury must still negotiate the terms and conditions of the Company's participation in the Program, which means that closing of the transaction is not guaranteed. Although the Company has no reason to believe that the Company will not be able to participate in the Program, no assurances can be given that the Company will be able to participate in the Program, and the approximate number of shares of preferred stock that the Company may issue pursuant to the Program or the approximate amount of consideration the Company will receive as compensation from the Treasury for any such shares that may be issued by the Company under the Program cannot be determined at this time. - -------------------------------------------------------------------------------- - 80 - Item 9 - Changes In and Disagreements with Accountants on Accounting and Financial Disclosure. Not Applicable. Item 9A - Controls and Procedures. Disclosure Controls and Procedures As required by paragraph (b) of Rule 13a-15 under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), an evaluation was carried out under the supervision and with the participation of the Company's management, including its Chief Executive Officer and Chief Financial Officer, of the effectiveness of the Company's disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this Annual Report. As defined in Rule 13a-15(e) and 15d-15(e) under the Exchange Act, the term disclosure controls and procedures means controls and other procedures of an issuer that are designed to ensure that information required to be disclosed by the issuer in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission's (the "SEC's") rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Exchange Act is accumulated and communicated to the issuer's management, including its principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. Based on their evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that as of the end of the period covered by this Annual Report, the Company's disclosure controls and procedures are effective, in that they provide reasonable assurances that information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods required by the SEC's rules and forms. Management's Report on Internal Control Over Financial Reporting Management of Four Oaks Fincorp, Inc. (the "Company") is responsible for establishing and maintaining effective internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934. Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles. Under the supervision and with the participation of management, including the principal executive officer and principal financial officer, the Company conducted an evaluation of the effectiveness of internal control over financial reporting, based on the framework in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation under the framework in Internal Control - Integrated Framework, management of the Company has concluded the Company maintained effective internal control over financial reporting as of December 31, 2008. Internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives because of its inherent limitations. Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial reporting can also be circumvented by collusion or improper management override. Because of such limitations, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. Management is also responsible for compliance with laws and regulations relating to safety and soundness which are designated by the FDIC and the appropriate federal banking agency. Management assessed its compliance with these designated laws and regulations relating to safety and soundness and believes that the Company complied, in all significant respects, with such laws and during the year ended December 31, 2008. Dixon Hughes PLLC, an independent, registered public accounting firm, has audited the Company's consolidated financial statements as of and for the year ended December 31, 2008 included in this annual report, and has issued an attestation report on management's assessment of the effectiveness of the Company's internal control over financial reporting as of December 31, 2008, which is included herein. This report appears on page 83. Changes in Internal Control Over Financial Reporting There have been no changes in the Company's internal control over financial reporting (as such term is defined in Rules 13d-15(f) and 15d-15(f) under the Exchange Act) that occurred during the fourth quarter of 2008 that the Company believes have materially affected or is likely to materially affect, its internal control over financial reporting. - -------------------------------------------------------------------------------- - 81 - REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders Four Oaks Fincorp, Inc. and Subsidiaries We have audited Four Oaks Fincorp, Inc. and Subsidiaries (the "Company")'s internal control over financial reporting as of December 31, 2008 based on criteria established in Internal Control--Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management's Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company's internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, Four Oaks Fincorp, Inc. and Subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control--Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements of Four Oaks Fincorp, Inc. and Subsidiaries as of and for the year ended December 31, 2008, and our report dated March 12, 2009, expressed an unqualified opinion on those consolidated financial statements. We do not express an opinion or any other form of assurance on management's statement referring to compliance with designated laws and regulations related to safety and soundness. /s/ Dixon Hughes PLLC Raleigh, North Carolina March 12, 2009 - -------------------------------------------------------------------------------- - 82 - Item 9B - Other Information. Not Applicable. PART III This Part incorporates certain information from the definitive proxy statement (the "2009 Proxy Statement") for the Company's 2009 Annual Meeting of Shareholders, to be filed with the SEC within 120 days after the end of the Company's fiscal year. Item 10 - Directors, Executive Officers and Corporate Governance. Director information is incorporated by reference from the sections entitled "Information about Our Board of Directors," "Election of Directors," and under the section entitled "Section 16(a) Beneficial Ownership Reporting Compliance," in the 2009 Proxy Statement. Information on our executive officers is included under the caption "Executive Officers of the Registrant" on Page 11 of this report. Information about our Code of Ethics is incorporated by reference from the section entitled "Code of Ethics," in the 2009 Proxy Statement. Information about the procedures by which shareholder nominations to our board of directors may be submitted, including material changes to such procedures, if any, is incorporated by reference from the section entitled "Information About our Board of Directors-- Board Committees--The Corporate Governance and Nominating Committee" in the 2009 Proxy Statement. Information regarding the Company's audit committee is hereby incorporated by reference from the section entitled "Information About our Board of Directors--Board Committees--The Audit Committee" in the 2009 Proxy Statement. Item 11 - Executive Compensation. This information is incorporated by reference from the section entitled "Executive Compensation" and "Compensation Committee Interlocks and Insider Participation" in the 2009 Proxy Statement. Item 12 - Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters. This information is incorporated by reference from the section entitled "Security Ownership of Management and Certain Beneficial Owners" and the sections entitled "Equity Compensation Plan Information," "Nonqualified Stock Option Plan" and "Employee Stock Purchase and Bonus Plan" in the 2009 Proxy Statement. The following table sets forth equity compensation plan information at December 31, 2008. Equity Compensation Plan Information - -------------------------------------------------------------------------------------------------------------------- Number of securities remaining available for Number of securities future issuance under to be issued up Weighted-average equity compensation plans exercise of exercise price of (excluding securities Plan Category outstanding options outstanding options reflected in column (a)) - -------------------------------------------------------------------------------------------------------------------- (a) (b) (c) - -------------------------------------------------------------------------------------------------------------------- Equity compensation plans approved by security holders - -------------------------------------------------------------------------------------------------------------------- Stock Option Plans 289,469 $14.84 366,946 - -------------------------------------------------------------------------------------------------------------------- Employee Stock Purchase Plan - - 268,544 - -------------------------------------------------------------------------------------------------------------------- Equity compensation plans not approved by security holders N/A N/A N/A - -------------------------------------------------------------------------------------------------------------------- Total 289,469 $14.84 635,490 - -------------------------------------------------------------------------------------------------------------------- Item 13 - Certain Relationships and Related Transactions, and Director Independence. Information about certain relationships and related transactions is incorporated by reference from the section entitled "Certain Transactions" in the 2009 Proxy Statement. Information about director independence is incorporated by reference from the section entitled "Information About our Board of Directors-General" in the 2009 Proxy Statement. Item 14 - Principal Accountant Fees and Services Information regarding principal accountant fees and services is incorporated by reference from the section entitled "Audit Firm Fee Summary" in the 2009 Proxy Statement. - -------------------------------------------------------------------------------- - 83 - Item 15 - Exhibits, Financial Statement Schedules. (a)(1) Financial Statements. The following financial statements and supplementary data are included in Item 8 of Part II of this Annual Report on Form 10-K. Financial Statements Form 10-K Page -------------- Report of Independent Registered Public Accounting Firm, Dixon Hughes PLLC, dated March 12, 2009 45 Consolidated Balance Sheets as of December 31, 2008 and 2007 46 Consolidated Statements of Operations for the years ended December 31, 2008, 2007 and 2006 47 Consolidated Statements of Comprehensive Income for the years ended December 31, 2008, 2007 and 2006 48 Consolidated Statements of Shareholders' Equity for the years ended December 31, 2008, 2007 and 2006 49 Consolidated Statements of Cash Flows for the years ended December 31, 2008, 2007 and 2006 50 Notes to Consolidated Financial Statements 51 (a)(2) Financial Statement Schedules. All applicable financial statement schedules required under Regulation S-X have been included in the Notes to Consolidated Financial Statements. (a)(3) Exhibits. The following exhibits are filed as part of this Annual Report on Form 10-K. Exhibit No. Description of Exhibit ----------- ---------------------- 2.1 Merger Agreement, dated as of December 10, 2007, by and among Four Oaks Fincorp, Inc., Four Oaks Bank & Trust Company and LongLeaf Community Bank (incorporated by reference to Exhibit 2.1 to the Company's Current Report on Form 8-K filed on December 13, 2007) 2.2 List of Schedules Omitted from Merger Agreement included as Exhibit 2.1 above (incorporated by reference to Exhibit 2.2 to the Company's Current Report on Form 8-K filed on December 13, 2007) 3.1 Articles of Incorporation of Four Oaks Fincorp, Inc. including Articles of Amendment to Articles of Incorporation. 3.2 Bylaws of Four Oaks Fincorp, Inc. (incorporated by reference to Exhibit 3.2 to the Company's Current Report on Form 8-K12G3 filed with the SEC on July 2, 1997) 4 Specimen of Certificate for Four Oaks Fincorp, Common Stock (incorporated by reference to Exhibit 4 to the Company's Current Report on Form 8-K12G3 filed with the SEC on July 2, 1997) 10.1 Employment Agreement with Ayden R. Lee, Jr. (incorporated by reference to Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the period ended June 30, 1997) (management contract or compensatory plan, contract or arrangement) 10.2 Severance Compensation Agreement with Ayden R. Lee, Jr. (incorporated by reference to Exhibit 10.2 to the Company's Quarterly Report on Form 10-Q for the period ended June 30, 1997) (management contract or compensatory plan, contract or arrangement) 10.3 Amended and Restated Nonqualified Stock Option Plan (incorporated by reference to Exhibit 10.2 to the Company's Quarterly Report on Form 10-Q for the period ended June 30, 2004) (management contract or compensatory plan, contract or arrangement) - -------------------------------------------------------------------------------- - 84 - Exhibit No. Description of Exhibit ----------- ---------------------- 10.4 Amended and Restated Employee Stock Purchase and Bonus Plan (incorporated by reference to Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the period ended June 30, 2004) (management contract or compensatory plan, contract or arrangement) 10.5 Second Amended and Restated Dividend Reinvestment and Stock Purchase Plan (incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K filed with the SEC on December 21, 2006) (management contract or compensatory plan, contract or arrangement) 10.6 Four Oaks Bank & Trust Company Supplemental Executive Retirement Plan (incorporated by reference to Exhibit 10.6 to the Company's Annual Report on Form 10-KSB for the fiscal year ended December 31, 1998) (management contract or compensatory plan, contract or arrangement) 10.7 Employment Agreement with Clifton L. Painter (incorporated by reference to Exhibit 10.7 to the Company's Annual Report on Form 10-KSB for the fiscal year ended December 31, 2001) (management contract or compensatory plan, contract or arrangement) 10.8 Severance Compensation Agreement with Clifton L. Painter (incorporated by reference to Exhibit 10.8 to the Company's Annual Report on Form 10-KSB for the period ended December 31, 2002) (management contract or compensatory plan, contract or arrangement) 10.9 Executive Employment Agreement with W. Leon Hiatt, III (incorporated by reference to Exhibit 10.9 to the Company's Annual Report on Form 10-KSB for the period ended December 31, 2003) (management contract or compensatory plan, contract or arrangement) 10.10 Severance Compensation Agreement with W. Leon Hiatt, III (incorporated by reference to Exhibit 10.10 to the Company's Annual Report on form 10-KSB for the period ended December 31, 2003) (management contract or compensatory plan, contract or arrangement) 10.11 Executive Employment Agreement with Nancy S. Wise (incorporated by reference to Exhibit 10.11 to the Company's Annual Report on Form 10-KSB for the period ended December 31, 2003) (management contract or compensatory plan, contract or arrangement) 10.12 Severance Compensation Agreement with Nancy S. Wise (incorporated by reference to Exhibit 10.12 to the Company's Annual Report on Form 10-KSB for the period ended December 31, 2003) (management contract or compensatory plan, contract or arrangement) 10.13 Form of Stock Option Agreement (Non-Employee Director) (incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K filed with the SEC on March 1, 2005) (management contract or compensatory plan, contract or arrangement) 10.14 Form of Stock Option Agreement (Employee) (incorporated by reference to Exhibit 10.2 to the Company's Current Report on Form 8-K filed with the SEC on March 1, 2005) (management contract or compensatory plan, contract or arrangement) 10.15 Executive Employment Agreement with Jeff D. Pope (incorporated by reference to Exhibit 10.15 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2004) (management contract or compensatory plan, contract or arrangement) 10.16 Severance Compensation Agreement with Jeff D. Pope (incorporated by reference to Exhibit 10.16 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2004) (management contract or compensatory plan, contract or arrangement) 10.17 Summary of Non-Employee Director Compensation (incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K filed with the SEC on January 25, 2006) (management contract or compensatory plan, contract or arrangement) - -------------------------------------------------------------------------------- - 85 - Exhibit No. Description of Exhibit ----------- ---------------------- 10.18 Amended and Restated Declaration of Trust of Four Oaks Statutory Trust I, dated as of March 30, 2006 (incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K filed with the SEC on April 4, 2006) 10.19 Guarantee Agreement of Four Oaks Fincorp, Inc. dated as of March 30, 2006 (incorporated by reference to Exhibit 10.2 to the Company's Current Report on Form 8-K filed with the SEC on April 4, 2006) 10.20 Indenture, dated as of March 30, 2006 by and between Four Oaks Fincorp, Inc. and Wilmington Trust Company, as Trustee, relating to Junior Subordinated Debt Securities due June 15, 2036 (incorporated by reference to Exhibit 10.3 to the Company's Current Report on Form 8-K filed with the SEC on April 4, 2006) 10.21 Amended and Restated Severance Agreement with W. Leon Hiatt, III (incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K filed with the SEC on February 26, 2008) (management contract or compensatory plan, contract or arrangement) 10.22 Summary of the Material Terms of the 2008 Bonus Plan (incorporated by reference to Exhibit 10.2 to the Company's Quarterly Report on Form 10-Q for the period ended March 31, 2008) (management contract or compensatory plan, contract or arrangement) 10.23 Consulting Agreement with John W. Bullard (incorporated by reference to Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the period ended June 30, 2008) 10.24 Third Amended and Restated Dividend Reinvestment and Stock Purchase Plan (incorporated by reference to Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the period ended September 30, 2008) (management contract or compensatory plan, contract or arrangement) 10.25 Amended and Restated Executive Employment Agreement with Ayden R. Lee, Jr. (incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K filed with the SEC on December 16, 2008) (management contract or compensatory plan, contract or arrangement) 10.25 Amended and Restated Executive Employment Agreement with Clifton L. Painter (incorporated by reference to Exhibit 10.2 to the Company's Current Report on Form 8-K filed with the SEC on December 16, 2008) (management contract or compensatory plan, contract or arrangement) 10.26 Amended and Restated Executive Employment Agreement with Nancy S. Wise (incorporated by reference to Exhibit 10.3 to the Company's Current Report on Form 8-K filed with the SEC on December 16, 2008) (management contract or compensatory plan, contract or arrangement) 10.27 Amended and Restated Executive Employment Agreement with W. Leon Hiatt, III (incorporated by reference to Exhibit 10.4 to the Company's Current Report on Form 8-K filed with the SEC on December 16, 2008) (management contract or compensatory plan, contract or arrangement) 10.28 Amended and Restated Executive Employment Agreement with Jeff D. Pope (incorporated by reference to Exhibit 10.5 to the Company's Current Report on Form 8-K filed with the SEC on December 16, 2008) (management contract or compensatory plan, contract or arrangement) 10.29 Supplemental Executive Retirement Plan (incorporated by reference to Exhibit 10.6 to the Company's Current Report on Form 8-K filed with the SEC on December 16, 2008) (management contract or compensatory plan, contract or arrangement) 10.30 Form of Capital Purchase Program Letter Agreement with Senior Executive Officers (incorporated by reference to Exhibit 10.7 to the Company's Current Report on Form 8-K filed with the SEC on December 16, 2008) (management contract or compensatory plan, contract or arrangement) 21 Subsidiaries of Four Oaks Fincorp, Inc. 23 Consent of Dixon Hughes PLLC 31.1 Certification of Chief Executive Officer Pursuant to Rule 13a- 14/15d-14 as Adopted Pursuant to Section 302 of the Sarbanes- Oxley Act of 2002 31.2 Certification of Chief Financial Officer Pursuant to Rule 13a- 14/15d-14 as Adopted Pursuant to Section 302 of the Sarbanes- Oxley Act of 2002 32.1 Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. [This exhibit is being furnished pursuant to Section 905 of the Sarbanes-Oxley Act of 2002 and shall not, except to the extent required by that Act, be deemed to be incorporated by reference into any document or filed herewith for the purposes of liability under the Securities Exchange Act of 1934, as amended, or the Securities Act of 1933, as amended, as the case may be.] 32.1 Certification of Chief Financial Officer to Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 [This exhibit is being furnished pursuant to Section 905 of the Sarbanes-Oxley Act of 2002 and shall not, except to the extent required by that Act, be deemed to be incorporated by reference into any document or filed herewith for the purposes of liability under the Securities Exchange Act of 1934, as amended, or the Securities Act of 1933, as amended, as the case may be.] (b) See (a) (3) above. (c) See (a) (2) above. - -------------------------------------------------------------------------------- - 86 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. FOUR OAKS FINCORP, INC. Date: March 12, 2009 By: /s/ Ayden R. Lee, Jr. --------------------- Ayden R. Lee, Jr. Chairman, President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Date: March 12, 2009 /s/ Ayden R. Lee, Jr. --------------------- Ayden R. Lee, Jr. Chairman, President and Chief Executive Officer Date: March 12, 2009 /s/ Nancy S. Wise --------------------- Nancy S. Wise Executive Vice President and Chief Financial Officer Date: March 12, 2009 /s/ William J. Edwards ---------------------- William J. Edwards Director Date: March 12, 2009 /s/ Warren L. Grimes --------------------- Warren L. Grimes Director Date: March 12, 2009 /s/ Dr. R. Max Raynor, Jr. --------------------------- Dr. R. Max Raynor, Jr. Director Date: March 12, 2009 /s/ Percy Y. Lee ---------------------- Percy Y. Lee Director Date: March 12, 2009 /s/ Paula C. Bowman -------------------- Paula C. Bowman Director Date: March 12, 2009 /s/ John W. Bullard ------------------- John W. Bullard Director Date: March 12, 2009 /s/ Michael A. Weeks -------------------- Michael A. Weeks Director Exhibit No. Description of Exhibit ----------- ---------------------- 2.1 Merger Agreement, dated as of December 10, 2007, by and among Four Oaks Fincorp, Inc., Four Oaks Bank & Trust Company and LongLeaf Community Bank (incorporated by reference to Exhibit 2.1 to the Company's Current Report on Form 8-K filed on December 13, 2007) 2.2 List of Schedules Omitted from Merger Agreement included as Exhibit 2.1 above (incorporated by reference to Exhibit 2.2 to the Company's Current Report on Form 8-K filed on December 13, 2007) 3.1 Articles of Incorporation of Four Oaks Fincorp, Inc. including Articles of Amendment to Articles of Incorporation. 3.2 Bylaws of Four Oaks Fincorp, Inc. (incorporated by reference to Exhibit 3.2 to the Company's Current Report on Form 8-K12G3 filed with the SEC on July 2, 1997) 4 Specimen of Certificate for Four Oaks Fincorp, Common Stock (incorporated by reference to Exhibit 4 to the Company's Current Report on Form 8-K12G3 filed with the SEC on July 2, 1997) 10.1 Employment Agreement with Ayden R. Lee, Jr. (incorporated by reference to Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the period ended June 30, 1997) (management contract or compensatory plan, contract or arrangement) 10.2 Severance Compensation Agreement with Ayden R. Lee, Jr. (incorporated by reference to Exhibit 10.2 to the Company's Quarterly Report on Form 10-Q for the period ended June 30, 1997) (management contract or compensatory plan, contract or arrangement) 10.3 Amended and Restated Nonqualified Stock Option Plan (incorporated by reference to Exhibit 10.2 to the Company's Quarterly Report on Form 10-Q for the period ended June 30, 2004) (management contract or compensatory plan, contract or arrangement) 10.4 Amended and Restated Employee Stock Purchase and Bonus Plan (incorporated by reference to Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the period ended June 30, 2004) (management contract or compensatory plan, contract or arrangement) 10.5 Second Amended and Restated Dividend Reinvestment and Stock Purchase Plan (incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K filed with the SEC on December 21, 2006) (management contract or compensatory plan, contract or arrangement) 10.6 Four Oaks Bank & Trust Company Supplemental Executive Retirement Plan (incorporated by reference to Exhibit 10.6 to the Company's Annual Report on Form 10-KSB for the fiscal year ended December 31, 1998) (management contract or compensatory plan, contract or arrangement) 10.7 Employment Agreement with Clifton L. Painter (incorporated by reference to Exhibit 10.7 to the Company's Annual Report on Form 10-KSB for the fiscal year ended December 31, 2001) (management contract or compensatory plan, contract or arrangement) 10.8 Severance Compensation Agreement with Clifton L. Painter (incorporated by reference to Exhibit 10.8 to the Company's Annual Report on Form 10-KSB for the period ended December 31, 2002) (management contract or compensatory plan, contract or arrangement) 10.9 Executive Employment Agreement with W. Leon Hiatt, III (incorporated by reference to Exhibit 10.9 to the Company's Annual Report on Form 10-KSB for the period ended December 31, 2003) (management contract or compensatory plan, contract or arrangement) 10.10 Severance Compensation Agreement with W. Leon Hiatt, III (incorporated by reference to Exhibit 10.10 to the Company's Annual Report on form 10-KSB for the period ended December 31, 2003) (management contract or compensatory plan, contract or arrangement) 10.11 Executive Employment Agreement with Nancy S. Wise (incorporated by reference to Exhibit 10.11 to the Company's Annual Report on Form 10-KSB for the period ended December 31, 2003) (management contract or compensatory plan, contract or arrangement) Exhibit No. Description of Exhibit ----------- ---------------------- 10.12 Severance Compensation Agreement with Nancy S. Wise (incorporated by reference to Exhibit 10.12 to the Company's Annual Report on Form 10-KSB for the period ended December 31, 2003) (management contract or compensatory plan, contract or arrangement) 10.13 Form of Stock Option Agreement (Non-Employee Director) (incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K filed with the SEC on March 1, 2005) (management contract or compensatory plan, contract or arrangement) 10.14 Form of Stock Option Agreement (Employee) (incorporated by reference to Exhibit 10.2 to the Company's Current Report on Form 8-K filed with the SEC on March 1, 2005) (management contract or compensatory plan, contract or arrangement) 10.15 Executive Employment Agreement with Jeff D. Pope (incorporated by reference to Exhibit 10.15 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2004) (management contract or compensatory plan, contract or arrangement) 10.16 Severance Compensation Agreement with Jeff D. Pope (incorporated by reference to Exhibit 10.16 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2004) (management contract or compensatory plan, contract or arrangement) 10.17 Summary of Non-Employee Director Compensation (incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K filed with the SEC on January 25, 2006) (management contract or compensatory plan, contract or arrangement) 10.18 Amended and Restated Declaration of Trust of Four Oaks Statutory Trust I, dated as of March 30, 2006 (incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K filed with the SEC on April 4, 2006) 10.19 Guarantee Agreement of Four Oaks Fincorp, Inc. dated as of March 30, 2006 (incorporated by reference to Exhibit 10.2 to the Company's Current Report on Form 8-K filed with the SEC on April 4, 2006) 10.20 Indenture, dated as of March 30, 2006 by and between Four Oaks Fincorp, Inc. and Wilmington Trust Company, as Trustee, relating to Junior Subordinated Debt Securities due June 15, 2036 (incorporated by reference to Exhibit 10.3 to the Company's Current Report on Form 8-K filed with the SEC on April 4, 2006) 10.21 Amended and Restated Severance Agreement with W. Leon Hiatt, III (incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K filed with the SEC on February 26, 2008) (management contract or compensatory plan, contract or arrangement) 10.22 Summary of the Material Terms of the 2008 Bonus Plan (incorporated by reference to Exhibit 10.2 to the Company's Quarterly Report on Form 10-Q for the period ended March 31, 2008) (management contract or compensatory plan, contract or arrangement) 10.23 Consulting Agreement with John W. Bullard (incorporated by reference to Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the period ended June 30, 2008) 10.24 Third Amended and Restated Dividend Reinvestment and Stock Purchase Plan (incorporated by reference to Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the period ended September 30, 2008) (management contract or compensatory plan, contract or arrangement) 10.25 Amended and Restated Executive Employment Agreement with Ayden R. Lee, Jr. (incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K filed with the SEC on December 16, 2008) (management contract or compensatory plan, contract or arrangement) 10.25 Amended and Restated Executive Employment Agreement with Clifton L. Painter (incorporated by reference to Exhibit 10.2 to the Company's Current Report on Form 8-K filed with the SEC on December 16, 2008) (management contract or compensatory plan, contract or arrangement) Exhibit No. Description of Exhibit ----------- ---------------------- 10.26 Amended and Restated Executive Employment Agreement with Nancy S. Wise (incorporated by reference to Exhibit 10.3 to the Company's Current Report on Form 8-K filed with the SEC on December 16, 2008) (management contract or compensatory plan, contract or arrangement) 10.27 Amended and Restated Executive Employment Agreement with W. Leon Hiatt, III (incorporated by reference to Exhibit 10.4 to the Company's Current Report on Form 8-K filed with the SEC on December 16, 2008) (management contract or compensatory plan, contract or arrangement) 10.28 Amended and Restated Executive Employment Agreement with Jeff D. Pope (incorporated by reference to Exhibit 10.5 to the Company's Current Report on Form 8-K filed with the SEC on December 16, 2008) (management contract or compensatory plan, contract or arrangement) 10.29 Supplemental Executive Retirement Plan (incorporated by reference to Exhibit 10.6 to the Company's Current Report on Form 8-K filed with the SEC on December 16, 2008) (management contract or compensatory plan, contract or arrangement) 10.30 Form of Capital Purchase Program Letter Agreement with Senior Executive Officers (incorporated by reference to Exhibit 10.7 to the Company's Current Report on Form 8-K filed with the SEC on December 16, 2008) (management contract or compensatory plan, contract or arrangement) 21 Subsidiaries of Four Oaks Fincorp, Inc. 23 Consent of Dixon Hughes PLLC 31.1 Certification of Chief Executive Officer Pursuant to Rule 13a- 14/15d-14 as Adopted Pursuant to Section 302 of the Sarbanes- Oxley Act of 2002 31.2 Certification of Chief Financial Officer Pursuant to Rule 13a- 14/15d-14 as Adopted Pursuant to Section 302 of the Sarbanes- Oxley Act of 2002 32.1 Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. [This exhibit is being furnished pursuant to Section 905 of the Sarbanes-Oxley Act of 2002 and shall not, except to the extent required by that Act, be deemed to be incorporated by reference into any document or filed herewith for the purposes of liability under the Securities Exchange Act of 1934, as amended, or the Securities Act of 1933, as amended, as the case may be.] 32.1 Certification of Chief Financial Officer to Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 [This exhibit is being furnished pursuant to Section 905 of the Sarbanes-Oxley Act of 2002 and shall not, except to the extent required by that Act, be deemed to be incorporated by reference into any document or filed herewith for the purposes of liability under the Securities Exchange Act of 1934, as amended, or the Securities Act of 1933, as amended, as the case may be.]