Form 10-K

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 


 

FORM 10-K

 

FOR ANNUAL AND TRANSITION REPORTS

PURSUANT TO SECTIONS 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

 

(Mark One)

 

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the fiscal year ended December 31, 2004

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                  to                 

 

Commission file number 000-16461

 

Community Bancshares, Inc.

(Exact Name of Registrant as Specified in Its Charter)

 

Delaware   63-0868361

(State or Other Jurisdiction of

Incorporation or Organization)

  (I.R.S. Employer Identification No.)

68149 Main Street

Blountsville, Alabama

  35031
(Address of Principal Executive Offices)   (Zip Code)

 

Registrant’s telephone number, including area code (205) 429-1000

 

Securities registered pursuant to Section 12(b) of the Act:

 

Title of Each Class


 

Name of Each Exchange on Which Registered


None   None

 

Securities registered pursuant to Section 12(g) of the Act:

 

Common Stock, $.10 Par Value Per Share

(Title of Class)


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

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes ¨    No x

 

State the aggregate market value of the voting and non-voting common equity held by nonaffiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter.

 

The aggregate market value of Community Bancshares, Inc.’s common stock, par value $.10 per share, held by non-affiliates on June 30, 2004 was $58.8 million, based on a price of $7.26 per share, which was the price at which the common stock was last sold in what Community Bancshares, Inc. believes to be arm’s length transactions on or prior to June 30, 2004.

 

Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date.

 

As of March 18, 2005, there were 8,524,505 shares of the common stock, par value $.10 per share, of Community Bancshares, Inc., issued and outstanding.

 



 

IMPORTANT INFORMATION ABOUT THIS REPORT

 

In this Annual Report on Form 10-K, which we refer to as this “report,” the words “Company,” “we,” “us” and “our” refer to the combined entities of Community Bancshares, Inc., Community Bank, 1st Community Credit Corporation, Community Insurance Corp., Southern Select Insurance, Inc., Community Appraisals, Inc. and Community Funding Corporation.

 

The words “Community Bancshares,” “Community Bank,” “Community Credit,” “Community Insurance,” “Southern Select,” “Community Appraisals,” and “Community Funding” refer, respectively, to each of the above entities in their individual capacities.

 

SPECIAL CAUTIONARY NOTICE

REGARDING FORWARD-LOOKING STATEMENTS

 

Certain statements made or incorporated by reference in this report are “forward-looking statements” within the meaning of, and subject to the protections of, Section 27A of the Securities Act of 1933, or the “Securities Act,” and Section 21E of the Securities Exchange Act of 1934, or the “Exchange Act.”

 

Forward-looking statements include statements with respect to our beliefs, plans, objectives, goals, expectations, anticipations, assumptions, estimates, intentions, and future performance, and involve known and unknown risks, uncertainties and other factors, many of which may be beyond our control, and which may cause our actual results, performance or achievements to be materially different from future results, performance or achievements expressed or implied by the forward-looking statements.

 

All statements other than statements of historical fact are statements that could be forward-looking statements. You can identify these forward-looking statements through our use of words such as “may,” “will,” “anticipate,” “hope,” “project,” “assume,” “should,” “indicate,” “would,” “believe,” “contemplate,” “expect,” “estimate,” “continue,” “plan,” “point to,” “could,” “intend,” “seek,” “target,” and other similar words and expressions of the future. Such forward-looking statements include, without limitation, statements regarding:

 

    our business strategy;

 

    future performance, developments, transactions or market forecasts;

 

    projected benefits to us as a result of any changes in our regulatory restrictions; and

 

    projected investments and dispositions of assets.

 

The forward-looking statements may not be realized due to a variety of factors, including, without limitation:

 

    future economic or business conditions;

 

    governmental monetary and fiscal policies, as well as legislative and regulatory changes, including changes in tax laws and regulations;

 

    the risks of changes in interest rates on the levels, composition and costs of deposits, loan demand, and the values of loan collateral, securities, and interest sensitive assets and liabilities;

 

    interest rate risks and credit risks of borrowers;

 

    the effects of competition from a wide variety of local, regional, national and other providers of financial, investment and insurance services;

 

    the failure of assumptions underlying the establishment of the allowance for loan losses and other estimates, and the uncertainty and costs of litigation;

 

    the risks of mergers, acquisitions and divestures, including, without limitation, the related time and costs of implementing such transactions, and the possible failure to achieve expected gains, revenue growth and/or expense savings expected from such transactions;

 

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    changes in accounting policies, rules and practices;

 

    difficulties with, or changes in the cost or effectiveness of technology and/or products;

 

    the effects of war or other conflict, acts of terrorism or other catastrophic events that affect general economic conditions; and

 

    other factors and other information discussed in this report, as well as other factors and risks described in any of our other reports that we make with the Securities and Exchange Commission, or the “SEC,” under the Exchange Act.

 

All written or oral statements that are made by or are attributable to us are expressly qualified in their entirety by this cautionary notice. We have no obligation and do not undertake to update, revise or correct any of the forward-looking statements after the date of this report, or after the respective dates on which such statements otherwise are made.

 

PART I

 

ITEM 1. BUSINESS.

 

General

 

Our company is made up of the following entities:

 

    Community Bancshares, Inc., a Delaware bank holding company that owns 100% of Community Funding, Community Bank and Community Bank’s subsidiaries;

 

    Community Bank, a community-focused Alabama commercial bank;

 

    1st Community Credit Corporation, a finance company subsidiary of Community Bank;

 

    Community Insurance Corp., a subsidiary of Community Bank that is as an insurance agency for the sale of title, property, casualty and life insurance to individuals and businesses;

 

    Southern Select Insurance, Inc., a subsidiary of Community Insurance that brokers agricultural, commercial and personal insurance products;

 

    Community Appraisals, Inc., a subsidiary of Community Bank that provides appraisal services in connection with the lending activities of Community Bank and its subsidiaries, but ceased operations in late 2003; and

 

    Community Funding Corporation, a subsidiary of Community Bancshares, Inc. formed on December 30, 2003 to purchase and maintain certain nonperforming assets of Community Bank.

 

As of December 31, 2004, we had total consolidated assets of approximately $553.4 million, total deposits of approximately $448.6 million, total consolidated liabilities, including deposits, of approximately $510.5 million, and consolidated stockholders’ equity of approximately $42.9 million.

 

Our principal executive offices, which also serve as the principal executive offices of Community Bank, Community Appraisals and Community Funding, are located at 68149 Main Street, Blountsville, Alabama 35031, and our telephone number at that address is (205) 429-1000. The principal executive offices of Community Credit are located at 587 Highway 31 N.W., Suite A, Hartselle, Alabama 35640, and the telephone number at that address is (256) 751-2031. The principal executive offices of Community Insurance and Southern Select are located at 401 Holmes Avenue, Huntsville, Alabama 35801, and the telephone number at that address is (256) 533-5600.

 

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Community Bancshares

 

Community Bancshares is a Delaware corporation that is registered as a bank holding company with the Board of Governors of the Federal Reserve System, or the “Federal Reserve,” under the Bank Holding Company Act of 1956, as amended, or the “BHC Act.” Community Bancshares was organized in 1983 and commenced business in 1985.

 

Our Commercial Banking Business

 

We conduct our commercial banking operations through Community Bank. Community Bank is an Alabama banking corporation founded in 1923. Community Bank is a member of the FDIC and its deposits are insured by the FDIC.

 

Community Bank provides a broad range of commercial and retail banking services through 20 locations in nine counties in Alabama. Community Bank offers a wide range of commercial and retail banking services, which principally include checking transaction accounts, and personal and commercial loans to customers in our target market area. Community Bank seeks to provide its customers with outstanding service and to become a vital component of each of the communities that it serves. We believe that the retail nature of Community Bank’s commercial banking operations allows for diversification of customers and that our loans to businesses are not concentrated in any one industry.

 

Community Bank’s lending activities include commercial, real estate and consumer loans. The majority of Community Bank’s loans are to individuals and small to mid-sized businesses in Alabama. Its commercial loan services include term loans, lines of credit and agricultural loans. It provides a broad range of short- to medium-term commercial loans, both secured and unsecured, to various local businesses for working capital, business expansion and the purchase of equipment and machinery. Its real estate lending activities include fixed and adjustable rate residential mortgage loans, construction loans, second mortgages, home improvement loans and home equity lines of credit. Its consumer lending services include loans for automobiles, recreation vehicles and boats, as well as unsecured personal loans and loans secured by deposit accounts.

 

Community Bank operates primarily in small non-urban communities. As of December 31, 2004, Community Bank operated 18 full service offices and two paying and receiving offices located in Wal-Mart® stores, which primarily open deposit accounts, cash checks and receive deposits and loan payments.

 

For the year ended December 31, 2004, Community Bank had pretax income of approximately $1.8 million. During the fiscal years 2002 and 2003, Community Bank had pretax income of approximately $3.2 million and a pretax loss of $(19.6) million, respectively. Its loan portfolio, which consisted of 54.3% of our assets at December 31, 2004, 56.6% at December 31, 2003 and 63.8% at December 31, 2002, continues to represent our largest earning asset. As of December 31, 2004, Community Bank had total commercial banking loans of $300.4 million.

 

Our Other Operations

 

Non-Traditional Banking Operations

 

1st Community Credit Corporation operates 14 finance company offices in Limestone, Madison, Morgan, Blount, Cullman, Marshall, Etowah, DeKalb, Walker, Talladega and St. Clair Counties, Alabama, primarily in local communities where Community Bank does not operate. Community Credit provides smaller loans to a market segment traditionally not pursued by Community Bank. These loans typically involve greater risk and generate higher yields than standard commercial bank loans. We believe that, by conducting this business, we are establishing a business presence and a customer base in communities where Community Bank may at some point commence full-scale commercial banking operations. For the year ended December 31, 2004, Community Credit had pretax income of $1.4 million. For the years ended December 31, 2003 and December 31, 2002, we had approximately $933,000 and $380,000, respectively, in pretax income from the operations of Community Credit. At December 31, 2004, the loan portfolio at Community Credit was $35.2 million, representing 6.4% of our total consolidated assets. At December 31, 2003 and 2002, the loan portfolio at Community Credit was $31.2 million and $27.9 million, representing 5.6% and 4.9% of our total assets, respectively.

 

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Insurance Operations

 

Community Insurance Corp. serves as an agency in the sale of title, property, casualty and life insurance products to individuals and businesses in the Huntsville metropolitan area. Community Insurance owns 100% of Southern Select Insurance, Inc., a managing general agency in Huntsville that brokers agricultural, commercial and personal insurance products. For the years ended December 31, 2004, 2003 and 2002, we had approximately $81,000, $(486,000) and $(154,000), respectively, in pretax income (losses) from our insurance operations.

 

Appraisal Operations

 

Community Appraisals, Inc. provides appraisal services in connection with the lending activities of Community Bank and Community Credit. For the years ended December 31, 2004, 2003 and 2002, our appraisal business generated approximately $(1,000), $(6,000) and $57,000, respectively, in pretax income (loss). At this time, Community Appraisals is inactive, and Community Bank is outsourcing its appraisal needs to third parties.

 

Asset Quality Improvement

 

Community Funding Corporation was formed in December 2003 for the purpose of purchasing and maintaining certain of Community Bank’s nonperforming assets in order to improve Community Bank’s asset quality. Community Funding conducted no business in 2003. During 2004, Community Bancshares capitalized Community Funding with $3.9 million. Community Funding has used the cash to purchase nonperforming assets and at December 31, 2004 owned $3.9 million in nonperforming assets. The pretax loss for Community Funding for the year ended December 31, 2004 was $(2,300).

 

Our Market Area

 

Community Bank currently has 20 branches in nine counties, most of which are situated in northern Alabama. We serve customers in five counties in north Alabama – Blount, Lauderdale, Limestone, Madison and Morgan Counties; two counties in northwest Alabama – Marion and Winston Counties; and two counties in southwest Alabama – Marengo and Perry Counties. We have focused on those market areas between the Birmingham and Huntsville metropolitan areas, where significant growth and economic change have transpired over the last decade.

 

Community Bank’s primary market area is Blount County, which was added to the Birmingham metropolitan area in 1983. The Birmingham Metropolitan Statistical Area, or “MSA,” consists of seven counties and is home to approximately 1.1 million people, representing the most populous MSA in the State of Alabama. Once known as the South’s largest manufacturing center, Birmingham previously relied heavily on both the steel and manufacturing industries. Manufacturing remains an important part of Birmingham’s economy but the economy has become more diverse in its industries, and, according to the Birmingham Regional Chamber of Commerce, the healthcare, banking and professional services industries are its leading economic sectors and largest employers.

en cities in total banking assets.

 

Community Bank also has customers in four counties – Lauderdale, Limestone, Madison and Morgan Counties – which are proximate to or within the Huntsville MSA, currently one of Alabama’s fastest growing metropolitan areas. It has been identified by the U.S. Census Bureau figures, March 2000, as one of the “Top 50” fastest growing metropolitan areas in the United States and consistently ranks among the top three wealthiest counties in the Southeast in average annual wages according to the Alabama Regional Chamber of Commerce.

 

Huntsville possesses a diverse economic base and is home to numerous industries, including technology, space and defense, manufacturing, and retail and service. Huntsville is home to numerous centers of global excellence, including the Cummings Research Park (over 23,000 employees and 225 companies, according to the Huntsville Chamber of Commerce), the NASA Marshall Space Flight Center, and the US Army Redstone Arsenal.

 

Community Bank has branches in Marion, Lauderdale and Winston Counties, located in northwest Alabama, near the Mississippi border. These counties are economically driven by manufacturing and furniture production. Community Bank also operates in Marengo and Perry Counties, located in southwest Alabama, where manufacturing, catfish

 

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farming, livestock and the timber industry are important components of the local economy. These are relatively low growth areas, with income levels that are below Alabama averages.

 

In the first half of 2002, we sold two branch offices of Community Bank located in Pulaski, Tennessee, and eight branch offices located in Marshall and DeKalb Counties, Alabama, two of which were paying and receiving offices located in Wal-Mart stores.

 

Community Bank Foundation

 

In early 2004, the Board of Directors of Community Bank authorized the establishment of the Community Bank Foundation (the “Foundation”). The Foundation is a private non-profit organization established as a vehicle for making a positive contribution to the communities in which Community Bank and its subsidiaries do business. The Foundation has been notified by the Internal Revenue Service of its approval as a tax exempt organization. It is anticipated that the Foundation will award college scholarships to deserving high school seniors, make contributions to schools, hospitals, senior citizen centers, centers for abused children or spouses, children’s camps and other worthy organizations whose purpose is to make our communities better places to live and work.

 

Competition

 

The banking business in Alabama is highly competitive with respect to loans, deposits and other financial services and is dominated by a number of major banks and bank holding companies that have offices and affiliates operating over wide geographic areas, and that have greater resources at their disposal than we do. We compete for deposits, loans and other business with these institutions as well as with other types of financial services entities, including savings and loan associations, credit unions, securities and mutual fund firms, mortgage companies, and insurance companies. Many of the major commercial banks operating in or around Community Bank’s service areas offer services such as investment and trust services, which we do not currently offer.

 

Our competitive environment has been and will continue to be materially affected by the enactment by Congress of the Gramm-Leach-Bliley Financial Services Modernization Act of 1999, or the “GLB Act.” This law authorized a bank holding company that possesses a prescribed amount of capital and meets other criteria to become a “financial holding company,” which enables it to then engage in investment banking, insurance underwriting and the sale of insurance, as well as any other activity that federal regulators view as “financial in nature.” We may face greater competition as more financial holding companies enter our market area and offer a more diverse line of financial products and consolidated financial services than we may offer.

 

In addition, during 2002, Community Bank sold ten of its branch offices located in Pulaski, Tennessee, and DeKalb and Marshall Counties, Alabama, to competing third party commercial banks. In connection with those sales, we entered into non-competition agreements that imposed restrictions, but all restrictions had expired by May 31, 2004.

 

Seasonality

 

Our management believes that our business, including our subsidiaries’ businesses, is not seasonal in nature.

 

Customer Concentration

 

For each of the years ended December 31, 2004, 2003 and 2002, we did not, and we presently do not expect for the year ended December 31, 2005 will derive more than 10% of our revenues, on a consolidated basis, from any one customer.

 

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Supervision and Regulation

 

The banking and financial services industry is extensively regulated under both federal and state law. The following discussion summarizes certain statutes, rules and regulations affecting our business and operations. This summary is qualified in its entirety by reference to the statutory and regulatory provisions referred to below and elsewhere and is not intended to be an exhaustive description of the statutes or regulations applicable to us. Changes in the laws and regulations that apply to us can affect our operations in substantial and unpredictable ways. We cannot accurately predict whether legislation will be enacted, and, if enacted, the ultimate effect that it or any implementing regulations will have on our business, financial condition or results of operations.

 

The following summary describes our regulatory environment in the absence of any restrictive memoranda, orders or agreements with our regulators and therefore is further subject to, and does not address, the regulatory restrictions to which we have been subject. You should refer to and carefully review these restrictions, which are described below in this report. To the extent that the limitations imposed by those regulatory restrictions on our business activities are different than as described in this summary, then the regulatory restrictions govern.

 

Supervision, regulation, and examination of holding companies and banks by bank regulatory agencies are intended primarily for the protection of depositors rather than holders of our securities, including our preferred stock and common stock.

 

Holding Company Regulation

 

General

 

Community Bancshares is a bank holding company within the meaning of the BHC Act, and is subject to supervision, examination, and reporting by the Federal Reserve. The State of Alabama does not currently regulate bank holding companies. Community Bancshares is required to file with the Federal Reserve periodic reports and any additional information as the Federal Reserve may require. The Federal Reserve regularly examines Community Bancshares and may examine its subsidiaries.

 

Investment Activities

 

The BHC Act requires prior Federal Reserve approval for, among other things:

 

    the acquisition by a bank holding company of direct or indirect ownership or control of more than 5% of the voting shares or substantially all of the assets of any bank; and

 

    a merger or consolidation of a bank holding company with another bank holding company.

 

The Change in Bank Control Act and Federal Reserve regulations also generally require a notice and prior action thereon if anyone not subject to the BHC Act application acquires 10% or more of a bank’s or its parent holding company’s securities where the bank or holding company has a class of securities registered under the Exchange Act.

 

A bank holding company may acquire direct or indirect ownership or control of voting shares of any company that is engaged directly or indirectly in banking, managing or controlling banks, or performing services for its authorized subsidiaries. A bank holding company may also engage in or acquire an interest in a company that engages in activities that the Federal Reserve has determined by regulation or order to be so closely related to banking as to be a proper incident to those activities.

 

The Gramm-Leach-Bliley Financial Services Modernization Act of 1999, or the “GLB Act,” made substantial revisions to the statutory restrictions separating banking activities from certain other financial activities. Under the GLB Act, bank holding companies that are well-capitalized and well-managed and meet other conditions can elect to become “financial holding companies.” Financial holding companies and their subsidiaries are permitted to acquire or engage in previously impermissible activities such as insurance underwriting, securities underwriting and distribution, travel agency activities, board insurance agency activities, merchant banking, and other activities that the Federal Reserve determines to be financial in nature or complementary to those activities. In addition, under the merchant banking

 

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authority added by the GLB Act and Federal Reserve regulations, financial holding companies are authorized to invest in companies that engage in activities that are not financial in nature, as long as the financial holding company makes its investment with the intention of limiting the investment in duration, does not manage the company on a day-to-day basis, and the investee company does not cross-market with any of the financial holding company’s controlled depository institutions. Financial holding companies continue to be subject to the overall oversight and supervision of the Federal Reserve, but the GLB Act applies the concept of functional regulation to the activities conducted by subsidiaries. For example, insurance activities would be subject to supervision and regulation by state insurance authorities. Community Bancshares has not sought approval to become a financial holding company and presently has no intention of doing so.

 

Source of Financial Strength

 

Federal Reserve policy requires a bank holding company to act as a source of financial and managerial strength to its subsidiary banks. This means that a bank holding company must be prepared to use available resources to provide adequate capital funds to its bank subsidiaries during periods of financial stress and must have sufficient financial flexibility and capital-raising capacity to provide ongoing support to the banks. In addition, under the Financial Institutions Reform, Recovery and Enforcement Act of 1989, or “FIRREA,” if a bank holding company has more than one bank or thrift subsidiary, each of the bank holding company’s subsidiary depository institutions are responsible for any losses to the FDIC as a result of an affiliated depository institution’s failure. As a result, a bank holding company may be required to loan money to its subsidiaries in the form of capital notes or other instruments which qualify as capital under regulatory rules. Any loans from a bank holding company to its subsidiary banks likely will be unsecured and subordinated to the bank’s depositors and perhaps to other creditors of that bank.

 

Transactions With Affiliates

 

Community Bancshares is a legal entity separate and distinct from Community Bank. Various legal limitations restrict Community Bank from lending or otherwise supplying funds to Community Bancshares or its other affiliates. Section 23A of the Federal Reserve Act limits a bank’s “covered transactions,” which include extensions of credit with any affiliate, to 10% of the bank’s capital and surplus. All covered and exempt transactions between a bank and its affiliates must be on terms and conditions consistent with safe and sound banking practices, and banks and their subsidiaries are prohibited from purchasing low-quality assets from the bank’s affiliates. Finally, all of a bank’s extensions of credit to an affiliate must be appropriately secured by acceptable collateral, generally United States government or agency securities.

 

Section 23B of the Federal Reserve Act requires that covered and exempt transactions among affiliates be on terms and under circumstances, including credit standards, that are substantially the same, or at least as favorable to the bank or its subsidiary, as those prevailing at the time for transactions with unaffiliated companies.

 

Bank Regulation

 

General

 

Community Bank is an Alabama bank whose deposits are insured by the FDIC. Community Bank is subject to regulation and examination by the Alabama Superintendent of Banks and by the FDIC. The Alabama Superintendent of Banks and the FDIC regulate and examine all of Community Bank’s operations, including its overall financial condition and resources, loan loss reserves, the quality of its loan portfolio, mortgages, payments of dividends, interest rates charged, the establishment of branches, the actions of its directors and management, the investment of its funds, and compliance with its charter and the law.

 

The powers of Alabama-chartered banks include provisions designed to provide these banks with competitive equality to the powers of national banks. In addition, the GLB Act permits banks to engage in “financial activities” through subsidiaries in a manner similar to financial holding companies.

 

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Dividends

 

Dividends from Community Bank historically have been Community Bancshares’ primary source of funds for servicing debt and paying cash dividends to our stockholders.

 

Under Alabama law, a bank may not pay a dividend in excess of 90% of its net earnings until its surplus is equal to at least 20% of its capital. The prior approval of the FDIC and/or the Alabama Superintendent is required if the total of all dividends declared by a bank in any calendar year will exceed the sum of that bank’s net earnings for the year and its retained net earnings for the preceding two calendar years, less any required transfers to surplus. In addition, a bank may not pay dividends from its surplus without the prior approval of the Superintendent. During 2003 and 2004, Community Bank paid no cash dividends to Community Bancshares. As of December 31, 2004, Community Bank could not have declared or paid any dividend without prior approval of the Superintendent of Banks.

 

In addition, Community Bancshares and Community Bank are subject to various regulatory policies and requirements that affect the payment of dividends, including requirements to maintain adequate capital. The appropriate federal and state regulatory authorities are authorized to determine, based on the financial condition of a bank or bank holding company, that the payment of dividends would be an unsafe or unsound practice and to prohibit payment of those dividends. The FDIC and the Alabama Superintendent have indicated that paying dividends that deplete a bank’s capital base to an inadequate level would be an unsound and unsafe banking practice.

 

As to Community Bancshares, the Federal Reserve may prohibit the payment of dividends to our stockholders if it determines that the payment would constitute an unsafe or unsound practice. The Federal Reserve’s position is that a bank holding company should not pay dividends if it is experiencing earnings weaknesses or other financial pressures and should not pay dividends that exceed its net income, that are inconsistent with its capital position or that could only be funded in ways that weaken its financial health, such as by borrowing or selling its assets. In addition, a bank holding company must not pay dividends if such payment would affect its ability to provide adequate financial support for its subsidiary banks. As of December 31, 2004, under a Memorandum of Understanding (“MOU”) between Community Bancshares and the Federal Reserve Bank of Atlanta, the Federal Reserve restricted Community Bancshares from declaring or paying any dividends, including the payments on our trust preferred securities, or repurchasing its capital stock without prior Federal Reserve approval. However, we have been notified that, because of the improved financial condition of our organization, combined with our compliance with the MOU, the MOU between Community Bancshares and the Federal Reserve was terminated effective March 17, 2005.

 

Safety and Soundness

 

The FDIC has adopted the Federal Financial Institutions Examination Council’s, or the “FFIEC,” internal rating system for assessing the soundness of financial institutions on a uniform basis and for identifying those institutions requiring special supervisory attention. Each financial institution is assigned a confidential composite “CAMELS” rating based on an evaluation and rating of the following six components of an institution’s financial condition and operations:

 

    Capital adequacy;

 

    Asset quality;

 

    Management;

 

    Earnings;

 

    Liquidity; and

 

    Sensitivity to market risk.

 

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For most institutions, the FFIEC has indicated that market risk primarily reflects exposures to changes in interest rates. When regulators evaluate this component, consideration is expected to be given to the sensitivity of the financial institution’s earnings or the economic value of its capital to adverse changes in interest rates, foreign exchange rates, commodity prices, or equity prices; management’s ability to identify, measure, monitor and control exposure to market risk; the nature and complexity of interest rate risk exposure arising from non-trading positions; and the adequacy of its capital and earnings in relation to its level of exposure.

 

Capital Regulations

 

The federal bank regulatory agencies have adopted risk-based capital guidelines for bank holding companies and banks. The guideline for a minimum ratio of capital to risk-weighted assets, including certain off-balance-sheet activities, such as standby letters of credit, is 8.0%. At least half of the total capital must consist of “Tier 1 Capital,” which includes common equity, retained earnings and a limited amount of qualifying preferred stock, less goodwill. The remainder may consist of “Tier 2 Capital,” which includes non-qualifying preferred stock, qualifying subordinated, perpetual, and/or mandatory convertible debt, term subordinated debt, intermediate term preferred stock and up to 45.0% of the pretax unrealized holding gains on available-for-sale equity securities with readily determinable market values that are prudently valued, and a limited amount of any loan loss allowance.

 

All bank holding companies and banks are expected to hold capital commensurate with the level and nature of their risks, including the volume and severity of their problem loans. The federal agencies have established minimum leverage ratio guidelines for bank holding companies, national banks, and state banks, which provide for a minimum leverage ratio of Tier 1 Capital to adjusted average quarterly assets equal to 3.0%, plus an additional cushion of 1.0% to 2.0% if the institution has less than the highest regulatory rating. The guidelines also provide that institutions experiencing internal growth or making acquisitions will be expected to maintain capital positions substantially above the minimum supervisory levels. Higher capital may be required in individual cases, depending upon a bank holding company’s risk profile. Lastly, the Federal Reserve’s guidelines indicate that the Federal Reserve will continue to consider a “Tangible Tier 1 Leverage Ratio,” calculated by deducting all intangibles, in evaluating proposals for expansion or new activity.

 

FDICIA requires the federal banking agencies to take “prompt corrective action” in respect of depository institutions that do not meet minimum capital requirements. FDICIA established five capital tiers:

 

    well capitalized;

 

    adequately capitalized;

 

    undercapitalized;

 

    significantly undercapitalized; and

 

    critically undercapitalized.

 

A depository institution’s capital tier will depend upon how its capital levels compare to various measures and certain other factors, as established by regulation. The capital measures used by the federal banking regulators are:

 

    the Total Capital ratio, which is the ratio of the total of Tier 1 Capital and Tier 2 Capital to total risk-weighted assets;

 

    the Tier 1 Capital ratio; and

 

    the Leverage Ratio.

 

Under these regulations, a bank will be:

 

    “well capitalized” if it has a Total Capital ratio of 10.0% or greater, a Tier 1 Capital ratio of 6.0% or greater, and is not subject to any written agreement, order, capital directive, or prompt corrective action directive by a federal bank regulatory agency to meet and maintain a specific capital level for any capital measure;

 

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    “adequately capitalized” if it has a Total Capital ratio of 8.0% or greater, a Tier 1 Capital ratio of 4.0% or greater, and a leverage ratio of 4.0% or greater – or 3.0% in some circumstances – and is not well capitalized;

 

    “undercapitalized” if it has a Total Capital ratio of less than 8.0% or a Tier 1 capital ratio of less than 4.0%, or 3.0% in some circumstances;

 

    “significantly undercapitalized” if it has a Total Capital ratio of less than 6.0%, a Tier 1 Capital ratio of less than 3.0%, or a leverage ratio of less than 3.0%; or

 

    “critically undercapitalized” if its tangible equity is equal to or less than 2.0% of average quarterly tangible assets.

 

The following table sets forth the capital information of Community Bancshares and Community Bank as of December 31, 2004:

 

CAPITAL ADEQUACY RATIOS

 

     Actual

    Minimum Capital
Requirement


    Minimum
to be
Well Capitalized


 
     Amount

   Ratio

    Amount

   Ratio

    Amount

   Ratio

 
     (Dollars in thousands)  

Total risk based capital to risk weighted assets:

                                       

Consolidated

   $ 56,019    17.06 %   $ 26,265    8.00 %   $ 32,831    10.00 %

Community Bank

     49,573    15.42       25,712    8.00       32,141    10.00  

Tier 1 capital to risk weighted assets:

                                       

Consolidated

     51,909    15.81       13,132    4.00       19,699    6.00  

Community Bank

     45,548    14.17       12,856    4.00       19,284    6.00  

Tier 1 capital to average assets (leverage ratio):

                                       

Consolidated

     51,909    9.58       21,674    4.00 (1)     27,093    5.00  

Community Bank

     45,548    8.47       21,517    4.00 (2)     26,896    5.00  

 

(1) As of December 31, 2004, the Company was required to maintain a 6.5% leverage ratio under the MOU.

 

(2) As of December 31, 2004, the Bank was required to maintain a 7% leverage ratio under the Compliance Plan.

 

Community Reinvestment Act

 

Community Bancshares and Community Bank are subject to the Community Reinvestment Act, or the “CRA,” and the federal banking agencies’ related regulations. Under the CRA, all banks and thrifts have a continuing and affirmative obligation, consistent with their safe and sound operation, to help meet the credit needs for their entire communities, including low- and moderate-income neighborhoods. The CRA does not establish specific lending requirements or programs for financial institutions, nor does it limit an institution’s discretion to develop the types of products and services that it believes are best suited to its particular community, consistent with the CRA. The CRA requires a depository institution’s primary federal regulator, in connection with its examination of the institution, to assess the institution’s record of assessing and meeting the credit needs of the community served by that institution, including low- and moderate-income neighborhoods. The regulatory agency’s assessment of the institution’s record is made available to the public. Further, such assessment is required of any institution that has applied to:

 

    charter a bank;

 

    obtain deposit insurance coverage for a newly-chartered institution;

 

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    establish a new branch office that accepts deposits;

 

    relocate an office; or

 

    merge or consolidate with, or acquire the assets or assume the liabilities of, a federally regulated financial institution.

 

A less than satisfactory CRA rating will slow, if not preclude, expansion of banking activities.

 

Current CRA regulations rate institutions based on their actual performance in meeting community credit needs. CRA performance is evaluated by the FDIC, Community Bank’s primary federal regulator using a lending test, an investment test, and a service test. The FDIC also will consider:

 

    demographic data about the community;

 

    the institution’s capacity and constraints;

 

    the institution’s product offerings and business strategy; and

 

    data on the prior performance of the institution and similarly situated lenders.

 

The Federal bank regulators recently proposed changes to their CRA regulations. Financial holding company subsidiaries must receive “satisfactory” or better CRA ratings to engage in financial holding company or subsidiary activities permitted by the GLB Act. Community Bank received a “satisfactory” CRA rating on its most recent examination.

 

Consumer Regulations

 

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

 

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

 

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

 

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

 

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

 

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

 

    The GLB Act, which requires banks and their affiliated companies to adopt and disclose privacy policies, including policies regarding the sharing of personal information they obtain from customers with third parties; and

 

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

 

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FDIC Insurance Assessments

 

Community Bank’s deposits are primarily insured by the FDIC’s Bank Insurance Fund, or “BIF.” The FDIC utilizes a risk-based deposit insurance premium schedule to determine the assessment rates for Bank Insurance Fund-insured depository institutions. Each financial institution is assigned to one of three capital groups:

 

    well capitalized;

 

    adequately capitalized; or

 

    undercapitalized.

 

Each financial institution is further assigned to one of three subgroups within a capital group, on the basis of supervisory evaluations by the institution’s primary federal and, if applicable, state regulators and other information relevant to the institution’s financial condition and the risk posed to the applicable insurance fund. The actual assessment rate applicable to a particular institution will, therefore, depend in part upon the risk assessment classification so assigned to the institution by the FDIC. The FDIC is presently considering whether to charge deposit insurance premiums based upon management weaknesses and whether the bank’s underwriting practices, concentrations of risk, and growth are undisciplined or outside industry norms.

 

The BIF assessment rates currently range from zero basis points on deposits for a financial institution in the highest category, to 27 basis points on deposits for an institution in the lowest category. In addition, the Deposit Insurance Funds Act of 1996 authorizes the FDIC to collect The Financing Corporation, or “FICO,” deposit assessments on Bank Insurance Fund – and Savings Association Insurance Fund-assessable deposits at the same rate. FICO assessments are set quarterly, and in 2004 ranged from 1.46 to 1.54 cents per $100 of assessable deposits. For the first quarter of 2005, the FICO assessment rate for such deposits will be 1.44 cents per $100 of assessable deposits. Community Bank paid insurance premiums in 2002, 2003 and 2004 of $532,118, $776,814 and $762,644, respectively, and paid FICO assessments of approximately $99,000, $73,000 and $68,000, in each of these years, respectively. As a result of our recent and much improved regulatory examination, we anticipate a decline in our cost of FDIC insurance.

 

Enforcement Policies and Actions

 

The Federal Reserve, the FDIC and the Alabama Superintendent monitor compliance with laws and regulations. Violations of laws and regulations, or other unsafe and unsound practices, may result in these agencies imposing fines or penalties, issuing cease and desist orders or memorandums of understanding, or taking other enforcement actions. Under certain circumstances, these agencies may enforce these remedies directly against officers, directors, employees and others participating in the affairs of a bank or bank holding company. The regulatory agencies have extensive powers to enforce their agreements with banks and bank holding companies, including, among other actions, civil money penalties, and possible proceedings to terminate FDIC insurance. We previously have been subject to a memorandum of understanding, a safety and soundness compliance plan and two cease and desist orders. However, we were notified in March 2005 that all regulatory memoranda, agreements, plans and orders to which we were subject had been terminated. See “Our Current Regulatory Restrictions.”

 

Fiscal and Monetary Policy

 

Banking is a business that depends on interest rate differentials. In general, the difference between the interest paid by a bank on its deposits and its other borrowings, and the interest received by a bank on its loans and securities holdings, constitutes the major portion of a bank’s earnings. Thus, our earnings and growth will be subject to the influence of economic conditions generally, both domestic and foreign, and also to the monetary and fiscal policies of the United States and its agencies, particularly the Federal Reserve.

 

The Federal Reserve regulates the supply of money through various means, including open market dealings in United States government securities, the discount rate at which banks may borrow from the Federal Reserve, and the reserve requirements on deposits. The monetary policies of the Federal Reserve historically have had a significant effect on the operating results of commercial banks and will continue to do so in the future. The conditions in the national and international economies and money markets, as well as the actions and changes in policy by monetary and fiscal authorities, and their effect on us cannot be predicted.

 

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Money Laundering

 

The International Money Laundering Abatement and Anti-Terrorism Funding Act of 2001 restricts money laundering by terrorists in the United States and abroad. This Act specifies new “know your customer” requirements that will obligate financial institutions to take actions to verify the identity of the account holders in connection with opening an account at any U.S. financial institution. Banking regulators will consider compliance with the act’s money laundering provisions in making decisions regarding approval of acquisitions and mergers. In addition, sanctions for violations of the act can be imposed in an amount equal to twice the sum involved in the violating transaction, up to $1.0 million.

 

In the wake of the tragic events of September 11th, on October 26, 2001, the President signed the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001, (“USA PATRIOT”). Under the USA PATRIOT Act, financial institutions are subject to prohibitions against specified financial transactions and account relationships as well as enhanced due diligence and “know your customer” standards in their dealings with foreign financial institutions and foreign customers. For example, the enhanced due diligence policies, procedures, and controls generally require financial institutions to take reasonable steps:

 

  to conduct enhanced scrutiny of account relationships to guard against money laundering and report any suspicious transaction;

 

  to ascertain the identity of the nominal and beneficial owners of, and the source of funds deposited into, each account as needed to guard against money laundering and report any suspicious transactions;

 

  to ascertain for any foreign bank, the shares of which are not publicly traded, the identity of the owners of the foreign bank, and the nature and extent of the ownership interest of each such owner; and

 

  to ascertain whether any foreign bank provides correspondent accounts to other foreign banks and, if so, the identity of those foreign banks and related due diligence information.

 

The USA PATRIOT Act requires financial institutions to establish anti-money laundering programs. The USA PATRIOT Act sets forth minimum standards for these programs, including:

 

  the development of internal policies, procedures, and controls;

 

  the designation of a compliance officer;

 

  an ongoing employee training program; and

 

  an independent audit function to test the programs.

 

In addition, the USA PATRIOT Act authorizes the Secretary of the Treasury to adopt rules increasing the cooperation and information sharing between financial institutions, regulators, and law enforcement authorities regarding individuals, entities and organizations engaged in, or reasonably suspected based on credible evidence of engaging in, terrorist acts or money laundering activities.

 

Insurance Regulation

 

Community Insurance and Southern Select are licensed insurance agents and brokers for various insurance companies, and are subject to regulation by the Alabama Insurance Commission.

 

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Legislative and Regulatory Changes

 

Legislative and regulatory proposals regarding changes in banking laws, the regulation of banks, thrifts and other financial institutions, as well as bank and bank holding company powers are being considered by the executive branch of the Federal government, Congress and various state governments, including Alabama. The FDIC has proposed comprehensive deposit insurance reform legislation. Other proposals pending in Congress would, among other things, allow banks to pay interest on checking accounts and to establish interstate branches de novo. The Alabama Banking Department has introduced legislation in the Alabama legislature that would, among other things, permit interstate de novo branching in Alabama by out-of-state banks, regulate bank holding companies and expand the enforcement powers of the Alabama Banking Department. Certain of these proposals, if adopted, could significantly change the regulation of banks and the financial services industry. It cannot be predicted whether any of these proposals will be adopted, and, if adopted, how these proposals will affect us.

 

Our Current Regulatory Restrictions

 

Special and Important Update

 

During the entire year of 2004, Community Bancshares and Community Bank were subject to four different regulatory agreements or orders as discussed in the following section. Since their inception, the Company has materially complied with the requirements and expectations contained in the documents and cooperated fully with the regulatory authorities. Based on our compliance with, and performance under, those documents, as well as the result of our most recent examinations conducted by the FDIC, the Federal Reserve Bank of Atlanta and the Alabama State Banking Department, all of these agreements and orders, the terms of which are described in our 2003 Annual Report on Form 10-K, were terminated during March 2005. Such restrictions were in place during all of 2004.

 

Statistical Disclosure

 

Statistical and other information regarding the following items are set forth in “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

ITEM 2. PROPERTIES.

 

Our corporate headquarters is owned by Community Bank and located at 68149 Main Street (U.S. Highway 231) in Blountsville, Alabama. Community Bank’s administrative, operational, accounting and legal functions are housed in three buildings which were constructed in 1997, all of which are located on the same property as the corporate headquarters. These buildings, which collectively provide a total of approximately 72,500 square feet of office space on seven acres of land, are in good condition.

 

The main commercial banking office of Community Bank is located at 69156 Main Street, Blountsville, Alabama. The premises are owned by Community Bank. This building offers a total of 7,500 square feet of office space and is in good condition.

 

At December 31, 2004, Community Bank owned or leased buildings that were used in the normal course of business in nine counties in Alabama, including Blount, Lauderdale, Limestone, Madison, Marengo, Marion, Morgan, Perry and Winston Counties. Community Credit owned or leased buildings that were used in the normal course of business in eleven counties in Alabama, including Blount, Cullman, Marshall, Morgan, Limestone, Lawrence, Etowah, Madison, DeKalb, Walker, Talladega and St. Clair Counties. Community Insurance and Southern Select leased space in a building that is used in the normal course of business in Madison County, Alabama. We presently believe that none of these other facilities are, individually, material to our operations, and, if forced for any reason to vacate or

 

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sell any of these other facilities, we presently believe that we would be able to timely identify and occupy suitable alternative locations on equally favorable terms.

 

For information about the amounts at which bank premises, equipment and other real estate are recorded in our financial statements and information relating to commitments under leases, see our consolidated financial statements and the accompanying notes to consolidated financial statements included elsewhere in this report.

 

ITEM 3. LEGAL PROCEEDINGS.

 

Background

 

At a June 20, 2000, meeting of the board of directors of Community Bank, one of Community Bank’s directors brought to the attention of the board of directors the total amount of money that Community Bank had paid to subcontractors in connection with the construction of a new Community Bank branch office in Guntersville, Alabama. Based upon the significance of the amount paid, management commenced an investigation into these expenditures.

 

At the request of management, the architects and subcontractors involved in the construction project made presentations to the boards of directors of both Community Bancshares and Community Bank on July 15 and July 18, 2000, respectively. At the July 18, 2000 meeting of the board of directors of Community Bank, another director alleged that Community Bank had been overcharged by subcontractors on the construction project in question, as well as on another construction project that was incomplete at that time.

 

On July 18, 2000, the boards of directors of Community Bancshares and Community Bank appointed a joint committee comprised of independent directors from both boards to investigate these alleged overcharges. The joint committee retained independent legal counsel and an independent accounting firm to assist its investigation and made its report to both boards of directors on .

 

Community Bank’s directors who alleged the construction overcharges also informed bank regulatory agencies and law enforcement authorities of their concerns. These agencies and authorities conducted their own investigations into the matter. Based on its findings, the FDIC issued restitution and/or removal orders against Kennon R. Patterson, Sr., former Chairman and Chief Executive Officer of the Company and Community Bank, and Larry Bishop, former Vice President of Community Bank. These regulatory actions are still pending at this time. The board of directors of Community Bancshares and the board of directors of Community Bank terminated Kennon R. Patterson, Sr. on January 27, 2003, and the board of directors of Community Bank terminated Larry Bishop on February 6, 2003. On October 29, 2003, the United States Department of Justice announced the filing of a 25-count indictment against Messrs. Patterson and Bishop, and a construction contractor, in connection with a scheme to divest Community Bank’s funds for Mr. Patterson’s personal benefit. On November 14, 2003, Mr. Patterson informed Community Bancshares that he was taking a leave of absence from Community Bancshares’ board of directors pending a resolution of the criminal charges against him. Mr. Patterson stated that he would not seek re-election to Community Bancshares’ board of directors if the criminal charges were not resolved prior to the expiration of his current term in 2005. On June 24, 2004, at the annual meeting of stockholders, Mr. Patterson was removed as a director of the Company. On March 10, 2005, Mr. Patterson, Mr. Bishop and the construction contractor were convicted of conspiracy, bank fraud and causing false entries to be made in bank records in connection with the Department of Justice proceedings. Mr. Patterson was also convicted of filing false income tax returns. It is likely that Messrs, Patterson and Bishop will appeal their convictions and a sentencing date has yet to have been set for either party. The U.S Attorney has indicated its desire to seek $1.9 million in restitution from the connected parties when and provided that the men are sentenced. Community Bancshares and Community Bank continue to seek recovery of all amounts owed by Mr. Patterson to Community Bank.

 

In the first quarter 2005 issue of Bank Director Magazine, the Board of Directors of Community Bancshares was awarded the L. William Seidman Courage award. This annual award is presented to one Board whose directors, during a time of great adversity, had the courage to do the right thing. Our Board received this award after Bank Director, solicited nominations from industry consultants, investment bankers, attorneys, trade associations officials and others who work closely with bank boards. Editors and management of Bank Director then reviewed

 

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submissions and made a final determination about the winner in each category. The full article can be read at www.bankdirector.com.

 

Patterson Litigation I

 

Plaintiffs:

   Kennon R. Patterson, Sr., Community Bancshares’ former Chairman, President and Chief Executive Officer

Defendants:

   Community Bancshares, Community Bank, five of the directors of Community Bancshares and Community Bank, and Powell, Goldstein, Frazer and Murphy, LLP, as counsel to Community Bank’s Audit Committee

 

On April 9, 2003, Mr. Patterson filed an adversary proceeding against the defendants in the United States Bankruptcy Court for the Northern District of Alabama in connection with his petition for protection under Chapter 11 of the United States Bankruptcy Code. Mr. Patterson’s complaint:

 

    alleges that Community Bancshares breached its employment agreement with Mr. Patterson by terminating his employment on January 27, 2003 and failing to pay him for compensation and benefits that had accrued prior to his termination; and

 

    alleges that Community Bank, members of Community Bank’s Audit Committee, the Audit Committee’s independent counsel and Community Bancshares’ current Chairman, President and Chief Executive Officer conspired to interfere with Mr. Patterson’s contract and business relationship with Community Bancshares.

 

The suit seeks damages in excess of $150.0 million for, among other things, lost compensation and benefits, mental anguish, and damage to Mr. Patterson’s reputation.

 

On May 9, 2003, the defendants filed a motion to dismiss the suit, and, on June 17, 2003, the court denied the motion to dismiss the suit as to Community Bancshares, Community Bank and the named directors. On July 7, 2003, those defendants filed a counterclaim against Mr. Patterson asserting that Mr. Patterson breached his employment agreement with Community Bancshares, engaged in fraudulent conduct, and converted property belonging to Community Bank to his personal use.

 

On January 12, 2004, the bankruptcy proceeding filed by Mr. Patterson was dismissed without prejudice. Community Bancshares, Community Bank and the individual defendants moved to dismiss the adversary proceeding in bankruptcy filed against them by Mr. Patterson. That motion was granted on July 26, 2004, and the adversary proceeding was dismissed.

 

Patterson Litigation II

 

Plaintiffs:

   Community Bancshares, Inc. and Community Bank

Defendants:

   Kennon R. Patterson, Sr., Community Bancshares’ former Chairman, President and Chief Executive Officer

 

On September 14, 2004, Community Bancshares and Community Bank filed suit against Mr. Patterson in the Circuit Court of Blount County, Alabama in order to pursue those claims which had been asserted against him as counterclaims in the adversary proceeding in bankruptcy. Community Bancshares’ and Community Bank’s complaint:

 

    alleges that Mr. Patterson breached his employment agreement with Community Bancshares by failing to faithfully perform the duties assigned to him;

 

   

alleges that Mr. Patterson made fraudulent misrepresentations to, or suppressed material information from, Community Bancshares and Community Bank and/or their officers, directors and agents concerning his

 

18


 

bankruptcy, the release of mortgages which Community Bank held on his house, and payments made by Community Bancshares and Community Bank to companies owned by Mr. Patterson and members of his family;

 

    alleges that Mr. Patterson removed property belonging to Community Bancshares and Community Bank following the termination of his employment; and

 

    alleges that Mr. Patterson breached a duty of loyalty and other fiduciary duties owed to Community Bancshares and Community Bank.

 

On October 18, 2004, Mr. Patterson filed an answer and counterclaim against Community Bancshares and Community Bank. Mr. Patterson’s counterclaim:

 

    alleges that Community Bancshares breached its employment agreement with Mr. Patterson by terminating his employment;

 

    alleges that Community Bancshares failed to pay to Mr. Patterson compensation and benefits of $2.4 million which had allegedly accrued prior to the termination of his employment;

 

    alleges that Community Bank intentionally interfered with the employment contract between Mr. Patterson and Community Bancshares by instigating, promoting, assisting in and participating in the termination of Mr. Patterson’s employment agreement; and

 

 

    alleges that Community Bancshares falsely represented to Mr. Patterson that his employment would not be terminated until Match 31, 2008.

 

On January 25, 2005, Mr. Patterson filed a third-party complaint in this lawsuit against R.B. Jackson, Jimmie Trotter, Glynn Debter, John J. Lewis, Jr., Patrick M. Frawley and Powell, Goldstein, Frazer & Murphy, LLP. The third-party complaint alleges that Messrs. Jackson, Trotter, Debter and Lewis, as members of Community Bank’s Audit Committee, Powell, Goldstein, Frazier & Murphy, LLP, as the independent counsel for Community Bank’s Audit Committee, and Mr. Frawley, acting individually and in concert with one another, interfered with Mr. Patterson’s employment agreement with Community Bancshares.

 

Patterson Litigation III

 

Plaintiffs:

   Community Bancshares, Inc. Employee Stock Ownership Plan (the “ESOP”) and North Star Trust Company, as Trustee of the ESOP

Defendants:

   Kennon R. Patterson, Sr., Community Bancshares’ former Chairman, President and Chief Executive Officer

 

On March 15, 2004 the Employee Stock Ownership Plan, or “ESOP,” of Community Bancshares, together with the ESOP trustee, North Star Trust Company, filed suit against Mr. Patterson in the United States District Court for the Northern District of Alabama. The ESOP’s complaint:

 

    alleges that Mr. Patterson breached his fiduciary duty to the ESOP by engaging in activities which adversely affected the value of the Community Bancshares stock held by the ESOP and concealing information with respect to those activities from other ESOP fiduciaries; and

 

    seeks a declaratory judgment that Mr. Patterson is not entitled to a distribution of his accrued benefits in the ESOP and that such benefits may be held and used to offset the damages which the ESOP suffered as a result of Mr. Patterson’s alleged breach of fiduciary duty.

 

On July 7, 2004, the Court denied Mr. Patterson’s motion to dismiss the case. On or about July 23, 2004, Mr. Patterson filed a counterclaim seeking a judgment that he is entitled to benefits from the ESOP and declaratory and

 

19


injunctive relief compelling the payment of such benefits. On July 26, 2004 the Court, at Mr. Patterson’s request, stayed discovery in the case pending Mr. Patterson’s trial on criminal charges.

 

Patterson Litigation IV

 

Plaintiff:

   Kennon R. Patterson, Sr.

Defendant:

   Community Bancshares, Inc. Benefit Restoration Plan

 

On February 17, 2005, Mr. Patterson filed suit in the United States District Court for the Northern District of Alabama to compel payment of his accrued benefits under the Community Bancshares, Inc. Benefit Restoration Plan, a nonqualified supplemental retirement plan. The complaint seeks a judgment against the plan and an order compelling the payment of benefits.

 

Benson Litigation

 

Plaintiffs:

   M. Lewis Benson, Doris E. Benson, John M. Packard, Jr. and Andy C. Mann, four of Community Bancshares’ stockholders

Defendants:

   Community Bancshares, Community Bank, certain of the present and former directors of Community Bancshares and Community Bank, an employee of Community Bank and two construction subcontractors previously hired by the Company

 

On July 21, 2000, the plaintiffs filed a lawsuit, styled as a stockholder derivative suit, in the state Circuit Court of Marshall County, Alabama against the defendants, relating to alleged overcharges in construction costs. At the time, these charges were being investigated by a joint committee of the boards of directors of Community Bancshares and Community Bank.

 

The complaint:

 

    alleges that the directors, officers and employee named as defendants (i) breached their fiduciary duties, (ii) failed to properly supervise officers and agents of Community Bancshares and Community Bank, and (iii) permitted waste of corporate assets by permitting the subcontractor defendants to overcharge Community Bank in connection with the construction of two new Community Bank branch offices, and to perform the construction work without written contracts, budgets, performance guarantees and assurances of indemnification;

 

    alleges that Kennon R. Patterson, Sr., the Company’s former Chairman, President and Chief Executive Officer, breached his fiduciary duties by permitting the two named subcontractors to overcharge for work performed on the two construction projects in exchange for discounted charges for work these subcontractors performed in connection with the construction of Mr. Patterson’s residence;

 

    alleges that the director defendants knew or should have known of this alleged arrangement between Mr. Patterson and the subcontractors; and

 

    alleges that Mr. Patterson, the Community Bank employee and the two subcontractor defendants made false representations and suppressed information about the overcharges and arrangement between Mr. Patterson and the subcontractors.

 

On August 15, 2000, the plaintiffs filed an amended complaint that generally reiterates the allegations of the original complaint, and further:

 

    alleges that the Bank was overcharged on all construction projects from January 1997 to the present; and

 

    alleges that the defendants breached their fiduciary duties and are guilty of gross financial mismanagement, including making or approving loans and taking improper actions to conceal the fact that the loans were uncollectible.

 

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On September 18, 2000, the plaintiffs filed a second amended complaint generally reiterating the allegations of the original and first amended complaints, and further:

 

    alleging that the plaintiffs were improperly denied their rights to inspect and copy certain records of Community Bancshares and Community Bank; and

 

    alleging that the directors of Community Bancshares abdicated their roles as directors either by express agreement or as a result of wantonness and gross negligence.

 

The second amended complaint further asserts that the counts involving inspection of corporate records and director abdication are individual, non-derivative claims. The second amended complaint seeks, on behalf of Community Bancshares, an unspecified amount of compensatory damages in excess of $1.0 million, punitive damages, disgorgement of improperly paid profits and appropriate equitable relief. Upon a motion of the defendants, the case was transferred to the state Circuit Court in Blount County, Alabama by order dated September 21, 2000, as amended on October 12, 2000.

 

Tentative settlements of the lawsuit were announced in November 2002, August 2003 and November 2003 but were not finalized.

 

On January 31, 2005, the Circuit Court of Blount County, Alabama approved a pro tanto settlement of the Benson and Packard derivative lawsuits. Pursuant to the pro tanto settlement, Community Bancshares and Community Bank received a total of $625,000, and the defendants who were current or former directors or officers of Community Bancshares or Community Bank, except for Kennon R. Patterson, Sr., were dismissed from the lawsuits. Community Bancshares and Community Bank have been realigned as plaintiffs in the lawsuits against the remaining defendants.

 

Packard Derivative Litigation

 

Plaintiffs:

   M. Lewis Benson, Doris E. Benson, John M. Packard, Jr. and Andy C. Mann, four of Community Bancshares’ stockholders

Defendants:

   Sheffield Electrical Contractors, Inc., Steve Sheffield, Jay Bolden, Dudley, Hopton-Jones, Sims & Freeman, PLLP, Glynn C. Debter, Kennon R. Patterson, Jr., Robert O. Summerford, Jimmie A. Trotter, John L. Lewis, Jr., Merritt M. Robbins, Stacey W. Mann, B. K. Walker, Jr., Denny Kelly, Roy B. Jackson, Loy D. McGruder, and Hodge Patterson

 

On April 4, 2003, the plaintiffs, which are the same as in the Benson case described above, filed a derivative action against the defendants. This action, while stemming from the same facts alleged in the Benson Litigation, is based not upon what the director-defendants “did (and did not do) before learning of the over billing [sic.] allegations against [Mr.] Patterson in July 2000” but, instead, is based upon “what they have done (and failed to do) after the filing of the Benson lawsuit – that is, after they learned of the allegations against [Mr.] Patterson in July 2000.”

 

On June 18, 2003, the Circuit Court of Jefferson County, Alabama granted the motion filed by Community Bancshares, Community Bank and most of the individual defendants to transfer the suit to the Circuit Court of Blount County, Alabama.

 

On or about October 1, 2003, one of the defendants, Dudley, Hopton-Jones, Sims & Freeman, PLLP, formerly the certified public accountants and outside auditors for Community Bancshares and Community Bank, filed a cross-claim against Community Bank, Community Bancshares, Glynn C. Debter, Kennon R. Patterson, Jr., Robert O. Summerford, Jimmie A. Trotter, John L. Lewis, Jr., Merritt M. Robbins, Stacey W. Mann, B. K. Walker, Jr., Denny Kelly, Roy B. Jackson, Loy D. McGruder, and Hodge Patterson, all of whom are directors or former directors of Community Bancshares and/or Community Bank. The cross-claim demands “compensatory damages, interest, and costs, including the amount of any adverse judgment entered in this cause” against Dudley, Hopton-Jones. Punitive damages are also demanded in some counts. The basis for the claims is common law indemnity, contractual indemnity, negligence, misrepresentation, suppression, and concealment of material facts, and, civil conspiracy.

 

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On November 11, 2003, Community Bancshares, Community Bank, and certain individual defendants entered into an agreement to settle this case, which was not finalized.

 

On January 31, 2005, the Circuit Court of Blount County, Alabama approved a pro tanto settlement of the Benson and Packard derivative lawsuits. Pursuant to the pro tanto settlement, Community Bancshares and Community Bank received a total of $625,000, and the defendants who were current or former directors or officers of Community Bancshares or Community Bank, except for Kennon R. Patterson, Sr., were dismissed from the lawsuits. Community Bancshares and Community Bank have been realigned as plaintiffs in the lawsuits against the remaining defendants.

 

Fidelity Bond Litigation

 

Plaintiffs:    Community Bancshares and Community Bank
Defendant:    Travelers Casualty & Surety Company of America
Third-Party Defendants:    Certain present and former directors of Community Bancshares and Community Bank, a former officer of Community Bank, and two accounting firms formerly engaged by Community Bancshares

 

On August 20, 2004, Community Bancshares and Community Bank filed suit in the Circuit Court of Blount County, Alabama against Travelers Casualty & Surety Company of America, issuer of a financial institution fidelity bond purchased by Community Bancshares and Community Bank. The complaint:

 

    alleges that Travelers breached its contract with Community Bancshares and Community Bank by failing to pay a claim related to employee dishonesty in connection with the construction of Mr. Patterson’s house; and

 

    seeks a declaratory judgment to the effect that Community Bancshares and Community Bank are entitled to the full amount of the claim, and that Travelers is not entitled to subrogation of the claims of Community Bancshares and Community Bank against certain individual defendants in the Benson derivative litigation.

 

On October 19, 2004, Travelers filed a third-party complaint against certain present and former directors of Community Bancshares and Community Bank, a former officer of Community Bank, and two accounting firms which were formerly engaged by Community Bancshares. The third-party complaint:

 

    alleges that the individual defendants breached a duty of loyalty, duty of care, duty of fair dealing and other duties to Community Bancshares and Community Bank in connection with their actions and/or their failure to act with respect to the construction overcharges and other related matters;

 

    alleges that the individual defendants wasted assets of Community Bank by agreeing to excessive construction payments and making certain other expenditures;

 

    alleges that the director defendants permitted certain insiders of Community Bank to receive loans from Community Bank which involved more than the normal risk of repayment or presented other unfavorable features in violation of Alabama banking law;

 

    alleges that the director defendants abdicated their role as board members by not supervising the actions of Mr. Patterson;

 

    alleges that Mr. Patterson and Larry Bishop made false representations and/or suppressed material information concerning construction projects and certain Community Bank loans;

 

    alleges that the director defendants, Mr. Patterson and Mr. Bishop all conspired to commit the alleged wrongs stated above;

 

22


    alleges that the accounting firms breached a duty of care and committed malpractice in negligently auditing Community Bancshares and Community Bank during the time when the construction overcharges and other alleged improprieties occurred; and

 

    seeks damages from the third-party defendants equal to the amount of Community Bancshares’ and Community Bank’s claim against Travelers under the financial institution fidelity bond.

 

On October 1, 2004, Travelers filed a notice that the case was being removed from the Circuit Court of Blount County, Alabama to the United States District Court for the Northern District of Alabama. On October 28, 2004, Community Bancshares and Community Bank filed a motion to remand the case to the Circuit Court of Blount County.

 

On December 21, 2004, the parties settled this litigation. Pursuant to the settlement, Community Bank received a payment of $450,000. This amount was appropriately recorded as a receivable as of December 31, 2004.

 

Lending Acts Litigation

 

Plaintiffs:

   William Alston, Murphy Howard, and Jason Tittle

Defendants:

   Community Bancshares, Community Bank, Holsombeck Motors, Inc., Lee Brown d/b/a Alabama Bond & Investigation a/k/a ABI Recovery, Chris Holmes d/b/a Alabama Bond & Investigation a/k/a ABI Recovery, Regina Holsombeck, Kennon “Ken” Patterson, Sr., Hodge Patterson, James Timothy “Tim” Hodge, Ernie Stephens, and the State of Alabama Department of Revenue

 

On October 11, 2002, the plaintiffs filed a class action against the defendants alleging that Community Bank and others conspired or used extortionate methods to effect a lending scheme of “churning phantom loans,” and that profits from the scheme were used to secure an interest in and/or to invest in an enterprise that affects interstate commerce. The plaintiffs specifically allege that Community Bank used various methods to get uneducated customers with fair to poor credit to sign numerous “phantom loans” when the customers only intended to sign for one loan. Claims include racketeering activity within the meaning of the Racketeer Influenced and Corrupt Organizations Act of 1970, conspiracy, spoliation, conversion, negligence, wantonness, outrage, and civil conspiracy.

 

On or about February 17, 2004, an amended complaint was filed in this lending acts litigation. The amended complaint, which completely replaces the original complaint, omits class action and racketeering claims and alleges violations of the Truth in Lending Act and Regulation Z of the Federal Reserve Board in addition to conversion, negligence, outrage, suppression, fraud and misrepresentation, trespass, conspiracy and failure to provide notice before disposition of collateral for loans. On April 2, 2004, eighty-one individuals, most of whom were formerly members of the purported class in the lending acts litigation filed by William Alston, filed suit against Community Bancshares, Community Bank and a former Community Bank employee in the Circuit Court of Jefferson County, Alabama. This suit claims that the defendants injured the plaintiffs, primarily in connection with lending at Community Bank’s office in Double Springs, Alabama, by wrongfully taking property, committing fraud, furnishing inaccurate information to credit reporting agencies, negligently hiring, training and supervising employees, negligently handling customer accounts, altering loan documents and failing to honor oral and written contracts with the plaintiffs.

 

On February 2, 2005, Community Bancshares and Community Bank settled the claims of Mr. Alston and Mr. Howard for amounts which are not material to the financial statements of Community Bancshares.

 

Employee Litigation

 

Plaintiffs:

   Bishop K. Walker, Jr., former Senior Executive Vice President and General Counsel of Community Bancshares, and his wife, Wanda Walker, and Denny G. Kelly, former President of Community Bank, and his wife, Arlene Kelly

Defendants:

   Community Bancshares, Community Bank, Kennon R. Patterson, Sr., and a number of unidentified defendants

 

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On May 5, 2003, the plaintiffs filed separate suits in the Circuit Court of Blount County, Alabama, against the defendants alleging that they were induced to retire based upon misrepresentations made by Kennon R. Patterson, Sr., who at the time was Community Bancshares’ Chairman, President and Chief Executive Officer. The plaintiffs claim that Mr. Patterson’s actions constituted fraud, promissory fraud, fraudulent suppression, fraud in the inducement, deceit, fraudulent deceit, negligence, recklessness, wantonness and breach of contract. The complaints seek an unspecified amount of compensatory and punitive damages.

 

On October 23, 2003, Community Bancshares and Community Bank filed counterclaims against Mr. Walker and Mr. Kelly seeking repayment of amounts paid to them as part of a severance arrangement and, in the case of Mr. Kelly, amounts owed to Community Bank in connection with the two loans from Community Bank to Mr. Kelly.

 

Mr. Kelly and Mr. Walker each filed an amended complaint on or about April 20, 2004. The amended complaints add Mrs. Kelly and Mrs. Walker as parties plaintiff and allege that representations were made by the defendants to Mrs. Kelly and Mrs. Walker that the defendants would purchase their personal and jointly owned stock of the Company. The complaints assert that the defendants’ failure to purchase such stock constitutes promissory fraud, fraudulent misrepresentation, fraudulent suppression, negligence and/or wantonness. Mr. Walker’s amended complaint also seeks damages based on Community Bank’s refusal to accept a deed in lieu of foreclosure on Mr. Walker’s home. On June 15, 2004, Community Bank amended its counterclaim against Mr. Walker to recover a loan deficiency balance following Community Bank’s foreclosure on Mr. Walker’s home.

 

Other Litigation

 

In addition to the foregoing, Community Bancshares and its affiliates also are from time to time parties to other legal proceedings arising in the ordinary course of Community Bancshares’ business. We presently believe that, other than the litigation discussed above, there is no other litigation to which Community Bancshares or its affiliates presently are party that, if such litigation were to result in an outcome unfavorable to Community Bancshares, would, individually or in the aggregate, have a material adverse effect on our financial condition or results of operations.

 

Our certificate of incorporation and bylaws provide that, in certain circumstances, we will indemnify our directors and officers, and, provided such persons acted in accordance with the standards set forth in the Delaware General Corporation Law and our organizational documents, advance expenses to our directors and officers in connection with investigations and proceedings in connection with their service as officers and directors.

 

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.

 

No matter was submitted to a vote of our security holders by solicitation of proxies or otherwise during the fourth quarter of 2004.

 

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PART II

 

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.

 

Number of Shares and Holders

 

We presently have no shares of our preferred stock outstanding. At March 24, 2005, we had approximately 8,524,505 shares of our common stock outstanding and held by approximately 2,300 stockholders of record.

 

Market Information

 

Beginning on February 26, 2004, our common stock was traded on the over-the-counter market under the symbol “COMB.” Share price data for 2004 presented below is based on reported information on the over the counter market.

 

Before February 26, 2004, there was no trading market for our common stock. Our common stock was purchased and sold infrequently in private transactions, and there was no reliable information available as to trades of our common stock, or as to the prices at which our common stock had traded. During 2003 and 2002, our management reviewed the limited information available as to the ranges at which shares of our common stock was traded. Data for 2003 and 2002 below regarding our common stock is provided for informational purposes only, and should not be viewed as indicative of the actual or market value of our common stock.

 

    

Estimated Price Range

Per Share


     High

   Low

2004:

             

Fourth Quarter

   $ 7.25    $ 6.60

Third Quarter

     7.25      6.56

Second Quarter

     8.25      6.80

First Quarter

     6.80      5.25

2003:

             

Fourth Quarter

   $ 5.50    $ 5.00

Third Quarter

     8.00      4.50

Second Quarter

     7.00      4.50

First Quarter

     15.00      10.00

2002:

             

Fourth Quarter

   $ 15.00    $ 15.00

Third Quarter

     15.00      15.00

Second Quarter

     20.00      15.00

First Quarter

     15.00      15.00

 

In addition, we engaged Alex Sheshunoff & Co. Investment Banking, LP, to perform independent valuations of the fair market value of our common stock held by our Employee Stock Ownership Program, or “ESOP,” as of December 31, 2003 and 2002, and, at each of those dates, Alex Sheshunoff determined the value of the shares of our common stock held by the ESOP to be $5.35 and $7.00 per share, respectively. We have again engaged the firm to perform an independent valuation of the fair market value of our common stock, but as of the date of this report, we have not received the results of the valuation.

 

On February 16, 2005, the Company submitted an application for listing on the NASDAQ stock market. As of the date of this report, we do not know if or when the listing will be approved.

 

25


Recent Sales of Unregistered Securities

 

During the fourth quarter of 2003, we commenced a private placement of our common stock, and, as of December 31, 2003, we had sold 2,151,552 shares of our common stock at a price of $5.35 per share, resulting in net proceeds of approximately $10.4 million. In addition, we granted to those investors who purchased shares in the offering prior to December 31, 2003, as well as to one investor who purchased an additional 40,345 shares after December 31, 2003, an option to exchange by December 31, 2008, in whole but not in part, the shares of our common stock purchased in the offering for shares of our newly designated Series 2003 noncumulative preferred stock. We completed the private placement on February 20, 2004, selling an additional 1,586,771 shares of our common stock at a price of $5.35 per share after December 31, 2003, for $7.9 million of additional net proceeds, resulting in the sale of a total of 3,738,323 shares for total net proceeds from the offering of $18.3 million.

 

Our Series 2003 noncumulative preferred stock has a liquidation preference equal to the aggregate purchase price of the 2,191,897 shares of common stock initially purchased in the offering, and each whole share of the Series 2003 noncumulative preferred stock will have a liquidation preference of $500,000. The Series 2003 noncumulative preferred stock has, among other things, the following designations:

 

    The Series 2003 noncumulative preferred stock has terms consistent with the Company’s Tier 1 capital treatment for regulatory purposes;

 

    The Series 2003 noncumulative preferred stock is noncumulative and is not entitled to the payment of, or otherwise accrue, any dividends;

 

    The Series 2003 noncumulative preferred stock is not entitled to the benefit of any sinking fund or similar arrangement;

 

    The Series 2003 noncumulative preferred stock has no preemptive, preferential or other right to purchase, subscribe for or convert into any other of the Company’s securities;

 

    The Company is not required to purchase the shares of Series 2003 noncumulative preferred stock;

 

    Holders of the Series 2003 noncumulative preferred stock do not have registration rights requiring the Company to register the shares of the Series 2003 noncumulative preferred stock; and

 

    The Series 2003 noncumulative preferred stock has no voting power with respect to any Company matters, except in the case of a merger or a significant acquisition or sales transaction, in which case, the Series 2003 noncumulative preferred stock will be entitled to one vote per whole share, and will vote together, as one class, with the holders of our common stock.

 

The complete terms of the Series 2003 noncumulative preferred stock are set forth in the Certificate of Designation of the Series 2003 Noncumulative Preferred Stock of Community Bancshares, Inc., which the Company has filed with the Secretary of State of the State of Delaware as part of our certificate of incorporation.

 

No underwriters were involved in the private placement. FIG Partners, L.L.C., an affiliate of Burke Capital Group, L.L.C., served as our sole placement agent in the offering. The investors in the offering were comprised entirely of “accredited investors,” as that term is defined in Rule 501 of Regulation D promulgated under the Securities Act. The common stock and options we issued in the offering were not registered under the Securities Act, in reliance upon the exemption from registration under Section 4(2) and the safe harbor afforded by Rule 506 of Regulation D. The certificates evidencing the shares of common stock and the options sold in the offering bear restrictive legends permitting the transfer of the underlying securities only upon registration of the securities or an exemption under the Securities Act, together with an opinion of counsel.

 

In connection with the offering, we entered into an engagement letter with FIG Partners, pursuant to which FIG Partners agreed to serve as placement agent for the offering, and we agreed to grant to FIG Partners, upon the closing of the offering, a warrant to purchase shares of the Company’s common stock. In connection with the closing of the offering on February 20, 2004, the Company became obligated to issue to FIG Partners a warrant to purchase up to

 

26


140,187 shares of the Company’s common stock at an exercise price of $5.89 per share. The warrant expires on February 20, 2008, and, until that date, may be exercised either in cash or pursuant to a “cashless exercise.”

 

Dividends

 

We have not declared or paid any dividends on our common stock since December 31, 2000. Generally, the payment of dividends on our common stock is subject to the prior payment of principal and interest on our long-term debt, the retention of sufficient earnings and capital in our operating subsidiaries and regulatory restrictions. Currently, Community Bank is subject to restrictions on its activities imposed by bank regulators, which, among other things, limit Community Bank’s ability to pay dividends to Community Bancshares. Dividends from Community Bank historically have been the primary source of cash and income to Community Bancshares and, consequently, any restrictions on Community Bank’s ability to pay dividends severely limits our liquidity and ability to pay dividends on our common stock. As of December 31, 2004, Community Bancshares was similarly subject to a memorandum of understanding with the Federal Reserve that, among other things, prohibited us from declaring or paying any dividends on our common stock without the prior written approval of the Federal Reserve. However, on March 17, 2005, we were notified by the Federal Reserve that the MOU was terminated, effective that same day, based on the improved financial condition of our organization, combined with our previous compliance with the MOU while it was in effect.

 

We presently do not anticipate declaring or paying dividends on our common stock during 2005. Until our core earnings have improved to levels that would support it, we do not anticipate declaring and paying dividends in the foreseeable future.

 

27


 

ITEM 6. SELECTED FINANCIAL DATA.

 

The following table sets forth selected financial data for the last five years, and should be read in conjunction with the section in this report entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” as well as our consolidated financial statements and related notes contained elsewhere herein. All averages are daily averages.

 

     Years ended December 31,

 
     2004

    2003

    2002

    2001

    2000

 
     (Dollars in thousands except per share data)  

Selected consolidated operations data:

                                        

Net interest income

   $ 18,675     $ 18,860     $ 23,505     $ 22,853     $ 22,418  

Provision for loan losses

     987       11,381       10,033       6,096       7,573  

Income (loss) from continuing operations

     177       (13,100 )     (5,023 )     (2,381 )     (2,853 )

Income (loss) from discontinued operations

     —         —         5,927       958       (167 )

Net income (loss)

     177       (13,100 )     904       (1,423 )     (3,019 )

Selected per share data:

                                        

Earnings (loss) per share from continuing operations – basic

     0.02       (2.79 )     (1.08 )     (0.52 )     (0.64 )

Earnings (loss) per share from continuing operations - diluted

     0.02       (2.79 )     (1.08 )     (0.52 )     (0.61 )

Earnings (loss) per share – basic

     0.02       (2.79 )     0.19       (0.31 )     (0.68 )

Earnings (loss) per share – diluted

     0.02       (2.79 )     0.19       (0.31 )     (0.65 )

Cash dividends

     —         —         —         —         0.75  

Selected consolidated balance sheet data:

                                        

Loans

     300,380       316,207       359,184       501,519       528,316  

Total assets

     553,424       558,555       567,596       727,591       713,518  

Deposits

     448,627       453,946       459,464       617,706       600,901  

FHLB long-term debt

     38,000       38,000       38,000       38,000       38,000  

Other long-term debt

     —         3,169       3,578       4,667       5,675  

Trust preferred securities

     —         10,000       10,000       10,000       10,000  

Junior subordinated debt

     10,310       —         —         —         —    

Average equity

     46,903       36,984       42,848       42,938       41,776  

Average assets

     549,816       556,591       629,481       725,461       710,915  

Selected ratios:

                                        

Return on average assets

     0.03 %     (2.35 )%     0.14 %     (0.20 )%     (0.42 )%

Return on average equity

     0.38       (35.42 )     2.11       (3.31 )     (7.23 )

Average equity to average assets

     8.53       6.64       6.81       5.92       5.88  

 

28


 

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

The purpose of this discussion is to assist in the understanding of the significant changes in, the financial condition and results of operations of the Company and its subsidiaries during each of 2002, 2003 and 2004. This discussion and analysis is intended to supplement and highlight information contained in, and should be read in conjunction with, the Company’s consolidated financial statements and related notes and the selected financial data presented elsewhere in this report.

 

Overview

 

We conduct our operations, which consist primarily of traditional commercial banking operations, through Community Bank and its subsidiaries. Through Community Bank, we provide a full range of banking services to individual and corporate customers in five counties in north Alabama – Blount, Lauderdale, Limestone, Madison and Morgan Counties; two counties in northwest Alabama – Marion and Winston Counties; and two counties in southwest Alabama – Marengo and Perry Counties. The retail nature of Community Bank’s commercial banking operations allows for diversification of depositors and borrowers, and Community Bank’s management believes it is not dependent upon a single or a few customers. Community Bank does not have a significant portion of commercial banking loans concentrated within a single industry or group of related industries. Also, we do not consider our commercial banking operations to be seasonal in nature.

 

During 2004, many positive developments occurred at our Company. A summary of several key 2004 developments include:

 

    following our December 2003 private placement of $10.4 million of our common stock, we sold an additional $7.9 million of our common stock in an extension of that private placement during February 2004. These capital infusions provided the resources necessary to continue execution of the Bank’s recovery, rehabilitation, and growth strategies;

 

    a $13.3 million improvement in net income, primarily as a result of improved non-interest expenses as well as reductions in the loan loss provision;

 

    significant improvement in asset quality, driven by improved credit risk management and the sale of $18.0 million in poor quality loans;

 

    after the elimination of various legal entanglements, the foreclosure on our largest single loan ($5.2 million) providing us the ability to market and liquidate the collateral securing this problem asset;

 

    the resolution of certain shareholder related litigation for which we have incurred significant legal fees over the past several years;

 

    the settlement of a fidelity bond claim/litigation resulting in a $450,000 payment to the Company; and

 

    improved regulatory relations and results.

 

Subsequent events, during the first quarter of 2005, represent additional positive developments for the Company. These include:

 

    Approval of the settlement of the Benson and Packard derivative lawsuits on January 31, 2005, resulting in a $625,000 payment to the Company;

 

    The conviction of our former Chairman, Kennon R. Patterson, Sr. on March 11, 2005, on 15 counts of conspiracy to commit fraud, bank fraud, false entries in bank records and filing false income tax returns, among others, which we view as another positive development for the Company’s image and future prospects; and

 

29


    Notice during March, 2005 from the FDIC, the Federal Reserve Bank of Atlanta, and the Alabama State Banking Department that all regulatory agreements, memoranda, plans and/or orders have been terminated, which actions we expect to:

 

    substantially reduce costs associated with complying with these documents;

 

    substantially reduce our FDIC insurance expense (by an estimated $400,000 per year);

 

    improve liquidity as a result of lower pledging requirements on public funds;

 

    ease collateral requirements on FHLB borrowings;

 

    enable us to expand freely into growth markets;

 

    allow us to expand correspondent and vendor relationships; and

 

    enable us to attract competent management and board members.

 

Management believes the combined effect of these developments helps position the Company for a renewed focus on customer attraction and retention, improved marketing of competitive products and services, expansion into higher growth markets, and management of an improved balance sheet.

 

During the fourth quarter of 2003, we commenced a private placement of our common stock, and, as of December 31, 2003, we had sold 2,151,552 shares of our common stock at a price of $5.35 per share, resulting in net proceeds of approximately $10.4 million. In addition, we granted to those investors who purchased shares in the offering prior to December 31, 2003, as well as to one investor who purchased an additional 40,345 shares after December 31, 2003, an option to exchange by December 31, 2008, in whole but not in part, the shares of our common stock purchased in the offering for shares of our designated Series 2003 noncumulative preferred stock. The Series 2003 noncumulative preferred stock has a liquidation preference equal to the aggregate purchase price of the 2,191,897 shares of common stock initially purchased in the offering, and each whole share of the Series 2003 noncumulative preferred stock will have a liquidation preference of $500,000. We completed the private placement on February 20, 2004, selling an additional 1,586,771 shares of our common stock at a price of $5.35 per share after December 31, 2003, for $7.9 million of additional net proceeds, resulting in the sale of a total of 3,738,323 shares for total net proceeds from the offering of $18.3 million.

 

In connection with the offering, the Company entered into an engagement letter with FIG Partners, L.L.C., an affiliate of Burke Capital Group, L.L.C., pursuant to which FIG Partners agreed to serve as placement agent for the offering, and the Company agreed to grant to FIG Partners, upon the closing of the offering, a warrant to purchase shares of the Company’s common stock. Upon the closing of the offering on February 20, 2004, the Company granted FIG Partners a warrant to purchase up to 140,187 shares of the Company’s common stock at an exercise price of $5.89 per share. The warrant expires on February 20, 2008, and, until that date, may be exercised either in cash or pursuant to a “cashless exercise.”

 

Primary Sources of Revenues and Expenses

 

Net Interest Income

 

While Community Bank provides most traditional banking services, its principal activities as a community bank are the taking of demand and time deposits and the making of secured and unsecured consumer loans and commercial loans in its markets. As a result, our principal source of revenue is net interest income at Community Bank. Net interest income is the difference between:

 

    income we receive on our interest-earning assets, such as investment securities and loans; and

 

    payments we make on our interest-bearing sources of funds, such as deposits and borrowings.

 

30


The level of net interest income is determined primarily by the average balances, or volume, of interest-earning assets and the various rate spreads between the interest-earning assets and our funding sources. Changes in our net interest income from period to period result from, among other things:

 

    increases or decreases in the volumes of interest-earning assets and interest-bearing liabilities;

 

    increases or decreases in the average rates earned and paid on those assets and liabilities;

 

    our ability to manage the interest-earning asset portfolio, which includes loans;

 

    the availability and costs of particular sources of funds, such as noninterest-bearing deposits; and

 

    our ability to “match” our liabilities to fund our assets.

 

Net Noninterest Income

 

Our noninterest revenues consist primarily of:

 

    service charges on customer deposit accounts;

 

    insurance commissions;

 

    securities gains or losses; and

 

    other service fees charged to customers.

 

Our noninterest expenses consist primarily of:

 

    salaries and employee benefits;

 

    costs to hold and maintain premises and equipment;

 

    insurance;

 

    director and committee fees;

 

    professional service fees, especially legal and accounting; and

 

    cost of foreclosed assets.

 

Critical Accounting Policies

 

Our accounting policies are established in accordance with accounting principles generally accepted in the United States, or GAAP, and general practices within our industry. The application of certain of these accounting policies involves a significant amount of judgment as well as the use of estimates and assumptions based upon information that we have at the time of these judgments. These estimates and judgments involve significant uncertainties, and are susceptible to change. If different assumptions or conditions were to prevail, depending upon the magnitude of any discrepancies from our estimates and judgments, then our financial condition and results of operations may prove to be materially different from the presentation herein.

 

31


We recognize the following as our critical accounting policies:

 

    Accounting for Allowance for Loan Losses. We analyze our loan portfolio to determine the adequacy of allowance for loan losses and the appropriate provision required to maintain a level that we consider to be adequate to absorb anticipated loan losses. When we believe that the collection of the principal of a loan is unlikely, that loan is charged off against the allowance for loan losses. Subsequent recoveries of principal on that loan are added back to the allowance for loan losses. Our evaluation of the adequacy of the allowance for loan losses is based on a formal analysis which assesses the risks within the loan portfolio. Among other factors that we consider are the following:

 

    our past loan loss experience;

 

    known and inherent risks in the loan portfolio, including past due and nonperforming loans;

 

    adverse situations that may affect the borrowers’ ability to repay those loans;

 

    the estimated value of any underlying collateral;

 

    our internal loan reviews;

 

    the reviews of regulators; and

 

    an analysis of current economic conditions.

 

The consideration and application of many of these factors involve assumptions, estimates and judgments that are inherently uncertain and are subject to change. We believe that the allowance for loan losses was adequate at December 31, 2004. While we use available information to recognize losses on loans, future additions to the allowance for loan losses may be necessary based on economic changes and changes to various borrowers. Certain economic and interest rate factors could have a material effect on the determination of the allowance for loan losses. Our allowance for loan losses is also subject to regulatory examinations and determinations as to adequacy, which may take into account such factors as the methodology used to calculate the allowance for loan losses and the size of the allowance for loan losses in comparison to a group of peer banks identified by our regulators. During their routine examinations of banks, the Federal Deposit Insurance Corporation and the Alabama State Banking Department may require us to make additional provisions to our allowance for loan losses where, in the opinion of the regulators, credit evaluations and allowance for loan loss methodology differ materially from ours.

 

    Accounting for Income Taxes. We use the asset and liability method of accounting for income taxes. Our determination of the deferred and current provision for income taxes requires analysis of certain transactions and the related tax laws and regulations applicable to those transactions. We exercise significant judgment in evaluating the amount and timing of the recognition of the resulting tax liabilities and assets. Our judgments and estimates are re-evaluated on a continual basis as regulatory and business factors change. However, because our judgments and estimates are inherently subjective and subject to change, there can be no assurance that our determination of the provision for income taxes will not be changed, upward or downward, in future periods.

 

    Accounting for Contingencies. Statement of Financial Accounting Standard No. 5 (“SFAS 5”), “Accounting for Contingencies,” defines a contingency as an existing condition, situation, or set of circumstances involving uncertainty as to possible gain or loss. It will ultimately be resolved when one or more future events occur or fail to occur. SFAS 5 defines the different levels of probability as to whether or not future events will confirm the existence of a loss as follows:

 

    “probable” – meaning that the future event or events are likely to occur;

 

32


    “reasonably possible” – meaning that the chance of the future event or events occurring is more than remote but less than likely; or

 

    “remote” – meaning that the chance of the future event or events is slight.

 

Professional judgment is required to classify the likelihood of the future events occurring. In assessing these levels of probability, we acquire all relevant information concerning the uncertain set of circumstances. An accrual of a loss occurs when it is both probable that an asset has been impaired or a liability has been incurred and when the amount of loss can be reasonably estimated.

 

As discussed in Note 15 to our consolidated financial statements, legal proceedings are pending or threatened against us, our subsidiaries as well as their respective indemnities. Except as discussed in Note 15:

 

    we have not concluded that it is probable that a loss has been incurred in any pending litigation;

 

    we are unable to make a meaningful estimate of the amount or range of loss that could result from an unfavorable outcome of pending litigation; and

 

    accordingly, we have not provided any amounts in the consolidated financial statements for unfavorable outcome, if any.

 

As discussed in Note 15, as of December 31, 2003, we have accrued $2.5 million for potential losses on pending litigation, where in our best judgment, losses were both probable and reasonably estimated. The estimates were based on current circumstances of pending matters. As of December 31, 2004, $309,896 of this reserve remained and is reported in other liabilities on our balance sheet. We believe this reserve is warranted based on the status of pending settlements. Settlement agreements reached and paid for during 2004 totaled $2.2 million.

 

The present litigation environment, though improved, is substantially uncertain, and it is possible that our consolidated results of operations, cash flows or financial position could be materially affected by unfavorable outcomes or settlements of certain pending litigation. All such cases are, and will continue to be, vigorously defended. However, we and our subsidiaries may enter into discussions in an attempt to settle particular cases if it is in the best interests of our stockholders to do so.

 

    Accounting for Impaired Assets. Statement of Financial Accounting Standard No. 144 (“SFAS 144”), “Accounting for the Impairment or Disposal of Long-Lived Assets,” requires long-lived assets to be sold to be classified as held for sale when certain criteria are met. A long-lived asset classified as held for sale is measured at the lower of its carrying amount or fair value less cost to sell and no longer depreciated while it is classified as held for sale. As discussed in Note 5 to our consolidated financial statements, we classified three properties as held for sale during 2003. Consequently, we incurred a loss of $928,397 for the year ended December 31, 2003 on these assets in transferring them to held for sale.

 

We used estimates in determining the fair values of these assets and, although we believe the fair values established are reasonable, it is possible that our results of operations, cash flows or financial position could be materially affected by the eventual sale of the assets.

 

FINANCIAL CONDITION

 

General

 

Our total assets at December 31, 2004 were $553.4 million, a decrease of $5.2 million (0.9%) from $558.6 million at December 31, 2003. Net loans (excluding loans held for sale) declined by $6.0 million to $295.8 million in 2004, compared to $301.8 million in 2003. Total loans (before deducting the allowance for loan losses) declined by $15.8 million to $300.4 million in 2004 due to loans sold of $16.2 million, charge-offs as a result of loan sales of $4.1 million, other charge-offs of $8.1 million and foreclosures of $5.0 million, all offset by new loan production, net of paydowns.

 

33


We also experienced a $5.3 million (1.2%) decline in deposits from December 31, 2003 to December 31, 2004, primarily due to management’s decision not to pursue higher priced certificates of deposits. Management’s decision was based upon our reduced funding needs resulting from the decline in loans, as well as our focus on building profitable relationships. Community Bank currently is not in need of funding for its liquidity. Noninterest-bearing deposits increased by $14.0 million (24.9%) from December 31, 2003 to December 31, 2004, where they were $70.3 million and interest-bearing deposits decreased by $19.4 million (4.9%) to $378.3 million during that same period.

 

Earning Assets

 

Our earning assets are mainly comprised of:

 

    loans;

 

    investment securities;

 

    interest-bearing balances in other banks; and

 

    federal funds sold.

 

Our average total assets in 2004 were $549.8 million, representing a decrease of $6.8 million, or 1.2%, from average total assets of $556.6 million in 2003. Average total assets decreased $72.9 million, or 11.6% from $629.5 million in 2002. Average earning assets were $485.9 million, $488.2 million and $526.0 million in each of 2004, 2003 and 2002, respectively, accounting for approximately 88.4%, 87.7% and 83.6% of our average total assets for the respective years. Average earning assets have decreased primarily because of loan sales as we sold poorer quality assets.

 

Average loans, excluding those associated with discontinued operations, net of unearned income, were $312.9 million, $330.9 million and $382.1 million, representing 64.4%, 67.8% and 72.6% of average earning assets during 2004, 2003 and 2002, respectively. Despite an increase in new loan volume during 2004, average loans decreased as a result of loan sales, charge-offs related to the loan sales, other charge-offs and foreclosures. Average investment securities were $152.8 million in 2004, representing 31.4% of average earning assets for the year and an increase of $22.8 million, or 17.5%, from the average investment securities for 2003. This increase was due to our reinvestment of funds resulting from the sale of loans into investment securities, as well as decreases in federal funds sold and into higher yielding securities. Our average investment securities were $130.1 million in 2003 and represented 26.6% of average earning assets in 2003, compared to 22.2% in 2002. The change in the mix of loans and securities has been attributable to the decrease in loans described above. Average federal funds sold as a percent of average earning assets was 2.4%, 4.9% and 4.6% for 2004, 2003 and 2002, respectively. The decrease in average federal funds from $23.9 million to $11.9 million in 2004 was related to the increased securities investments as we sought higher yields. The other earning asset categories accounted for less than 3.0% of average earning assets for all three periods.

 

34


Loans comprise the largest single category of our assets. The following table shows the classification of loans by major category at December 31, 2004, and at the end of each of the preceding four years:

 

LOAN PORTFOLIO

 

     December 31,

 
     2004

    2003

    2002

    2001

    2000

 
     Percent

    Percent

    Percent

    Percent

    Percent

 
     Amount of

    Total

    Amount of

    Total

    Amount of

    Total

    Amount of

    Total

    Amount of

    Total

 
     (Dollars in thousands)  

Commercial, financial and agricultural

   $ 66,168     22.0 %   $ 73,746     23.3 %   $ 101,841     28.3 %   $ 146,210     29.1 %   $ 140,773     26.6 %

Real estate - construction

     4,702     1.6       3,386     1.1       2,017     0.6       3,126     0.6       5,429     1.0  

Real estate - mortgage

     177,786     59.2       176,097     55.7       174,775     48.7       233,216     46.5       236,592     44.8  

Installment loans to individuals

     51,603     17.2       62,826     19.9       80,596     22.4       119,031     23.8       145,673     27.6  

Unamortized premiums in loans

     122     —         184     —         —       —         —       —         —       —    

Unearned income

     (1 )   —         (32 )   —         (45 )   —         (64 )   —         (151 )   —    
    


 

 


 

 


 

 


 

 


 

Loans, net of unearned income

     300,380     100.0 %     316,207     100.0 %     359,184     100.0 %     501,519     100.0 %     528,316     100.0 %

Allowance for loan losses

     (4,625 )           (14,358 )           (9,784 )           (7,292 )           (7,107 )      
    


       


       


       


       


     

Net loans

   $ 295,755           $ 301,849           $ 349,400           $ 494,227           $ 521,209        
    


       


       


       


       


     

 

The following table provides maturities of certain loan classifications and an analysis of these loans maturing in over one year as of December 31, 2004:

 

SELECTED LOAN MATURITY AND INTEREST RATE SENSITIVITY

 

     Maturity

       

Rate Structure for Loans

Maturing Over One Year


     One
Year or
Less


   Over One
Year
Through
Five Years


  

Over

Five

Years


   Total

  

Predetermined
Interest

Rate


   Floating or
Adjustable
Rate


     (In thousands)

Commercial, financial and agricultural

   $ 32,746    $ 13,909    $ 19,513    $ 66,168    $ 8,067    $ 25,355

Real estate - construction.

     2,929      201      1,572      4,702      629      1,144
    

  

  

  

  

  

Total

   $ 35,675    $ 14,110    $ 21,085    $ 70,870    $ 8,696    $ 26,499
    

  

  

  

  

  

 

During the fourth quarter of 2003, we began a process of identifying certain nonperforming loans we wanted to sell. As these loans are identified, they are classified as held for sale and written down to fair market value based on bids received from prospective purchasers. At December 31, 2003, the net value of loans that had been transferred to held for sale was $1.8 million. The loans identified as held for sale at December 31, 2003 were sold during the first quarter of 2004. At March 31, 2004, loans with a net value of $3.6 million were identified and transferred to held for sale. In order to get to that net value, we were required to charge off $1.0 million. Those loans were sold in April 2004. Finally, in December 2004, we identified an additional group of loans and transferred a net value of $12.6 million of loans to held for sale. A charge-off of $3.1 million was necessary for those loans which were subsequently sold on December 30, 2004. All charge-offs resulting from the transfer of loans to held for sale are included in charge-offs in the allowance for loan losses.

 

Nonperforming Assets and Past Due Loans

 

Our nonperforming assets are comprised of:

 

    nonaccruing loans;

 

    loans 90 days past due or greater;

 

35


    restructured loans;

 

    nonaccruing securities; and

 

    other real estate owned.

 

Total nonperforming assets as of December 31, 2004 were $12.8 million, comprised primarily of other real estate owned, represented a significant decrease of $11.3 million, or 46.9%, from the $24.1 million of nonperforming assets at December 31, 2003. The decrease in nonperforming assets resulted mostly from the sale of problem loans. During 2004, we charged down $4.1 million in loans transferred to held for sale and sold the remaining net value of $16.2 million in order to purge these problem assets. In addition, loans classified as held for sale at December 31, 2003 of $1.8 million were sold. The total nonperforming assets at December 31, 2003 increased approximately $1.8 million, or 8.1%, to approximately $24.1 million, from approximately $22.3 million at December 31, 2002. The increase during 2003 was the result of poor asset quality and the migration of poor quality loans to nonperforming status.

 

At December 31, 2004, other real estate owned of $11.1 million accounted for 85.3% of our $13.0 million in nonperforming assets and increased $4.2 million over 2003. During 2004, some progress was made by us in selling other real estate owned; however, on December 8, 2004, property owned by former Chief Executive Officer Kennon R. Patterson, Sr. was foreclosed on. The Company had a nonaccrual real estate loan on a mansion and twenty acres of land in the amount of $5.4 million outstanding to Mr. Patterson and in prior years had charged off $0.2 million. On the date of foreclosure, the remaining loan balance was $5.2 million, of which $2.2 million was reserved for in the allowance for loan losses. The Company charged off $2.2 million and transferred $3.0 million to other real estate owned. Then, on December 30, 2004, in order to protect its interest and facilitate an orderly sale of the property, the Company purchased at the foreclosure of another financial institution, the surrounding land (approximately 900 acres) and attached buildings to Mr. Patterson’s property for $3.4 million. After giving effect to this purchase, the total property formerly owned by Mr. Patterson is carried at $6.4 million; accordingly, the Company has $8.6 million in principal exposure on the property. The Company is focusing all efforts to sell the property at a price that would enable the Company to recoup the losses taken on the loan to Mr. Patterson.

 

At December 31, 2004, total nonaccruing loans amounted to $1.1 million, a decrease of $13.0 million, or 92.2%, from total nonaccruing loans at December 31, 2003 of $14.1 million. Also, a result of the loan sales as well as the foreclosure discussed in the previous paragraph. During 2003, nonaccruing loans increased 39.6%, from $10.1 million at December 31, 2002 to $14.1 million at December 31, 2003. This increase primarily resulted from the migration of problem loans to nonaccrual status. Loans past due 90 days or more decreased $0.3 million, or 50.0%, from $0.6 million at December 31, 2003 to $0.3 million at December 31, 2004. We recognized our weaknesses in asset quality and increased credit standards through various enhancements and initiatives including but not limited to the following:

 

    improvements in lending personnel and credit administration process;

 

    establishment of a Special Assets division to focus on nonperforming loans, other real estate owned and other foreclosed assets;

 

    centralized loan processing to ensure that loan policies and procedures and documentation are applied consistently and accurately;

 

    improved collection and analysis of updated financial data on borrowers;

 

    tighter lending authority limits for lenders;

 

    improved credit training, risk selection and loan underwriting;

 

    renewed focus on reducing past due loans;

 

    ongoing improvements and updates to overall loan policies; and

 

    written, comprehensive strategies and policies required for all problem assets above $150,000.

 

36


Although we presently believe that we have improved our asset quality, we can give no assurance that continued deterioration will not occur. However, it is our policy to adequately reserve for losses in the loan portfolio. See “Results of Operations – Provision for Loan Losses, Net Charge-Offs and Allowance for Loan Losses” for more information and detail below.

 

The following table summarizes our nonperforming assets at December 31 during each of the last five years:

 

NONPERFORMING ASSETS

 

     December 31,

 
     2004

    2003

    2002

    2001

    2000

 
     (Dollars in thousands)  

Nonaccruing loans

   $ 1,115     $ 14,138     $ 10,099     $ 5,859     $ 1,877  

Loans past due 90 days or more

     290       611       1,241       2,346       2,571  

Restructured loans

     238       2,390       3,244       —         —    
    


 


 


 


 


Total nonperforming loans

     1,643       17,139       14,584       8,205       4,448  

Other real estate

     11,126       6,945       7,676       4,287       1,881  
    


 


 


 


 


Total nonperforming assets

   $ 12,769     $ 24,084     $ 22,260     $ 12,492     $ 6,329  
    


 


 


 


 


Ratios:

                                        

Allowance for loan losses to total nonperforming assets

     36.22 %     59.62 %     43.95 %     58.37 %     112.29 %

Total nonperforming loans to total loans

     0.55       5.42       4.06       1.64       0.84  

Total nonperforming assets to total assets

     2.31       4.31       3.92       1.72       0.89  

 

If nonaccrual loans had performed in accordance with their original contractual terms, gross interest income on these loans would have been an estimated $0.6 million for the year ended December 31, 2004, compared to $0.9 million and $0.6 million for the years ended December 31, 2003 and 2002, respectively.

 

Investment Portfolio

 

The composition of our investment securities portfolio reflects the Company’s investment strategy of maximizing portfolio yields subject to risk and liquidity considerations. Our entire portfolio is classified as “available for sale.” The primary objectives of our investment strategy are to maintain an appropriate level of liquidity and to provide a tool to assist in controlling our interest rate position, while at the same time producing adequate levels of interest income. Managing the maturity of the portfolio is necessary to provide liquidity and to reduce interest rate risk. During 2004, gross investment securities sales, calls and pay downs were approximately $72.2 million and there were no maturities, compared to $113.5 million of sales, calls and paydowns and $18.4 million of maturities in 2003, and $88.6 million and $15.0 million, respectively in 2002. The increase in gross investment securities in 2003 was due to decreases in the loan portfolio, and the resulting reinvestment of funds into investment securities that would otherwise have been employed in the loan portfolio. The decrease in gross investment securities in 2004 resulted from increased cash balances at year end reinvested again in early 2005.

 

Net gains realized on investment security sales totaled approximately $193,000 in 2004, compared to $1.1 million during 2003, and $653,000 in 2002. At December 31, 2004, gross unrealized gains in our investment portfolio were approximately $174,000, compared to $693,000 at December 31, 2003, and approximately $2.7 million at December 31, 2002. Gross unrealized losses amounted to approximately $2.5 million at December 31, 2004, $1.7 million at December 31, 2003, and approximately $227,000 at December 31, 2002. These fluctuations in the gross unrealized gains and losses in our investment portfolio resulted from changing bond prices. Unrealized losses on a bond occur when the bond’s yield is less than we could currently receive in the market. The opposite is true when a bond is paying more yield than the current market resulting in unrealized gains. The substantial decrease in net gains realized was due primarily to our selling more bonds in 2003 in order to restructure the portfolio prior to the rate increases during 2004 while these securities still had market gains.

 

37


Mortgage-backed securities have varying degrees of risk of impairment of principal, compared to U.S. Treasury and U.S. government agency obligations, which are considered to contain virtually no default or prepayment risk for the Company. Impairment risk is primarily associated with accelerated prepayments, particularly with respect to longer maturities purchased at a premium and interest-only strip securities. At each of December 31, 2004, 2003 and 2002 our mortgage-backed securities portfolio had no interest-only strips, and the amount of unamortized premium on mortgage-backed securities was $1.8 million at December 31, 2004, and $2.2 million and $1.7 million at December 31, 2003 and December 31, 2002, respectively. As prepayment rates on mortgage-backed securities change, the speed at which unamortized premiums are amortized will change as well, in order to amortize the premium over the expected life of the security. This change will be reflected in the overall yield on the security. The recoverability of our investment in mortgage-backed securities is reviewed periodically by management, and, if necessary, appropriate adjustments for impaired value are made to income.

 

The carrying amount of investment securities at the end of each of the last three years is set forth in the following table:

 

INVESTMENT PORTFOLIO

 

     December 31,

     2004

   2003

   2002

     (In thousands)

U. S. Treasury and agency securities

   $ 58,529    $ 61,216    $ 6,523

Mortgage-backed securities

     79,353      86,623      107,534

State and municipal securities

     5,454      6,427      7,056

Corporate bonds

     1,006      —        —  

Federal Home Loan Bank stock

     2,826      2,005      2,788
    

  

  

Total investment securities

   $ 147,168    $ 156,271    $ 123,901
    

  

  

 

Total investment securities decreased approximately $9.1 million, or 5.8%, from approximately $156.3 at December 31, 2003, to approximately $147.2 million at December 31, 2004. This decrease primarily was due to the implementation of strategies in the third and fourth quarters of 2004 to reduce investment securities and make more funds available for lending. In 2003, total investment securities increased $32.4 million, or 26.2%, from approximately $123.9 million at December 31, 2002, to approximately $156.3 million at December 31, 2003. This increase primarily was due to increased security purchases, as a means of employing the funds from payments received on loans, which had exceeded new loan growth. At December 31, 2004, non-taxable investment securities were $5.5 million, representing a decrease of $900,000 in 2004 related to maturities of these securities and no reinvestment into additional non-taxable investment securities as a result of the Company operating with taxable losses that would limit the potential benefit of these investments. During 2003, non-taxable investment securities decreased $700,000 from $7.1 million at December 31, 2002, to approximately $6.4 million.

 

The composition of the Company’s investment securities portfolio stayed relatively constant during 2004, but changed in 2003 primarily as the result of the Company selling certain collateralized mortgage obligations due to (i) their price volatility, (ii) their high extension risk in an increasing rate environment, and (iii) their high prepayment risk in a decreasing rate environment, and also as the result of the Company reinvesting the resulting funds into government agency and mortgage-backed securities with shorter average maturities. At December 31, 2004, U.S. government and agency securities (including mortgage-backed securities) represented 93.7% of the Company’s total investment securities portfolio, compared to 94.6% at December 31, 2003 and 92.1% at December 31, 2002, while state and municipal securities represented 3.7%, 4.1% and 5.7% of the investment securities portfolio at December 31, 2004, 2003 and 2002, respectively. During 2004, the Company’s investment strategy has been to seek the best yield while maintaining acceptable price risk volatility in an expected future rising rate environment. The Company has implemented strategies during 2004 to reduce duration in order to better protect the portfolio during increased rates.

 

38


The maturities and weighted average yields of the investments in the December 31, 2004 portfolio of investment securities are presented below. The weighted average maturity of the investment portfolio was 4.39 years at December 31, 2004, compared to 5.12 years at December 31, 2003 and 6.21 years at December 31, 2002, with an average yield of 3.7%, 4.00% and 5.78% at December 31, 2004, 2003 and 2002, respectively. Mortgage-backed securities are included in U.S. Government agencies and are based upon the guaranteed payoff date of each security.

 

INVESTMENT PORTFOLIO MATURITY SCHEDULE

 

     Maturing

 
     Within
One Year


    After One But
Within Five Years


    After Five But
Within Ten Years


    After
Ten Years


 
     Amount

   Yield

    Amount

   Yield

    Amount

   Yield

    Amount

   Yield

 
     (Dollars in thousands)  

December 31, 2004:

                                                    

Securities - all available-for-sale:

                                                    

U. S. Government agencies

   $ 10,251    1.98 %   $ 97,151    3.40 %   $ 24,797    4.48 %   $ 5,683    5.11 %

State and municipal securities

     —      —         —      —         —      —         5,454    5.06  

Corporate bonds

     —      —         1,006    4.18       —      —         —      —    

FHLB stock

     —      —         —      —         —      —         2,826    —    
    

        

        

        

      
     $ 10,251    1.98     $ 98,157    3.41     $ 24,797    4.48     $ 13,963    5.08  
    

        

        

        

      

 

With the exception of some securities issued by U.S. Government agencies, the Company held one municipal bond, issued by Hartselle Utilities, which exceeded 10% of the Company’s consolidated stockholders’ equity on December 31, 2004. This bond was called in early 2005 and is no longer owned by the Company as of the date of this report.

 

Cash and amounts due from banks along with interest-bearing deposits in banks increased $8.4 million during 2004, from $30.6 million at December 31, 2003 to $39.0 million at December 31, 2004. Cash balances were high on December 31, 2004 because of a bulk sale of loans on December 30, 2004. As a result, approximately $12.6 million was received in cash and had not yet been redeployed into earnings assets. We accomplished this by investing those funds into securities in early 2005. Average balances in cash and due from banks for the year ended December 31, 2004 and 2003 were $27.8 million and $28.3 million, respectively. Cash and due from banks balances were high during 2004 and 2003 primarily due to earnings credit rates, which are applied to balances held in our correspondent bank accounts that are maintained with other banks. We receive credits based on balances at these correspondent banks, and the credits are used to offset the service charges experienced. These earnings credit rates are currently higher than the federal funds sold rates; therefore, we increased our balances in our main correspondent account to take advantage of the better rate. We ultimately received a larger credit against the service charges that would have been paid compared to the interest income that otherwise would have been received had the funds been held in federal funds sold. The balance of interest-bearing deposits held by the Company with other banks was $5.4 million at December 31, 2004, and $3.3 million at December 31, 2003.

 

Federal funds sold decreased $800,000, or 5.6%, during 2004, from $14.3 million at December 31, 2003 to $13.5 million at December 31, 2004, as a result of the Company’s continued efforts to earn higher yields by keeping excess funds in such federal funds, which the Company believes to be suitable investment securities. Federal funds sold decreased $9.7 million, or 40.4%, during 2003, from $24.0 million at December 31, 2002 to $14.3 million at December 31, 2003 for the same reason.

 

Deposits

 

Dividends from Community Bank have historically been Community Bancshares’ primary source of funds, and Community Bank’s primary source of funds for dividends comes from its deposits. Community Bank anticipates geographic expansion as early as 2005, which we believe will lead to deposit increases. Community Bank intends to expand its consumer base into higher growth markets than those it currently serves, such as Huntsville, Alabama. To achieve future deposit growth, the Bank intends to enhance existing products and emphasize better customer service in all markets.

 

39


During 2004, the Company’s average total deposits decreased approximately $7.8 million, or 1.7%, from $452.4 million at December 31, 2003, to approximately $444.6 million at December 31, 2004. During 2003, the Company’s average total deposits decreased approximately $15.1 million, or 3.2%, from $467.5 million at December 31, 2002. The Company’s total deposits at December 31, 2004 were $448.6 million, a decrease of $5.3 million from December 31, 2003. The decreases have been due, for the most part, to lowering of high priced deposit rates leading to decreases in more volatile deposits.

 

The following table presents the average deposit balances and the average rates paid for each of the major classifications of deposits for the 12 month periods ending December 31, 2004, 2003 and 2002, and excludes averages associated with discontinued operations:

 

     Average Deposit Balances and Rates Paid

 
     2004

    2003

    2002

 
     Average
Balance


   Average
Rate
Paid(2)


    Average
Balance


   Average
Rate
Paid(2)


    Average
Balance


   Average
Rate
Paid(2)


 
     (Dollars in thousands)  

Noninterest-bearing demand

   $ 61,872    0.00 %   $ 55,463    0.00 %   $ 56,994    0.00 %

Interest-bearing demand

     106,743    1.90       86,053    1.62       79,386    2.17  

Savings

     71,102    1.40       63,464    1.47       56,606    2.04  

Time

     204,893    2.83       247,417    3.24       274,552    3.81  
    

        

        

      

Total (1)

   $ 444,610    2.30     $ 452,397    2.60     $ 467,538    3.25  
    

        

        

      

(1) The rate paid on total average deposits represents the rate paid on total average interest-bearing deposits only.

 

(2) Average rates paid are computed on expense and average balances from continuing operations.

 

Our average interest-bearing deposits decreased $14.2 million, or 3.6%, in 2004 from $396.9 million at December 31, 2003 to $382.7 million at December 31, 2004. This decrease occurred in time deposits and was partially offset by increases in interest-bearing demand and savings deposits. Average interest-bearing deposits decreased in 2003 by $13.6 million, or 3.3%, from $410.5 million at December 31, 2002. Average savings deposits and average time deposits increased 12.0% and decreased 17.2%, respectively, during 2004, compared to an increase of 12.1% and a decrease of 9.9%, respectively, during 2003. The movement in both savings and time deposits during 2004 and 2003 was related to the current low interest rate environment where customers chose to move their deposit money from longer term time deposits to shorter term savings deposits in anticipation of an upward rate movement. We have also tried to lower our overall cost of funds by aggressively managing our cost of time deposits. Average noninterest-bearing demand deposits increased 11.5% during 2004, compared to a decrease of 2.6% in 2003. Total average deposits decreased 1.7% in 2004 and decreased 3.2% in 2003, which related to the loss of more volatile time deposits as the Company lowered or held its rates paid on time deposits. The two categories of the Company’s lowest cost deposits, noninterest-bearing demand deposits and interest-bearing demand deposits, comprised the following percentages of the Company’s total average deposits during 2004, 2003 and 2002, respectively: (i) 13.9%, 12.3% and 12.2% of average noninterest-bearing demand deposits; and (ii) 24.0%, 19.0% and 17.0% of average interest-bearing demand deposits. Of total time deposits at December 31, 2004, approximately 24.7% were large denomination certificates of deposit and other time deposits of $100,000 or more, up slightly from 24.6% at December 31, 2003.

 

40


The maturities of the time certificates of deposit and other time deposits of $100,000 or more issued by the Company at December 31, 2004 are summarized in the table below:

 

MATURITIES OF TIME DEPOSITS OF $100,000 OR MORE

 

     December 31, 2004

     Time
Certificates
of Deposit


   Other
Time
Deposits


   Total

     (In thousands)

Maturing in three months or less

   $ 4,716    $ 15,385    $ 20,101

Maturing in over three through six months.

     4,247      —        4,247

Maturing in over six through twelve months

     10,197      —        10,197

Maturing in over twelve months

     29,776      —        29,776
    

  

  

Total

   $ 48,936    $ 15,385    $ 64,321
    

  

  

 

Borrowed Funds

 

Borrowed funds consist primarily of short-term borrowings and long-term debt.

 

Total short-term borrowings remained level at $0.6 million at both December 31, 2004 and 2003.

 

Community Bank is a member of the Federal Home Loan Bank of Atlanta, or the “FHLBA,” and, since 1999, has been approved to borrow up to $38.0 million under the FHLBA’s “Convertible Advance Program.” As of December 31, 2004, Community Bank had borrowed the entire $38.0 million available under this program. These borrowings accrue interest at a fixed rate of 5.93% per annum and have a final maturity of March 1, 2010. These borrowings are subject to a call feature upon every quarterly payment date during the life of the obligation. The first call date for this advance was March 1, 2001, and the advance has not been called to date. These borrowings are secured under a specific lien agreement on qualifying mortgage instruments in Community Bank’s loan and investment portfolios. Under this lien agreement, in an “event of default,” the FHLBA may declare all or any part of the indebtedness and accrued interest, including any prepayment fees, to be immediately due and payable. Included in the list of “events of default” is the situation where the FHLBA reasonably and in good faith determines that a “material adverse change” has occurred in the financial condition of Community Bank from that disclosed at the time of the making of any advance or from the condition of Community Bank as most recently disclosed to the FHLBA. The Company’s FHLBA long-term debt remained constant at $38.0 million for each December 31, 2003, 2002, and 2001.

 

In March 2000, the Company completed an offering of $10.0 million of trust preferred securities, pursuant to which:

 

    the Company organized a Delaware statutory business trust called Community (AL) Capital Trust I, or the “Trust,” governed by an Amended and Restated Declaration of Trust;

 

    the Company issued and sold to the Trust approximately $10.3 million in aggregate principal amount of unsecured junior subordinated debentures, or “debentures,” which were issued under an Indenture, and which represent the sole assets of the Trust;

 

    the Trust issued and sold:

 

    $10,000,000 of preferred capital securities, or “trust preferred securities,” representing undivided beneficial interests in the assets of the Trust, to a third party special purpose Company, which in turn pooled the trust preferred securities together with similar securities of other issuers and sold certificates representing interests in that closed-end, unmanaged pool to investors; and the Trust used the proceeds from the sale of the trust preferred securities to the pool to purchase the debentures from the Company; and

 

41


    $310,000 of its common securities to the Company, which represent all of the Trust’s outstanding common securities; and

 

    pursuant to a Guarantee Agreement, the Company fully and unconditionally guaranteed the payments of all amounts due on the trust preferred securities, which guarantee is limited to the extent the Trust has funds available for payment of distributions.

 

Both the debentures and the trust preferred securities accrue and pay interest semiannually at a rate of 10.875% per annum and have a maturity date of March 8, 2030, at which time the principal amount of the debentures becomes due and the trust preferred securities become mandatorily redeemable by the Company. When the Company makes payments to the Trust, as the holder of the debentures, the Trust, in turn, makes payments to the pool, as the holder of the trust preferred securities. The debentures represent the sole asset of the Trust. The debentures and related income statement effects are eliminated in the Company’s consolidated financial statements. The Company is entitled to treat the aggregate liquidation amount of the debentures as Tier 1 capital under Federal Reserve guidelines.

 

The Company may elect to defer payments of interest due on the debentures for up to ten semiannual payment periods. The Company elected to defer the March 2002, September 2002, March 2003, September 2003 and March 2004 interest payments, but on September 8, 2004, the Company paid all deferred interest plus the accrued interest thereon totaling $3.7 million. The accrued interest payable on the debentures at December 31, 2004 was $0.3 million.

 

The trust preferred securities are mandatorily redeemable upon their maturity, or upon their earlier redemption as provided in the indenture. Additionally, the Company has the right to redeem the debentures purchased by the Trust:

 

  in whole or in part, on or after, but not at any time before, March 8, 2010; and

 

  in whole, but not in part, at any time within 90 days following the occurrence and during the continuation of a “tax event,” “capital treatment event” or “investment company event,” as those terms are defined in the indenture.

 

As specified in the indenture, if the debentures are redeemed prior to maturity, then the redemption price will be a percentage of the principal amount, ranging from 105.438% during the 12 months following March 8, 2010 to 100.00% following March 8, 2020, plus any accrued but unpaid interest due on the debentures at the time of redemption. If the debentures are redeemed prior to March 8, 2010 following a “tax event,” “capital treatment event” or investment Company event,” the redemption price will be the greater of (i) 100% of the principal amount of debentures redeemed and (ii) the present value of the remaining principal and interest payments between the redemption date and March 8, 2010, plus, in either case, any accrued but unpaid interest due on the debentures at the time of redemption.

 

The Company sponsors an Employee Stock Ownership Plan, or “ESOP,” to provide the Company’s employees with a means of owning its common stock. An employee becomes an eligible participant in the ESOP on June 30 or December 31 of any given year after completing 12 months of employment during which the employee is credited with 1,000 or more hours of service. Contributions by the Company to the ESOP are made at the discretion of the Company’s board of directors, but may not be less than the amount required to cover any debt service due on the ESOP’s loan, which is described below.

 

On November 3, 1993, the ESOP borrowed $1.2 million from Colonial Bank to purchase shares of the Company’s common stock, and the Company guaranteed all obligations of the ESOP under this ESOP loan. The ESOP loan has been amended from time to time, including additional borrowings, and, as of December 31, 2003, $1.8 million remained outstanding under the ESOP note, which amount was secured by 123,111 shares of the Company’s common stock previously purchased and held by the ESOP. On February 11, 2004, the ESOP replaced the ESOP loan from Colonial Bank with a loan directly from the Company. As a result, Colonial Bank released the shares of the common stock of Community Bank that it previously held as collateral to secure the Company’s guaranty of the ESOP loan with Colonial Bank. As a result of this refinancing of the ESOP loan, the ESOP had borrowings from the Company of $1.7 million at February 11, 2004. The new ESOP loan from the Company bears interest at an adjustable rate equal

 

42


to the prime rate of interest, with a maturity date of November 16, 2010. This loan is secured by the ESOP’s pledge of unallocated shares of the Company’s common stock held by the ESOP.

 

The Company made contributions to the ESOP that enabled the ESOP to make payments due under the ESOP loan and to make cash distributions to eligible participants. The Company made contributions of approximately $448,000 during the year ended December 31, 2004, $934,000 during the year ended December 31, 2003, and $604,000 during the year ended December 31, 2002. Under the terms of the ESOP, after a person ceases to be an employee of Community Bancshares and/or its affiliates, that person is no longer eligible to participate in the ESOP. In that case, the person may demand to receive, as a lump sum payment, all amounts accrued to his benefit under the ESOP as of the end of the year immediately preceding that person’s termination of employment with the Company.

 

Mr. Kennon R. Patterson, Sr., whose employment with the Company terminated in January 2003, has demanded to receive from the ESOP a total of approximately $298,000, representing the total amount accrued by Mr. Patterson during his participation in the ESOP. To enable the ESOP to make this lump sum cash payments, the Company may be required to contribute cash to the ESOP in addition to its ongoing requirement to make contributions to service the ESOP debt. As of December 31, 2003, the Company had denied Mr. Patterson’s request for payment and was evaluating its obligations to Mr. Patterson in light of Mr. Patterson’s recent indictment and the requirements of law applicable to ESOPs. As of December 31, 2004, the Company continues to deny the request for payment. The Company is hopeful that Mr. Patterson’s recent conviction related to charges under the indictment will help resolve the question regarding the ESOP payments in the Company’s favor.

 

The Company’s had long-term debt consisting of a FHLB borrowing and junior subordinated debt. Both mature beyond 5 years, but the following table sets forth expected interest expense on debt service for the next five years based on interest rates and repayment provisions as of December 31, 2004:

 

MATURITIES OF LONG-TERM DEBT

 

     2005

   2006

   2007

   2008

   2009

     (In thousands)

Interest on:

                                  

FHLB long-term debt

   $ 2,285    $ 2,285    $ 2,285    $ 2,285    $ 2,285

Junior subordinated debt

     1,088      1,088      1,088      1,088      1,088
    

  

  

  

  

     $ 3,373    $ 3,373    $ 3,373    $ 3,373    $ 3,373
    

  

  

  

  

 

Liquidity

 

Liquidity is defined as the ability of a Company to convert assets into cash or cash equivalents without significant loss. Liquidity management involves maintaining the Company’s ability to meet the day-to-day cash flow requirements of Community Bank’s customers, whether they are depositors wishing to withdraw funds or borrowers requiring funds to meet their credit needs. Without proper liquidity management, the Company would not be able to perform the primary function of a financial intermediary and would, therefore, not be able to meet the production and growth needs of the communities it serves.

 

The primary function of asset and liability management is not only to assure adequate liquidity in order for the Company to meet the needs of its customer base, but to maintain an appropriate balance between interest-sensitive assets and interest-sensitive liabilities so that the Company can also meet the investment objectives of its stockholders. Daily monitoring of the sources and uses of funds is necessary to maintain an acceptable cash position that meets both its customers’ needs and its stockholders’ objectives. In a banking environment, both assets and liabilities are considered sources of liquidity funding and both are, therefore, monitored on a daily basis.

 

The following is a discussion of the Company’s current cash flows and liquidity. The Company experienced an approximate $7.6 million increase in cash and cash equivalents during 2004, due primarily to cash flows from investing activities. Cash used by operating activities during 2004 was $1.7 million, compared to $6.7 million and $1.8 million for the years ended December 31, 2003 and December 31, 2002, respectively. Investing activities provided cash of $9.3 million during 2004, mostly through securities proceeds net of purchases. Financing activities used $28,000 of cash and cash equivalents during 2004, compared to its providing of $3.2 million and its use of $22.8 million during each of 2003 and 2002, respectively. Certificates of deposits decreased $20.9 million during 2004, but this was mostly offset by increases in cash from the growth of demand deposits, NOW deposits, and other savings deposits totaling $15.5 million.

 

43


The issuance of common stock (from both the capital raise and stock options exercised), net of transaction costs brought cash inflow of $8.5 million and $10.4 million in 2004 and 2003, respectively.

 

Community Bank represents the Company’s principal operating subsidiary and source of cash. Dividends paid by Community Bank historically have been the primary source of funds available to the Company to pay expenses, service debt and pay dividends to stockholders. Generally, the Federal Reserve Act, Section 23A, limits loans and extensions of credit from banks to their affiliated holding companies. The Company also receives cash from its subsidiaries for its portion of tax benefit on intercompany income tax settlements. The intercompany tax settlements, however, are only possible if the subsidiaries generate taxable income sufficient to pay income taxes. Community Bank discontinued paying the Company a management fee in 2003.

 

In addition to debt service, as described above, the Company also will expend capital to settle, resolve and pay legal and other professionals to assist it in defending against, the litigation to which it presently is subject, as described in Note 15 to the Company’s consolidated financial statements included in this report. The Company also may apply cash to maintain and improve capital levels at the parent Company and at each subsidiary, as described below under “Capital Resources.” The Company also may use cash if it determines to review and possibly sell any of its branches that do not contribute to the Company’s improved operations, or if it determines to resolve its non-performing assets.

 

At the end of 2003, the Company’s management evaluated various alternatives to improve its cash flows, liquidity, and capital position. Since the Bank could not make payments to the Company without prior regulatory approval, the Company had relied, since April 2001, upon income tax refunds to fund its obligations. Such refunds resulted from carrybacks to prior years. Accordingly, to pay its ordinary expenses, as well as, debt service requirements and the expenses of litigation and restructuring, it was determined the Company needed additional capital. In addition, management believed, that as part of its plan to restore Community Bank’s profitability and grow in its core markets, it needed capital in order to dispose of other real estate owned and non-performing assets, to rationalize and/or sell certain branches, to refinance or repay approximately $3.2 million of long-term indebtedness, and to seek a restructuring of approximately $12.6 million of outstanding trust preferred securities obligations. Management believed that new capital was needed for these purposes.

 

As a result, during the fourth quarter of 2003, the Company commenced a private placement of its common stock, which it completed in the first quarter of 2004 raising total net capital of $18.3 million. The Company granted to those investors who initially purchased shares in the offering prior to December 31, 2003, as well as to one investor who purchased an additional 40,345 shares after December 31, 2003, an option to exchange by December 31, 2008, in whole but not in part, the shares of the Company’s common stock purchased in the offering for shares of the Company’s newly designated Series 2003 noncumulative preferred stock.

 

The terms of the Series 2003 noncumulative preferred stock are set forth in the certificate of designation of the Series 2003 Noncumulative Preferred Stock of Community Bancshares, Inc., which the Company has filed with the Secretary of State of the State of Delaware as part of its Certificate of Incorporation.

 

In connection with the offering, the Company entered into an engagement letter with FIG Partners, L.L.C., an affiliate of Burke Capital Group, L.L.C., pursuant to which FIG Partners agreed to serve as placement agent for the offering, and the Company agreed to grant to FIG Partners, upon the closing of the offering, a warrant to purchase shares of the Company’s common stock. In connection with the closing of the offering on February 20, 2004, the Company granted FIG Partners a warrant to purchase up to 140,187 shares of the Company’s common stock at an exercise price of $5.89 per share. The warrant expires on February 20, 2008, and, until that date, may be exercised either in cash or pursuant to a “cashless exercise.”

 

As of December 31, 2003, the Company had used approximately $5.1 million of the net proceeds from this offering as follows:

 

    $3.0 million to replace capital in Community Bank; and

 

    $2.1 million to capitalize Community Funding which will purchase certain nonperforming assets from Community Bank thus lowering its level of nonperforming assets.

 

44


As of December 31, 2004, the Company had used an additional $11.3 million of the net proceeds from this offering as follows:

 

    $3.2 million to pay off long-term debt;

 

    $2.0 million to further supplement capital in Community Bank;

 

    $4.3 million to pay deferred and accrued interest on junior subordinated debt; and

 

    $1.8 million to further capitalize Community Funding so that it could purchase other real estate to protect Community Bank’s property acquired in the foreclosure of Kennon R. Patterson, Sr.’s real estate loan.

 

In addition, the Company will continue to use any remaining proceeds from this offering for general corporate purposes and other capital needs, in each case as permitted by the Company’s regulatory authorities and as determined by the Company’s Board of Directors and/or management to be in the best interests of the Company and its stockholders. The Company was unable to achieve a restructuring of its outstanding trust preferred securities obligations (junior subordinated debt).

 

Capital

 

The Company’s total stockholders’ equity at December 31, 2004 was 7.75% of total assets, as compared to 6.32% at December 31, 2003 and 7.10% at December 31, 2002. The increase in 2004 is primarily a result of additional net capital raised in early 2004. The decrease in 2003 was primarily due to net operating losses of $13.1 million which were mitigated by $10.4 million of net capital raised in the fourth quarter of 2003.

 

The following table summarizes the equity-to assets and dividend payout ratios for each of the last three years:

 

CAPITAL GROWTH RATIOS

 

     Years ended
December 31,


 
     2004

    2003

    2002

 

Dividend payout ratio

   0 %   0 %   0 %

Average equity to average assets ratio

   8.53     6.64     6.81  

 

The Company’s return on average assets ratio, which is computed by dividing net income (loss) by average assets was 0.03%, (2.35)% and 0.14% for 2004, 2003 and 2002, respectively. The Company’s return on average equity ratio, which is computed by dividing net income (loss) by average stockholders’ equity, was 0.38%, representing an increase from 2003 due to net income of $177,000. The decrease in 2003 to (35.42)% was due to the net loss of $13.1 million.

 

The Company’s dividend payout ratio is determined by dividing the dividends per share by the basic net earnings or loss per share for the relevant period. The Company did not pay dividends in 2004, 2003 or 2002, and, therefore, the payout ratio remained zero.

 

The Company’s average equity to average assets ratio, which is computed by dividing average stockholders’ equity by average assets, is presented above. The increase in 2004 resulted from a 26.8% increase in average equity and a 1.2% decrease in average assets, while the decrease in 2003 was due to a 13.7% decrease in average stockholders’ equity during 2003, while average assets decreased by 11.6%.

 

In addition, the Company must satisfy the capital requirements established by the Company’s regulatory authorities, as described under “Business – Our Regulatory Environment” and “— Our Current Regulatory Restrictions.”

 

45


RESULTS OF OPERATIONS

 

Net Income and Earnings per share

 

The Company’s net income of approximately $0.2 million for 2004 represented an increase of $13.3 million from its net loss of $13.1 million for 2003, which was a $14.0 million decrease from the Company’s net income of approximately $0.9 million for the year ended December 31, 2002. When stated as changes in basic earnings (losses) per share, the basic earnings per share for the Company in 2004 was $0.02, an increase of $2.81 from the 2003 basic loss per share of $(2.79). The loss per share in 2003 reflected a $2.98 decrease from the 2002 basic earnings per share of $0.19 experienced by the Company. There are various factors contributing to the $13.3 million increase in 2004, including positive changes such as:

 

    a decrease of approximately $11.7 million in noninterest expenses due to: (i) significant reductions in professional fees in 2004; (ii) decreased foreclosed assets and related costs in 2004 resulting from addressing identified problems in our loan portfolio; (iii) impairments on fixed assets recorded in 2003 as part of the Company’s branch rationalization decisions, and (iv) losses that were realized on certain pending litigation matters in 2003; and

 

    a decrease of approximately $10.4 million in the provision for loan losses, reflecting our significant improvement in asset quality.

 

The above positive results were somewhat offset by negative factors including:

 

    a decrease in noninterest income of $183,000 as a result of a $910,000 decrease in securities gains of which were mostly offset by increases in service charges and other noninterest income items;

 

    a slight decline of approximately $184,000 in net interest income occurred in 2004, primarily due to: (i) lower levels of earning assets, resulting from the Company’s sale of sub-par and delinquent assets, as well as charge-offs, and (ii) lower yields on earning assets due to: (x) loans repricing at lower rates and (y) increased levels of investment securities, which typically have lower yields than loans; and

 

    a decrease in tax benefits recognized of $8.5 million.

 

For the year ended December 31, 2003, the Company had a loss of approximately $13.1 million. In comparison, the Company reported a net income of approximately $904,000 for the year ended December 31, 2002. This approximately $14.0 million change is attributable to a variety of factors, including, among other things:

 

    income of approximately $8.5 million from discontinued operations, which was recorded in the Company’s 2002 net income, and no similar income was realized in 2003;

 

    an increase of approximately $7.1 million in noninterest expenses due to: (i) increased professional fees associated with continued litigation and regulatory issues the Company was confronting, (ii) increased foreclosed assets and related costs, as the Company identified and addressed problems in its loan portfolio and the resulting increase in foreclosed assets, (iii) impairments on fixed assets as part of the Company’s branch rationalization decisions, and (iv) losses that were realized on certain pending litigation matters;

 

    a decline of approximately $4.6 million in net interest income occurred in 2003, primarily due to: (i) lower levels of earning assets, resulting from the Company’s decreased new loan growth and an increase in contractual and early payments, as well as charge-offs and foreclosures, and (ii) lower yields on earning assets due to: (x) an overall lower interest rate environment, (y) increased nonaccrual loans, and (z) increased levels of investment securities, which typically have lower yields than loans; and

 

    an increase of approximately $1.4 million in the provision for loan losses, reflecting the Company’s continuing efforts to timely identify and resolve problem loans.

 

46


These factors were partially offset by a related tax benefit during 2003 of approximately $8.1 million.

 

Net Interest Income

 

Net interest income generally is the principal source of a financial institution’s earnings stream and represents the difference or spread between interest income generated from the Company’s earning assets and the cost born by the Company on its interest-bearing liabilities. Fluctuations in interest rates as well as volume and mix changes in earning assets and interest-bearing liabilities impact net interest income.

 

Net interest income for 2004 decreased approximately $184,000, or 0.9%, to approximately $18.7 million from approximately $18.9 million in 2003, compared to a decrease of approximately $4.6 million, or 19.6%, during 2003 from approximately $23.5 million in 2002. The relatively stable net interest income for 2004 was a result of declines in net interest income due to lower volumes of earning assets, and rates earned on those assets, offset by declines in interest expense due to both lower volumes of interest bearing liabilities and rates paid on those liabilities. The decrease in the Company’s net interest income for 2003 was due to a decrease in interest income that was partially offset by a decrease in interest expense. The “Rate/Volume Variance Analysis” below provides additional information regarding changes in the Company’s interest income, interest expense and net interest income due to changes in average balances and rates.

 

The Company’s interest income decreased approximately $1.8 million, or 5.4%, to $31.3 million in 2004 from $33.1 million in 2003. This decrease was due to a decrease of 34 basis points in the yield on average earning assets during 2004 together with a decrease of $2.4 million in the volume of average earning assets. The decreased yield was related to assets repricing at lower interest rates, while the decrease in the volume of the Company’s average earning assets was due to loan sales and charge-offs. For the year ended December 31, 2004, the Company experienced interest income on loans of $25.3 million, which was an 8.0% decrease from the interest income on loans in 2003 of $27.5 million. The primary reason for the decrease was lower volumes of loans from loan sales and charge-offs of loans which generally carry higher yields. Interest income for the year ended December 31, 2003 was $33.1 million representing a decrease of $7.5 million, or 18.4%, over interest income during 2002. This decrease was due to a decrease of 95 basis points in yield coupled with a $37.8 million decrease in average earning assets. Yield attributed to 52.1% of the decrease in interest income while volume attributed to 47.9%.

 

During 2004, the Company’s interest expense decreased approximately $1.7 million, or 11.9%, to approximately $12.6 million from approximately $14.3 million in 2003. This decrease resulted from a 3.7% decrease in average interest-bearing liabilities outstanding during 2004 due to lower levels of time deposits and other long-term debt, coupled with a decrease in the average rate paid on interest-bearing liabilities during 2004 of 25 basis points due to time deposits repricing at lower rates. Interest-bearing deposits are the major component of the Company’s interest-bearing liabilities, representing 87.8% in 2004, 87.7% in 2003 and 87.6% in 2002 of average total interest-bearing liabilities outstanding. Average interest-bearing deposits outstanding decreased in both 2003 and 2004 by $13.6 million and $14.2 million, respectively, and the rate paid on these average balances reflected a decrease of 30 basis points during 2004 and 65 basis points during 2003. For the year ended December 31, 2003, the Company’s interest expense totaled $14.3 million, representing a decrease of $2.9 million from the interest expense incurred during 2002. This decrease was due mostly to lower rates paid on interest-bearing liabilities. The increase in interest expense on long-term debt for the year ended December 31, 2003 was $200,000 due to interest accrued on deferred interest of trust preferred securities. The decrease in interest expense on long-term debt during 2004 was the result of lower volumes due to payoffs of those debts. Interest expense on FHLBA borrowings during 2004 of $2.3 million was stable compared to that of 2003 and 2002. Interest expense was high on junior subordinated debt at an average cost of 12.60% and 11.90% due to the fact that the Company was accruing interest on interest. On September 8, 2004, the Company paid all deferred and accrued interest and should now see that cost more in line with the debt instrument’s stated rate of 10.875%.

 

The trend in net interest income is also evaluated in terms of average rates using the net interest margin and the interest rate spread. The net interest margin, or the net yield on the Company’s earning assets, is computed by dividing net interest income by average earning assets. This ratio represents the difference between the average yield returned on average earning assets and the average rate paid for funds used to support those earning assets, including both interest-bearing and noninterest-bearing sources. The Company’s net interest margin for 2004 was 3.84%, compared to 3.86% and 4.47% for 2003 and 2002, respectively. The main factors contributing to the decrease in the net interest margin for 2003 were declines in yields on earning assets of 34 basis points with declines in rates paid of only 25 basis points, coupled with a decline in average earning assets of $2.4 million and a decline in average interest-bearing liabilities of $16.6 million. We are pleased that net interest margin held steady during 2004.

 

47


The interest rate spread measures the difference between the average yield on earning assets and the average rate paid on interest-bearing sources of funds. The interest rate spread eliminates the impact of noninterest-bearing funds and gives a more direct perspective to the effect of market interest rate movements. The net interest spread in 2004 was 3.54%, a decrease of 9 basis points from 2003, primarily as a result of greater decreases in assets yields than rates paid on liabilities. The net interest spread for 2003 decreased 44 basis points to 3.63% from the Company’s 2002 spread of 4.07% as the cost of interest-bearing sources of funds decreased only 51 basis points, but the yield on earning assets decreased 44 basis points. The Company has continuously seen decreases in both net interest margin and net interest spread during 2003 and 2004 as it has sought higher quality credits in its loan portfolio which generally results in lower asset yields. See the tables in this section below entitled “Consolidated Average Balances, Interest Income/Expenses and Yields/Rates” and “Rate/Volume Variance Analysis” for more information.

 

The following tabulation presents certain net interest income data without modification for assumed tax equivalency:

 

     Years ended December 31,

 
     2004

    2003

    2002

    2001

    2000

 

Rate earned on earning assets

   6.44 %   6.78 %   7.73 %   8.95 %   9.71 %

Rate paid on borrowed funds

   2.90     3.15     3.66     5.23     5.71  

Interest rate spread.

   3.54     3.63     4.07     3.72     4.00  

Net interest margin

   3.84     3.86     4.47     4.31     4.45  

 

The “Consolidated Average Balances, Interest Income/Expenses and Yields/Rates” and the “Rate/Volume Variance Analysis” tables are presented on the following two pages. The Consolidated Average Balances/Interest Income/Expenses and Yields/Rates table presents, for the periods shown, the average balance of certain balance sheet items, the dollar amount of interest income from average earning assets and resultant yields, the interest expense and rate paid on average interest-bearing liabilities, and the net-interest margin. The Rate/Volume Variance Analysis table presents an analysis of changes in interest income, interest expense and net interest income attributable to changes in volume and interest rate.

 

48


 

CONSOLIDATED AVERAGE BALANCES, INTEREST INCOME/EXPENSE AND YIELDS/RATES

 

     Years ended December 31,

 
     2004

    2003

    2002

 
     Average
Balance


    Income/
Expense


   Yield/
Rate


    Average
Balance


    Income/
Expense


   Yield/
Rate


    Average
Balance


    Income/
Expense


   Yield/
Rate


 
     (Dollars in thousands)  

Assets (3)

                                                               

Earning assets:

                                                               

Loans, (1)(2)

   $ 312,876     $ 25,251    8.07 %   $ 330,941     $ 27,468    8.30 %   $ 382,126     $ 33,506    8.77 %

Investment securities:

                                                               

Taxable

     147,289       5,375    3.65       123,402       4,861    3.94       107,566       6,280    5.84  

Tax-exempt

     5,560       284    5.11       6,680       342    5.12       9,028       456    5.05  
    


 

        


 

        


 

      

Total investment securities

     152,849       5,659    3.70       130,082       5,203    4.00       116,594       6,736    5.78  

Other interest-bearing assets

     8,185       235    2.87       3,252       198    6.09       2,899       29    1.00  

Federal funds sold

     11,949       156    1.31       23,952       255    1.06       24,406       386    1.58  
    


 

        


 

        


 

      

Total earning assets

     485,859       31,301    6.44       488,227       33,124    6.78       526,025       40,657    7.73  

Noninterest-bearing assets:

                                                               

Cash and due from banks

     27,779                    28,315                    20,927               

Premises and equipment

     21,678                    24,456                    34,133               

Accrued interest and other assets.

     26,098                    26,544                    13,315               

Allowance for loan losses.

     (11,598 )                  (10,951 )                  (7,511 )             

Average balances associated with discontinued operations

     —                      —                      42,592               
    


              


              


            

Total assets

   $ 549,816                  $ 556,591                  $ 629,481               
    


              


              


            

Liabilities and stockholders’ equity (3)

                                                               

Interest-bearing liabilities:

                                                               

Demand deposits

   $ 106,743       2,026    1.90 %   $ 86,053       1,391    1.62     $ 79,386       1,725    2.17  

Savings deposits

     71,102       997    1.40       63,464       930    1.47       56,606       1,154    2.04  

Time deposits

     204,893       5,793    2.83       247,417       8,017    3.24       274,552       10,474    3.81  
    


 

        


 

        


 

      
       382,738       8,816    2.30       396,934       10,338    2.60       410,544       13,353    3.25  

Short-term borrowings

     364       4    1.10       365       3    82       2,126       36    1.69  

FHLB long-term debt

     38,000       2,291    6.03       38,000       2,285    6.01       38,000       2,266    5.96  

Capitalized lease obligations

     3,937       169    4.29       4,020       166    4.13       4,096       225    5.49  

Junior subordinated debt

     10,282       1,296    12.60       10,000       1,283    12.83       10,000       1,190    11.90  

Other long-term debt

     798       50    6.27       3,369       190    5.64       3,965       83    2.09  
    


 

        


 

        


 

      

Total interest-bearing liabilities

     436,119       12,626    2.90       452,688       14,265    3.15       468,731       17,153    3.66  
            

  

         

  

         

  

Noninterest-bearing liabilities:

                                                               

Demand deposits

     61,872                    55,463                    56,994               

Accrued interest and other liabilities

     4,922                    11,456                    6,846               

Stockholders’ equity

     46,903                    36,984                    42,848               

Average balances associated with discontinued operations

     —                      —                      54,062               
    


              


              


            

Total liabilities and stockholders’ equity

   $ 549,816                  $ 556,591                  $ 629,481               
    


              


              


            

Net interest income/net interest spread

             18,675    3.54 %             18,859    3.63 %             23,504    4.07 %
            

  

         

  

         

  

Net interest margin

                  3.84 %                  3.86 %                  4.47 %
                   

                

                


(1) Average loans include nonaccrual loans. All loans and deposits are domestic.

 

(2) Income on loans, net of unearned income, includes loan fees.

 

(3) All yields are computed on income/expense and average balances from continuing operations.

 

49


 

RATE/VOLUME VARIANCE ANALYSIS

 

     Average Volume

   Change in Volume

    Average Rate

 
     2004

   2003

   2002

   2004-2003

    2003-2002

    2004

    2003

    2002

 
     (Dollars in thousands)  

Earning Assets:

                                                       

Loans

   $ 312,876    $ 330,941    $ 382,126    $ (18,065 )   $ (51,185 )   8.07     8.30 %   8.77 %

Investment securities:

                                                       

Taxable

     147,289      123,402      107,566      23,887       15,836     3.65     3.94     5.84  

Tax-exempt

     5,560      6,680      9,028      (1,120 )     (2,348 )   5.11     5.12     5.05  
    

  

  

  


 


                 

Total investment securities

     152,849      130,082      116,594      22,767       13,488     3.70     4.00     5.78  

Other interest-bearing assets

     8,185      3,252      2,899      4,933       353     2.87     6.09     1.00  

Federal funds sold

     11,949      23,952      24,406      (12,003 )     (454 )   1.31     1.06     1.58  
    

  

  

  


 


                 

Total earning assets

   $ 485,859    $ 488,227    $ 526,025    $ (2,368 )   $ (37,798 )   6.44     6.78     7.73  
    

  

  

  


 


                 

Interest-bearing Liabilities:

                                                       

Deposits:

                                                       

Demand

   $ 106,743    $ 86,053    $ 79,386    $ 20,690     $ 6,667     1.90     1.62     2.17  

Savings

     71,102      63,464      56,606      7,638       6,858     1.40     1.47     2.04  

Time

     204,893      247,417      274,552      (42,524 )     (27,135 )   2.83     3.24     3.81  
    

  

  

  


 


                 

Total interest-bearing deposits

     382,738      396,934      410,544      (14,196 )     (13,610 )   2.30     2.60     3.25  

Short-term borrowings

     364      365      2,126      (1 )     (1,761 )   1.10     0.82     1.69  

FHLB long-term debt

     38,000      38,000      38,000      —         —       6.03     6.01     5.96  

Capitalized lease obligations

     3,937      4,020      4,096      (83 )     (76 )   4.29     4.13     5.49  

Junior subordinated debt

     10,282      10,000      10,000      282       —       12.60     12.83     11.90  

Other long-term debt

     798      3,369      3,965      (2,571 )     (596 )   6.27     5.64     2.09  
    

  

  

  


 


                 

Total interest-bearing liabilities

   $ 436,119    $ 452,688    $ 468,731    $ (16,569 )   $ (16,043 )   2.90     3.15     3.66  
    

  

  

  


 


                 

Net interest spread

                                        3.54 %   3.63 %   4.07 %
                                         

 

 

Net interest margin

                                        3.84 %   3.86 %   4.47 %
                                         

 

 

 

                                Variance Attributed to (1)

 
     Interest Income/Expense

   Variance

    2004

    2003

 
     2004

   2003

   2002

   2004-2003

    2003-2002

    Volume

    Rate

    Volume

    Rate

 
     (Dollars in thousands)  

Earning Assets:

                                                                     

Loans

   $ 25,251    $ 27,468    $ 33,506    $ (2,217 )   $ (6,038 )   $ (1,471 )   $ (746 )   $ (4,313 )   $ (1,725 )

Investment securities:

                                                                     

Taxable

     5,375      4,861      6,280      514       (1,419 )     891       (377 )     831       (2,250 )

Tax-exempt

     284      342      456      (58 )     (114 )     (57 )     (1 )     (120 )     6  
    

  

  

  


 


 


 


 


 


Total investment securities

     5,659      5,203      6,736      456       (1,533 )     834       (378 )     711       (2,244 )

Other interest-bearing assets

     235      198      29      37       169       183       (146 )     4       165  

Federal funds sold

     156      255      386      (99 )     (131 )     (149 )     50       (7 )     (124 )
    

  

  

  


 


 


 


 


 


Total earning assets

   $ 31,301    $ 33,124    $ 40,657    $ (1,823 )   $ (7,533 )   $ (603 )   $ (1,220 )   $ (3,605 )   $ (3,928 )
    

  

  

  


 


 


 


 


 


Interest-bearing Liabilities:

                                                                     

Deposits:

                                                                     

Demand

   $ 2,026      1,391    $ 1,725    $ 635     $ (334 )   $ 369     $ 266     $ 134     $ (468 )

Savings

     997      930      1,154      67       (224 )     112       (45 )     127       (351 )

Time

     5,793      8,017      10,474      (2,224 )     (2,457 )     (1,281 )     (943 )     (977 )     (1,480 )
    

  

  

  


 


 


 


 


 


Total interest-bearing deposits

     8,816      10,338      13,353      (1,522 )     (3,015 )     (800 )     (722 )     (716 )     (2,299 )

Short-term borrowings

     4      3      36      1       (33 )     —         1       (20 )     (13 )

FHLB long-term debt

     2,291      2,285      2,266      6       19       —         6       0       19  

Capitalized lease obligations

     169      166      225      3       (59 )     (3 )     6       45       (104 )

Junior subordinated debt

     1,296      1,283      1,190      13       93       36       (23 )     —         93  

Other long-term debt

     50      190      83      (140 )     107       (159 )     19       (14 )     121  
    

  

  

  


 


 


 


 


 


Total interest-bearing liabilities

     12,626      14,265      17,153      (1,639 )     (2,888 )     (926 )     (713 )     (705 )     (2,183 )
    

  

  

  


 


 


 


 


 


Net interest income

   $ 18,675    $ 18,859    $ 23,504    $ (184 )   $ (4,645 )   $ 323     $ (507 )   $ (2,900 )   $ (1,745 )
    

  

  

  


 


 


 


 


 



(1) The change in interest due to both rate and volume has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each.

 

 

50


 

Provision for Loan Losses, Net Charge-Offs and Allowance for Loan Losses

 

The Company maintains an allowance for loan losses to absorb losses inherent in its loan portfolio. The following discussion relates to the Company’s policies as presently in effect:

 

Interest on loans is accrued from the date an advance is made. The performance of loans is evaluated primarily on the basis of a review of each customer relationship over a period of time and the judgment of lending officers as to the ability of borrowers to meet the repayment terms of loans. If there is reasonable doubt as to the repayment of a loan in accordance with the agreed terms, the loan may be placed on a nonaccrual basis pending the sale of any collateral or a determination as to whether sources of repayment exist. This action may be taken even though the financial condition of the borrower or the collateral may be sufficient ultimately to reduce or satisfy the obligation. Generally, when a loan is placed on a nonaccrual basis, all payments are applied to reduce principal to the extent necessary to eliminate doubt as to the repayment of the loan. Thereafter, any interest income on a nonaccrual loan is recognized only on a cash basis.

 

The Company’s policy generally is to place a loan on nonaccrual status when it is contractually past due 90 days or more as to payment of principal or interest. A loan may be placed on nonaccrual status at an earlier date when concerns exist as to the ultimate collections of principal or interest. At the time a loan is placed on nonaccrual status, interest previously accrued but not collected is reversed and charged against current earnings. Loans that are contractually past due 90 days or more which are well secured and are in the process of collection generally are not placed on nonaccrual status.

 

Lending officers are responsible for the ongoing review and administration of loans assigned to them. As such, they make the initial identification of loans which present some difficulty in collection or where circumstances indicate that the possibility of loss exists. The responsibilities of the lending officers include the collection effort on a delinquent loan. To strengthen internal controls in the collection of delinquencies, senior management and the Directors’ Asset Quality Committee are informed of the status of delinquent and “watch” or problem loans on a monthly basis. Senior management reviews the allowance for loan losses and makes recommendations to the Board of Directors as to loan charge-offs on a monthly basis.

 

The allowance for loan losses represents management’s assessment of the risk associated with extending credit and its evaluation of the quality of the loan portfolio, and is inherently subjective and subject to change. Management analyzes the loan portfolio to determine the adequacy of the allowance for loan losses and the appropriate provision required to maintain a level believed adequate to absorb anticipated loan losses. In assessing the adequacy of the allowance, management reviews the size, quality and risk of loans in the portfolio. Management also considers such factors as the Bank’s loan loss experience, the amount of past due and nonperforming loans, specific known risks, the status and amount of nonperforming assets, underlying collateral values securing loans, current and anticipated economic conditions and other factors which affect the allowance for loan losses. An analysis of the credit quality of the loan portfolio and the adequacy of the allowance for loan losses is prepared by the Bank’s Director of Risk Management and presented to the Board of Directors on a monthly basis. In addition, the Bank is in the process of engaging outside loan review consultants, on a quarterly basis, to perform an independent review of the quality of the loan portfolio.

 

The Bank’s allowance for loan losses is also subject to regulatory examinations and determinations as to adequacy, which may take into account such factors as the methodology used to calculate the allowance for loan losses and the size of the allowance for loan losses in comparison to a group of peer banks identified by the regulators. During their routine examinations of banks, the FDIC and the Alabama State Banking Department may require a bank to make additional provisions to its allowance for loan losses where, in the opinion of the regulators, credit evaluations and allowance for loan loss methodology differ materially from those of management.

 

While it is the Bank’s policy to charge off in the current period loans for which a loss is considered probable, there are additional risks of future losses which cannot be quantified precisely or attributed to particular loans or classes of loans. Because these risks include the state of the economy, management’s judgment as to the adequacy of the allowance is necessarily approximate and imprecise.

 

51


At December 31, 2004, the Company’s allowance for loan losses was $4.6 million, representing a decrease of $9.8 million, or 68.1%, from the allowance at December 31, 2003. The provision for loan losses in 2004 was $987,000. At December 31, 2003, the allowance for loan losses was $14.4 million, which represented an increase of $4.6 million, or 46.9%, over the December 31, 2002 amount of $9.8 million. This increase in the overall level of the allowance for loan losses during 2002 and 2003 was primarily due to management’s decision to make continued provisions for loan losses to maintain the allowance at a level it deems appropriate to cover loan losses. This is reflective in the provisions for loan losses of $11.4 million and $10.1 million, including amounts related to discontinued operations, made by the Company in 2003 and 2002, respectively. Management continues to make provisions for current losses in the Company’s loan portfolio, as well as for any other deterioration in loans identified. During 2004, provisions decreased greatly as losses had previously been reserved for in 2003 and the Company sold most of its poor quality loans, thus eliminating the respective reserve required on those loans. This also decreased the levels of allowance for loan losses to total loans at December 31, 2004. As a percentage of total loans, net of unearned income, the allowance for loan losses decreased to 1.54% at December 31, 2004, compared to 4.51% at December 31, 2003, and 2.72% at December 31, 2002. Management believes that the Company’s allowance for loan losses at December 31, 2004 is adequate; however, no assurance can be given that additional losses may not occur or that additional provisions to the allowance for loan losses will not be necessary.

 

A provision for loan losses is charged against current earnings for the Company for any given period. Actual loan losses, net of recoveries, are charged directly to the allowance for loan losses. The amount of the provision for loan losses is based on the growth of the loan portfolio, the amount of net loan losses incurred and management’s estimation of potential future losses based on an evaluation of the risk in the loan portfolio. The provision for loan losses was $987,000, $11.4 million and $10.1 million including amounts related to discontinued operations, in 2004, 2003 and 2002, respectively. This represented a decrease of $10.4 million, or 91.2%, in 2004, and an increase of $1.3 million, or 12.9%, in 2003. The provision for loan loss increased in 2003 as a result of continued high charge offs experienced by the Company as well as management’s determination that increased levels of provision were necessary based on its assessment of the quality of the loan portfolio and inherent losses within the portfolio. The provision for loan loss in 2002 was significantly higher due to increased loan charge-offs during the year as a result of the deteriorating quality of the loan portfolio.

 

Loan charge-offs exceeded recoveries for the Company by $10.7 million in 2004, a 57.4% increase from the excess experienced in 2003. The excess of loan charge-offs over recoveries during 2003 amounted to $6.8 million, which represented a slight decrease, 1.4%, from the excess of $6.9 million experienced during 2002. The high levels of loan charge-offs during 2004 occurred for several reasons. First, charge-offs of $4.1 million resulted from loan sales as loans designated to be sold were written down to the bid price received from the purchaser. Second, a charge-off of $2.2 million resulted from the foreclosure of Heritage Valley Farms, the property securing the real estate loan to our former Chairman, Kennon R. Patterson, Sr. The remaining $4.4 million was from normal charge-offs, and was lower than in prior years. Since the Company’s poor quality loans have been sold, we presently expect significant improvement in future charge-offs; however, we make no assurance that this will be the case.

 

52


The following table sets forth certain information with respect to the Company’s loans, net of unearned income, and the allowance for loan losses for the five years ended December 31, 2004:

 

SUMMARY OF LOAN LOSS EXPERIENCE

 

     2004

    2003

    2002

    2001

    2000

 
     (In thousands)  

Allowance for loan losses at beginning of period

   $ 14,358     $ 9,784     $ 7,292     $ 7,107     $ 2,603  

Loans charged off:

                                        

Commercial, financial and agricultural.

     3,888       1,203       2,033       1,056       620  

Real estate - mortgage.

     6,046       2,629       1,106       726       319  

Consumer.

     2,226       3,439       4,169       4,785       4,114  
    


 


 


 


 


Total loans charged off

     12,160       7,271       7,308       6,567       5,053  
    


 


 


 


 


Recoveries on loans previously charged off:

                                        

Commercial, financial and agricultural

     517       60       44       7       10  

Real estate - mortgage.

     272       26       57       40       2  

Consumer.

     651       378       343       391       256  
    


 


 


 


 


Total recoveries.

     1,440       464       444       438       268  
    


 


 


 


 


Net loans charged off.

     10,720       6,807       6,864       6,129       4,785  

Reserves (sold) acquired through (branch divestitures) acquisitions

     —         —         (752 )     —         —    

Provision for loan losses included in continuing operations

     987       11,381       10,033       6,096       7,573  

Provision for loan losses included in discontinued operations

     —         —         75       218       1,716  
    


 


 


 


 


Allowance for loan losses at end of period

   $ 4,625     $ 14,358     $ 9,784     $ 7,292     $ 7,107  
    


 


 


 


 


Loans at end of period

   $ 300,380       318,028     $ 359,184     $ 501,519     $ 528,316  
    


 


 


 


 


Average loans, net of unearned income, outstanding for the period (*)

   $ 312,876     $ 330,941     $ 419,337     $ 516,954     $ 522,301  
    


 


 


 


 


     2004

    2003

    2002

    2001

    2000

 

Ratios:

                                        

Allowance for loan losses to loans, net of unearned income, at end of period

     1.54 %     4.51 %     2.72 %     1.45 %     1.35 %

Allowance for loan losses at end of period to average loans, net of unearned income (*)

     1.48       4.34       2.33       1.41       1.36  

Net charge-offs to average loans, net of unearned income (*)

     3.43       2.06       1.64       1.19       0.92  

Net charge-offs to allowance for loan losses, at end of period

     231.78       47.41       70.16       84.05       67.33  

Recoveries to prior year charge-offs

     19.80       6.35       6.76       8.67       5.17  

 

(*) Average loans, for this purpose, include those associated with discontinued operations.

 

53


Management allocated the allowance for loan losses to specific loan classes, as of the dates indicated, as follows:

 

ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES

 

     December 31,

 
     2004

    2003

    2002

    2001

    2000

 
     Amount

   Percent
of
Total


    Amount

   Percent
of
Total


    Amount

  

Percent
of

Total


    Amount

  

Percent
of

Total


    Amount

  

Percent
of

Total


 

Domestic loans

                                                                 

Commercial, financial and agricultural

   $ 509    11 %   $ 2,297    16 %   $ 2,678    27 %   $ 802    11 %   $ 711    10 %

Real estate - mortgage

     3,006    65       5,456    38       3,696    38       583    8       497    7  

Consumer

     1,110    24       6,605    46       3,410    35       5,907    81       5,899    83  
    

  

 

  

 

  

 

  

 

  

     $ 4,625    100 %   $ 14,358    100 %   $ 9,784    100 %   $ 7,292    100 %   $ 7,107    100 %
    

  

 

  

 

  

 

  

 

  

 

The Bank has been engaged in enhanced reviews of its loan approval and credit grading processes. The Bank has sought to better price its loans consistent with its costs of funds and its assessment of potential credit risk. These efforts have had the effect of slowing the Bank’s loan growth as well as resulting in a larger allowance for loan losses as risks are being identified better.

 

Management believes that the $4.6 million allowance for loan losses at December 31, 2004, (representing 1.54% of total outstanding loans), was adequate to absorb known risks in the portfolio at such date. However, no assurance can be given that adverse economic circumstances, generally, including current economic events, or other events, including additional loan review or examination findings or changes in borrowers’ financial conditions, will not result in increased losses in the Bank’s loan portfolio or in additional provisions to the allowance for loan losses.

 

The ratio of allowance for loan losses to total nonperforming assets decreased to 35.58% at December 31, 2004 from 59.62% of total nonperforming assets, due to the decrease in allowance for loan losses. The same ratio increased during 2003, from 43.95% at December 31, 2002. The increase in this ratio for 2003 and 2001 resulted from the substantial increase in the Company’s allowance for loan losses during 2003 as it was needed as a result of poor credit standards of the past. The ratio of total nonperforming loans to total loans, net of unearned income, was 0.06% at December 31, 2004, a decrease from the 5.42% at December 31, 2003, due to much lower non performing loan balances resulting from loan sales during 2004. The ratio of total nonperforming loans to total loans, net of unearned income, was 4.06% at December 31, 2002. The ratio of total nonperforming assets to total assets was 2.35% at December 31, 2004, a decrease from the ratio at December 31, 2003 of 4.31%, primarily due to lower nonperforming assets, resulting also from the loan sale. The ratio of total nonperforming assets to total assets was 3.92% at year end 2002. There were no concentrations of loans exceeding 10% of total loans, which are not otherwise disclosed as a category of loans at December 31, 2004, 2003 and 2002. See “Financial Condition – Nonperforming Assets and Past Due Loans” above for further discussion and detail.

 

It is the general policy of Community Bank to stop accruing interest income and place the recognition of interest on a cash basis when any commercial, industrial or real estate loan is past due as to principal or interest and the ultimate collection of either is in doubt. Normally, accrual of interest income on consumer installment loans is suspended when any payment of principal or interest, or both, is more than 90 days delinquent. When a loan is placed on nonaccrual status, any uncollected interest accrued in a prior year is charged against the allowance for loan losses and any uncollected interest accrued in the current year is reversed against current income unless the collateral for the loan is sufficient to cover the accrued interest or a guarantor assures payment of interest.

 

54


Noninterest Income

 

The Company’s noninterest income is comprised of the following items:

 

    services charges received on deposits;

 

    insurance commissions;

 

    investment securities gains and losses;

 

    bank club dues (representing a deposit account packaged with other financial services);

 

    debt cancellation fees; and

 

    other operating income, made up mostly of other fees charges to customers such as safe deposit fees, ATM fees, check cashing fees, and various other service fees.

 

During 2004, the Company’s noninterest income was $6.8 million, representing a decrease of $0.2 million, or 2.6%, from the noninterest income experienced by the Company in 2003. The decrease in 2004 primarily resulted from lower net securities gains as the Company restructured its portfolio in 2003 and was able to take gains on securities sold in the restructuring.

 

Service charges on deposit accounts increased 8.7% in 2004 and decreased 11.5% during 2003. The decrease during 2003 primarily was attributable to the decline in insufficient check charges, while the increase in 2004 was also attributable to insufficient check charges as the Company implemented a courtesy overdraft program in early 2004. This program is designed to pay customers’ insufficient funds checks rather than returning them while at the same time collecting a fee for that service. Insurance commissions increased by 25.9% during 2004, improving in two ways. First, by increased efforts at both Community Bank and Community Credit to sell credit life insurance on its consumer loans which resulted in additional income of $235,000, and second, increased commissions of $296,000 at Community Insurance in its sales of property, casualty and life insurance. Debt cancellation fees declined 167.5% and, in fact, were negative in 2004, as a result of the Company’s no longer selling debt cancellation, but credit life insurance instead. The ($54) resulted from refunds of previously collected fees on loans paid off prior to maturity. Other operating income comprised of various other service fees increased 21.4% in 2004, and decreased 18.5% in 2003. However, the 2004 other operating income includes the $450,000 settlement to Community Bank in the fidelity bond litigation. Other operating income for 2003 includes a $113,000 sign-on bonus from Community Bank’s check order provider that was not reoccurring income. Components of other operating income reflecting decreases in both years were fee income associated with wire transfers, safe deposit box rentals, and other miscellaneous service fees.

 

NONINTEREST INCOME

 

     Years ended December 31,

   Percent Change

 
     2004

    2003

   2002

   2004/2003

    2003/2002

 
     (In thousands)             

Service charges on deposits

   $ 2,837     $ 2,611    $ 2,950    8.7 %   (11.5 )%

Insurance commissions

     2,580       2,049      2,237    25.9     (8.4 )

Securities gains, net

     193       1,103      653    (82.5 )   68.9  

Bank club dues

     350       409      438    (14.4 )   (6.6 )

Debt cancellation fees

     (54 )     80      233    (167.5 )   (65.7 )

Other operating income

     925       762      935    21.4     (18.5 )
    


 

  

            
     $ 6,831     $ 7,014    $ 7,446    (2.6 )   (5.8 )
    


 

  

            

 

55


Noninterest Expenses

 

Noninterest expenses in 2004 improved significantly, down $11.7 million, or 32.4% from the high levels experienced in 2003 and have also improved compared to 2002 levels. Almost every category of noninterest expenses improved during 2004 from 2003 levels. Salaries and benefits expenses are down $0.9 million or 6.8% in 2004 as a result of slight declines in salary, but significant declines in benefit costs. The Company froze its defined benefit plan on December 31, 2003 and implemented a more cost effective 401(k) plan, saving the Company in excess of $600,000 annually. Expenses related to the Company’s ESOP were reduced in 2004 by more than $417,000 from 2003. During 2003, the Company was required to make increased contributions to the ESOP related to the pay-out of benefits to terminated employees. Occupancy and furniture and equipment expenses have remained relatively stable despite the Company’s increased investment in technology during the past year. Foreclosed assets, net, disposal or impairment of assets and litigation expenses have all decreased at levels well above 80% from 2003. During 2003, the Company expensed significant amounts related to writedowns in values of other real estate owned. The Company also recognized impairment losses during 2003 of $1.6 million on three office buildings and outdated equipment as it evaluated its investment in fixed assets. Litigation expenses were high in 2003 as the Company reasonably estimated and recognized expenses on potential settlements that it determined probable to settle. In 2004, legal fees and other professional services declined $1.6 million and $1.2 million, respectively, as the Company incurred significant fees in 2003 due to regulatory orders and pending litigation. We believe that the fees will decrease further in the future as the Company receives relief from regulatory orders and experiences a reduction in pending litigation. Holding cost on foreclosed assets was up slightly in 2004 at $328,000 compared to $297,000 in 2003. This expense may remain at similar levels during 2005, especially until the Company is able to sell Heritage Valley Farms, currently recorded in other real estate owned at a carrying value of $6.4 million. The largest dollar increase in 2004 was for telephone and data communications expense, which increased $162,000, or 23.4%, as a result of increased data line costs required for the installation of the Company’s wide area network.

 

The Company’s noninterest expenses incurred during 2003 amounted to $36.2 million, representing an increase of $7.1 million, or 24.5%, over the noninterest expenses incurred during the year ended December 31, 2002, primarily related to asset impairments, litigation losses, increased insurance costs, and increased legal and other professional service fees. The primary component of the Company’s noninterest expenses is salaries and employee benefits, which decreased $0.7 million or 4.8%, during 2003, primarily as a result of the net effect of the termination of the former Chairman and Chief Executive Officer of the Company, offset by an increase in staff positions that were added to build a more effective management team. The Company has also centralized more backroom operations in an attempt to reduce overall staffing levels. As discussed previously, losses on foreclosed assets, losses on impairment or disposal of assets and litigation losses increased substantially in 2003. Also, as a result of these lawsuits, as well as regulatory matters, legal fees were at extremely high levels in 2003 at $2.7 million. Other professional services expenses for 2003 were $1.7 million, up 30.7% from $1.3 million for 2002. This expense increase in 2003 is attributable to the necessity to hire an outside firm to investigate payments made in connection with several construction projects of Community Bank as well as fees paid in connection with investigations and litigation to which the Company is party or in which the Company was involved.

 

56


Noninterest expenses and the percent changes therein for 2004, 2003 and 2002 are shown in the following table.

 

NONINTEREST EXPENSES

 

     Years ended December 31,

    Percent Change

 
     2004

   2003

   2002

    2004/2003

    2003/2002

 
     (In thousands)              

Salaries and employee benefits

   $ 12,823    $ 13,763    $ 14,455     (6.8 )%   (4.8 )%

Occupancy

     2,283      2,351      2,276     (2.9 )   3.3  

Furniture and equipment

     1,548      1,542      1,651     (0.4 )   (6.6 )

Director and committee fees

     369      468      444     (21.2 )   5.4  

Foreclosed assets, net

     590      3,309      1,260     (82.2 )   162.6  

Disposal or impairment of assets

     246      2,051      (215 )   (88.0 )   1,054.0  

Litigation, fraud, burglary

     47      2,537      561     (98.1 )   352.2  

Amortization of intangibles-other

     79      79      77     —       2.6  

Advertising

     119      44      45     170.5     (2.2 )

Insurance

     1,230      1,239      832     (0.7 )   48.9  

Legal fees

     1,099      2,687      1,962     (59.1 )   37.0  

Other professional services

     502      1,711      1,309     (70.7 )   30.7  

Supplies

     526      572      590     (8.0 )   (3.1 )

Postage

     307      295      289     4.1     (2.1 )

Telephone and data communications

     853      691      598     23.4     15.6  

Training and education

     88      85      35     3.5     142.9  

Holding cost on foreclosed assets

     328      297      253     10.4     17.4  

Other

     1,429      2,458      2,649     (41.9 )   (7.2 )
    

  

  


           
     $ 24,466    $ 36,179    $ 29,071     (32.4 )   24.5  
    

  

  


           

 

Quantitative and Qualitative Disclosures about Market Risk

 

Market risk is the risk of loss arising from adverse changes in the fair value of financial instruments due to a change in economic conditions, interest rates, regulations and laws. We are inherently affected by different market risks. Our primary risk is interest rate risk. We do not conduct foreign exchange transactions or trading activities, which would produce price risk

 

Interest Rate Sensitivity

 

Interest rate risk is the risk to earnings or market value of equity from the potential movement in interest rates. The primary purpose of managing interest rate risk is to reduce interest rate volatility and achieve reasonable stability to earnings from changes in interest rates and preserve the value of the Company’s equity. Changes in interest rates affect, among other things, the Company’s net interest income, volume of loan production and the fair value of financial instruments, as well as of the Company’s loan portfolio.

 

Community Bank manages its exposure to fluctuations in interest rates through policies established by its Asset/Liability Committee, which is referred to as “ALCO.” The ALCO meets periodically to monitor its interest rate risk exposure and implement strategies that might improve its balance sheet positioning and/or earnings. Management utilizes an Interest Rate Simulation model to estimate the sensitivity of the Bank’s net interest income and net income to changes in interest rates of given magnitudes. Such estimates are based upon a number of assumptions for each scenario, including balance sheet growth, deposit repricing characteristics and prepayment rates. Because this model involves a number of estimates and assumptions, which are inherently uncertain and subject to change, the Company makes no assurance that the model is accurate or reliable, or that the results are meaningful or reflective of any actual results.

 

57


The estimated impact on Community Bank’s net interest income sensitivity over a one year time horizon at December 31, 2004 follows. Such analysis assumes an immediate and proportional shift in interest rates and assumes interest-bearing transaction accounts will reprice immediately.

 

INTEREST RATE SENSITIVITY

 

    

-100

Basis

Points


    Level

    +100
Basis
Points


 
     (Dollars in thousands)  

December 31, 2004:

                        

Prime rate

     4.25       5.25       6.25  

Interest income

   $ 28,337     $ 29,896     $ 31,294  

Interest expense

     13,562       14,986       16,411  
    


 


 


Net interest income

   $ 14,775     $ 14,910     $ 14,883  
    


 


 


Dollar change from level

   $ (135 )           $ (27 )

Percentage change from level

     (0.90 )%             (0.18 )%

December 31, 2003:

                        

Prime rate

     3.00 %     4.00 %     5.00 %

Interest income

   $ 30,903     $ 32,593     $ 33,828  

Interest expense

     12,224       12,904       14,282  
    


 


 


Net interest income

   $ 18,679     $ 19,689     $ 19,546  
    


 


 


Dollar change from level

   $ (1,010 )           $ (143 )

Percentage change from level

     (5.13 )%             (0.73 )%

 

As shown above, in both a 100 basis point rising rate environment and 100 basis point falling rate environment, the net interest margin is projected to decrease minimally. These percent changes from a level rate scenario fall comfortably within Community Bank’s ALCO policy limit of +/-10.00%.

 

The Company uses additional tools to manage interest rate sensitivity, and continually tries to manage and monitor its interest rate sensitivity. Attempting to manage the Company’s interest rate sensitivity is a constant challenge in a changing interest rate environment and one of the objectives of the Company’s asset/liability management strategy. The Company manages its interest rate sensitivity with monitoring tools such as GAP analysis, interest rate simulation modeling and forecasting, using both interest rate shocks and likely rate scenarios and, finally, analysis of the Company’s economic value of equity.

 

Effects of Inflation

 

Inflation generally increases the cost of funds and operating overhead, and, to the extent loans and other assets bear variable rates, the yields on such assets. Unlike most industrial companies, virtually all of the Company’s assets and liabilities, as a financial institution, are monetary in nature. As a result, interest rates generally have a more significant impact on performance than the effects of general levels of inflation. Although interest rates do not necessarily move in the same direction, or to the same extent, as the prices of goods and services, low inflation or deflation generally has resulted in decreased interest rates. During 2004, the prime interest rate increased 125 basis points to 5.25% at December 31, 2004 from 4.00% at December 31, 2003.

 

In addition, inflation results in an increased cost of goods and services purchased, cost of salaries and benefits, occupancy expense and similar items. Inflation and related increases in interest rates generally decrease the market value of investments and loans held and may adversely affect the liquidity and earnings of our commercial banking and mortgage banking businesses, and our stockholders’ equity. Mortgage originations and refinancings tend to slow as interest rates increase, and increased interest rates would likely reduce our earnings from such activities. Although earnings from the sale of residential mortgage loans in the secondary market have been insignificant to the

 

58


Company’s earnings over the past two years, the income from the sale of residential mortgage loans in the secondary market could be reduced by inflationary effects.

 

Off-Balance Sheet Arrangements

 

As of December 31, 2004, we had no material unconditional purchase obligations that were not recorded on the balance sheet.

 

The Company in the normal course of business is party to credit related financial instruments with off-balance-sheet risk to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters–of-credit. Such commitments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets.

 

The Company’s exposure to credit loss is represented by the contractual amount of these commitments. The Company follows the same credit policies in making commitments as it does for on-balance-sheet instruments.

 

At December 31, 2004 and 2003, the following financial instruments were outstanding whose contract amounts represent credit risk:

 

     Contract Amount

     2004

   2003

     (in thousands)

Commitments to grant loans

   $ 24,026    $ 15,097

Standby letters of credit

     465      194

 

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. The commitments for equity lines of credit may expire without being drawn upon. Therefore, the total commitments amounts do not necessarily represent future cash requirements. The amount of collateral obtained, if it is deemed necessary by the Company, is based on management’s credit evaluation of the customer.

 

Standby letters-of-credit are conditional lending commitments issued by the Company to guarantee the performance of a customer to a third party. These letters-of-credit are primarily issued to support public and private borrowing arrangements. Almost all letters-of-credit issued by the Company have expiration dates within one year, but the majority is automatically renewable for the beneficiary. The credit risk involved in issuing letters-of-credit is essentially the same as that involved in extending loan facilities to customers. The Company occasionally holds collateral supporting those commitments, and at December 31, 2004 and 2003 such collateral amounted to $122,880 and $90,180, respectively.

 

Contractual Obligations

 

The table below shows the Company’s future contractual obligations as of December 31, 2004:

 

     Total

  

Less than

1 year


   1-3 years

   3-5 years

  

More than

5 years


Contractual obligations:

                                  

FHLB long-term debt

   $ 38,000,000    $ —      $ —      $ —      $ 38,000,000

Junior subordinated debt

     10,310,000      —        —        —        10,310,000

Capitalized lease obligations

     7,205,118      272,749      545,498      545,498      5,841,373

Operating lease obligations

     1,902,291      469,283      710,038      414,729      308,241
    

  

  

  

  

Total

   $ 57,417,409    $ 742,032    $ 1,255,536    $ 960,227    $ 54,459,614
    

  

  

  

  

 

59


 

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

 

The financial statements and supplementary data required by Regulation S-X and by Item 302 of Regulation S-K are set forth in the pages listed below:

 

Financial Statements


   Page(s)

Report of Independent Registered Public Accounting Firm

   61

Consolidated Balance Sheets as of December 31, 2004 and 2003

   62

Consolidated Statements of Operations for the years ended December 31, 2004, 2003 and 2002

   63 - 64

Consolidated Statements of Changes in Stockholders’ Equity for the years ended December 31, 2004, 2003 and 2002

   65

Consolidated Statements of Cash Flows for the years ended December 31, 2004, 2003 and 2002

   66 - 67

Notes to Consolidated Financial Statements

   68 -113

 

60


 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

To the Board of Directors and Stockholders Community Bancshares, Inc.:

 

We have audited the accompanying consolidated balance sheets of Community Bancshares, Inc. and subsidiaries (Company) as of December 31, 2004 and 2003, and the related consolidated statements of operations, changes in stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2004. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

 

We conducted our audits in accordance with 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 consolidated financial position of Community Bancshares, Inc. and subsidiaries as of December 31, 2004 and 2003, and the results of their consolidated operations and their cash flows for each of the three years in the period ended December 31, 2004, in conformity with accounting principles generally accepted in the United States of America.