COMMUNITY FINANCIAL CORP /MD/ - Quarter Report: 2005 September (Form 10-Q)

 

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the Quarterly Period Ended September 30, 2005

o		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 0-18279

Tri-County Financial Corporation

(Exact name of registrant as specified in its charter)

Maryland		52-1652138
(State of other jurisdiction of		(I.R.S. Employer
incorporation or organization)		Identification No.)

3035 Leonardtown Road, Waldorf, Maryland				20601
(Address of principal executive offices)				(Zip Code)

(301) 843-0854
(Registrant’s telephone number, including area code)

Not applicable
(Former name, former address and former fiscal year, if changed since last report)

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 þ   No o

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

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

As of October 31, 2005, the registrant had 1,160,942 shares of common stock outstanding.

 

 

TRI-COUNTY FINANCIAL CORPORATION
FORM 10-Q

		INDEX

		Page
PART I — FINANCIAL INFORMATION
Item 1 — Financial Statements (Unaudited)
Consolidated Balance Sheets — September 30, 2005 and December 31, 2004		3
Consolidated Statements of Income and Comprehensive Income — Three and Nine Months Ended September 30, 2005 and 2004		4 - 5
Consolidated Statements of Cash Flows — Nine Months Ended September 30, 2005 and 2004		6 - 7
Notes to Consolidated Financial Statements		8 - 11
Item 2— Management’s Discussion and Analysis of Financial Condition and Results of Operations		11 - 18
Item 3 — Quantitative and Qualitative Disclosures about Market Risk		18
Item 4 — Controls and Procedures		18-19
PART II — OTHER INFORMATION
Item 1 — Legal Proceedings		19
Item 2 — Unregistered Sales of Equity Securities and Use of Proceeds		19
Item 3 — Defaults Upon Senior Securities		19
Item 4 — Submission of Matters to a Vote of Security Holders		19
Item 5 — Other Information		19
Item 6 — Exhibits		19
SIGNATURES		20
EX-10.1 AMENDMENT TO EMPLOYMENT AGEEMENT WITH C. MARIE BROWN
EX-10.2 AMENDMENT TO EMPLOYMENT AGREEMENT WITH GREGORY C. COCKERHAM
EX-10.3 AMENDMENT TO EMPLOYMENT AGREEMENT WITH WILLIAM J. PASENELLI
EX-31 SECTION 302 CERTIFICATION OF CEO AND CFO
EX-32 SECTION 906 CERTIFICATION OF CEO AND CFO

PART I FINANCIAL STATEMENTS

		September 30, 2005				December 31, 2004
ASSETS
Cash and due from banks		$	4,487,454			$	6,018,096
Federal funds sold			383,705				777,519
Interest-bearing deposits with banks			14,486,622				10,920,164
Securities available for sale			7,996,391				12,948,971
Securities held to maturity — at amortized cost			128,093,569				162,741,155
Federal Home Loan Bank and Federal Reserve Bank stock — at cost			6,538,200				6,144,300
Loans receivable — net of allowance for loan losses of $3,258,582 and $3,057,558, respectively			348,652,999				289,325,051
Premises and equipment, net			6,675,367				6,011,913
Foreclosed real estate			475,561				475,561
Accrued interest receivable			2,191,972				1,870,135
Investment in bank owned life insurance			6,369,909				6,182,955
Other assets			2,370,749				2,351,303
TOTAL ASSETS		$	528,722,498			$	505,767,123
LIABILITIES AND STOCKHOLDERS’ EQUITY
LIABILITIES:
Noninterest-bearing deposits		$	40,288,440			$	35,552,503
Interest-bearing deposits			291,905,297				231,202,001
Total deposits			332,193,737				266,754,504
Short-term borrowings			50,496,120				115,304,210
Long-term debt			97,832,221				82,931,113
Guaranteed preferred beneficial interest in junior subordinated debentures			12,000,000				7,000,000
Accrued expenses and other liabilities			3,035,485				2,653,721
Total liabilities			495,557,563				474,643,548
STOCKHOLDERS’ EQUITY:
Common stock — par value $.01; authorized — 15,000,000 shares; issued and outstanding 1,155,925 and 1,146,864 shares, respectively			11,559				11,469
Additional paid in capital			8,447,202				8,252,152
Retained earnings			24,763,828				22,833,112
Accumulated other comprehensive income			69,627				186,140
Unearned ESOP shares			(127,281	)			(159,298	)
Total stockholders’ equity			33,164,935				31,123,575
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY		$	528,722,498			$	505,767,123

See notes to consolidated financial statements

TRI-COUNTY FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME (UNAUDITED)

THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2005 AND 2004

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2005				2004				2005				2004
INTEREST INCOME:
Interest and fees on loans		$	5,765,253			$	4,182,698			$	16,081,572			$	11,549,192
Taxable interest and dividends on investment securities			1,644,284				1,725,835				5,147,636				3,592,995
Interest on deposits with banks			24,165				7,321				53,401				16,096
Total interest income			7,433,702				5,915,854				21,282,609				15,158,283
INTEREST EXPENSE:
Interest on deposits			1,767,789				842,329				4,268,209				2,290,241
Interest on short term borrowings			553,415				315,333				2,192,712				494,574
Interest on long term debt			1,245,426				928,546				3,284,245				2,467,717
Total interest expense			3,566,630				2,086,208				9,745,166				5,252,532
NET INTEREST INCOME			3,867,072				3,829,646				11,537,443				9,905,751
PROVISION FOR LOAN LOSSES			11,183				232,996				200,307				316,970
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES			3,855,889				3,596,650				11,337,136				9,588,781

TRI-COUNTY FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME (UNAUDITED)
THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2005 AND 2004

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2005				2004				2005				2004
NONINTEREST INCOME:
Loan appraisal, credit, and miscellaneous charges		$	68,666			$	67,071			$	193,546			$	215,023
Net gain on sale of loans held for sale			—				—				—				21,404
Net gain on the sale of foreclosed property			—				—				39,756				—
Income from bank owned life insurance			63,624				73,848				186,954				221,544
Loss on sale of investment securities			—				(99,371	)			(14,581	)			(126,875	)
Service charges			334,360				280,078				896,110				820,783
Other income			—				8,250				—				8,250
Total noninterest income			466,650				329,876				1,301,785				1,160,129
NONINTEREST EXPENSE:
Salary and employee benefits			1,547,190				1,305,832				4,369,643				3,921,756
Occupancy			309,796				185,484				835,254				575,624
Advertising			112,982				128,084				318,552				368,314
Data processing			152,285				122,348				475,647				411,568
Legal and professional fees			201,260				66,220				450,428				141,492
Depreciation of furniture, fixtures, and equipment			118,161				107,700				314,511				287,900
Telephone communications			12,381				26,961				65,783				84,416
Valuation allowance on foreclosed real estate			—				—				—				147,203
ATM expenses			61,346				87,345				211,227				251,218
Office supplies			33,567				43,572				101,518				105,337
Office equipment			10,010				23,120				39,686				68,805
Other			210,586				210,896				725,944				657,163
Total noninterest expense			2,769,564				2,307,562				7,908,193				7,020,796
INCOME BEFORE INCOME TAXES			1,552,975				1,618,964				4,730,728				3,728,114
Income tax expense			562,908				537,658				1,637,211				954,034
NET INCOME			990,067				1,081,306				3,093,517				2,774,080
OTHER COMPREHENSIVE INCOME NET OF TAX
Net unrealized holding (losses) gains arising during period			(33,443	)			481,926				(125,462	)			(33,482	)
Loss: Reclassification adjustment for losses (net of taxes of $0,$38,377,$5,631 and $48,999)			—				60,994				8,950				77,876
COMPREHENSIVE INCOME		$	956,624			$	1,624,226			$	2,977,005			$	2,818,474
EARNINGS PER COMMON SHARE
Basic		$	0.86			$	0.94			$	2.68			$	2.42
Diluted			0.80				0.90				2.51				2.32

See notes to consolidated financial statements

Share and per share data have been retroactively adjusted to effect a three for two common stock split declared on October 22, 2004 as if it had occurred on January 1, 2004.

TRI-COUNTY FINANCIAL CORPORATION

		Nine Months Ended
		September 30,
		2005				2004
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income		$	3,093,517			$	2,774,080
Adjustments to reconcile net income to net cash provided by operating activities:
Valuation allowance on foreclosed real estate			—				147,203
Provision for loan losses			200,307				316,970
Loss on sales of investment securities			14,581				126,875
Depreciation and amortization			594,906				450,764
Net amortization of premium/discount on investment securities			288,210				189,666
Increase in cash surrender of bank owned life insurance			(186,954	)			(147,696	)
Deferred income tax benefit			(111,680	)			(37,788	)
Increase in accrued interest receivable			(321,837	)			(468,852	)
(Decrease) Increase in deferred loan fees			(210,792	)			65,278
Increase in accrued expenses and other liabilities			381,764				72,716
Decrease in other assets			112,499				620,292
Gain on sales of loans held for sale			—				(21,404	)
Proceeds from sale of loans held for sale			—				496,284
Net cash provided by operating activities			3,854,521				4,584,388
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of investment securities available for sale			(8,439	)			(27,914,392	)
Proceeds from sale, redemption or principal payments of investment securities available for sale			4,754,373				48,498,352
Purchase of investment securities held to maturity			(25,749,248	)			(132,068,945	)
Proceeds from maturities or principal payments of investment securities held to maturity			60,124,155				25,716,946
Net purchase of FHLB and Federal Reserve stock			(393,900	)			(1,335,150	)
Loans originated or purchased			(157,502,581	)			(148,832,804	)
Principal collected on loans			98,185,118				90,749,534
Purchase of premises and equipment			(1,258,360	)			(685,956	)
Proceeds from foreclosed real estate			39,756				25,000
Net cash used in investing activities			(21,809,126	)			(145,847,415	)

TRI-COUNTY FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
NINE MONTHS ENDED SEPTEMBER 30, 2005 AND 2004

		Nine Months Ended
		September 30,
		2005				2004
CASH FLOWS FROM FINANCING ACTIVITIES:
Net increase in deposits		$	65,439,233			$	29,018,383
Proceeds from long-term borrowings			20,000,000				25,000,000
Payments of long-term borrowings			(5,098,892	)			(10,111,929	)
Trust preferred debentures			5,000,000				7,000,000
Net (decrease) increase in short term borrowings			(64,808,090	)			91,508,528
Exercise of stock options			166,815				223,474
Net change in unearned ESOP shares			60,395				52,532
Dividends paid			(930,669	)			(541,633	)
Redemption of common stock			(232,185	)			(408,827	)
Net cash provided by financing activities			19,596,607				141,740,528
INCREASE IN CASH AND CASH EQUIVALENTS			1,642,002				477,501
CASH AND CASH EQUIVALENTS — JANUARY 1			17,715,779				12,169,798
CASH AND CASH EQUIVALENTS — SEPTEMBER 30		$	19,357,781			$	12,647,299
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid during the nine months for:
Interest		$	9,693,637			$	5,305,519
Income taxes		$	1,447,500			$	437,500

See notes to consolidated financial statements

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

	1.		BASIS OF PRESENTATION
			General - The consolidated financial statements of Tri-County Financial Corporation (the “Company”) and its wholly owned subsidiary, Community Bank of Tri-County (the “Bank”) included herein are unaudited; however, they reflect all adjustments consisting only of normal recurring accruals that, in the opinion of Management, are necessary to present fairly the Company’s financial condition, results of operations, and cash flows for the periods presented. Certain information and note disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission. The Company believes that the disclosures are adequate to make the information presented not misleading. The balances as of December 31, 2004 have been derived from audited financial statements. There have been no significant changes to the Company’s accounting policies as disclosed in the Company’s 2004 Annual Report. The results of operations for the three and nine months ended September 30, 2005 are not necessarily indicative of the results of operations to be expected for the remainder of the year or any other period. Certain previously reported amounts have been restated to conform to the 2005 presentation.
			These consolidated financial statements should be read in conjunction with the consolidated financial statements and notes included in the Company’s 2004 Annual Report.
	2.		NATURE OF BUSINESS
			The Company, through its bank subsidiary, provides financial services primarily in southern Maryland. The primary financial services include real estate, commercial and consumer lending, as well as traditional demand deposits and savings products.
	3.		INCOME TAXES
			The Company uses the liability method of accounting for income taxes as required by SFAS No. 109, “Accounting for Income Taxes.” Under the liability method, deferred-tax assets and liabilities are determined based on differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities (i.e., temporary differences) and are measured at the enacted rates that will be in effect when these differences reverse.
	4.		EARNINGS PER SHARE
			Basic earnings per common share is computed by dividing net income by the weighted average number of common shares outstanding during the period. Diluted earnings per common share is computed by dividing net income by the weighted average number of common shares outstanding during the period, including any potential dilutive common shares outstanding, such as options and warrants. As of September 30, 2005, there were no shares excluded from the diluted earnings per share computation because the average market price exceeded the exercise price of all outstanding options. Basic and diluted earnings per share have been computed based on weighted-average common and common equivalent shares outstanding as follows:

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2005				2004				2005				2004
Basic			1,155,926				1,150,308				1,154,806				1,146,044
Diluted			1,230,351				1,200,576				1,230,874				1,197,512

Share and per share data have been retroactively adjusted to effect a three for two common stock split declared on October 22, 2004 as if it had occurred on January 1, 2004.

			5. STOCK—BASED COMPENSATION
			Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock Based Compensation, encourages all entities to adopt a fair value based method of accounting for employee stock compensation plans, whereby compensation cost is measured at the grant date based on the value of the award and is recognized over the service period, which is usually the vesting period. However, it also allows an entity to continue to measure compensation cost for these plans using the intrinsic value based method of accounting prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, whereby compensation cost is the excess, if any, of the quoted market price of the stock at the grant date (or other measurement date) over the amount an employee must pay to acquire the stock. The Company has elected to continue with the accounting methodology in Opinion No. 25. Stock options issued under the Company’s stock option plans have no intrinsic value at the grant date, and under Opinion No. 25 no compensation cost is recognized for them.
			In December 2004, FASB issued SFAS No. 123R, “Share-Based Payment,” which is a revision of SFAS No. 123, “Accounting for Stock Issued for Employees.” SFAS No. 123R requires that all share-based payments to employees, including grants of employee stock options, be valued at fair value on the grant date and be expensed over the applicable vesting period. SFAS No. 123R is effective for the Company on January 1, 2006. The Company will transition to SFAS No. 123R using the “modified prospective application.” Under the “modified prospective application,” compensation costs will be recognized in the financial statements for all new share-based payments granted after January 1, 2006. Additionally, the Company will recognize compensation costs for the portion of previously granted awards for which the requisite service has not been rendered (“nonvested awards”) that are outstanding as of January 1, 2006 over the remaining requisite service period of the awards. The compensation expense to be recognized for the non-vested awards will be based on the fair value of the awards. The Company does not expect the impact of utilizing the “modified prospective application” to adopt SFAS No. 123R to be materially different from the pro-forma information shown below.
			Under the terms of the incentive stock plan, management will be compensated for performance based upon a percentage of net income after tax but before incentive accrual. This percentage will be determined by the Board of Directors annually. For 2005, the total incentive payout in both cash and stock based compensation will be based upon 14% of net income. Total cash incentive compensation will be capped at approximately $300,000. Remaining amounts due under the incentive compensation plan will be awarded in the form of stock options. For plan purposes these options will be valued using the Black-Scholes method. Actual option awards will be made at year end.
			If the Company had elected to recognize stock-based compensation cost based on fair value at the grant dates for awards consistent with the method prescribed by SFAS No. 123, net income and earnings per share would have been changed to the pro-forma amounts shown below for the three- and nine-month periods ended September 30, 2005 and 2004.

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2005				2004				2005				2004
Net Income as reported		$	990,067			$	1,081,306			$	3,093,517			$	2,774,080
Less pro forma stock based compensation expense determined under the fair value method, net of tax effect			45,979				60,000				239,592				308,579
Pro forma net income		$	944,088			$	1,021,306			$	2,853,925			$	2,465,501
Net Income per share
Basic — as reported		$	0.86			$	0.94			$	2.68			$	2.42
Basic — pro forma		$	0.82			$	0.89			$	2.47			$	2.15
Diluted — as reported		$	0.80			$	0.90			$	2.51			$	2.32
Diluted — pro forma		$	0.77			$	0.85			$	2.32			$	2.06

Share and per share data have been retroactively adjusted to effect a three for two common stock split declared on October 22, 2004 as if it had occurred on January 1, 2004.

			6. GUARANTEED PREFERRED BENEFICIAL INTEREST IN JUNIOR SUBORDINATED DEBENTURES
			On June 15, 2005, Tri County Capital Trust II (“Capital Trust II”), a Delaware business trust formed, funded and wholly owned by the Company, issued $5,000,000 of variable-rate capital securities with an interest rate of 5.07% in a private pooled transaction. The variable rate is based on the 90-day LIBOR rate plus 1.70%. The Trust used the proceeds from this issuance to purchase $5.2 million of the Company’s junior subordinated debentures. The interest rate on the debentures and the trust preferred securities is variable and adjusts quarterly. The Company has, through various contractual arrangements, fully and unconditionally guaranteed all of Capital Trust II’s obligations with respect to the capital securities. These capital securities qualify as Tier I capital and are presented in the Consolidated Balance Sheets as “Guaranteed Preferred Beneficial Interests in Junior Subordinated Debentures.” Both the capital securities of Capital Trust II and the junior subordinated debentures are scheduled to mature on June 15, 2035, unless called by the Company not earlier than June 15, 2010.
			On July 22, 2004, Tri County Capital Trust I (“Capital Trust I”), a Delaware business trust formed, funded and wholly owned by the Company, issued $7,000,000 of variable-rate capital securities with an interest rate of 4.22% in a private pooled transaction. The variable rate is based on the 90-day LIBOR rate plus 2.60%. The Trust used the proceeds from this issuance to purchase $7.2 million of the Company’s junior subordinated debentures. The interest rate on the debentures and the trust preferred securities is variable and adjusts quarterly. The Company has, through various contractual arrangements, fully and unconditionally guaranteed all of Capital Trust I’s obligations with respect to the capital securities. These capital securities qualify as Tier I capital and are presented in the Consolidated Balance Sheets as “Guaranteed Preferred Beneficial Interests in Junior Subordinated Debentures.” Both the capital securities of Capital Trust I and the junior subordinated debentures are scheduled to mature on July 22, 2034, unless called by the Company not earlier than July 22, 2009.
			Costs associated with the issuance of the trust-preferred securities were less than $10,000 and were expensed as period costs.
	7.		NEW ACCOUNTING STANDARDS
			In December 2004, the Financial Accounting Standards Board (“FASB”) issued SAFS No. 153, “Exchanges of Non-monetary Assets, an amendment of APB Opinion No. 29, Accounting for Non-monetary Transactions.” This statement amends the principal that exchanges of non-monetary assets should be measured based on the fair value of the assets exchanged and more broadly provides for exceptions regarding exchanges of non-monetary assets that do not have commercial substance. This Statement is effective for non-monetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. The adoption of this standard has not had a material impact on the Company’s financial condition, results of operations, or liquidity.
			In March 2004, FASB Emerging Issues Task Force (EITF) released Issue 03-01, “Meaning of Other Than Temporary Impairment and Its Application to Certain Investments.” EITF 03-1 provides guidance for determining whether impairment for certain debt and equity investments is other-than-temporary and the measurement of the impaired loss. Certain disclosure requirements of EITF 03-1 were adopted in 2003 and the Company complied with the new disclosure requirements in its consolidated financial statements. The recognition and measurement requirements of EITF 03-01 were initially effective for periods beginning after June 15, 2004. In September 2004, however, the FASB staff issued FASB Staff Position (“FSP”) EITF 03-1-1, which delayed the effective date for certain measurement and recognition guidance contained in Issue 03-1. The FSP requires the application of pre-existing other-than-temporary guidance during the period of delay until a final consensus is reached. Management does not anticipate the issuance of the final consensus will have a material impact on the Company’s financial condition, results of operations, or liquidity.
			In December 2003, the American Institute of Certified Public Accountants issued Statement of Position (SOP) 03-3, “Accounting for Certain Loans or Debt Securities Acquired in a Transfer.” SOP 03-3 requires acquired loans, including debt from the seller for those-individually-evaluated loans that have evidence of deterioration in credit quality since origination, and it is probable all contractual cash flows on the loan will be unable to be collected. SOP 03-3 also requires the excess of all undiscounted cash flows expected to be collected at acquisition over the purchase’s initial investment to be recognized as interest income on a level-yield basis over the life of the loan. Subsequent increases in cash flows expected to be collected are recognized as impairment. Loans carried at fair

value, loans held for sale, and loans to borrowers in good standing under revolving credit agreements are excluded from the scope of SOP 03-3. The guidance is effective for loans acquired in fiscal years beginning after December 15, 2004 and did not have a material impact on the Company’s financial condition, results of operations, or liquidity.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF OPERATIONS AND FINANCIAL CONDITION

This document may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, including discussions of Tri-County Financial Corporation’s (the “Company”) goals, strategies and expected outcomes; estimates of risks and future costs; and reports of the Company’s ability to achieve its financial and other goals. Forward-looking statements are generally preceded by terms such as “expects,” “believes,” “anticipates,” “intends” and similar expressions. These forward-looking statements are subject to significant known and unknown risks and uncertainties because they are based upon future economic conditions, particularly interest rates, competition within and without the banking industry, changes in laws and regulations applicable to the Company, changes in accounting principles and guidelines, demand for loan products, deposit flows and various other matters. Because of these uncertainties, there can be no assurance that actual results, performance or achievements of the Company will not differ materially from any future results, performance or achievements expressed or implied by these forward-looking statements. The Company does not undertake – and specifically disclaims any obligation – to publicly release the result of any revisions that may be made to any forward-looking statement to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events.

GENERAL

The Company is a bank holding company organized in 1989 under the laws of the State of Maryland. It presently owns all the outstanding shares of capital stock of Community Bank of Tri-County (the “Bank”), a Maryland-chartered commercial bank. The Company engages in no significant activity other than holding the stock of the Bank and paying the obligations of its subordinated debt. Accordingly, the information set forth in this report, including financial statements and related data, relates primarily to the Bank and its subsidiaries.

The Bank serves the Southern Maryland area through its main office and eight branches located in Waldorf, Bryans Road, Dunkirk, Prince Frederick, Leonardtown, La Plata, Charlotte Hall, and California, Maryland. The Prince Frederick location in Calvert County opened on May 19, 2005. The Bank is engaged in the commercial and retail banking business as authorized by the banking statutes of the State of Maryland and applicable Federal regulations. The Bank accepts demand and time deposits and uses these funds along with borrowings from the Federal Home Loan Bank (“FHLB”), to fund loan originations to individuals, associations, partnerships and corporations. The Bank makes real estate loans including residential first and second mortgage loans, home equity lines of credit and commercial mortgage loans. The Bank also makes commercial loans including secured and unsecured loans. The Bank is a member of the Federal Reserve and FHLB Systems. The Savings Association Insurance Fund (“SAIF”) of the Federal Deposit Insurance Corporation (“FDIC”) provides deposit insurance coverage up to applicable limits.

Since its conversion to a state chartered commercial bank in 1997, the Bank has sought to increase its commercial, commercial real estate, construction, second mortgage, home equity, and consumer lending business as well as the level of transactional deposits to levels consistent with similarly sized commercial banks. As a result of this emphasis, the Bank’s percentage of assets invested in residential first mortgage lending has declined since 1997. Conversely, targeted loan types have increased. The Bank has also seen an increase in transactional deposit accounts while the percentage of total liabilities represented by certificates of deposits has declined. Management believes that these changes will enhance the Bank’s overall long-term financial performance.

Management recognizes that the shift in composition of the Bank’s loan portfolio will tend to increase its exposure to credit losses. The Bank continues to evaluate its allowance for loan losses to compensate for the increased risk. Any evaluation of the allowance for loan losses is inherently inexact and reflects management’s expectations as to future economic conditions in the Southern Maryland area as well as individual borrower’s circumstances. Management believes that its allowance for loan losses is adequate. For further information on the Bank’s allowance for loan losses see the discussion in the sections captioned “Financial Condition” and “Critical Accounting Policies” as well as the relevant discussions in the Company’s report on Form 10-K for the year ended December 31, 2004.

For several quarters until the fourth quarter of 2004, the economy was recovering from a mild recession. Since then, the Federal Reserve has indicated through rate increases and statements, its belief that the economy’s greatest danger appears to be inflation rather than recession. Accordingly, the Federal Funds rate has increased from its recent low of 1.00% in

June 2004 to 3.75% in September 2005. While we believe that we are positioned to perform well in a moderate rate increase environment, substantially higher interest rates could affect our future financial performance. Additionally, continued flattening of the yield curve, whereby short-term market interest rates (which we use as a guide to price our deposits) increase while longer-term market interest rates (which we use as a guide to price our loans) remain at current rates, may negatively impact our profitability. Further, our ability to increase asset yields in a rising interest rate environment is limited by periodic and lifetime caps on interest rates embedded in many of our loans and investments. In addition, certain of our loans and investments are for fixed rates. Moreover, substantially higher interest rates would tend to increase borrowing costs for our customers and might lead to an increase in loan delinquency caused by the borrowers’ inability to pay these higher costs in some cases.

SELECTED FINANCIAL DATA

		Nine Months Ended								Three Months Ended
		September 30,								September 30,
		2005				2004				2005				2004
Condensed Income Statement
Interest Income		$	21,282,609			$	15,158,283			$	7,433,702			$	5,915,854
Interest Expense			9,745,166				5,252,532				3,566,630				2,086,208
Net Interest Income			11,537,443				9,905,751				3,867,072				3,829,646
Provision for Loan Loss			200,307				316,970				11,183				232,996
Noninterest Income			1,301,785				1,160,129				466,650				329,876
Noninterest Expense			7,908,193				7,020,796				2,769,564				2,307,562
Income Before Income Taxes			4,730,728				3,728,114				1,552,975				1,618,964
Income Taxes			1,637,211				954,034				562,908				537,658
Net Income			3,093,517				2,774,080				990,067				1,081,306
Per Common Share
Basic Earnings		$	2.68			$	2.42			$	0.86			$	0.94
Diluted Earnings		$	2.51			$	2.32			$	0.80			$	0.90
Book Value		$	28.69			$	26.20			$	28.69			$	26.20

Share and per share data have been retroactively adjusted to effect a three for two common stock split declared on October 22, 2004 as if it had occurred on January 1, 2004.

RESULTS OF OPERATIONS— YEAR TO DATE

Net income for the nine-month period ended September 30, 2005 totaled $3,093,517 ($2.68 basic and $2.51 diluted earnings per share) compared with a total of $2,774,080 ($2.42 basic and $2.32 diluted earnings per share) for the same period in the prior year. This increase of $319,437, or 11.52%, was caused by increases in net interest income and non-interest income, combined with a decrease in provision for loan losses, partially offset by higher non-interest and tax expenses.

For the nine-month period ended September 30, 2005, interest income increased by $6,124,326, or 40.40%, to $21,282,609. The increase was due to higher average balances of earning assets combined with higher yields. The Bank earned higher yields on loans reflecting the changes in the interest rate environment. Yields on investments were unchanged as the Bank has not purchased significant amounts of investments in the current year. Interest expense increased to $9,745,166 for the nine-month period ending September 30, 2005 as compared to $5,252,532 for the same period in the prior year, an increase of $4,492,634 or 85.53%. The increase was the result of higher average balances and higher rates. The average rate paid on liabilities increased as short term interest rates have increased throughout the year. In addition, the Bank has increased its use of non-retail deposit funding sources including brokered deposits and Federal Home Loan Bank advances. The changes in interest income and expense reflect the effects of the changing interest rate environment, increased size of the balance sheet, and changes in balance sheet composition that have taken place in the last year.

The provision for loan losses decreased to $200,307 for the nine months ended September 30, 2005 from $316,970 for the nine month period ended September 30, 2004. The decrease in provision expense was the result of lower average write-offs and delinquencies in the current period as well as smaller losses indicated in our assessment of individual loans. This was partially offset by the Bank’s continued growth in lending, particularly in non-residential loans, which carry a higher risk of default. Management will continue to periodically review its allowance for loan losses and the related

provision and make adjustments as deemed necessary. This review will include a review of economic conditions nationally and locally, as well as a review of the performance of significant major loans and the overall loan portfolio.

Noninterest income increased to $1,301,785 for the nine-month period ending September 30, 2005, an increase of $141,656, or 12.21%, compared to $1,160,129 during the same period in 2004. In the nine-month period ending September 30, 2005, the Bank’s loan appraisal, credit, and miscellaneous charges declined by $21,477, or 9.99%, to $193,546 from $215,023 for the same period in the prior year. This decline was caused by the continued decline in these fees due to market competition. In 2004, the Bank reported a net gain on selling mortgage loans of $21,404. No gains from selling loans were earned in 2005. As the Bank continues to decrease its emphasis on originating mortgage loans for sale, it does not expect to have significant loan sales in the future. In 2005, the Bank sold certain foreclosed property which had previously been written off. The gain of $39,756 was recognized in 2005, while no similar gain was recognized in 2004. The Bank recorded a $34,590, or 15.61%, decline in income from bank-owned life insurance based on a decline in yield in 2005. The Bank also recorded a loss of $14,581 in 2005 on the sale of certain short-term securities compared to a loss of $126,875 in 2004. The Bank sold very few short-term securities in 2005, reducing losses. Finally, service charges for the nine months ended September 30, 2005 increased to $896,110 from the prior year amount of $820,783, an increase of $75,327, or 9.18%, due to higher amounts of activity in certain demand deposit accounts and increases in demand deposit account balances and number of accounts.

Noninterest expense for the nine-month period increased by $887,397, or 12.64%, to $7,908,193 from $7,020,796 for the same period for the prior year. Salary and employee benefits increased by 11.42% or $447,890 to $4,369,643 from $3,921,756 for the same period in the prior year. The increase was attributable to an increase in employees and to increases in average salary costs per employee. Occupancy expense increased from $575,624 to $835,254, an increase of 45.10%, due to the opening of the Prince Frederick branch as well as by increased costs at other existing locations. Advertising expenses decreased to $318,552 from $368,314, a decrease of $49,762 or 13.51%. The reduction in expenses was attributable to the internalization of the marketing function. Data processing expense for the nine months ended September 30, 2005 increased to $475,647 from $411,568 in the prior year period, an increase of $64,079 or 15.57%. This increase was due to increases in the Bank’s size and customer base. Legal and professional fees increased to $450,428 from $141,492, an increase of $308,936 or 218.34%. This increase in expense included increased expenses relating to preparing the Company to meet the additional requirements of Sarbanes–Oxley compliance, including increases in outsourced accounting, legal, and other professional services. Depreciation of furniture fixtures and equipment increased to $314,511 from $287,900 in the prior year period, an increase of $26,611 or 9.24%. This increase was caused by the addition of the Prince Frederick Branch and related equipment as well as by the continued purchase of premises and equipment in other locations. Telephone communications expense declined to $65,783 from $84,416 in the prior year period, a decline of $18,633 or 22.07%. This decline reflected a change in service providers, which offset higher usage. The provision for valuation allowances on foreclosed real estate decreased to $0 in 2005 from $147,203 for the nine months ended September 30, 2004 as no further increases to the valuation allowance were considered necessary. ATM related expenses decreased by $39,991 to $211,227 for the period ending September 30, 2005, a decrease of 15.92% due to price concessions by our ATM service providers, which offset higher volumes. Office equipment expenses decreased to $39,686 for the nine months ended September 30, 2005 from $68,805 for the nine months ended September 30, 2004, a decrease of $29,119 or 42.32%. This decrease was caused by the retirement of certain equipment. Other expenses increased to $725,944 from $657,163 an increase of $68,781 or 10.47%, reflecting larger asset size and increased overall business activity.

Income tax expense increased to $1,637,211, or 34.61% of pretax income in the current year, from $954,034 or 25.59% of pretax income in the prior year. The prior year’s low income tax rate was primarily attributable to the contribution of a foreclosed property to an environmental organization which generated a large income tax deduction, effectively reducing the overall rate.

RESULTS OF OPERATIONS — THIRD QUARTER

The Company recorded net income for the third quarter of 2005 of $990,067 compared to $1,081,306 for the same period in 2004. The decrease was the result of an increase in non-interest expense which was partially offset by an increase in non-interest income as well as by a decrease in the provision for loan losses.

Net interest income increased by .98% to $3,867,072 for the three months ended September 30, 2005 from $3,829,646 for the three months ended September 30, 2004. The increase was a result of increased asset size offset by a lower net interest margin. As noted above, the lower net interest margin was the result of increased amounts of wholesale funds which tended to increase the average rate paid on liabilities. Interest margin was also negatively impacted by the flattening of the yield curve as discussed above. The provision for loan losses decreased by 95.2% to $11,183 for the

three months ended September 30, 2005 from $232,996 for the three months ended September 30,2004. The decrease in 2005 was caused by the continued strong results in controlling delinquencies and write-offs.

Noninterest income increased $136,774 from $329,876 for the three months ended September 30, 2004 to $466,650 for the three months ended September 30, 2005, primarily due to the absence of losses on the sale of investment securities in the 2005 period, and an increase in service charges in 2005. Service charges increased as the Bank has increased balances and the number of accounts in its transaction deposits.

Noninterest expense increased $462,002, or 20.02%, from $2,307,562 for the three months ended September 30, 2004 to $2,769,564 for the three months ended September 30, 2005. Salary and employee expense increased to $1,547,190 from $1,305,832, an increase of $241,358, or 18.48%, due to an increased average salary per employee, a higher number of employees, and the addition of certain benefits. Occupancy expense increased by $124,312, or 67.02%, reflecting the costs of the new Prince Frederick branch that opened in April 2005, as well as renovations to our home office. Advertising expenses decreased by $15,102, or 11.79%, to $112,982, reflecting certain functions previously outsourced being brought in-house. Data processing expense increased to $152,285, an increase of $29,937 or 24.47%, from expense in the prior year period of $122,348. These costs have increased as the Bank has grown in size and also reflect added systems. Legal and professional fees have increased by $135,040, or 203.93%, to $201,260. These costs include additional amounts spent on compliance with the provisions of Sarbanes-Oxley including additional monies spent on internal audit, accountants and other professionals. Depreciation of furniture, fixtures and equipment increased by $10,461 to $118,161. This increase was due to the purchase of additional furniture and equipment for both the Prince Frederick branch and home office renovation. Telephone communications expense decreased to $12,381, or by 54.08%, from $26,961 due to decreased rates offset by a higher volume of calls. ATM expenses declined by $25,999, or 29.77%, to $61,346 in the current year as lower per unit costs were partially offset by higher volumes of transactions. Office supplies expense decreased to $33,567 from $43,572 a decrease of $10,005 or 22.96% reflecting the timing of certain purchases. The income tax rate was 36.25% compared to 33.21% for the same period in the prior year. This was caused by a decrease in certain nontaxable income.

FINANCIAL CONDITION

In 2004, the Company began implementing a leveraging strategy. This strategy included issuing $7,000,000 of trust preferred securities in July 2004, the proceeds of which was subsequently invested in the Bank. The Bank used the proceeds to purchase securities and fund loans. These increases in interest earning assets were also funded by increases in short and long term borrowings as well as by increases in retail deposits. In 2005, the Company issued an additional $5,000,000 of trust preferred securities. In 2005, the Company restrained the growth of its investment portfolio and focused on retail loan and deposit growth. These changes have had the effect of lowering wholesale assets such as investments and wholesale liabilities such as reverse repurchase agreements.

Total assets as of September 30, 2005 increased by $22,955,375, or 4.54%, to $528,722,498 from the December 31, 2004 level of $505,767,123. Cash and due from banks decreased by $1,530,642, or 25.43%, from December 31, 2004’s total. Federal funds sold decreased to $383,705 from $777,519, a decline of $393,814 or 50.65%. Interest-bearing deposits with banks increased by $3,566,458, or 32.66%, during the period to $14,486,622 at September 30, 2005. Changes in the amounts of these cash equivalents reflect short-term cash changes to fund loans and investments. Investment securities, including both the available for sale and held to maturity portfolios, decreased from $175,690,126 to $136,089,960, a decrease of $39,600,166 or 22.54%. Decreases were the result of principal repayments collected in the current year. These repayments were used to fund loan growth, as well as to pay off short-term debt.

The Bank’s loan portfolio (net of allowance for loan losses), increased by $59,327,948 or 20.51% during the nine-month period ended September 30, 2005 to $348,652,999 from $289,325,051 at December 31, 2004. The increase was primarily the result of increases in the Bank’s portfolio of commercial real estate loans, residential construction loans, and commercial lines of credit. The increase in commercial real estate lending was a reflection of the strong local economy and continuing sales efforts by the Bank in this area. Residential construction has increased as local builders continue to develop land. The increase in commercial lines of credit reflects the Bank’s continued effort to build its commercial lending business.

At September 30, 2005, the Bank’s allowance for loan losses totaled $3,258,582 or 0.92% of loan balances as compared to $3,057,558 or 1.04% of loan balances at December 31, 2004. Management’s determination of the adequacy of the allowance for loan loss is based on a periodic evaluation of the portfolio with consideration given to the overall loss experience; current economic conditions; growth and composition of the loan portfolio; financial condition of the borrowers; and other relevant factors that, in management’s judgment, warrant recognition in providing an adequate

allowance. Management believes that the allowance for loan loss is adequate. Additional loan information for prior years is presented in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004.

The following table sets forth information concerning the Bank’s aggregate loans by type at the dates indicated.

 

		September 30, 2005								December 31, 2004
		Amount				%				Amount				%
Loan Portfolio
Real Estate Loans
Commercial		$	158,953,882				45.10	%		$	136,341,597				46.51	%
Residential First Mortgages			67,353,456				19.11	%			59,087,000				20.16	%
Residential Construction			31,229,856				8.86	%			17,597,911				6.00	%
Second Mortgage Loans			27,034,735				7.67	%			23,925,108				8.16	%
Commercial lines of credit			48,857,727				13.86	%			39,136,778				13.35	%
Consumer loans			3,357,785				0.95	%			3,462,613				1.18	%
Commercial equipment			15,677,722				4.45	%			13,595,978				4.64	%
Total Loans			352,465,163				100.00	%			293,146,985				100.00	%
Less:
Deferred loan fees, net			553,582				0.16	%			764,374				0.26	%
Allowance for loan losses			3,258,582				0.92	%			3,057,558				1.04	%
Loans Receivable, net		$	348,652,999							$	289,325,053

The following table summarizes changes in the allowance for loan losses for the periods indicated.

		9 Months Ended				9 Months Ended
		September 30, 2005				September 30, 2004
Beginning Balance		$	3,057,558			$	2,572,799
Charge Offs			(4,468	)			(1,040	)
Recoveries			5,185				42,487
Net Recoveries			717				41,447
Additions charged to operations			200,307				316,970
Balance at end of period		$	3,258,582			$	2,931,216
Ratio of net recoveries during the period to loans			0.00	%			0.02	%

The following table provides information with respect to our non-performing assets at the dates indicated.

		Balances as of				Balances as of
		September 30, 2005				December 31, 2004
Restructured Loans		$	—			$	—
Accruing loans which are contractually past due 90 days or more:		$	—			$	—
Loans accounted for on a non-accrual basis		$	608,164			$	674,961
Total non-performing loans		$	608,164			$	674,961
Non-performing loans to total loans			0.17	%			0.23	%
Allowance for loan losses to non-performing loans			535.81	%			453.00	%

Premises and equipment increased due to the renovation of parts of the home office building and the construction of the

Prince Frederick Branch. These improvements were partially offset by depreciation. Accrued interest receivable increased by $321,837 due to increases in asset size. Investment in bank-owned life insurance increased due to income accruals. Other assets increased to $2,370,749 from $2,351,303 at December 31, 2004, due to increases in certain prepaid expenses.

Liabilities

Total liabilities increased $20,914,015, or 4.41% from $474,643,548 at December 31, 2004 to $495,557,563 at September 30, 2005. Deposit balances increased by $65,439,233, or 24.53%, for the nine months ended September 30, 2005. This increase was primarily in interest bearing deposits. Approximately $24,000,000 of the increase was due to increases in brokered deposits. Retail deposits increased as the Bank continued to focus on building local market share. Short-term borrowings decreased to $50,496,120, a decrease of $64,808,090, or 56.21%, while long-term debt increased to $97,832,221, an increase of $14,901,108 or 17.97%. Generally the Bank has decreased short-term borrowings by paying off the borrowings or replacing them with either long-term borrowings or deposits. Funding in excess of amounts used to repay short-term debt has been used to fund growth in the loan portfolio. The increase in liabilities was used to fund loan growth. On June 15, 2005, the Company completed the sale of an additional $5,000,000 in trust preferred securities. The proceeds were used to increase capital levels at the Bank. Accrued expenses increased slightly to $3,035,485. The increase was caused by increases in accrued interest expense.

Stockholders’ Equity

Stockholders’ equity increased $2,041,360, or 6.56%, to $33,164,935 at September 30, 2005 compared to $31,123,575 at December 31, 2004. Increases in equity were caused by net income of $3,093,517 for the nine-month period, the exercise of options for $166,815, and a net increase in ESOP shares of $60,395 as shares were released from the suspense account upon repayment of related loans. These increases were partially offset by cash dividends of $930,669, stock repurchases of $232,185, and unrealized holding losses of $116,512. Book value on a per share basis was $28.69 at September 30, 2005, as compared to $27.14 at December 31, 2004.

LIQUIDITY AND CAPITAL RESOURCES

The Company currently has no business other than that of the Bank and does not currently have any material funding commitments, other than the payment of dividends, the payment of dividends and principal on debentures, and the repurchase of common shares. The Company’s principal sources of liquidity are cash on hand and dividends received from the Bank. The Bank is subject to various regulatory restrictions on the payment of dividends.

The Bank’s principal sources of funds for investments and operations are net income, deposits from its primary market area, brokered deposits, advances from the Federal Home Loan Bank, principal and interest payments on loans, interest received on investment securities and proceeds from maturing investment securities. Its principal funding commitments are for the origination or purchase of loans and the payment of maturing deposits. Deposits are considered a primary source of funds supporting the Bank’s lending and investment activities. The Bank has occasionally used brokered deposits as a funding source and at September 30, 2005 approximately $24,000,000 of brokered deposits had been accepted. The Bank also uses various other wholesale funding instruments including FHLB advances and reverse repurchase agreements. The Bank may borrow up to 40% of consolidated Bank assets on a line of credit available from the FHLB. As of September 30, 2005, the maximum amount of funds available under this line would be $211 million, while outstanding advances totaled $113 million. In order to draw on this line of credit the Bank must have sufficient collateral. Qualifying collateral includes residential 1-4 family first mortgage loans, certain second mortgage loans, certain commercial real estate loans, and various investment securities. At September 30, 2005, the Bank had pledged collateral sufficient to draw $156 million under the line. In addition, the Bank has identified additional collateral of $32 million which has not been pledged.

The Bank’s most liquid assets are cash and cash equivalents, which are cash on hand, amounts due from financial institutions, federal funds sold, and money market mutual funds. The levels of such assets are dependent on the Bank’s operating, financing and investment activities at any given time. The variations in levels of cash and cash equivalents are influenced by deposit flows and anticipated future deposit flows.

At September 30, 2005, the Company had $84.4 million in loan commitments outstanding, which included $35.3 million in undisbursed construction loans, $18.6 million in unused home equity lines of credit and $30.5 million in commercial lines of credit. Certificates of deposit due within one year of September 30, 2005 totaled $98.7 million, or 57% of certificates of deposit. If these maturing deposits do not remain with us, we will be required to seek other sources of

funds including other certificates of deposit and lines of credit. The Company believes, however, based on past experience, that a significant portion of our certificates of deposit will remain with it. The Company has the ability to attract and retain deposits by adjusting the interest rates offered.

Cash, cash equivalents, and interest-bearing deposits with banks as of September 30, 2005 totaled $19,357,781, an increase of $1,642,002, or 9.27%, from the December 31, 2004 total of $17,715,779. The Bank’s principal sources of cash flows are its financing activities including deposits and borrowings. During the first three quarters in 2005, all financing activities provided $19,596,607 in cash compared to $141,740,528 for the first three quarters of 2004. The decrease in cash flows from financing activities was due to the decrease in short-term borrowings for the nine months ended September 30, 2005, compared to an increase for the nine months ended September 30, 2004. Short-term borrowing provided a net use of cash of $64,808,090 for the nine months ended September 30, 2005, compared to a source of cash of $91,508,528 for the nine months ended September 30, 2004. This decline in net cash flows from borrowing was partially offset by an increase in cash flows from net deposits in 2005. In 2005, net deposit growth was $65,439,233 compared to $29,018,383 in 2004. The issuance of trust preferred securities of $5,000,000 in 2005 also offset the uses of cash noted above.

The Bank’s principal use of cash has been its investments in loans for portfolio, investment securities and other assets. During the nine months ended September 30, 2005, the Bank invested a total of $21,809,126 compared to $145,847,415 in 2004. The principal reason for the decrease in cash used in investing activities was a decrease in the use of funds for the purchase of investments and an increase in principal collected in the sale, redemption, or principal payment of investments. In the nine-month period ended September 30, 2005, the Bank originated or acquired $157,502,581 in loans compared to $148,832,804 in 2004. This increase in the use of cash for lending was partially offset by an increase in principal collected on loans. For the nine months ended September 30, 2005, the Bank collected $98,185,118 on loans compared to $90,749,534 for the nine months ended September 30, 2004.

REGULATORY MATTERS

The Bank and Company are subject to Federal Reserve Board capital requirements as well as statutory capital requirements imposed under Maryland law. At September 30, 2005, the Bank’s tangible, leverage and risk-based capital ratios were 8.27%, 11.47% and 12.34%, respectively. These levels are in excess of the 4.0%, 4.0% and 8.0% ratios required the Federal Reserve Board as well as the 5.0%, 5.0%, and 10% ratios required to be considered well capitalized. At September 30, 2005, the Company’s tangible, leverage and risk-based capital ratios were 8.40%, 11.28% and 12.09%, respectively. These levels are also in excess of the 4.0%, 4.0% and 8.0% ratios required by the Federal Reserve Board as well as the 5.0%, 5.0%, and 10% ratios required to be considered well capitalized.

CRITICAL ACCOUNTING POLICIES

The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America and the general practices of the United States banking industry. Application of these principles requires management to make estimates, assumptions, and judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates assumptions and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, the financial statements could reflect different estimates, assumptions, and judgments. Certain policies inherently have a greater reliance on the use of estimates, assumptions and judgments and as such have a greater possibility of producing results that could be materially different than originally reported. The Company considers its determination of the allowance for loan losses and the valuation allowance on its foreclosed real estate to be critical accounting policies. Estimates, assumptions, and judgments are necessary when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset not carried on the financial statements at fair value warrants an impairment write-down or valuation reserve to be established, or when an asset or liability needs to be recorded contingent upon a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by other third-party sources, when available. When these sources are not available, management makes estimates based upon what it considers to be the best available information.

The allowance for loan losses is an estimate of the losses that may be sustained in the loan portfolio. The allowance is based on two principles of accounting: (a) Statement on Financial Accounting Standards (“SFAS”) No. 5, “Accounting for Contingencies”, which requires that losses be accrued when they are probable of occurring and are estimable and (b) SFAS No. 114, “Accounting by Creditors for Impairment of a Loan”, which requires that losses be accrued when it is probable that the Company will not collect all principal and interest payments according to the contractual terms of the

loan. The loss, if any, is determined by the difference between the loan balance and the value of collateral, the present value of expected future cash flows, or values observable in the secondary markets.

The loan loss allowance balance is an estimate based upon management’s evaluation of the loan portfolio. Generally the allowance is comprised of a specific and a general component. The specific component consists of management’s evaluation of certain loans and their underlying collateral. Loans are examined to determine the specific allowance based upon the borrower’s payment history, economic conditions specific to the loan or borrower, or other factors that would impact the borrower’s ability to repay the loan on its contractual basis. Management assesses the ability of the borrower to repay the loan based upon any information available. Depending on the assessment of the borrower’s ability to pay the loan as well as the type, condition, and amount of collateral, management will establish an allowance amount specific to the loan.

In establishing the general component of the allowance, management analyzes non-classified and non-impaired loans in the portfolio including changes in the amount and type of loans. Management also examines the Bank’s history of write-offs and recoveries within each loan category. The state of the local and national economy is also considered. Based upon these factors the Bank’s loan portfolio is categorized and a loss factor is applied to each category. These loss factors may be higher or lower than the Bank’s actual recent average losses in any particular loan category, particularly in loan categories where the Bank is rapidly increasing the size of its portfolio. Based upon these factors, the Bank will adjust the loan loss allowance by increasing or decreasing the provision for loan losses.

Management has significant discretion in making the judgments inherent in the determination of the provision and allowance for loan losses, including in connection with the valuation of collateral, a borrower’s prospects of repayment, and in establishing allowance factors on the general component of the allowance. Changes in allowance factors will have a direct impact on the amount of the provision, and a corresponding effect on net income. Errors in management’s perception and assessment of the global factors and their impact on the portfolio could result in the allowance not being adequate to cover losses in the portfolio, and may result in additional provisions or charge-offs. For additional information regarding the allowance for loan losses, refer to Notes 1 and 4 to the Consolidated Financial Statements as presented in the Company’s annual report on Form 10-K.

In addition to the loan loss allowance, the Company also maintains a valuation allowance on its foreclosed real estate. As with the allowance for loan losses the valuation allowance on foreclosed real estate is based on SFAS No. 5, “Accounting for Contingencies,” as well as SFAS No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets.” These statements require that the Company establish a valuation allowance when it has determined that the carrying amount of a foreclosed asset exceeds its fair value. Fair value of a foreclosed asset is measured by the cash flows expected to be realized from its subsequent disposition. These cash flows should be reduced for the costs of selling or otherwise disposing of the asset.

In estimating the cash flow from the sale of foreclosed real estate, management must make significant assumptions regarding the timing and amount of cash flows. In cases where the real estate acquired is undeveloped land, management must gather the best available evidence regarding the market value of the property, including appraisals, cost estimates of development, and broker opinions. Due to the highly subjective nature of this evidence, as well as the limited market, long time periods involved, and substantial risks, cash flow estimates are highly subjective and subject to change. Errors regarding any aspect of the costs or proceeds of developing, selling, or otherwise disposing of foreclosed real estate could result in the allowance being inadequate to reduce carrying costs to fair value and may require an additional provision for valuation allowances.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

Not applicable. The Company qualifies as a “small business issuer.”

ITEM 4. CONTROLS AND PROCEDURES

As of the end of the period covered by this report, management of the Company carried out an evaluation, under the supervision and with the participation of the Company’s principal executive officer and principal financial officer, of the effectiveness of the Company’s disclosure controls and procedures. Based on this evaluation, the Company’s principal executive officer and principal financial officer concluded that the Company’s disclosure controls and procedures are effective in ensuring that information required to be disclosed by the Company in reports that it files or submits under the Securities Exchange Act of 1934, as amended, (1) is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and (2) is accumulated and

communicated to the Company’s management, including its principal executive and financial officers as appropriate to allow timely decisions regarding required disclosure. It should be noted that the design of the Company’s disclosure controls and procedures is based in part upon certain reasonable assumptions about the likelihood of future events, and there can be no reasonable assurance that any design of disclosure controls and procedures will succeed in achieving its stated goals under all potential future conditions, regardless of how remote, but the Company’s principal executive and financial officers have concluded that the Company’s disclosure controls and procedures are, in fact, effective at a reasonable assurance level.

PART II — OTHER INFORMATION

Item 1 — Legal Proceedings – The Company is not involved in any legal proceedings. The Bank is not involved in any legal proceedings other than routine legal proceedings occurring in the ordinary course of business. Such routine legal proceedings, in the aggregate, are believed by management to be immaterial to the financial condition and results of operations of the Company.

Item 2 — Unregistered sales of equity securities and use of proceeds

	(a)		Not applicable
	(b)		Not applicable
	(c)		The Company did not repurchase any shares of its Common Stock during the quarter ended September 30, 2005. On October 25, 2004, Tri-County Financial Corporation announced a repurchase program under which it would repurchase approximately 5% of the outstanding shares of its stock (57,000 shares of common stock after adjusting for the three for two stock split announced at the same time). The program will continue until it is completed or terminated by the Board of Directors. At September 30, 2005, 51,708 shares may yet be repurchased under this program.

Item 3 — Default Upon Senior Securities — None

Item 4 — Submission of Matters to a Vote of Security Holders— None

Item 5 — Other Information —None.

Item 6 — Exhibits

	Exhibit 10.1	Amendment to the Community Bank of Tri-County Employment Agreement with C. Marie Brown
	Exhibit 10.2	Amendment to the Community Bank of Tri-County Employment Agreement with Gregory C. Cockerham
	Exhibit 10.3	Amendment to the Community Bank of Tri-County Employment Agreement with William J. Pasenelli
	Exhibit 31	Rule 13a-14(a) Certifications
	Exhibit 32	Section 1350 Certifications

SIGNATURES

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

     

						TRI-COUNTY FINANCIAL CORPORATION:
Date:		November 10, 2005				By:		/s/ Michael L. Middleton
								Michael L. Middleton, President and Chairman of the Board
Date:		November 10, 2005				By:		/s/ William J. Pasenelli
								William J. Pasenelli, Executive
								Vice President and Chief Financial Officer