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SMARTFINANCIAL INC. - Annual Report: 2009 (Form 10-K)

Unassociated Document
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

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

For the fiscal year ended December 31, 2009
 
OR

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

 
For transition period from __________  to  __________

Commission file number 000-30497

CORNERSTONE LOGO
(Exact Name of Registrant as Specified in its Charter)
 
Tennessee
62-1173944
(State of Incorporation)
(I.R.S. Employer Identification No.)

835 Georgia Avenue,
Chattanooga, TN  37402
(Address of principal executive offices)(Zip Code)

(423) 385-3000
(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $1.00 Par Value

Indicate by check mark if Registrant is a well known seasoned issuer, as defined in Rule 405 of the of the Securities Act.
Yeso No x

Indicate by check mark if Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.
Yes  o  No x

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities and 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 o

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (229.405 of this chapter) is not contained herein, and will not be contained, to the best of 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. o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company.  See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer o Accelerated filer o Non-accelerated filer  o Smaller reporting company x
 
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act)    
Yes o No x
 
The aggregate market value of the common stock held by non-affiliates of the Registrant on June 30, 2009 was $32 million. The market value calculation was determined using the closing sale price of the Registrant’s common stock on June 30, 2009, as reported on the OTC Bulletin Board. For purposes of this calculation, the term “affiliate” refers to all directors, executive officers and 10% shareholders of the Registrant. As of the close of business on December 31, 2009 there were 6,500,396 shares of the Registrant’s common stock outstanding.
 
DOCUMENTS INCORPORATED BY REFERENCE
 
Portions of the Registrant’s Proxy Statement for the 2010 Annual Meeting of Shareholders (the “2010 Proxy Statement”) are incorporated by reference into Part III of this Annual Report on Form 10-K to the extent described herein.
 
 
TABLE OF CONTENTS
 
Item No.
    
Page No.
PART I
  
 
  
4
ITEM 1.
  
BUSINESS
  
4
ITEM 1A.
  
RISK FACTORS
  
10
ITEM 1B.
  
UNRESOLVED STAFF COMMENTS
  
16
ITEM 2.
 
 PROPERTIES
  
16
ITEM 3.
  
LEGAL PROCEEDINGS
  
17
ITEM 4.
 
SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
  
17
PART II
  
 
  
17
ITEM 5.
  
 MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
  
17
ITEM 6.
  
SELECTED FINANCIAL DATA
  
18
ITEM 7.
  
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
  
20
ITEM 7A.
  
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
  
41
ITEM 8.
  
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
  
43
ITEM 9.
  
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
  
86
ITEM 9A(T).
  
CONTROLS AND PROCEDURES
  
86
ITEM 9B.
  
OTHER INFORMATION
  
86
PART III
  
 
  
86
ITEM 10.
  
DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
  
86
ITEM 11.
  
EXECUTIVE COMPENSATION
  
87
ITEM 12.
  
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
  
87
ITEM 13.
  
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
  
87
 
PRINCIPAL ACCOUNTANT FEES AND SERVICES
  
87
ITEM 15.
  
EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
  
88
 
2

FORWARD-LOOKING STATEMENTS

Cornerstone Bancshares, Inc. (“Cornerstone”) may from time to time make written or oral statements, including statements contained in this report (including, without limitation, certain statements in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7), that constitute forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 (the “Exchange Act”). The words “expect,” “anticipate,” “intend,” “consider,” “plan,” “believe,” “seek,” “should,” “estimate,” and similar expressions are intended to identify such forward-looking statements, but other statements may constitute forward-looking statements. These statements should be considered subject to various risks and uncertainties. Such forward-looking statements are made based upon management’s belief as well as assumptions made by, and information currently available to, management pursuant to “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. Cornerstone’s actual results may differ materially from the results anticipated in forward-looking statements due to a variety of factors. Such factors include, without limitation, those specifically described in Item 1A of Part I of this Annual Report on Form 10-K, as well as the following:  (i) unanticipated deterioration in the financial condition of borrowers resulting in significant increases in loan losses and provisions for those losses, (ii) increased competition with other financial institutions, (iii) lack of sustained growth in the economy in the Chattanooga, Tennessee area, (iv) rapid fluctuations or unanticipated changes in interest rates, (v) the inability of Cornerstone to grow its loan portfolio at historic or planned rates and (vi) changes in the legislative and regulatory environment, including compliance with the various provisions of the Sarbanes-Oxley Act of 2002. Many of such factors are beyond Cornerstone’s ability to control or predict, and readers are cautioned not to put undue reliance on such forward-looking statements. Cornerstone does not intend to update or reissue any forward-looking statements contained in this report as a result of new information or other circumstances that may become known to Cornerstone.
 
3
 
PART I

ITEM 1.  BUSINESS

OVERVIEW

Cornerstone was incorporated on September 19, 1983 under the laws of the State of Tennessee.  Cornerstone is a bank holding company registered under the Bank Holding Company Act of 1956, as amended, and was formerly known as East Ridge Bancshares, Inc.  It has one wholly-owned subsidiary: Cornerstone Community Bank, a Tennessee banking corporation (the “Bank”), which resulted from the merger of The Bank of East Ridge and Cornerstone Community Bank effective October 15, 1997.  The Bank has one wholly-owned subsidiary: Eagle Financial Inc., a Tennessee corporation (“Eagle”), created December 1, 2005 with the assets acquired from Eagle Financial, LLC, a Tennessee limited liability company, and Eagle Funding, LLC, a Nevada limited liability company.

Cornerstone

The primary activity of Cornerstone currently is, and is expected to remain for the foreseeable future, the ownership and operation of the Bank.  As a bank holding company, Cornerstone intends to facilitate the Bank’s ability to serve its customers’ requirements for financial services.  The holding company structure also provides flexibility for expansion through the possible acquisition of other financial institutions and the provision of additional banking-related services, as well as certain non-banking services, which a traditional commercial bank may not provide under present laws.  The holding company structure also affords additional flexibility in terms of capital formation and financing opportunities.  In prior years, Eagle was owned and operated by Cornerstone.  However, on June 30, 2009, Eagle was sold to the Bank.  This transaction allowed the Bank to consolidate additional capital and improve its regulatory capital position.

While Cornerstone may seek in the future to acquire additional banks or bank holding companies or to engage in other activities appropriate for bank holding companies under appropriate circumstances as permitted by law, Cornerstone currently has no plans, understandings or agreements concerning any other activities other than as described below.  The results of operations and financial condition of Cornerstone for the foreseeable future, therefore, will be determined primarily by the results of operations and financial condition of the Bank.

The Bank

The Bank is a Tennessee-chartered commercial bank established in 1985 which has its principal executive offices in Chattanooga, Tennessee. The principal business of the Bank consists of attracting deposits from the general public and investing those funds, together with funds generated from operations and from principal and interest payments on loans, primarily in commercial loans, commercial and residential real estate loans, consumer loans and residential and commercial construction loans.  Funds not invested in the loan portfolio are invested by the Bank primarily in obligations of the U.S. Government, U.S. Government agencies, various states and their political subdivisions.  In addition to deposits, sources of funds for the Bank loans and other investments include amortization and prepayment of loans, sales of loans or participations in loans, sales of its investment securities and borrowings from other financial institutions.  The principal sources of income for the Bank are interest and fees collected on loans, fees collected on deposit accounts and interest and dividends collected on other investments.  The principal expenses of the Bank are interest paid on deposits, employee compensation and benefits, office expenses and other overhead expenses.

At December 31, 2009, the Bank had five full-service banking offices located in Hamilton County, Tennessee.

In 2007, the Bank established two loan production offices (“LPO”).  The first LPO is located in Dalton, Georgia and has expanded the Bank’s presence in North Georgia.  In September 2009, the Bank closed the second LPO, which was located in Knoxville, Tennessee.

Eagle

Eagle’s business concentrates on the purchase of accounts receivable from small businesses and commercial loan placement on a conduit basis.  The principal sources of Eagle’s income are fees derived from the collection of accounts receivable and fees generated from the placement of loans with conduit financial institutions.  Eagle’s principal expenses are employee compensation and benefits, office expenses and other overhead expenses.
 
4
 
Employees

As of December 31, 2009, Cornerstone had 105 full-time equivalent employees.  The employees are not represented by a collective bargaining unit.  Cornerstone believes that its relationship with its employees is good.

Competition

All phases of the Bank’s banking activities are highly competitive.  The Bank competes actively with over 20 commercial banks, as well as finance companies, credit unions, and other financial institutions located in its service area, which includes Hamilton County, Tennessee.

The Bank’s deposits totaled approximately $405 million as of December 31, 2009.  The deposit base represents approximately 5% of the deposit base in the Chattanooga, Tennessee Metropolitan Statistical Area (MSA).  Three major regional banks represent approximately 70% of the deposits in the Chattanooga, Tennessee MSA.  These larger financial institutions have greater resources, higher lending limits than the Bank, and each of the three institutions has over 20 branches in the Chattanooga, Tennessee MSA.  There are also several credit unions located in Hamilton County, Tennessee.  Credit unions are not subject to the same income tax structure as commercial banks.  This advantage enables credit unions to offer competitive rates to potential customers.  The Bank also faces competition in certain areas of its business from mortgage banking companies, consumer finance companies, insurance companies, money market mutual funds and investment banking firms, some of which are not subject to the same degree of regulation as the Bank.

The Bank competes for deposits principally by offering depositors a variety of deposit programs with competitive interest rates, quality service and convenient locations and hours.  The Bank focuses its resources to seek out and attract small business relationships and take advantage of the Bank’s ability to provide flexible service that meets the needs of this customer class.  Management feels this market niche is the most promising business area for the future growth of the Bank.

Supervision and Regulation

Cornerstone is a bank holding company within the meaning of the Bank Holding Company Act of 1956, as amended (the “Act”), and is registered with and regulated by the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”).  Cornerstone is required to file with the Federal Reserve Board annual reports and such additional information as the Federal Reserve Board may require pursuant to the Act.  The Federal Reserve Board may also make examinations of Cornerstone and its subsidiary.  Cornerstone is also required to comply with the rules and regulations of the Securities and Exchange Commission (the “Commission”) under federal securities laws.

The Bank is a Tennessee-chartered commercial bank and is subject to the supervision and regulation of the Tennessee Department of Financial Institutions (the “TDFI”).  In addition, the Bank’s deposit accounts are insured up to applicable limits by the Deposit Insurance Fund (the “DIF”) of the Federal Deposit Insurance Corporation (the “FDIC”) and consequently, the Bank is also subject to regulation and supervision by the FDIC.  The Bank is not a member of the Federal Reserve System.

Federal and state banking laws and regulations govern all areas of the operations of Cornerstone and the Bank, including reserves, loans, mortgages, capital, issuance of securities, payment of dividends and establishment of branches.  Federal and state banking agencies also have the general authority to limit the dividends paid by insured banks if such payments should be deemed to constitute an unsafe or unsound banking practice.  The TDFI, FDIC and Federal Reserve Board have the authority to impose penalties, initiate civil and administrative actions and take other steps intended to prevent banks from engaging in unsafe or unsound practices.

FDIC Insurance of Deposit Accounts

Deposits of the Bank are insured by the FDIC to a maximum of $250,000 for each insured depositor through the DIF.  As an insurer, the FDIC issues regulations, conducts examinations and generally supervises the operations of its insured institutions (institutions insured by the FDIC hereinafter are referred to as “insured institutions”).  Any insured institution which does not operate in accordance with or conform to FDIC regulations, policies and directives, may be sanctioned for non-compliance.  For example, proceedings may be instituted against an insured institution if the institution or any director, officer or employee thereof engages in unsafe and unsound practices, is operating in an unsafe or unsound condition, or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC.  If insurance of accounts is terminated by the FDIC, the deposits in the institution will continue to be insured by the FDIC for a period of two years following the date of termination.  The FDIC recommends an annual audit by independent accountants and also periodically makes its own examinations of the Bank.  The FDIC may revalue assets of an institution, based upon appraisals and other analyses, and require establishment of general or specific reserves in amounts equal to the difference between such reevaluation and the book value of the assets.
 
5

On September 15, 1992, the FDIC approved final regulations adopting a risk-related deposit insurance system.  The risk-related regulations, which became effective January 1, 1993, resulted in a significant spread between the highest and lowest deposit insurance premiums.  Under the risk-related insurance regulations, each insured depository institution is assigned to one of three risk classifications: “well capitalized,” “adequately capitalized,” or “under capitalized.”  Within each risk classification, there are three subgroups.  Each insured depository institution is assigned to one of these subgroups within its risk classification based upon supervisory evaluations submitted to the FDIC by the institution’s primary federal regulator.  The FDIC may terminate its insurance of deposits if it finds that the institution has engaged in unsafe and unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC.

Subsequent to the enactment of the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (“FIRREA”), the FDIC issued risk-based bank capital guidelines which went into effect in stages through 1992.  In accordance with the FDIC’s risk-based standards, an institution’s assets and off-balance sheet activities are categorized into one of four risk categories, with either a 0%, 20%, 50%, or 100% amount of capital to be held against these assets.  In addition, the guidelines divide capital instruments into Tier 1 (core) capital and Tier 2 (supplementary) capital.  The risk-based capital adequacy guidelines require that (i) Tier 1 capital equal or exceed 4% of risk-weighted assets; (ii) Tier 2 capital may not exceed 100% of Tier 1 capital, although certain Tier 2 capital elements are subject to additional limitations; (iii) assets and off-balance sheet items must be weighted according to risk; and (iv) the total capital to risk-weighted assets ratio must be at least 8.0%.  The FDIC’s current leverage capital requirement requires banks receiving the highest regulatory rating based upon the FDIC’s routine examination process, to maintain Tier 1 capital equal to 3.0% of the bank’s total assets.  The FDIC may determine that an insured institution needs to maintain a higher capital level based on the institution’s particular risk profile. When determining an insured institution’s minimum capital level, the FDIC will consider whether the financial history or condition; managerial resources; the future earnings prospects; significant risks from concentrations of credit or nontraditional activities; excessive interest rate risk exposure; or a significant volume of criticized assets poses a risk to the insured institution’s capital adequacy.

Certain provisions of the Federal Reserve Act, made applicable to the Bank by Section 18(j) of the Federal Deposit Insurance Act (“FDIA”) (12 U.S.C. §1828(j)) and administered with respect to the Bank by the FDIC, establish standards for the terms of, limit the amount of, and establish collateral requirements with respect to any loans or extensions of credit to, and investments in, affiliates by the Bank as well as set arms-length criteria for such transactions and for certain other transactions (including payment by the Bank for services) between the Bank and its affiliates.  In addition, related provisions of the Federal Reserve Act and the Federal Reserve regulations (also administered with respect to the Bank by the FDIC) limit the amounts of, and establish required procedures and credit standards with respect to, loans and other extensions of credit to officers, directors and principal shareholders of the Bank and to related interests of such persons.

The FDIC may impose sanctions on any insured bank that does not operate in accordance with FDIC regulations, policies and directives.  Proceedings may be instituted against any insured bank or any director, officer or employee of the bank that is believed by the FDIC to be engaged in unsafe or unsound practices, including violation of applicable laws and regulations.  The FDIC is also empowered to assess civil penalties against companies or individuals who violate certain federal statutes, orders or regulations.  In addition, the FDIC has the authority to terminate insurance of accounts, after notice and hearing, upon a finding by the FDIC that the insured institution is or has engaged in any unsafe or unsound practice that has not been corrected, or is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule or order of, or condition imposed by, the FDIC.  Neither Cornerstone nor the Bank knows of any past or current practice, condition or violation that might lead to termination of its deposit insurance.

Although the Bank is not a member of the Federal Reserve System, it is subject to Federal Reserve Board regulations that require the Bank to maintain reserves against its transaction accounts (primarily checking accounts).  Because reserves generally must be maintained in cash or in non-interest bearing accounts, the effect of the reserve requirements is to increase the Bank’s cost of funds.  The Federal Reserve Board regulations currently require that average daily reserves be maintained against transaction accounts in the amount of 3% of the aggregate of such net transaction accounts up to $52.6 million, plus 10% of the total in excess of $52.6 million.

State of Tennessee Supervision and Regulation

As a commercial bank chartered and regulated by the TDFI, the Bank is subject to various state laws and regulations which limit the amount that can be loaned to a single borrower and the borrower’s related interests, the types of permissible investments, and geographic and new product expansion, among other things.  The Bank must submit an application to, and receive the approval of, the TDFI before opening a new branch office or merging with another financial institution.  The Commissioner of the TDFI has the authority to enforce state laws and regulations by ordering a director, officer or employee of the Bank to cease and desist from violating a law or regulation or from engaging in unsafe or unsound banking practices.

Tennessee law contains limitations on the interest rates that may be charged on various types of loans and restrictions on the nature and amount of loans that may be granted and on the type of investments which may be made.  The operations of banks are also affected by various consumer laws and regulations, including those relating to equal credit opportunity and regulation of consumer lending practices.  All Tennessee banks, including the Bank, must become and remain insured under the FDIA.
 
6

State banks are subject to regulation by the TDFI with regard to capital requirements and the payment of dividends.  Tennessee has adopted the provisions of the Federal Reserve Board’s Regulation O with respect to restrictions on loans and other extensions of credit to bank “insiders”.  Further, under Tennessee law, state banks are prohibited from lending to any one person, firm or corporation amounts more than fifteen percent (15%) of the bank’s equity capital accounts, except (i) in the case of certain loans secured by negotiable title documents covering readily marketable nonperishable staples, or (ii) with the prior approval of the bank’s board of directors or finance committee (however titled), the bank may make a loan to any person, firm or corporation of up to twenty-five percent (25%) of its equity capital accounts.  Tennessee law requires that dividends be paid only from retained earnings (or undivided profits) except that dividends may be paid from capital surplus with the prior, written consent of the TDFI.  Tennessee laws regulating banks require certain charges against and transfers from an institution’s undivided profits account before undivided profits can be made available for the payment of dividends.

Federal Supervision and Regulation

Cornerstone is regularly examined by the Federal Reserve Board, and the Bank is supervised and examined by the FDIC.  Cornerstone is required to file with the Federal Reserve Board annual reports and other information regarding its business operations and the business operations of the Bank. Approval of the Federal Reserve Board is required before Cornerstone may acquire, directly or indirectly, ownership or control of the voting shares of any bank, if, after such acquisition, Cornerstone would own or control, directly or indirectly, more than 5% of the voting stock of the bank.  In addition, pursuant to the provisions of the Act and the regulations promulgated thereunder, Cornerstone may only engage in, or own or control companies that engage in, activities deemed by the Federal Reserve Board to be so closely related to banking as to be a proper incident thereto.

The Bank and Cornerstone are “affiliated” within the meaning of the Act.  Certain provisions of the Act establish standards for the terms of, limit the amount of, and establish collateral requirements with respect to, any loans or extensions of credit to, and investments in, affiliates by the Bank, as well as set arms-length criteria for such transactions and for certain other transactions (including payment by the Bank for services under any contract) between the Bank and its affiliates.  In addition, related provisions of the Act and the regulations promulgated under the Act limit the amounts of, and establish required procedures and credit standards with respect to, loans and other extensions of credit to officers, directors, and principal shareholders of the Bank, Cornerstone and any other subsidiary of Cornerstone, and to related interests of such persons.

In addition to the banking regulations imposed on Cornerstone, the offer and sale of securities of Cornerstone, as well as the securities of the Bank, is subject to compliance with applicable federal and state securities laws.  Accordingly, any such offering must be registered under both the Securities Act of 1933 (the “Securities Act”) and applicable state securities laws or qualify for exemptions from such requirements.

Under Section 106(b) of the 1970 Amendments to the Act (12 U.S.C. § 1972), the Bank is prohibited from extending credit, selling or leasing property or furnishing any service to any customer on the condition or requirement that the customer (i) obtain any additional property, service or credit from Cornerstone, the Bank (other than a loan, discount, deposit, or trust service) or any other subsidiary of Cornerstone; (ii) refrain from obtaining any property, credit or service from any competitor of Cornerstone, the Bank or any subsidiary of Cornerstone; or (iii) provide any credit, property or service to Cornerstone, the Bank (other than those related to and usually provided in connection with a loan, discount, deposit or trust service) or any subsidiary of Cornerstone.

Most bank holding companies are required to give the Federal Reserve Board prior written notice of any purchase or redemption of their outstanding equity securities if the gross consideration for the purchase or redemption, when combined with the net consideration paid for all such purchases or redemptions during the preceding 12 months, is equal to 10% or more of the bank holding company’s consolidated net worth.  The Federal Reserve Board may disapprove such a purchase or redemption if it determines that the proposal constitutes an unsafe or unsound practice that would violate any law, regulation, Federal Reserve Board order or directive or any condition imposed by, or written agreement with, the Federal Reserve Board.  The prior notice requirement does not apply to certain “well-capitalized” bank holding companies that meet specified criteria.

In November 1985, the Federal Reserve Board adopted its Policy Statement on Cash Dividends Not Fully Covered by Earnings.  The Policy Statement sets forth various guidelines that the Federal Reserve Board believes that a bank holding company should follow in establishing its dividend policy.  In general, the Federal Reserve Board stated that bank holding companies should not pay dividends except out of current earnings and unless the prospective rate of earnings retention by the holding company appears consistent with its capital needs, asset quality and overall financial condition.
 
7

Legislation Affecting Cornerstone and the Bank

The following information describes certain statutory and regulatory provisions affecting Cornerstone and the Bank and is qualified in its entirety by reference to such statutory and regulatory provisions.

FIRREA and FDICIA

Far-reaching legislation, including FIRREA and the Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”) have for years impacted the business of banking.  FIRREA primarily affected the regulation of savings institutions rather than the regulation of commercial banks and bank holding companies like the Bank and Cornerstone, but did include provisions affecting deposit insurance premiums, acquisitions of thrifts by banks and bank holding companies, liability of commonly controlled depository institutions, receivership and conservatorship rights and procedures and substantially increased penalties for violations of banking statutes, regulations and orders.

FDICIA resulted in extensive changes to the federal banking laws.  The primary purpose of FDICIA was to authorize additional borrowings by the FDIC in order to assist in the resolution of failed and failing financial institutions.  However, the law also instituted certain changes to the supervisory process and contained various provisions affecting the operations of banks and bank holding companies.

The additional supervisory powers and regulations mandated by FDICIA, include a “prompt corrective action” program based upon five regulatory zones for banks, in which all banks are placed largely based on their capital positions.  Regulators are permitted to take increasingly harsh action as a bank’s financial condition declines.  Regulators are also empowered to place in receivership or require the sale of a bank to another depository institution when a bank’s capital leverage ratio reaches two percent.  Better capitalized institutions are generally subject to less onerous regulation and supervision than banks with lesser amounts of capital.  The FDIC has adopted regulations implementing the prompt corrective action provisions of the FDICIA, which place financial institutions in the following five categories based upon capitalization ratios: (1) a “well capitalized” institution has a total risk-based capital ratio of at least 10%, a Tier 1 risk-based ratio of at least 6% and a leverage ratio of at least 5%; (2) an “adequately capitalized” institution has a total risk-based ratio of at least 8%, a Tier 1 risk-based ratio of at least 4% and a leverage ratio of at least 4%; (3) an “undercapitalized” institution has a total risk-based capital ratio of under 8%, a Tier 1 risk-based capital ratio of under 4% or a leverage ratio of under 4%; (4) a “significantly undercapitalized” institution has a total risk-based capital ratio of under 6%, a Tier 1 risk-based ratio of under 3% or a leverage ratio of under 3%; and (5) a “critically undercapitalized” institution has a leverage ratio of 2% or less.  Institutions in any of the three undercapitalized categories would be prohibited from declaring dividends or making capital distributions.  The proposed regulations also establish procedures for “downgrading” an institution to a lower capital category based on supervisory factors other than capital.  Various other sections of the FDICIA impose substantial audit and reporting requirements and increase the role of independent accountants and outside directors.  Set forth below is a list containing certain significant provisions of the FDICIA:

 
§
annual on-site examinations by regulators (except for smaller, well-capitalized banks with high management ratings, which must be examined every 18 months);
     
 
§
mandated annual independent audits by independent public accountants and an independent audit committee of outside directors for institutions with more than $500,000,000 in assets;
     
 
§
new uniform disclosure requirements for interest rates and terms of deposit accounts;
     
 
§
a requirement that the FDIC establish a risk-based deposit insurance assessment system;
     
 
§
authorization for the FDIC to impose one or more special assessments on its insured banks to recapitalize the Bank Insurance Fund (now called the Deposit Insurance Fund);
     
 
§
a requirement that each institution submit to its primary regulators an annual report on its financial condition and management, which report will be available to the public;
     
 
§
a ban on the acceptance of brokered deposits except by well capitalized institutions and by adequately capitalized institutions with the permission of the FDIC and the regulation of the brokered deposit market by the FDIC;
     
 
§
restrictions on the activities engaged in by state banks and their subsidiaries as principal, including insurance underwriting, to the same activities permissible for national banks and their subsidiaries unless the state bank is well capitalized and a determination is made by the FDIC that the activities do not pose a significant risk to the insurance fund;
     
 
§
a review by each regulatory agency of accounting principles applicable to reports or statements required to be filed with federal banking agencies and a mandate to devise uniform requirements for all such filings;
     
 
§
the institution by each regulatory agency of noncapital safety and soundness standards for each institution it regulates which cover (1) internal controls, (2) loan documentation, (3) credit underwriting, (4) interest rate exposure, (5) asset growth, (6) compensation, fees and benefits paid to employees, officers and directors, (7) operational and managerial standards, and (8) asset quality, earnings and stock valuation standards for preserving a minimum ratio of market value to book value for publicly traded shares (if feasible);
     
 
§
uniform regulations regarding real estate lending; and
     
 
§
a review by each regulatory agency of the risk-based capital rules to ensure they take into account adequate interest rate risk, concentration of credit risk, and the risks of non-traditional activities.
 
8
 
Gramm-Leach-Bliley Act

The activities permissible to Cornerstone and the Bank were substantially expanded by the Gramm-Leach-Bliley Act (the “Gramm Act”).  The Gramm Act repeals the anti-affiliation provisions of the Glass-Steagall Act to permit the common ownership of commercial banks, investment banks and insurance companies.  The Gramm Act amended the Act to permit a financial holding company to engage in any activity and acquire and retain any company that the Federal Reserve Board determines to be (i) financial in nature or incidental to such financial activity, or (ii) complementary to a financial activity and that does not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally.  The Gramm Act also modifies current law relating to financial privacy and community reinvestment.  The new financial privacy provisions generally prohibit financial institutions, including the Bank and Cornerstone, from disclosing nonpublic personal financial information to third parties unless customers have the opportunity to “opt out” of the disclosure.

Temporary Liquidity Guarantee Program

On November 21, 2008, the Board of Directors of the FDIC adopted a final rule relating to the Temporary Liquidity Guarantee Program (“TLGP”).  The TLGP was announced by the FDIC on October 14, 2008, preceded by the determination of systemic risk by the U.S. Treasury, as an initiative to counter the system-wide crisis in the nation’s financial sector.  Under the TLGP, the FDIC will (i) guarantee, through the earlier of maturity or June 30, 2012, certain newly issued senior unsecured debt issued by participating institutions and (ii) provide unlimited FDIC deposit insurance coverage for noninterest bearing transaction deposit accounts, Negotiable Order of Withdrawal Accounts (commonly known as NOW accounts) paying less than 0.5% interest per annum and Interest on Lawyers Trust Accounts (commonly known as IOLTA) held at participating FDIC-insured institutions through June 30, 2010.  Coverage under the TLG Program was available for the first 30 days without charge.  The fee assessment for coverage of senior unsecured debt ranges from 50 basis points to 100 basis points per annum, depending on the initial maturity of the debt.  The fee assessment for deposit insurance coverage is 10 basis points per quarter on amounts in covered accounts exceeding $250,000.  The Bank elected to participate in the unlimited deposit insurance coverage for noninterest bearing transaction deposit accounts, but declined to participate in the senior unsecured debt guarantee coverage.

Future Legislation

Legislation is regularly introduced in both the United States Congress and the Tennessee General Assembly that contains wide-ranging proposals for altering the structures, regulations and competitive relationships of the nation’s financial institutions.  Such legislation may change banking statutes and the operating environment of Cornerstone and/or the Bank in substantial and unpredictable ways and could increase or decrease the cost of doing business, limit or expand permissible activities or affect the competitive balance, depending upon whether any of this potential legislation will be enacted and, if enacted, the effect that it or any implementing regulations would have on the financial condition or results of operations of Cornerstone and/or the Bank.

Financial Regulatory Reform Legislation – General

Financial regulatory reform legislation pending in the United States Congress may impact all regulated financial institutions, including Cornerstone and the Bank. Bills pending include the “Wall Street Reform and Consumer Protection Act of 2009,” which passed the House of Representatives on December 11, 2009 (the “Wall Street Reform Act”). This bill included the provisions of the “Corporate and Financial Institution Compensation Fairness Act of 2009 (the “Compensation Fairness Act” ), which the House previously passed on July 31, 2009. Examples of provisions in pending legislation follow but are not intended to be all inclusive.

Say on Pay and Say on Parachutes Provisions

The Compensation Fairness Act incorporated the principal aspects of the Obama administration’s legislative proposal on executive compensation and includes corporate governance provisions commonly referred to as “Say on Pay,” and “Say on Parachutes.” The “Say on Pay” provisions apply to all companies that distribute proxies subject to the Commission’s proxy rules. “Say on Pay” requires companies to have an annual stockholder vote to approve the company’s executive compensation and related compensation disclosure. The stockholder vote is advisory only, and the new legislation would not impose any new fiduciary duties on the company’s board of directors. If the “Say on Pay” provisions of the Wall Street Reform Act become part of the final legislation, this practice will be mandatory for all companies subject to the Commission’s proxy rules, including Cornerstone.
 
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The Wall Street Reform Act also contains “Say on Parachutes” provisions that are similar to the “Say on Pay” rules. Under the Wall Street Reform Act’s version of “Say on Parachutes,” whenever a company asks stockholders to approve an acquisition, merger, consolidation, or proposed sale or other disposition of all or substantially all of the company’s assets, these companies must propose a stockholder vote to approve any agreement or understanding with certain executive officers concerning any type of compensation, whether present, deferred or contingent based on or related to the proposed transaction. The stockholder vote would be advisory and would not impose new fiduciary duties on directors.

Compensation Committee; Compensation Advisors

The Wall Street Reform Act in its current form requires all companies that have a stock-exchange listing or stock-exchange listed equity to establish a compensation committee that is composed exclusively of independent directors. While federal securities laws, federal tax law, and stock exchange rules already contain definitions of director independence, the bills before Congress may result in a new and more stringent definition of independence for this purpose.

The Wall Street Reform Act and other bills would require that companies grant the board’s compensation committee the power to retain its own independent advisors. The expenses of these advisors would be borne by the company at the discretion of the compensation committee.

Proxy Access

The Wall Street Reform Act and other bills before Congress authorize the Commission to promulgate proxy access rules that allow stockholders to have their director nominees included in the company’s proxy materials.

Consumer Financial Protection Agency

The Wall Street Reform Act creates a new Consumer Financial Protection Agency (the “Agency”) as an independent executive agency to regulate the provision of consumer financial products or services, including (i) the Electronic Funds Transfer Act; (ii) the Equal Credit Opportunity Act; (iii) provisions of the Fair Credit Reporting Act; (iv) the Fair Debt Collection Practices Act; (v) the Home Mortgage Disclosure Act; (vi) the Real Estate Settlement Procedures Act; (vii) the Truth in Lending Act; and (viii) the Truth in Savings Act.

The Wall Street Reform Act further transfers to the Agency authorities concerning consumer financial protection functions of the Federal Reserve, the Comptroller of the Currency, the Director of the Office of Thrift Supervision, the FDIC, the Federal Trade Commission, and the National Credit Union Administration.

Because the exact scope of the Agency’s powers and priorities are not yet well-defined, Cornerstone cannot yet predict the impact of the formation of this new regulator on the conduct of Cornerstone’s and the Bank’s businesses.

ITEM 1A. RISK FACTORS

Investing in our common stock involves various risks which are particular to Cornerstone, its industry and its market area.  Several risk factors regarding investing in our common stock are discussed below.  This listing should not be considered as all-inclusive.  If any of the following risks were to occur, we may not be able to conduct our business as currently planned and our financial condition or operating results could be negatively impacted.  These matters could cause the trading price of our common stock to decline in future periods.

There are substantial doubts as to Cornerstone’s ability to continue as a going concern.

In its report dated March 29, 2010, Cornerstone’s independent registered public accounting firm stated that uncertainty regarding Cornerstone’s holding company loans raises substantial doubt about Cornerstone’s ability to continue as a going concern.  In that firm’s opinion, such doubt arises from Cornerstone’s failure to comply with certain debt covenants under two loans totaling approximately $5.4 million and secured by a pledge of all of the Bank’s common stock.  If Cornerstone is unable to comply with such covenants or obtain a waiver from the lender for such violations, the lender may declare the loans in default and take possession of the Bank’s common stock.  If this event were to occur, Cornerstone’s assets and operations would be substantially reduced and therefore its ability to continue as a going concern would be in substantial doubt.  The Board of Directors and management are actively considering strategic alternatives, which may include a capital infusion through the issuance and sale of common stock, preferred stock or other securities (including securities convertible into shares of common stock) in public or private offerings, to provide sufficient proceeds to Cornerstone to pay off the holding company debt.  Cornerstone can give no assurance that any such alternative, if and once consummated, will provide greater value to shareholders than that reflected in the current stock price.  In addition, to the extent such alternatives involve equity financing, as presently anticipated, it could result in substantial dilution to current shareholders and could adversely affect the price of Cornerstone’s common stock.  The going concern risk is discussed further in Item 7 herein (Management’s Discussion and Analysis of Financial Condition and Results of Operations) and in footnote 2 to Cornerstone’s audited consolidated financial statements in Item 8 herein.
 
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Cornerstone may face risks with respect to future expansion.

From time to time Cornerstone may engage in additional de novo branch expansion as well as the acquisition of other financial institutions or parts of those institutions. Cornerstone may also consider and enter into new lines of business or offer new products or services. In addition, Cornerstone may receive future inquiries and have discussions regarding an acquisition. Acquisitions and mergers involve a number of risks, including:
 
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the time and costs associated with identifying and evaluating potential acquisitions and merger partners;
     
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inaccuracies in the estimates and judgments used to evaluate credit, operations, management and market risks with respect to the target institution;  
     
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the time and costs of evaluating new markets, hiring experienced local management and opening new offices, and the time lags between these activities and the generation of sufficient assets and deposits to support the costs of the expansion;  
     
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Cornerstone’s ability to finance an acquisition and possible dilution to its existing shareholders;  
     
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the diversion of Cornerstone’s management’s attention to the negotiation of a transaction, and the integration of the operations and personnel of the combining businesses;  
     
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entry into new markets where Cornerstone lacks experience;  
     
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the introduction of new products and services into Cornerstone’s business;  
     
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the incurrence and possible impairment of goodwill associated with an acquisition and possible adverse short-term effects on Cornerstone’s results of operations; and  
     
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the risk of loss of key employees and customers.
 
Cornerstone may incur substantial costs to expand. There can be no assurance that integration efforts for any future mergers or acquisitions will be successful. Also, Cornerstone may issue equity securities, including common stock and securities convertible into shares of Cornerstone’s common stock in connection with future acquisitions, which could cause ownership and economic dilution to Cornerstone’s shareholders. There is no assurance that, following any future mergers or acquisitions, Cornerstone’s integration efforts will be successful or after giving effect to the acquisition, will achieve profits comparable to or better than its historical experience.
 
Cornerstone’s success depends significantly upon economic conditions in the local markets where the Bank operates.

Substantially all of the Bank’s loan and deposit customers live, work and bank in the Chattanooga, Tennessee MSA. As a result, the success of the Bank and, in turn, Cornerstone depends upon a sound local economy to provide opportunities for new business ventures, increased loan demand and the need for deposit services. Cornerstone’s profitability is impacted by these local factors as well as general economic conditions and interest rates. For example, Cornerstone’s earnings may be negatively impacted by increases in unemployment rates or reductions in population, income levels, deposits and housing starts. Adverse economic conditions in the local markets where the Bank operates may reduce its growth rate and diminish the ability of its customers to service their loan obligations. A prolonged economic downturn could also negatively impact collateral values or cash flows of borrowing businesses, and as a result the Bank’s primary source of repayment could be insufficient to service the debt. In addition, adverse consequences to the Bank (and, consequently, to Cornerstone) in the event of a prolonged economic downturn in its local markets could be compounded by the fact that many of the Bank’s commercial and real estate loans are secured by real estate located in those market areas. Significant decline in real estate values in these market areas would mean that the collateral for many of the Bank’s loans would provide less security. As a result, the Bank would be more likely to suffer losses on defaulted loans because its ability to fully recover on defaulted loans by selling the real estate collateral would be diminished. Adverse economic conditions in the Bank’s local markets, including sustained periods of increased payment delinquencies, foreclosures or losses in the State of Tennessee or the State of Georgia, could impair the Bank’s ability to collect loans and could otherwise have a negative effect on the Bank’s and Cornerstone’s assets, revenues, results of operations and financial condition.

Continuing negative developments in the financial services industry and U.S. and global capital and credit markets may lead to additional regulation and further deterioration of Cornerstone’s results of operations and financial condition.

Negative developments in the capital and credit markets during 2008 and 2009 have resulted in uncertainty in the financial markets.  It is anticipated that these negative economic developments will continue into 2010.  Financial institutions across the United States, including the Bank, have experienced deteriorating asset quality.  Loan portfolios include impaired loans to businesses struggling to stay in operation or achieve adequate cash flow. A decline in collateral values supporting these loans have also impacted the ability of businesses or consumers to obtain loans or increased financial institutions’ losses in the event of foreclosure and liquidation.  At the same time financial institutions have experienced concerns regarding liquidity.  This concern has increased the competition for deposits in Cornerstone’s local market as well as wholesale funding options.  These events have impacted Cornerstone’s, as well as other bank holding companies’, stock prices.  The potential impact of these events may be an expansion of existing or creation of new federal or state laws and regulations regarding lending and funding practices, liquidity standards and compliance issues.  Continued negative developments or Cornerstone’s inability to respond to these new operating and regulatory requirements could further negatively impact Cornerstone’s results of operations.  The negative consequences could limit Cornerstone’s ability to originate new loans or obtain adequate funding or increase costs associated with regulatory compliance.   Ultimately, these changes could result in modifications to Cornerstone’s existing or future strategic plans, capital requirements, compensation, financial performance and/or stock performance.
 
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There can be no assurance that recently enacted legislation will stabilize the U.S. financial system.

Under the Temporary Liquidity Guarantee Program (“TLGP”) the FDIC may offer a guarantee of certain financial institution indebtedness in exchange for an insurance premium to be paid to the FDIC by issuing financial institutions.  Participation in the TLGP likely will require the payment of additional insurance premiums to the FDIC.  We may be required to pay higher FDIC premiums than those published for 2009 because market developments have depleted the deposit insurance fund of the FDIC and reduced the ratio of reserves to insured deposits.  The U.S. Congress enacted the Emergency Economic Stabilization Act of 2008 (“EESA”) in response to the impact of the volatility and disruption in the capital and credit markets on the financial sector.  The U.S. Department of the Treasury (“U.S. Treasury”) and the federal banking regulators implemented a number of programs under this legislation to address these conditions and the asset quality, capital and liquidity issues they have caused for certain financial institutions and to improve the general availability of credit for consumers and businesses.  In addition, the U.S. Congress enacted the American Recovery and Reinvestment Act of 2009 (“ARRA”) in an effort to save and create jobs, stimulate the U.S. economy and promote long-term growth and stability.  The EESA and ARRA have been followed by numerous actions by the Federal Reserve, the U.S. Congress, the U.S. Treasury, the FDIC, the Commission and others to address the liquidity and credit crisis that followed the sub-prime meltdown. These measures include homeowner relief that encourages loan restructuring and modification; the establishment of significant liquidity and credit facilities for financial institutions and investment banks; the lowering of the federal funds rate; emergency action against short selling practices; a temporary guaranty program for money market funds; the establishment of a commercial paper funding facility to provide back-stop liquidity to commercial paper issuers; and coordinated international efforts to address illiquidity and other weaknesses in the banking sector. The purpose of these legislative and regulatory actions is to stabilize the U.S. financial system. The TLGP, the EESA, the ARRA and the other regulatory initiatives described above may not have their desired effects. If the volatility in the markets continues and economic conditions fail to improve or worsen, Cornerstone’s business, financial condition, results of operations and/or access to credit, as well as the trading price of its common stock, could be materially and adversely affected.

Cornerstone cannot fully predict the impact of future legislation on its and the Bank’s businesses.

Financial regulatory reform legislation pending in the U.S. Congress may impact all regulated financial institutions, including Cornerstone and the Bank. Bills pending include, among others, the “Wall Street Reform and Consumer Protection Act of 2009,” which passed the House of Representatives on December 11, 2009 (the “Wall Street Reform Act”). This bill included the provisions of the “Corporate and Financial Institution Compensation Fairness Act of 2009 (the “Compensation Fairness Act”), which the House previously passed on July 31, 2009. The proposed legislation in its current form includes changes in corporate governance and executive compensation that may impact how Cornerstone currently does business. The Wall Street Reform Act also creates a new Consumer Financial Protection Agency (the “Agency”) as an independent executive agency to regulate the provision of consumer financial products or services. The Wall Street Reform Act further transfers to the Agency authorities concerning consumer financial protection functions of the Federal Reserve, the Comptroller of the Currency, the Director of the Office of Thrift Supervision, the FDIC, the Federal Trade Commission, and the National Credit Union Administration.  Because the exact scope of the Agency’s powers and priorities are not yet well-defined, Cornerstone cannot yet predict the impact of the formation of this new regulator on the conduct of its and the Bank’s businesses and whether Cornerstone’s costs associated with compliance with consumer protection laws and regulations will increase.

Cornerstone and the Bank are subject to federal and state regulations that impact their operations and financial performance.

Cornerstone and the Bank operate in a highly regulated industry and are subject to examination, supervision and comprehensive regulation by various federal and state agencies, including the Federal Reserve Board, the FDIC and the TDFI. Compliance with the numerous banking regulations is costly and requires investment in human and information technology resources. Certain activities of Cornerstone and/or the Bank, such as the payment of dividends, mergers and acquisitions, investments, loans and interest rates charged, interest rates paid on deposits and locations of offices, are impacted by these regulations. The Bank is also subject to capitalization guidelines established by its regulators, which require it to maintain adequate capital to support its growth.
 
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The laws and regulations applicable to the banking industry are subject to change at any time. Cornerstone cannot predict the events that will result in regulatory changes nor their impact on the banking industry in general and Cornerstone and the Bank in particular. Because government regulation greatly affects the business and financial results of all commercial banks and bank holding companies, the cost of compliance for Cornerstone and the Bank could adversely affect their ability to operate profitably.

The Sarbanes-Oxley Act of 2002, and the related rules and regulations promulgated by the Commission, have increased the scope, complexity and cost of corporate governance, reporting and disclosure practices. As a result, Cornerstone has experienced, and may continue to experience, greater compliance costs.

As of December 31, 2009, the most recent notification from the Federal Deposit Insurance Corporation (FDIC) categorized the Bank as adequately capitalized under the regulatory framework for prompt corrective action.  To be categorized as well capitalized, an institution must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios.

In situations similar to the Bank’s the FDIC has been known to issue Consent Orders that have contained one or more of the following provisions: a requirement to augment capital; a requirement to closely monitor criticized assets; a requirement to closely monitor and manage liquidity; and other similar requirements.  If the Bank were to be presented with such a supervisory agreement, the Bank’s Board of Directors would likely consent to its terms.

The Bank’s  loan portfolio includes an elevated, although declining level, of residential construction and land development loans, which have a greater credit risk than residential mortgage loans.

The Bank engages in residential construction and land development loans to developers. This type of lending is generally considered to have more complex credit risks than traditional single-family residential lending because the principal is concentrated in a limited number of loans with repayment dependent on the successful operation of the related real estate project. Consequently, these loans are more sensitive to the current adverse conditions in the real estate market and the general economy. These loans are generally less predictable and more difficult to evaluate and monitor and collateral may be difficult to dispose of in a market decline. Furthermore, during adverse general economic conditions, such as are now being experienced in residential real estate construction nationwide, borrowers involved in the residential real estate construction and development business may suffer above normal financial strain. Throughout 2009, the number of newly constructed homes or lots sold in the Bank’s market areas has continued to decline, negatively affecting collateral values. As the residential real estate development and construction market in the Bank’s markets has deteriorated, the Bank’s borrowers in this segment have begun to experience difficulty repaying their obligations to the Bank. As a result, the Bank’s loans to these borrowers have deteriorated and may deteriorate further and may result in additional charge-offs negatively impacting the Bank’s (and consequently, Cornerstone’s) results of operations. Additionally, to the extent repayment is dependent upon the sale of newly constructed homes or lots, such sales are likely to be at lower prices or at a slower rate than was expected when the loan was made, which may result in such loans being placed on non-accrual status and subject to higher loss estimates even if the borrower keeps interest payments current. These adverse economic and real estate market conditions may lead to further increases in non-performing loans and other real estate owned, increased charge-offs from the disposition of non-performing assets, and increases in provision for loan losses, all of which would negatively impact the Bank’s (and, consequently, Cornerstone’s) financial condition and results of operations.

If the Bank’s asset quality continues to decline or it continues to experience greater loan losses than anticipated, the earnings and overall financial condition of the Bank and Cornerstone will be adversely affected even further.

The assets of Cornerstone and the Bank are primarily comprised of loans. The risk of credit losses on loans varies with, among other things, general economic conditions, the type of loan being made, the creditworthiness of the borrower over the term of the loan and, in the case of a collateralized loan, the value and marketability of the collateral for the loan. While the risk of nonpayment of loans is inherent in banking, the Bank has experienced higher nonpayment levels than it anticipated, which has had a significant adverse effect on its (and, consequently, Cornerstone’s) earnings and overall financial condition. Although the Bank has taken actions to prevent further decline, including the creation of a special asset committee to develop and review action plans for minimizing loan losses and the dedication of resources to assist in the collection and recovery process, there can be no assurance that the outcome of such actions will be successful. To minimize the likelihood of a substandard loan portfolio, the Bank assesses the credit worthiness of customers and performs collateral valuations. Management also maintains an allowance for loan losses based upon, among other things, historical experience and an evaluation of economic conditions and regular reviews of delinquencies and loan portfolio quality. Based upon such factors, management makes various assumptions and judgments about the ultimate collectability of the loan portfolio and provides an allowance for loan losses based upon a percentage of the outstanding balances and takes a charge against earnings with respect to specific loans when their ultimate collectability is considered questionable. If management’s assumptions and judgments prove to be incorrect and the allowance for loan losses is inadequate to absorb losses, or if regulatory authorities require the Bank to increase its allowance for loan losses as a part of their examination process, additional provision expense would be incurred and the earnings and capital of the Bank and Cornerstone could be significantly and adversely affected. For example, as previously reported, for the third quarter of 2009 the Bank was required to fund an additional provision of $1.625 million for loan losses following a joint examination of the Bank by the FDIC and the TDFI, and for the fourth quarter of 2009 the Bank provided $4.15 million of additional provision for loan losses after charging off possible losses and writing off other real estate losses. Moreover, additions to the allowance may be necessary based on changes in economic and real estate market conditions, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of management’s control. These additions may require increased provision expense which would negatively impact Cornerstone’s results of operations.
 
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Cornerstone has increased levels of other real estate, primarily as a result of foreclosures.

As the Bank has begun to resolve non-performing real estate loans, Cornerstone has increased the level of foreclosed properties, primarily those acquired from builders and from residential land developers. Foreclosed real estate expense consists of three types of charges: maintenance costs, valuation adjustments due to new appraisal values and gains or losses on disposition. As levels of other real estate increase and also as local real estate values decline, these charges will likely increase, negatively affecting Cornerstone’s results of operations.

The Bank may require additional capital which may not be able to be obtained.

The Bank may require capital from sources other than earnings generation. In November 2009, the FDIC downgraded the Bank’s status to an “adequately capitalized” institution, which, among other things, restricts the interest rates payable by the Bank for time deposits. To restore the Bank’s status as a “well capitalized” institution, Cornerstone intends to provide capital to the Bank through additional sources, which may include additional equity investments, public or private offerings of common stock (including securities convertible into common stock), preferred stock or trust preferred securities, borrowed funds or any combination of these sources of funds. Cornerstone’s ability to access these alternative capital sources may be limited due to regulatory restrictions or the condition of the capital markets. Therefore, Cornerstone’s ability to rebuild the Bank’s capital reserves may be impaired.

Liquidity needs could adversely affect Cornerstone’s results of operations and financial condition.

Cornerstone relies on dividends from the Bank as its primary source of funds. However, in November 2009, following the conclusion of a joint examination of the Bank by the FDIC and the TDFI, the FDIC placed restrictions on the Bank’s ability to pay cash dividends, requiring that the Bank first obtain a non-objection from the FDIC. Furthermore, the majority of the Bank’s funds are comprised of customer deposits and loan repayments. While scheduled loan repayments are a relatively stable source of funds, they are subject to the ability of borrowers to repay the loans. The repayment of loans can be adversely affected by a number of factors, including changes in economic conditions, adverse trends or events affecting business industry groups, reductions in real estate values or markets, business closings or lay-offs, inclement weather, natural disasters and international instability. Additionally, deposit levels may be affected by a number of factors, including rates paid by competitors, general interest rate levels, returns available to customers on alternative investments and general economic conditions. Accordingly, Cornerstone currently is, and may from time to time in the future be, required to rely on secondary sources of liquidity to meet withdrawal demands or otherwise fund operations. Alternative sources include advances from the Federal Home Loan Bank and federal funds lines of credit from correspondent banks. While Cornerstone believes that these sources are currently adequate, there can be no assurance they will be sufficient to meet future liquidity demands. Cornerstone may be required to slow or discontinue loan growth, capital expenditures or other investments or liquidate assets if these alternative sources are not adequate.

The Bank has a significant deferred tax asset and cannot assure you that it will be fully realized.

The Bank has net deferred tax assets of $551 thousand as of December 31, 2009. The Bank did not establish a valuation allowance against its federal net deferred tax assets as of December 31, 2009 because it believes that it is more likely than not that all of these assets will be realized. In evaluating the need for a valuation allowance, the Bank estimated future taxable income based on management prepared forecasts. This process required significant judgment by management about matters that are by nature uncertain. If future events differ significantly from current forecasts, the Bank may need to establish a valuation allowance, which could have a material temporary adverse effect on its results of operations and financial condition.

A decline in Cornerstone’s stock price or expected future cash flows, or a material adverse change in our results of operations or prospects, could result in impairment of our goodwill.

A significant and sustained decline in Cornerstone’s stock price and market capitalization below book value, a significant decline in our expected future cash flows, a significant adverse change in the business climate, slower growth rates or other factors could result in impairment of our goodwill. If Cornerstone were to conclude that a write-down of goodwill is necessary, then the appropriate charge would likely cause a material loss.
 
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Competition from financial institutions and other financial service providers may adversely affect Cornerstone’s profitability.

The banking business is highly competitive and the Bank experiences competition in each of its markets from many other financial institutions. The Bank competes with other commercial banks, credit unions, savings and loan associations, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market funds, and other mutual funds, as well as other community banks and super-regional and national financial institutions that operate offices in the Bank’s primary market areas and elsewhere.

Additionally, the Bank faces competition from de novo community banks, including those with senior management who were previously affiliated with other local or regional banks or those controlled by investor groups with strong local business and community ties. These de novo community banks may offer higher deposit rates or lower cost loans in an effort to attract the Bank’s customers, and may attempt to hire the Bank’s management and employees.

The Bank competes with these other financial institutions both in attracting deposits and in making loans. In addition, the Bank has to attract its customer base from other existing financial institutions and from new residents. The Bank expects competition to increase in the future as a result of legislative, regulatory and technological changes and the continuing trend of consolidation in the financial services industry.

Cornerstone may issue common stock or other equity securities in the future which could dilute the ownership interest of existing shareholders.

In order to maintain capital at desired or regulatory-required levels or to replace existing capital, Cornerstone may be required to issue shares of common stock, preferred stock or other securities, including securities convertible into, exchangeable for or representing rights to acquire shares of common stock. The sale of these shares may significantly dilute shareholder ownership. New investors in the future may also have rights, preferences and privileges senior to our current shareholders which may adversely impact our current shareholders.

Changes in interest rates could adversely affect Cornerstone’s results of operations and financial condition.

Changes in interest rates may affect Cornerstone’s level of interest income, the primary component of its gross revenue, as well as the level of its interest expense. Interest rates are highly sensitive to many factors that are beyond Cornerstone’s control, including general economic conditions and the policies of various governmental and regulatory authorities. Accordingly, changes in interest rates could decrease Cornerstone’s net interest income. Changes in the level of interest rates also may negatively affect Cornerstone’s ability to originate real estate loans, the value of its assets and the ability to realize gains from the sale of its assets, all of which ultimately affects earnings. Recent economic events have prompted the Federal Reserve to reduce its federal funds rate. Due to the rapid decline in interest rates, the Bank was unable to recalibrate its liabilities at the same rate at which loan rates declined. As a result, the net interest margin was impacted negatively during 2009 and is expected to continue into 2010. If the Federal Reserve’s federal funds rate remains at extremely low levels or does not increase above the Bank’s interest rate floors, Cornerstone’s funding costs may increase which will negatively impact the net interest margin and Cornerstone’s financial performance.

Cornerstone relies heavily on the services of key personnel and the unexpected loss of any of those personnel could adversely affect its operations.

In November 2009, Gregory B. Jones resigned as Cornerstone’s Chief Executive Officer, and this position was assumed by Nathaniel F. Hughes (in addition to his then existing role as President) on an interim basis until a permanent successor is named. The search for the successor is ongoing and will give consideration to external and internal candidates, including Mr. Hughes unless he declines such consideration. Cornerstone relies on the strategies and management services of Mr. Hughes, particularly during this critical transition period. Although Cornerstone has entered into an employment agreement with Mr. Hughes, the loss of his services could have a material adverse effect on Cornerstone’s business, results of operations and financial condition. Cornerstone is also dependent on certain other key officers who have important customer relationships or are instrumental to its lending and depository operations. Changes in key personnel and their responsibilities may be disruptive to operations and could have a material adverse effect on Cornerstone’s financial condition and earnings. Cornerstone believes that its future results will also depend upon its ability to attract and retain highly skilled and qualified personnel, particularly in those areas where Cornerstone may open new branches.
 
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Cornerstone is subject to Tennessee’s anti-takeover statutes and certain charter provisions that could decrease its chances of being acquired even if the acquisition is in the best interest of Cornerstone’s shareholders.

As a Tennessee corporation, Cornerstone is subject to various legislative acts that impose restrictions on and require compliance with procedures designed to protect shareholders against unfair or coercive mergers and acquisitions. These statutes may delay or prevent offers to acquire Cornerstone and increase the difficulty of consummating any such offers, even if the acquisition would be in its shareholders’ best interests. Cornerstone’s charter also contains provisions which may make it difficult for another entity to acquire it without the approval of a majority of the disinterested directors on its board of directors. Secondly, the amount of common stock owned by, and other compensation arrangements with, certain of Cornerstone’s officers and directors may make it more difficult to obtain shareholder approval of potential takeovers that they oppose. Agreements with Cornerstone’s senior management also provide for significant payments under certain circumstances following a change in control. These compensation arrangements, together with the common stock and option ownership of Cornerstone’s board of directors and management, could make it difficult or expensive to obtain majority support for shareholder proposals or potential acquisition proposals that the board of directors and officers oppose.

The success and growth of Cornerstone’s operations will depend on its ability to adapt to technological changes.

The banking industry and the ability to deliver financial services is becoming more dependent on technological advancement, such as the ability to process loan applications over the Internet, accept electronic signatures, provide process status updates instantly, reliable on-line banking capabilities and other customer expected conveniences that are cost efficient to Cornerstone’s business processes. As these technologies are improved in the future, Cornerstone may, in order to remain competitive, be required to make significant capital expenditures.

Even though Cornerstone’s common stock is currently traded on the OTC Bulletin Board, the trading volume in its common stock has been limited, and the sale of substantial amounts of Cornerstone’s common stock in the public market could depress the price.

Cornerstone cannot say with any certainty when a more active and liquid trading market for its common stock will develop or be sustained. Because of this, Cornerstone’s shareholders may not be able to sell their shares at the volumes, prices, or times that they desire. Cornerstone cannot predict the effect, if any, that future sales or the availability of common stock will have on the market price. Cornerstone, therefore, can give no assurance that sales of substantial amounts of its common stock in the market, or the potential for large amounts of sales in the market, would not cause the price of its common stock to decline or impair its ability to raise capital through sales of its common stock.

Cornerstone’s ability to declare and pay dividends is limited by law and it may be unable to pay future dividends.

Cornerstone derives the majority of its income from dividends on the shares of common stock of the Bank. The ability of the Bank to declare and pay dividends is limited by its obligations to maintain sufficient capital and by other general restrictions on its dividends that are applicable to banks that are regulated by the FDIC and the TDFI. On November 12, 2009, the FDIC placed restrictions on the Bank’s ability to pay cash dividends, requiring that the Bank first obtain a non-objection from the FDIC. In addition, the Federal Reserve Board may impose restrictions on Cornerstone’s ability to pay dividends on its common stock. As a result, Cornerstone cannot assure its shareholders that it will declare or pay dividends on shares of its common stock in the future.

ITEM 1B. UNRESOLVED STAFF COMMENTS

None

ITEM 2.  PROPERTIES

As of December 31, 2009, the principal offices of Cornerstone are located at 835 Georgia Avenue, Chattanooga, Tennessee 37402.  In addition, the Bank operates five full-service branches and one loan production office that are located at:
 
Banking Branches
4154 Ringgold Road, East Ridge, Tennessee (owned by the Bank)
 
5319 Highway 153, Hixson, Tennessee (owned by the Bank)
 
2280 Gunbarrel Road, Chattanooga, Tennessee (owned by the Bank)
 
8966 Old Lee Highway, Ooltewah, Tennessee (owned by the Bank)
 
835 Georgia Avenue, Chattanooga, Tennessee (leased by the Bank)
   
Loan Production Office
202 West Crawford Street, Dalton, Georgia (leased by the Bank)
 
16
 
The Georgia Avenue facility located in downtown Chattanooga, Tennessee serves as a branch location for the Bank’s customers as well as Cornerstone’s executive offices.  The Bank also owns a vacant building and lot at 103 S. Campbell Station Road Knoxville, Tennessee, which is currently for sale.  Cornerstone leases and operates a service center located at 6401 Lee Corners, Suite 119, Chattanooga, TN. to facilitate all of its noncustomer contact functions.

ITEM 3.  LEGAL PROCEEDINGS

As of the end of 2009, neither Cornerstone, the Bank nor Eagle was involved in any material litigation.  The Bank is periodically involved as a plaintiff or defendant in various legal actions in the ordinary course of its business.  Management believes that any claims pending against Cornerstone or its subsidiaries are without merit or that the ultimate liability, if any, resulting from them will not materially affect the Bank’s or Eagle’s financial condition or Cornerstone’s consolidated financial position.

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

No matters were submitted during the fourth quarter of 2009 to a vote of security holders of Cornerstone through a solicitation of proxies or otherwise.

PART II

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

On March 11, 2010, Cornerstone had 6,500,396 shares of common stock outstanding. Cornerstone’s common stock is quoted on the OTC Bulletin Board under the symbol “CSBQ” but is not listed on a national securities exchange.  There are ten market makers who provide a market for Cornerstone’s common stock.

There were approximately 550 holders of record of the common stock as of December 31, 2009.   This number does not include shareholders with shares in nominee name held by the Depository Trust Company (DTC).  As of the end of 2009, there were approximately 3,783,000 shares held in nominee name by DTC.  Cornerstone paid quarterly cash dividends in 2009 in the amount of $0.10 per share.  Cornerstone’s board of directors will continue to evaluate the amount of future dividends, if any, after capital needs required for expected growth of assets are reviewed.  The payment of dividends is within the discretion of the board of directors, considering Cornerstone’s expenses, the maintenance of reasonable capital and risk reserves, and appropriate capitalization requirements for state banks.  Currently, the Bank is under a restriction from the FDIC that no dividend can be paid from the Bank to the holding company without prior approval.

Table 1 presents the high and low closing prices of Cornerstone’s common stock for the periods indicated, as reported by published sources and cash dividends declared on its common stock for the last two fiscal years.  The prices reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not represent actual transactions.

TABLE 1
 
High and Low Common Stock Share Price for Cornerstone
  
Cash Dividends
  
2010 Fiscal Year
  
Low
    
High
    
Paid Per Share
  
First Quarter (through Feb. 17, 2010)
   $ 2.10     $ 2.30       -  
                         
2009 Fiscal Year
                        
First Quarter
   $ 3.50     $ 6.00     $ 0.07  
Second Quarter
   $ 4.00     $ 6.00     $ 0.03  
Third Quarter
   $ 2.65     $ 5.77       -  
Fourth Quarter
   $ 1.95     $ 3.71       -  
                         
2008 Fiscal Year
                        
First Quarter
   $ 7.99     $ 10.90     $ 0.07  
Second Quarter
   $ 5.85     $ 8.95     $ 0.07  
Third Quarter
   $ 5.25     $ 7.25     $ 0.07  
Fourth Quarter
   $ 4.75     $ 6.00     $ 0.07  
                         
 
17

ITEM 6.  SELECTED FINANCIAL DATA

Table 2 presents selected financial data for the periods indicated (amounts in thousands, except per share data).

TABLE 2
 
   
At and for the Fiscal Years Ended December 31,
  
   
2009
    
2008
    
2007
    
2006
    
2005
  
Total interest income
   $ 26,308     $ 30,680     $ 34,784     $ 29,158     $ 20,672  
Total interest expense
     11,189       12,698       14,414       10,306       6,077  
Net interest income
     15,119       17,982       20,370       18,852       14,594  
Provision for loan losses
     14,899       3,498       10,409       1,106       1,401  
Net interest income after provision for loan losses
     220       14,484       9,961       17,746       13,193  
Noninterest income
     541       1,892       1,695       2,111       1,904  
Noninterest expense
     14,276       12,568       10,926       10,718       8,216  
Income before income taxes
     (13,515 )     3,808       730       9,139       6,881  
Income tax (benefit) / expense
     (5,336 )     1,296       (141 )     3,328       2,556  
Net (loss) income
   $ (8,179 )   $ 2,512     $ 871     $ 5,811     $ 4,325  
                                         
Per Share Data:
                                        
Net income / (loss), basic
   $ (1.26 )   $ 0.39     $ 0.13     $ 0.87     $ 0.69  
Net income / (loss), assuming dilution
   $ (1.26 )   $ 0.38     $ 0.12     $ 0.83     $ 0.64  
Cash dividends paid
   $ 0.10     $ 0.28     $ 0.20     $ 0.12     $ 0.09  
Book value
   $ 4.28     $ 5.78     $ 5.70     $ 5.86     $ 5.07  
Tangible book value(1)
   $ 3.89     $ 5.33     $ 5.24     $ 5.40     $ 4.54  
                                         
Financial Condition Data:
                                        
Assets
   $ 532,404     $ 471,803     $ 444,421     $ 374,942     $ 323,611  
Loans, net of unearned interest
   $ 330,787     $ 378,472     $ 369,883     $ 305,879     $ 262,008  
Cash and investments
   $ 164,982     $ 57,286     $ 51,798     $ 51,577     $ 46,074  
Federal funds sold
   $ —     $ 11,025     $ —     $ —     $ —  
Deposits
   $ 404,742     $ 326,583     $ 313,250     $ 275,816     $ 252,435  
FHLB advances and line of credit
   $ 72,350     $ 71,250     $ 47,100     $ 39,500     $ 30,000  
Federal funds purchased and repurchase agreements
   $ 26,322     $ 35,790     $ 41,560     $ 19,249     $ 4,790  
Shareholders’ equity
   $ 27,837     $ 36,502     $ 36,327     $ 38,183     $ 32,466  
Tangible shareholders’ equity(1)
   $ 25,258     $ 33,661     $ 33,386     $ 35,137     $ 29,089  
                                         
Selected Ratios:
                                        
Interest rate spread
     2.95 %     3.67 %     4.51 %     5.16 %     4.93 %
Net interest margin(2)
     3.27 %     4.16 %     5.22 %     5.80 %     5.43 %
Return on average assets
     (1.69 )%     0.55 %     0.21 %     1.69 %     1.51 %
Return on average equity
     (24.34 )%     6.71 %     2.14 %     16.27 %     14.98 %
Return on average tangible equity(1)
     (26.36 )%     7.26 %     2.31 %     17.78 %     16.96 %
Average equity to average assets
     6.93 %     8.27 %     9.86 %     10.36 %     10.09 %
Dividend payout ratio
     N/A       70.59 %     149.71 %     13.33 %     12.17 %
Ratio of nonperforming assets to total assets
     3.36 %     1.48 %     0.40 %     0.40 %     0.47 %
Ratio of allowance for loan losses to nonperforming loans
     80.24 %     226.23 %     791.16 %     25.90 %     20.70 %
Ratio of allowance for loan losses to total average loans, net of unearned income
     1.63 %     2.49 %     3.88 %     1.50 %     1.50 %
 
(1) 
Tangible shareholders’ equity is shareholders’ equity less goodwill and intangible assets.
 
(2)
Net interest margin is the net yield on interest earning assets and is the difference between the interest yield earned on interest-earning assets less the interest rate paid on interest bearing liabilities.
 
18
 
GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures
 
Certain financial information included in Cornerstone’s summary consolidated financial data is determined by methods other than in accordance with U.S. generally accepted accounting principles (“GAAP”).  These non-GAAP financial measures are “tangible book value per share,” “tangible shareholders’ equity,” and “return on average tangible equity.” Management uses these non-GAAP measures in its analysis of Cornerstone’s financial performance.
 
·
“Tangible book value per share” is defined as total equity reduced by recorded goodwill and other intangible assets divided by total common shares outstanding. This measure is important to investors interested in changes from period-to-period in book value per share exclusive of changes in intangible assets. Goodwill, an intangible asset that is recorded in a purchase business combination, has the effect of increasing total book value while not increasing the tangible assets of a company. For companies such as Cornerstone that have engaged in business combinations, purchase accounting can result in the recording of significant amounts of goodwill related to such transactions.
 
·
“Tangible shareholders’ equity” is shareholders’ equity less goodwill and other intangible assets.

·
“Return on average tangible equity” is defined as earnings for the period divided by average equity reduced by average goodwill and other intangible assets.
 
These disclosures should not be viewed as a substitute for results determined in accordance with GAAP, and are not necessarily comparable to non-GAAP performance measures which may be presented by other companies. Table 3 presents a reconciliation to provide a more detailed analysis of these non-GAAP performance measures:
 
TABLE 3
 
   
At and for the Fiscal Years Ended December 31,
  
   
2009
    
2008
    
2007
    
2006
    
2005
  
Number of shares outstanding
     6,500,396       6,319,718       6,369,718       6,511,848       6,401,726  
                                         
Book value
   $ 27,837,479     $ 36,501,509     $ 36,327,350     $ 38,183,265     $ 32,466,363  
Book value per share
   $ 4.28     $ 5.78     $ 5.70     $ 5.86     $ 5.07  
                                         
Book value
   $ 27,837,479     $ 36,501,509     $ 36,327,350     $ 38,183,265     $ 32,466,363  
Less: goodwill and other intangible assets
     2,579,211       2,840,773       2,941,798       3,046,287       3,376,892  
Tangible book value
     25,258,268       33,660,736       33,385,552       35,136,978       29,089,471  
Effect of intangible assets per share
   $ 0.39     $ 0.45     $ 0.46     $ 0.46     $ 0.53  
                                         
Tangible book value per share
   $ 3.89     $ 5.33     $ 5.24     $ 5.40     $ 4.54  
                                         
Net (loss) / income
   $ (8,178,639 )   $ 2,511,824     $ 871,152     $ 5,811,600     $ 4,324,519  
Average equity
     33,600,000       37,435,000       40,737,000       35,728,000       28,874,000  
Return on average equity
     (24.34 )%   6.71 %     2.14 %     16.27 %     14.98 %
                                         
Average equity
   $
33,600,000
    
$
 37,435,000      $ 40,737,000     $ 35,728,000     $ 28,874,000  
Less: goodwill and other intangible assets
    
2,579,211
      
2,840,773
      
2,941,798
      
3,046,287
      
3,376,892 
  
Average tangible equity
   $
31,020,789
    
$
  34,594,227
     $ 37,795,202     $ 32,681,713      $ 25,497,108   
Effect of intangible assets
    
(2.02
)%
    
0.55
%
    
0.17
%
    
1.51
%
    
1.98
%
Return on average tangible equity
    
(26.36
)%
    
7.26
%
    
2.31
%
    
17.78
%
    
16.96
%
 
19
 
ITEM 7.   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Forward-Looking Statements

Management’s discussion and analysis of Cornerstone’s operations, prospects, and other matters, may include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and other provisions of applicable federal and state securities laws.  Although Cornerstone believes that the assumptions underlying such forward-looking statements contained in this report are reasonable, any of the assumptions could be inaccurate and, accordingly, there can be no assurance that the forward-looking statements included herein will prove to be accurate.  The use of such words as “expect,” “anticipate,” “forecast,” and comparable terms should be understood by the reader to indicate that the statement is “forward-looking” and thus subject to change in a manner that can be unpredictable.  Factors that could cause actual results to differ from the results anticipated, but not guaranteed, in this report, include (without limitation) economic and social conditions, competition for loans, mortgages, and other financial services and products, changes in interest rates, unforeseen changes in liquidity, results of operations, and financial conditions affecting Cornerstone’s customers, and other risks that cannot be accurately quantified or completely identified.  Many factors affecting Cornerstone’s financial condition and profitability, including changes in economic conditions, the volatility of interest rates, political events and competition from other providers of financial services simply cannot be predicted.  These factors are unpredictable and beyond Cornerstone’s control.  Earnings may fluctuate from period to period.  The purpose of this type of information is to provide readers with information relevant to understanding and assessing the financial condition and results of operations of Cornerstone, and not to predict the future or to guarantee results.  Cornerstone is unable to predict the types of circumstances, conditions and factors that can cause anticipated results to change.  Cornerstone undertakes no obligation to publish revised forward-looking statements to reflect the occurrence of changes or unanticipated events, circumstances, or results.
 
Going Concern Considerations

Prior to 2009, Cornerstone Community Bank (the “Bank”) had a history of profitable operations and sufficient sources of liquidity to meet its funding needs.  However, the Bank’s parent holding company, Cornerstone Bancshares, Inc. (“Cornerstone”), relies primarily on dividends from the Bank to meet its funding needs.  Cornerstone’s funding needs as of December 31, 2009 primarily consisted of principal and interest payments on two holding company loans totaling approximately $5.4 million secured by 100% of the Bank’s common stock.  In January 2010, the loans were renewed and Cornerstone received a waiver regarding previous covenant violations through September 30, 2009 with the understanding that future covenant violations would likely be waived as they were incurred.  As of December 31, 2009, the Bank was restricted from paying dividends to Cornerstone due to the Bank’s recent operating losses and the Bank’s capital position of less than “well capitalized” under the regulatory framework for prompt corrective action.  This restriction coupled with Cornerstone’s failure to meet certain holding company loan covenants has prompted management to perform an assessment of the going concern of Cornerstone.

Management’s business plan for 2010 projects the Bank’s return to profitability and a well capitalized position; however, covenant compliance is determined on a quarterly basis with certain of the covenants being based on rolling quarterly averages.  Thus, management’s projections do not anticipate full compliance with the covenants during 2010.  Because it is uncertain whether the holding company loans will be retained by the current lender or sold to the open market, management has placed a priority on replacing the holding company loans with capital.  Management believes Cornerstone’s ability to continue as a going concern would be in substantial doubt if the holding company loans were to be sold to the open market.  To avoid this possibility, Cornerstone believes that it must raise additional capital to allow repayment of the holding company indebtedness and further enhance the capital position of the Bank and is actively considering strategic alternatives, which may include a capital infusion through the issuance and sale of common stock, preferred stock or other securities (including securities convertible into shares of common stock) in public or private offerings.
 
Management’s Discussions and Analysis of Financial Condition and Results of Operations

Cornerstone is a bank holding company and the parent company of the Bank, a Tennessee banking corporation which operates primarily in and around Chattanooga, Tennessee.  The Bank has one wholly owned subsidiary Eagle Financial, Inc., (“Eagle”) an accounts receivable financing company.  In prior years, Eagle was owned and operated by Cornerstone.  However, on June 30, 2009, Eagle was sold to the Bank. The Bank has five full-service banking offices located in Hamilton County, Tennessee, and one loan production office located in Dalton, Georgia.  The Bank’s business consists primarily of attracting deposits from the general public and, with these and other funds, originating real estate loans, consumer loans, business loans, and residential and commercial construction loans. The Bank closed a second loan production office located in Knoxville, Tennessee as of September 2009.  The principal sources of income for the Bank are interest and fees collected on loans, fees collected on deposit accounts, and interest and dividends collected on other investments.  The principal expenses of the Bank are interest paid on deposits, employee compensation and benefits, office expenses, and other overhead expenses. Eagle’s principal source of income is revenue received from the purchase of receivables. Expenses are related to employee compensation and benefits, office and overhead expenses.
 
20

The following is a discussion of Cornerstone’s financial condition at December 31, 2009 and December 31, 2008 and Cornerstone’s results of operations for each of the three-years ended December 31, 2009, 2008 and 2007. The purpose of this discussion is to focus on information about Cornerstone’s financial condition and results of operations which is not otherwise apparent from the consolidated financial statements. The following discussion and analysis should be read along with Cornerstone’s consolidated financial statements and the related notes included elsewhere herein.

Review of Financial Performance

As of December 31, 2009, Cornerstone had total consolidated assets of approximately $532 million, total loans of approximately $337 million, total deposits of approximately $405 million and stockholders’ equity of approximately $28 million.  Cornerstone incurred a net loss of $8.2 million for 2009 compared to a net income of $2.5 million for 2008 and net income of $871 thousand for 2007.

Results of Operations

Net Interest Income-Net interest income represents the amount by which interest earned on various earning assets exceeds interest paid on deposits and other interest bearing liabilities.  Net interest income is also the most significant component of Cornerstone’s earnings.  For the year ended December 31, 2009, Cornerstone recorded net interest income of approximately $15,119,000, which resulted in a net interest margin of 3.27%.  For the year ended December 31, 2008, Cornerstone recorded net interest income of approximately $17,982,000, which resulted in a net interest margin of 4.16%.  For the year ended December 31, 2007, Cornerstone recorded net interest income of approximately $20,369,000, which resulted in a net interest margin of 5.22%.
 
21
Table 4 presents information with respect to interest income from average interest-earning assets, expressed both in dollars and yields, and interest expense on average interest-bearing liabilities, expressed both in dollars and rates, for the periods indicated.  The table includes loan yields, which reflect the amortization of deferred loan origination and commitment fees.  Interest income from investment securities includes the accretion of discounts and amortization of premiums.

TABLE 4
 
Yields Earned on Average Earning Assets and
Rates Paid on Average Interest Bearing Liabilities
  
Years Ended December 31,
  
   
2009
    
2008
    
2007
  
(In thousands)
 
ASSETS
  
Average
Balance
    
Interest Income/
Expense(1)
    
Yield/ Rate
    
Average
Balance
    
Interest Income/
Expense(1)
    
Yield/ Rate
    
Average 
Balance
    
Interest Income/
Expense(1)
    
Yield/ Rate
  
Interest-earning assets:
                                                      
Loans(1)(2)
   $ 363,146     $ 24,402       6.72 %   $ 385,957     $ 28,661       7.43 %   $ 353,278     $ 32,981       9.34 %
Investment securities(3)
     63,854       1,840       3.10 %     47,096       1,996       4.36 %     37,673       1,750       4.80 %
Other earning assets
     40,085       66       0.16 %     869       23       2.70 %     760       52       6.86 %
Total interest-earning assets
     467,085       26,308       5.66 %     433,922       30,680       7.08 %     391,711       34,783       8.89 %
Allowance for loan losses
     (8,088 )                     (8,496 )                     (5,009 )                
Cash and other assets
     25,672                       27,179                       26,341                  
Total assets
   $ 484,669                     $ 452,605                     $ 413,043                  
TOTAL
LIABILITIES
AND EQUITY
                                                                        
Interest-bearing liabilities:
                                                                        
Deposits:
                                                                        
NOW accounts
   $ 27,864     $ 98       0.35 %   $ 30,106     $ 211       0.70 %   $ 36,327     $ 802       2.21 %
Money market / Savings
     35,269       303       0.86 %     51,600       826       1.60 %     55,808       2,018       3.61 %
Time deposits, $100m and
                                                                        
Over
     61,533       2,049       3.33 %     59,083       2,371       4.01 %     61,172       3,134       5.12 %
Time deposits, under $100m
     195,018       5,559       2.85 %     131,138       5,891       4.49 %     107,498       5,387       5.01 %
Total interest-bearing deposits
     319,684       8,009       2.51 %     271,927       9,299       3.42 %     260,805       11,341       4.35 %
Federal funds purchased
     -       -       -       12,952       339       2.62 %     11,374       613       5.39 %
Securities sold under
                                                                        
agreement to repurchase
     21,624       174       0.80 %     18,580       261       1.41 %     8,103       244       3.01 %
Other borrowings
     72,150       3,006       4.17 %     68,578       2,799       4.08 %     48,282       2,216       4.59 %
Total interest-bearing
                                                                        
Liabilities
     413,458       11,189       2.71 %     372,037       12,698       3.41 %     328,564       14,414       4.39 %
Net interest spread
                     2.95 %                     3.67 %                     4.51 %
                                                                         
Other liabilities:
                                                                        
Demand deposits
     40,816                       42,915                       41,503                  
Accrued interest payable and
                                                                        
Other liabilities
     (3,205 )                     218                       2,240                  
Stockholders’ equity
     33,600                       37,435                       40,737                  
Total liabilities
                                                                        
And stockholders’ equity
   $ 484,669                     $ 452,605                     $ 413,043                  
                                                                         
Net interest margin
           $ 15,119       3.27 %           $ 17,982       4.16 %           $ 20,369       5.22 %
(1)  Interest income on loans includes amortization of deferred loan fees and other discounts of $78 thousand, $227 thousand, and $302 thousand for the fiscal years ended December 31, 2009, 2008, and 2007, respectively.
 
(2)  Nonperforming loans are included in the computation of average loan balances, and interest income on such loans is recognized on a cash basis.
 
(3)  Yields on securities are calculated on a fully tax equivalent basis.
22
 
Other matters related to the changes in net interest income, net interest yields and rates, and net interest margin are presented below:
 
·
The net interest margin decreased 89 basis points from 4.16% as of December 31, 2008 to 3.27% as of December 31, 2009.  Several factors related to the Bank’s interest revenue were the primary reasons for the decrease.  First, the yield on the Bank’s loan portfolio decreased from 7.43% as of December 31, 2008 to 6.72% as of December 31, 2009.  Interest income from the Bank’s loan portfolio was negatively affected by a combination of loan repricing and an increased level of nonaccrual loans.  A second factor was the change in the asset mix of the Bank’s earning asset portfolio.   During 2009, the Bank’s earning asset portfolio mix shifted from 85% loan to assets to 75% loan to assets.  The Bank anticipates that the asset portfolio mix will continue to decrease as the Bank reduces the amount of its loan portfolio to improve the Bank’s risk profile and improve liquidity.

·
In September 2007, the Federal Reserve Bank initiated a series of interest rate reductions to the Federal Funds Target rate from 5.25% to its current level 0.25%, which has been in effect since January 2009.  This 500 basis point reduction placed downward pressure on the banking industry’s net interest margins.  Cornerstone was also impacted by this reduction which lowered its net interest margin to 4.16% for the year ended December 31, 2008 compared to 5.22% for the year ended December 31, 2007.

·
As of December 31, 2009, the Bank’s investment portfolio resulted in a yield of 3.10% compared to 4.36% as of December 31, 2008.  The Bank’s investment portfolio is used primarily for pledging purposes with the State of Tennessee Collateral Pool, Federal Reserve Bank discount window, to secure repurchase agreements and to provide additional collateral to the Federal Home Loan Bank to secure the Bank’s fixed rate term advances.  During 2009, the Bank aggressively reshaped its investment portfolio to decrease its credit risk profile.  As of December 31, 2009, the Bank’s securities portfolio was invested approximately 75% in Government National Mortgage Association (GNMA) securities, approximately 13% in municipal general obligation securities and 12% in Agency-Backed securities.   During 2009, the Bank maintained its large position of variable rate securities and increased its longer term securities holdings to take advantage of the historically steep Treasury yield curve and artificially high spreads in the municipal bond market.  Currently, the Bank’s securities portfolio is larger than historic levels but management believes the higher level of liquidity is appropriate given the uncertain regulatory and credit environment.

·
As of December 31, 2008, the Bank’s investment portfolio resulted in a yield of 4.36% compared to 4.80% as of December 31, 2007.  As of December 31, 2008, approximately 50% of the security portfolio was invested in Agency LIBOR floaters to protect the Bank from rapid increases in interest rates.  

23
 
Tables 5 and 6 present the changes in interest income and interest expense that are attributable to three factors:

 
(i)
A change in volume or amount of an asset or liability.
     
 
(ii)
A change in interest rates.
     
 
(iii)
A change caused by the combination of changes in asset or deposit mix.

The tables describe the extent to which changes in interest rates and changes in volume of interest-earning assets and interest-bearing liabilities have affected Cornerstone’s interest income and expense during the periods indicated.  For each category of interest-earning assets and interest-bearing liabilities, information is provided as to changes attributable to change in volume (change in volume multiplied by current rate) and change in rates (change in rate multiplied by current volume).  The remaining difference has been allocated to mix.

TABLE 5
 
INTEREST INCOME AND EXPENSE ANALYSIS
 
   
Year Ended December 31,
  
   
2009 Compared to 2008
  
 
(In Thousands)
  
Volume
    
Rate
    
Mix
    
Net
Change
  
Interest income:
                        
  Loans (1)(2)
   $ (1,533 )   $ (2,578 )   $ (148 )   $ (4,259 )
  Investment securities
     520       (805 )     129       (156 )
  Other earning assets
     63       (1,018 )     998       43  
Total interest income
                             (4,372 )
                                 
Interest expense:
                                
  NOW accounts
     (8 )     (98 )     (7 )     (113 )
  Money market and savings accounts
     (140 )     (261 )     (122 )     (523 )
  Time deposits, $100,000 and over
     73       (911 )     516       (322 )
  Time deposits, less than $100,000
     1,897       (2,594 )     365       (332 )
  Other borrowings
     146       14       47       207  
  Federal funds purchased
     -       -       (339 )     (339 )
  Securities sold under agreement to repurchase
     32       (80 )     (39 )     (87 )
Total interest expense
                             (1,509 )
Change in net interest income (expense)
                           $ (2,863 )

(1)      Loan amounts include non-accruing loans
 
(2)      Interest income includes the portion of loan fees recognized in the respective periods.
 
24
 
TABLE 6
 
          INTEREST INCOME AND EXPENSE ANALYSIS
 
   
Year Ended December 31,
  
   
2008 Compared to 2007
  
 
(In Thousands)
  
Volume
    
Rate
    
Mix
    
Net
Change
  
Interest income:
                        
  Loans (1)(2)
   $ 2,428     $ (7,372 )   $ 622     $ (4,320 )
  Investment securities
     411       (188 )     23       246  
  Other earning assets
     3       (22 )     (10 )     (29 )
Total interest income
                             (4,103 )
                                 
Interest expense:
                                
  NOW accounts
     (44 )     (455 )     (92 )     (591 )
  Money market and savings accounts
     (67 )     (1,040 )     (85 )     (1,192 )
  Time deposits, $100,000 and over
     (93 )     (402 )     (268 )     (763 )
  Time deposits, less than $100,000
     1,017       (931 )     418       504  
  Other borrowings
     828       (349 )     104       583  
  Federal funds purchased
     41       (359 )     44       (274 )
  Securities sold under agreement to repurchase
     148       (297 )     166       17  
Total interest expense
                             (1,716 )
Change in net interest income (expense)
                           $ (2,387 )

(1) Loan amounts include non-accruing loans.
 
 (2) Interest income includes the portion of loan fees recognized in the respective periods.
 
Provision for Loan Losses- The provision for loan losses represents a charge to earnings necessary to establish an allowance for loan losses that, in management’s evaluation, should be adequate to provide coverage for the inherent losses on outstanding loans.  The provision for loan losses amounted to $14.9 million for the year ended December 31, 2009 compared to $3.5 million for the year ended December 31, 2008.  Cornerstone’s policies and procedures used to estimate the allowance for loan losses, as well as the resultant provision for loan losses, are considered adequate by management and are periodically reviewed by regulators.  However, there are factors beyond Cornerstone’s control, such as conditions in the local and national economy which may (and, for 2009, in fact did) negatively impact Cornerstone’s asset quality.  The measurements are approximations which may require additional provisions to loan losses based upon changing circumstances or when additional information becomes available or known.  Other matters relating to the changes in provision for loan losses are presented below:
 
·
Cornerstone’s provision for loan losses during 2009 was needed to address multiple credits that continued to deteriorate as a result of the prolonged economic downturn.  The Bank has seen material deterioration of its client’s cash reserves and collateral values during 2009.  However, the rate of decline slowed during the fourth quarter of 2009.

·
Cornerstone’s provision for loan losses during 2008 was needed to address multiple credits that were not able to maintain operations or cash flow due in large part to the economic downturn.  The provision allocation differs from the amount charged to earnings in 2007 which was concentrated in two large credits.  These large credits contained alleged fraud perpetrated by the customer against the Bank.  

·
To address the problem credits within the Bank’s loan portfolio a Special Asset Committee was created during 2008.  This committee has instructed the Bank’s loan review department to identify potential problem loans as quickly as possible.  This committee is also responsible for developing and reviewing action plans that identify possible strategies to minimize the Bank’s losses.  The early detection and proactive resolution process serves to assist customers with the severe economic environment while potentially minimizing losses.  During 2009, the Bank dedicated additional human resources to the Special Asset department to assist in the collection and recovery process.
 
Non Interest Income-Items reported as non interest income include service charges on checking accounts, insufficient funds charges, automated clearing house (“ACH”) processing fees and the Bank’s secondary mortgage department earnings.  Increases in income derived from service charges and ACH fees are primarily a function of the Bank’s growth while fees from the origination of mortgage loans will often reflect market conditions and fluctuate from period to period.
 
25
 
Table 7 presents the components of non interest income for the years ended December 31, 2009, 2008 and 2007 (in thousands).

 
TABLE 7
   
2009
    
2008
    
2007
  
Customer service fees
   $ 1,630     $ 1,727     $ 1,426  
Other noninterest income
     138       108       165  
Net (loss) gain from sale of loans & other assets
     (1,227 )     57       104  
  Total noninterest income
   $ 541     $ 1,892     $ 1,695  

Significant matters relating to the changes to non interest income are presented below:
 
·
The Bank experienced a slight decrease in its customer service fees from 2008 to 2009.  One factor contributing to the decrease was the impact of the economic recession as consumers monitored their deposit account balances closely.  This change resulted in a reduction in insufficient funds fees from approximately $715 thousand as of December 31, 2008 to approximately $599 thousand as of December 31, 2009.  While traditional account service fees are included in the $1.6 million generated during 2009, the amount also includes fees associated with the Bank’s payroll processing services.

·
The Bank had an increase in its customer service fees from 2007 to 2008.  While traditional account service fees are included in the $1.7 million generated during 2008 the amount also includes fees associated with the Bank’s payroll processing services.  Fiscal year 2008 marked the first full year the Bank provided processing services to payroll processors located across the United States.  The payroll processors generate thousands of payroll transactions each week while depositing relatively large amounts on a short term basis.  These ACH transactions are then forwarded through the Federal Reserve Bank to the recipient’s checking accounts.

·
There are two primary reasons for change in the net (loss) gain from sale of loans and other assets from 2008 to 2009.  First, the Bank realized a gain of approximately $400 thousand on the sale of securities with a book value of approximately $18.5 million.  Second, the Bank had a loss of $1.6 million on the sale of assets during 2009, which was incurred on multiple pieces of other real estate and foreclosed assets as values continued to decline in 2009.  The Bank could have additional losses in 2010 if foreclosed asset values continue to decline and losses are incurred on the disposition of the properties.  All other real estate is being carried at the lower of carrying amount or estimated fair value less costs to sell.
 
      Non Interest Expense-Items reported as non interest expense include salaries and employee benefits, occupancy and equipment expense, depository insurance and other operating expense.

Table 8 presents the components of non interest expense for the years ended December 31, 2009, 2008 and 2007 (in thousands).
 
TABLE 8
 
   
2009
    
2008
    
2007
  
Salaries and employee benefits
   $ 6,970     $ 7,140     $ 6,609  
Net occupancy and equipment expense
     1,548       1,520       1,355  
Depository insurance
     1,199       321       106  
Other operating expenses
     4,559       3,587       2,856  
  Total noninterest expense
   $ 14,276     $ 12,568     $ 10,926  

Significant matters relating to the changes to non interest expense are presented below:
 
·
Salary expense decreased 2.4% from 2008 to 2009.  The reduction is attributable to the Bank’s layoff of approximately 10% of its workforce during the second quarter of 2009 and the loss of former CEO Gregory B. Jones.

·
Salary expense increased 8.0% from 2007 to 2008.  This increase was due primarily to an increase in risk management personnel including one additional employee in the compliance department, two employees in internal audit department and one contracted consultant to assist with Information Technology security, along with cost of living adjustments.
 
26
 
·
For 2009 the other operating expense category of non interest expense increased significantly, by 27.1%, over 2008.  While the Bank was able to reduce certain expenses to minimize the total expense amount, two areas experienced a significant increase.  First, other real estate expense increased approximately $420 thousand; and second, legal expense increased $238 thousand.  These increases are related to the deterioration of asset quality and the expense required to properly foreclose, maintain and ultimately dispose of collateral securing problem loans.

·
The Bank continues to experience an increase in depository insurance premiums as a result of ongoing financial difficulties in the banking industry.  The Bank realized an increase of $878 thousand or 273.5% from 2008 to 2009.  Management expects depository insurance premiums will continue to exceed $1 million per year for the next three years.
 
·
From 2007 to 2008, the other operating expense and depository insurance categories of non interest expense increased significantly, by 31.9% and 202.8%, respectively.  The majority of the increases can be segmented into three areas.  First, the FDIC assessment increased $215 thousand; second, other real estate expense increased $167 thousand; and third, legal expense increased $160 thousand.  All of these increases are related to the deterioration of asset quality and the expense required to properly obtain and ultimately dispose of collateral securing problem loans.
 
Income Tax Expense
 
·
The difference between Cornerstone’s expected income tax expense, computed by multiplying income before income taxes by statutory income tax rates, and actual income tax expense, is primarily attributable to new market tax credits for federal and state purposes, tax exempt loans and tax exempt securities.
 
Financial Condition

Overview-Cornerstone’s consolidated balance sheet reflects significant changes over the last two years.  Total assets increased approximately $60 million or 12.7% from $472 million as of December 31, 2008 to $532 million as of December 31, 2009.  During 2009, total loans decreased $51 million or 13.1% from approximately $388 million as of December 31, 2008 to approximately $337 million as of December 31, 2009.  The reduction in loans was a result of the Bank’s collection process, and an increase in the Bank’s loan underwriting requirements.  Finally, stockholders’ equity decreased to approximately $28 million as of December 31, 2009 from approximately $37 million as of December 31, 2008.

Investments-The Bank’s investment portfolio totaled $126.8 million or 23.8% of total assets as of December 31, 2009, compared to a total of $46.4 million or 9.8% of total assets as of December 31, 2008.  The increase was a direct result of an increase in collateral requirements to maintain the Bank’s FHLB borrowings and to provide sufficient collateral at the Federal Reserve Bank to give the Bank guaranteed liquidity for daily Bank transactions. The portfolio is accounted for in two classifications:  “Held to Maturity” and “Available for Sale”.  The Bank also has an investment in Federal Home Loan Bank stock.   The objective of the Bank’s investment policy is to invest funds not otherwise needed to meet the loan demand of the Bank’s market area and to meet the following five objectives: Gap Management, Liquidity, Pledging, Return, and Local Community Support.  In doing so, the Bank uses the portfolio to provide structure and liquidity that the loan portfolio cannot.  The management investment committee balances the market and credit risks against the potential investment return, ensures investments are compatible with the pledge requirements of the Bank’s deposit of public funds, maintains compliance with regulatory investment requirements, and assists various public entities with their financing needs.  The management investment committee is authorized to execute security transactions for the investment portfolio based on the decisions of the Directors Asset Liability Committee of the Board of Directors (“ALCO”).  All investment transactions occurring since the previous ALCO meeting are reviewed by the ALCO at its next quarterly meeting, in addition to the entire portfolio.  The investment policy allows portfolio holdings to include short-term securities purchased to provide the Bank’s needed liquidity and longer-term securities purchased to generate stable income for the Bank during periods of interest rate fluctuations.
 
27



Table 9 presents the carrying value of the Bank’s investments at the dates indicated.  Available for sale securities are carried at fair market value and securities held to maturity are held at their book value (amounts in thousands).

TABLE 9
 
Investment Portfolio
Years Ended December 31,
Securities available for sale:
  
2009
    
2008
    
2007
  
U.S. Government and agency obligations
   $ 4,774     $ 8,252     $ 27,414  
Mortgage-backed securities
     102,885       31,182       3,836  
State & political subdivisions tax-exempt
     16,756       4,623       3,503  
Totals
   $ 124,415     $ 44,057     $ 34,753  
                         
Securities held to maturity:
                        
Mortgage-backed securities
   $ 135     $ 169     $ 200  
Totals
   $ 135     $ 169     $ 200  
                         
Federal Home Loan Bank stock, at cost
     2,229       2,188       1,912  
                         
Total Investments
   $ 126,779     $ 46,414     $ 36,865  

·
During 2009, the Bank elected to increase the amount of its investment in mortgage backed and municipal securities.  The mortgage-backed securities were obtained instead of U.S. Government and agency obligations, as traditionally acquired, to provide increased yield while maintaining a 20% risk weight classification for capital requirements.  During 2009 the Bank purchased mortgage-backed securities guaranteed by the Government National Mortgage Association (GNMA).  These securities qualify for 0% risk weight allocation thereby improving the Bank’s overall risk weighted capital position.   The increased investment in municipal securities was made due to higher yields when compared to alternative investments and to provide collateral at the Federal Reserve discount window.

·
A second objective of the security portfolio is to provide adequate collateral to satisfy pledging requirements with the State of Tennessee collateral pool, repurchase agreements and the Federal Reserve discount window.  During 2009, the Bank increased its Federal Reserve discount window borrowing to approximately $15 million by year-end.  This increase allowed the Bank to obtain additional funding, if needed, in the event the Bank’s daily fed fund lines were negatively impacted.

·
During 2009, the Federal Home Loan Bank (“FHLB”) notified the Bank that as a result of the decline in the Bank’s loan asset quality, additional collateral was required to secure the Bank’s fixed rate term advances.  As of December 31, 2009, the Bank had pledged approximately $54 million to the FHLB.

For December 31, 2009, tables 10 and 11 present the book value of the Bank’s investments, the weighted average yields on the Bank’s investments and the periods to maturity of the Bank’s investments for the “Securities Available for Sale” and the “Securities Held to Maturity,” respectively.  Tables 12 and 13 present this information for December 31, 2008.

TABLE 10 (amounts in thousands)
 
 Weighted Average Yields on the Available For Sale Investments
Periods of Maturity from December 31, 2009
   
Less than 1 year
    
1 to 5 years
    
5 to 10 years
    
Over 10 years
  
 
Securities available for sale:
  
 
Amount
    
Weighted
Avg.
Yield (1)
    
 
Amount
    
Weighted
Avg.
Yield (1)
    
 
Amount
    
Weighted
Avg.
 Yield (1)
    
 
Amount
    
Weighted
Avg.
Yield (1)
  
U.S. Government agencies
   $ -       -     $ -       -     $ -       -     $ 4,772       1.15 %
Mortgage-backed securities (2)
     -       -       -       -       39       5.68 %     103,329       3.01 %
Tax-exempt municipal bonds
     -       -       599       6.31 %     2,468       5.62 %     13,594       5.77 %
Totals
   $ -       -     $ 599       6.31 %   $ 2,507       5.62 %   $ 121,695       3.25 %
                                                                 
Total Securities Available for Sale
   $ 124,801       3.31 %                                                
 
(1) 
The weighted average yields on tax-exempt securities have been computed on a tax-equivalent basis.
   
(2)
 Mortgages are allocated by maturity and not amortized.
 
28
 
TABLE 11 (amounts in thousands)
 
Weighted Average Yields on the Held to Maturity Investments
Periods of Maturity from December 31, 2009
   
Less than 1 year
    
1 to 5 years
    
5 to 10 years
    
Over 10 years
  
 
Securities held to maturity:
  
 
Amount
    
Weighted
Avg.
 Yield(1)
    
 
Amount
    
Weighted
Avg.
Yield (1)
    
 
Amount
    
Weighted
Avg.
Yield (1)
    
 
Amount
    
Weighted
Avg.
 Yield (1)
  
Mortgage-backed securities (2)
   $ 1       6.43 %   $ -       -     $ 23       3.45 %   $ 111       4.47 %
Totals
   $ 1       6.43 %   $ -       -     $ 23       3.45 %   $ 111       4.47 %
                                                                 
Total Securities held to maturity
   $ 135       4.31 %                                                
                                                                 
Federal Home Loan Bank stock, at cost
   $ 2,229       4.58 %                                                
                                                                 
Total Investments
   $ 127,165       3.33 %                                                
 
(1)    The weighted average yields on tax-exempt securities have been computed on a tax-equivalent basis.
 
(2)    Mortgages are allocated by maturity and not amortized.

TABLE 12 (amounts in thousands)
 
Weighted Average Yields on the Available For Sale Investments
Periods of Maturity from December 31, 2008
   
Less than 1 year
    
1 to 5 years
    
5 to 10 years
    
Over 10 years
  
 
Securities available for sale:
  
Amount
    
Weighted
Avg.
Yield (1)
    
Amount
    
Weighted
Avg.
Yield (1)
    
Amount
    
Weighted
Avg.
Yield (1)
    
Amount
    
Weighted
Avg.
 Yield (1)
  
U.S. Government agencies
   $ 6,127       4.15 %   $ -       -     $ -       -     $ 2,125       6.12 %
Mortgage-backed securities (2)
     -       -       -       -       11       6.99 %     31,171       2.99 %
Tax-exempt municipal bonds
     127       5.02 %     925       6.38 %     1,793       6.06 %     1,778       6.26 %
Totals
   $ 6,254       4.16 %   $ 925       6.38 %   $ 1,804       6.07 %   $ 35,074       3.34 %
                                                                 
Total Securities Available for Sale
   $ 44,057       3.62 %                                                
 
(1)    The weighted average yields on tax-exempt securities have been computed on a tax-equivalent basis.
 
(2)    Mortgages are allocated by maturity and not amortized.

TABLE 13 (amounts in thousands)
 
Weighted Average Yields on the Held to Maturity Investments
Periods of Maturity from December 31, 2008
   
Less than 1 year
    
1 to 5 years
    
5 to 10 years
    
Over 10 years
  
 
Securities held to maturity:
  
 
Amount
    
Weighted
Avg.
 Yield(1)
    
 
Amount
    
Weighted
Avg.
Yield (1)
    
 
Amount
    
Weighted
Avg.
Yield (1)
    
 
Amount
    
Weighted
Avg.
Yield (1)
  
Mortgage-backed securities (2)
   $ -       -     $ 6       6.70 %   $ 17       3.74 %   $ 146       5.54 %
Totals
   $ -       -     $ 6       6.70 %   $ 17       3.74 %   $ 146       5.54 %
                                                                 
Total Securities held to maturity
   $ 169       5.40 %                                                
                                                                 
Federal Home Loan Bank stock, at cost
   $ 2,188       5.33 %                                                
                                                                 
Total Investments
   $ 46,414       3.73 %                                                
 
(1)    The weighted average yields on tax-exempt securities have been computed on a tax-equivalent basis.
 
(2)    Mortgages are allocated by maturity and not amortized.

29
 
Lending-All lending activities of the Bank are under the direct supervision and control of the Directors Loan Committee (DLC).  The DLC is comprised of three members of management and five independent directors that serve only in a director capacity and are not employees of the Bank.  Also present at meetings of the committee are the loan review officer and other lending officers as required. All lending activities of Eagle are under the direct supervision and control of its Board of Directors which is comprised of both management and independent directors.  These oversight committees enforce loan authorizations for each officer, make lending decisions on loans exceeding such limits, review and oversee problem credits, and determine the allocation of funds for each lending category.

At December 31, 2009 and 2008, Cornerstone’s loan portfolio constituted approximately 62.1% and 80.2% of Cornerstone’s total assets, respectively.

Table 14 presents the composition of the Cornerstone’s loan portfolio at the indicated dates.

TABLE 14
 
 Loan Portfolio Composition
Years Ended December 31,
   
2009
    
2008
    
2007
    
2006
    
2005
  
(In thousands)
  
Amount
    
Percent
    
Amount
    
Percent
    
Amount
    
Percent
    
Amount
    
Percent
    
Amount
    
Percent
  
Commercial, financial and agricultural
   $ 60,560       17.99 %   $ 83,140       21.42 %   $ 98,065       25.57 %   $ 98,542       31.77 %   $ 86,039       32.40 %
Real estate – construction
     47,651       14.15 %     70,456       18.15 %     76,832       20.03 %     57,606       18.57 %     47,071       17.72 %
Real estate – mortgage
     70,976       21.08 %     72,737       18.74 %     64,585       16.84 %     48,700       15.70 %     48,645       17.19 %
Real estate – commercial
     153,310       45.53 %     155,728       40.13 %     138,074       35.99 %     99,197       31.98 %     79,608       29.98 %
Consumer loans
     4,195       1.25 %     6,029       1.56 %     6,037       1.57 %     6,092       1.98 %     7,191       2.71 %
Total loans
   $ 336,692       100.00 %   $ 388,090       100.00 %   $ 383,593       100.00 %   $ 310,137       100.00 %   $ 265,554       100.00 %

Significant matters relating to the changes in the loan portfolio composition are presented below:

·
During 2009, the Bank’s total loans materially decreased by 13.1%.  The largest decreases occurred in the real estate construction category which decreased by 32.4% and the commercial, financial and agricultural category which decreased by 27.2%.  The Bank anticipates that its loan portfolio will continue to decrease during 2010, especially in the commercial real estate category.  However, the Bank is focused on maintaining and increasing its commercial and industrial loans and consumer mortgages.

Table 15 presents the scheduled maturities of the loans in Cornerstone’s loan portfolio as of December 31, 2009 based on their contractual terms to maturity.  Overdrafts are reported as due in less than one year.  Loans unpaid at maturity are renegotiated based on current market rates and terms.

TABLE 15
 
Loans Maturing
Year-end balance as of December 31, 2009
(In thousands)
  
Less than One Year
    
1 to 5 Years
    
Over 5 Years
    
Total
  
Commercial, financial and agricultural
   $ 43,026     $ 15,664     $ 1,870     $ 60,560  
Real estate – construction
     34,542       12,107       1002       47,651  
Real estate – mortgage
     20,709       40,030       10,237       70,976  
Real estate – commercial
     43,182       97,763       12,365       153,310  
Consumer
     1,480       2,693       22       4,195  
Total Loans
   $ 142,939     $ 168,257     $ 25,496     $ 336,692  

30
 
Types of Loans

Commercial Loans-The Bank’s commercial loan portfolio is comprised of commercial, industrial, and non-farm non-residential loans, hereinafter referred to as commercial loans (excluding commercial construction loans). These installment loans and lines of credit are extended to individuals, partnerships and corporations for a variety of business purposes, such as accounts receivable and inventory financing, equipment financing, business expansion and working capital.  The following is a list of terms imbedded in the Bank’s commercial loan portfolio:

·
The terms of the Bank’s commercial loans generally range from 90 days to a 15 year amortization with a five year balloon.
   
·
Commercial loans are generally tied to the prime index and adjust according with changes in the prime rate.
   
·
The Bank also extends fixed interest rate loans when appropriate to match the borrower’s needs.
   
·
Loans secured by marketable equipment are required to be amortized over a period not to exceed 60 months.
   
·
Generally, loans secured by current assets such as inventory or accounts receivable are structured as revolving lines of credit with annual maturities.
   
·
Loans secured by chattel, mortgages and accounts receivable may not exceed 85% of their market value.
   
·
Loans secured by listed stocks, municipal bonds and mutual funds may not exceed 70% of their market value.
   
·
Unsecured short-term loans and lines of credit must meet criteria set by the Bank’s Loan Committee.  Current financial statements support all commercial loans, and such financial statements are updated annually.
   
·
Substantially all of the Bank’s commercial loans are secured and are guaranteed by the principals of the borrower.

Real Estate: Construction Loans-The Bank makes residential construction loans to owner-occupants and to persons building residential properties for resale.  The Bank has two main areas of construction loans: one is to residential real estate developers for speculative or custom single-family residential properties, and the other is to custom commercial construction projects with guaranteed takeout provisions.  Construction loans are usually variable rate loans made for terms of one year or less, but extensions are permitted if construction has continued satisfactorily, the loan is current and other circumstances warrant the extension.  Construction loans are limited to 80% of the appraised value of the lot and the completed value of the proposed structure.

Construction financing generally is considered to involve a higher degree of credit risk than permanent mortgage financing of residential properties, and this additional risk usually is reflected in higher interest rates.  The higher risk of loss on construction loans is attributable in large part to the fact that loan funds are estimated and advanced upon the security of the project under construction, which is of uncertain value prior to the completion of construction.  Moreover, because of the uncertainties inherent in estimating construction costs, delays arising from labor problems, material shortages and other unpredictable contingencies, it is relatively difficult to accurately evaluate the total loan funds required to complete a project and to accurately evaluate the related loan-to-value ratios.  If the estimates of construction costs and the saleability of the property upon completion of the project prove to be inaccurate, the Bank may be required to advance funds beyond the amount originally committed to permit completion of the project.  If the estimate of value proves to be inaccurate, the Bank may be confronted, at or prior to the maturity of the loan, with a project with a value that is insufficient to assure full repayment.

The Bank’s underwriting criteria are designed to evaluate and minimize the risk of each construction loan.  Among other items, the Bank considers evidence of the availability of permanent financing or a take-out commitment to the borrower, the financial strength and reputation of the borrower, an independent appraisal and review of cost estimates, market conditions, and, if applicable, the amount of the borrower’s equity in the project, pre-construction sale or leasing information and cash flow projections of the borrower.

Real Estate: Mortgage Loans-Real estate mortgage loans include all one to four family residential loans secured by real estate for purposes other than construction or acquisition and development.  All real estate loans are held in the Bank’s loan portfolio except for loans that are designated as loans held for sale.  The loans held for sale are qualified by the Federal National Mortgage Association and have been pre-approved by an underwriting specialist prior to closing.  The remainder of the Bank’s mortgage loans are home equity loans and are made at fixed interest rates for terms of one to three years with balloon payment provisions and amortized over a 10 to 15 year period.  The Bank’s experience indicates that real estate loans normally remain outstanding for much shorter periods (seven years on average) than their stated maturity because the borrowers repay the loans in full either upon the sale of the secured property or upon the refinancing of the original loan.

31
 
In the case of owner occupied single-family residences, real estate loans are made for up to 95% of the value of the property securing the loan, based upon an appraisal if the loan amount is over $100,000.  When the loan is secured by real estate containing a non-owner occupied dwelling of one to four family units, loans generally are made for up to 80% of the value, based upon an appraisal if the loan amount is over $100,000.  The Bank also requires title insurance to insure the priority of the property lien on its real estate loans over $50,000 and requires fire and casualty insurance on all of its loans.

The real estate loans originated by the Bank contain a “due-on-sale” clause, which provides that the Bank may declare the unpaid balance of the loan immediately due and payable upon the sale of the mortgaged property.  Such clauses are an important means of reducing the average loan life and increasing the yield on existing fixed-rate real estate loans, and it is the Bank’s policy to enforce due-on-sale clauses.

Real Estate: Commercial-Commercial real estate mortgage loans include all one to four family residential loans secured by real estate for purposes other than construction or acquisition and development.  All real estate loans are held in the Bank’s loan portfolio except for loans that have been participated to correspondent banks.  The Bank will sell these participations if a loan exceeds the Bank’s legal lending limit or as is deemed appropriate by the Director’s Loan Committee.  Commercial real estate mortgage loans are a combination of properties that are leased out or used for a primary place of a business the Bank has a relationship with.   Most of the commercial real estate loans have fixed interest rates for terms of one to three years with balloon payment provisions and are amortized over a 10 to 15 year period, but whenever possible the Bank will seek a variable rate loan which would be tied to the New York prime rate and adjusted monthly.  The Bank’s experience indicates that real estate loans normally remain outstanding for much shorter periods (seven years on average) than their stated maturity because the borrowers repay the loans in full either upon the sale of the secured property or upon the refinancing of the original loan.  Commercial real estate loans are made for up to 85% of the value of the property securing the loan, based upon an appraisal if the loan amount is over $100,000.  The Bank also requires title insurance to insure the priority of the property lien on its real estate loans over $50,000 and requires fire and casualty insurance on all of its loans.
 
Consumer Loans-These loans consist of consumer installment loans and consumer credit card balances.  The Bank makes both secured and unsecured consumer loans for a variety of personal and household purposes.  Most of the Bank’s consumer loans are automobile loans, boat loans, property improvement loans and loans to depositors on the security of their certificates of deposit.  These loans are generally made for terms of up to five years at fixed interest rates.  The Bank considers consumer loans to involve a relatively high credit risk compared to real estate loans.  Consumer loans, therefore, generally yield a relatively high return to the Bank and provide a relatively short maturity.  The Bank believes that the generally higher yields and the shorter terms available on various types of consumer loans tend to offset the relatively higher risk associated with such loans, and contribute to a profitable spread between the Bank’s average yield on earning assets and the Bank’s cost of funds.

Lending Commitments-Commitments under standby letters of credit and undisbursed loan commitments totaled approximately $46 million as of December 31, 2009 compared to approximately $67 million as of December 31, 2008.  This number includes all lines of credit that have not been fully drawn and loan commitments in the same status.

Origination, Purchase and Sale of Loans

The Bank originates the majority of its loans in Hamilton County, Tennessee.  However, the Bank also originates loans in Marion, Sequatchie and Bradley Counties in Tennessee, and Dade, Walker, Whitfield and Catoosa Counties in Georgia, each of which is within 150 miles of Chattanooga, Tennessee.  Eagle markets to staffing companies in the United States.  Loans are originated by 17 relationship managers who operate from the Bank’s offices in Chattanooga, Tennessee and from the loan production office in Dalton, Georgia.  These relationship managers actively solicit loan applications from existing customers, local manufacturers and retailers, builders, real estate developers, real estate agents and others.  The Bank also receives numerous loan applications as a result of customer referrals and walk-ins to its offices.

Upon receipt of a loan application and all required supporting information from a prospective borrower, the Bank obtains a credit report and verifies specific information relating to the loan applicant’s employment, income and creditworthiness.  For significant extensions of credit in which real estate will secure the proposed loan, a certified appraisal of the real estate is undertaken by an independent appraiser approved by the Bank.  The Bank’s relationship managers then analyze the credit worthiness of the borrower and the value of any collateral involved.

The Bank’s loan approval process is intended to be conservative but also responsive to customer needs.  Loans are approved in accordance with the Bank’s written loan policy, which provides for several tiers of approval authority, based on a borrower’s aggregate debt with the Bank.  The Bank’s legal lending limit is 25% of the Bank’s qualifying equity for secured loans and 15% for unsecured loans.

32
 
The Bank has in the past purchased and sold commercial loan participations with correspondent banks and will continue the practice when management feels the action would be in the best interest of shareholders.  The purchase of loan participations allows the Bank to expand its loan portfolio and increase profitability while still maintaining the high credit standards, which are applied to all extensions of credit made by the Bank.  The sale of loan participations allows the Bank to make larger loans and retain a servicing fee for its labor, which it otherwise would be unable to make due to capital or other funding considerations.

Loan Fee Income

In addition to interest earned on loans, the Bank receives origination fees for making loans, commitment fees for making certain loans, and other fees for miscellaneous loan-related services.  Such fee income varies with the volume of loans made, prepaid or sold, and the rates of fees vary from time to time depending on the supply of funds and competitive conditions.

Commitment fees are charged by the Bank to the borrower for certain loans and are calculated as a percentage of the principal amount of the loan.  These fees normally are deducted from the proceeds of the loan and generally range from 0.5% to 2.0% of the principal amount, depending on the type and volume of loans made and market conditions such as the demand for loans, the availability of money and general economic conditions.  The Bank complies with Accounting Standard Codification Topic 310, “Receivables”, and amortizes all significant loan fees over the life of the loan.  The Bank also receives miscellaneous fee income from late payment charges, overdraft fees, property inspection fees, and miscellaneous services related to its existing loans.

Problem Loans and Allowance for Loan Losses

Problem Loans-In originating loans, Cornerstone recognizes that it will experience credit losses and that the risk of loss will vary with, among other things, the type of loan being made, the creditworthiness of the borrower over the term of the loan and, in the case of a secured loan, the quality of the security for the loan.  Cornerstone has instituted measures at the Bank and Eagle which are designed to reduce the risk of, and monitor exposure to, credit losses.

The Bank’s loan portfolio is systematically reviewed by the Bank’s management, internal auditors, external auditors, and State and Federal regulators to ensure that the Bank’s larger loan relationships are being maintained within the loan policy guidelines, and remain properly underwritten.  Input from all the above sources is used by the Bank to take corrective actions as necessary.  As discussed below, each of the Bank’s loans is assigned a rating in accordance with the Bank’s internal loan rating system.  All past due loans are reviewed by the Bank’s senior lending officers and all past due loans over $25,000 are reviewed monthly by the Director’s Loan Committee.  All loans classified as substandard or doubtful, as well as any “special mention” loans (defined in the following paragraph), are placed on the Bank’s watch list and reviewed at least monthly by the Director’s Loan Committee.  In addition, all loans to a particular borrower are reviewed, regardless of classification, each time such borrower requests a renewal or extension of any loan or requests an additional loan.  All lines of credit are reviewed annually prior to renewal.  Such reviews include, but are not limited to, the ability of the borrower to repay the loan, a re-assessment of the borrower’s financial condition, the value of any collateral and the estimated potential loss to the Bank, if any.

The Bank’s internal problem loan rating system establishes three classifications for problem assets: substandard, doubtful and loss.  Additionally, in connection with regulatory examinations of the Bank, Federal and State examiners have authority to identify problem assets and, if appropriate, require the Bank to classify them.  Substandard assets have one or more defined weaknesses and are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected.  Doubtful assets have the weaknesses of substandard assets with the additional characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions and values, highly questionable and improbable.  An asset classified as loss is considered uncollectible and of such little value that continuance as an asset of the Bank is not warranted.  Consequently, such assets are charged-off in the month they are classified as loss.  Federal regulations also designate a “special mention” category, described as assets which do not currently expose the Bank to a sufficient degree of risk to warrant classification but do possess credit deficiencies or potential weaknesses deserving management’s close attention.

Assets classified as substandard or doubtful require the Bank to establish general allowances for loan losses.  If an asset or portion thereof is classified as loss, the Bank must either establish specific allowances for loan losses in the amount of 100% of the portion of the asset classified as loss or charge off such amount.  General loss allowances established to cover possible losses related to assets classified as substandard or doubtful may be included, up to certain limits, in determining the Bank’s regulatory capital, while specific valuation allowances for loan losses do not qualify as regulatory capital.

The Bank’s collection procedures provide that when a loan becomes between 15 days and 30 days delinquent, the borrower is contacted by mail and payment is requested.  If the delinquency continues, subsequent efforts are made to contact and request payment from the delinquent borrower.  Most loan delinquencies are cured within 60 days and no legal action is required.  In certain circumstances, the Bank, for a fee, may modify the loan, grant a limited moratorium on loan payments or revise the payment schedule to enable the borrower to restructure his or her financial affairs.  Generally, the Bank stops accruing interest and any accrued non collected interest will be reversed in accordance with GAAP on delinquent loans when payment is in arrears for 90 days or when collection otherwise becomes doubtful.  If the delinquency exceeds 120 days and is not cured through the Bank’s normal collection procedures or through a restructuring, the Bank will institute measures to enforce its remedies resulting from the default, including commencing a foreclosure, repossession or collection action.  In certain cases, the Bank will consider accepting a voluntary conveyance of collateral in lieu of foreclosure or repossession.  Real property acquired by the Bank as a result of foreclosure or by deed in lieu of foreclosure is classified as foreclosed assets until it is sold and is carried at the lower of cost or fair value less estimated costs to dispose.  Accounting standards define fair value as the amount that is expected to be received in a current sale between a willing buyer and seller other than in a forced or liquidation sale.  Fair values at foreclosure are based on appraisals.  Losses arising from the acquisition of foreclosed properties are charged against the allowance for loan losses.  Subsequent write-downs are provided by a charge to income through losses on other real estate in the period in which the need arises.

33
 
Allowance for Loan Losses-The allowance or reserve for possible loan losses is a means of absorbing future losses, which could be incurred from the current loan portfolio.  The Bank maintains an allowance for possible loan losses, and management adjusts the general allowances monthly by charges to income in response to changes to outstanding loan balances.

The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectability of loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions.  This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.  A loan or portion thereof is charged off against the general allowance when management has determined that losses on such loans are probable.  Recoveries on any loans charged-off in prior fiscal periods are credited to the allowance.  It is the opinion of the Bank’s management that the balance in the general allowance for loan losses as of December 31, 2009 is adequate to absorb possible losses from loans currently in the portfolio.

Table 16 presents the Bank’s internal watchlist for loans classified as doubtful as of December 31, 2009 and 2008.  Table 17 presents the Bank’s internal watchlist for loans classified as substandard as of December 31, 2009 and 2008.

TABLE 16
 
Internal Watchlist Composition-Doubtful
   
December 31, 2009
    
December 31, 2008
  
(In thousands)
  
Amount
    
Impairment
    
Amount
    
Impairment
  
Commercial and industrial
   $  1,350     $ -     $ 5,178     $ 2,999  
Construction and development
     -       -       980       567  
Single family real estate
     -       -       -       -  
Multi-family real estate
     -       -       -       -  
Owner occupied commercial real estate
     -       -       109       94  
Non-owner occupied commercial real estate
     -       -       -       -  
Consumer
     -       -       -       -  
Totals
   $ 1,350     $ -     $ 6,267     $ 3,660  
 
TABLE 17
 
Internal Watchlist Composition-Substandard
   
December 31, 2009
    
December 31, 2008
  
(In thousands)
  
Amount
    
Impairment
    
Amount
    
Impairment
  
Commercial and industrial
   $ 2,578     $ 216     $ 3,895     $ 746  
Construction and development
     13,727       93       4,840       89  
Single family real estate
     6,498       689       5,035       157  
Multi-family real estate
     2,820       52       118       52  
Owner occupied commercial real estate
     6,038       131       1,962       33  
Non-owner occupied commercial real estate
     6,150       159       2,514       648  
Consumer
     100       6       292       153  
Totals
   $ 37,911     $ 1,346     $ 18,656     $ 1,878  
 
34

·
The information listed in tables 16 and 17 reflect the amount of the Bank’s loans net of any partial charge-off amount that has been previously recorded.

·
The Bank has received a judgment by the Federal Bankruptcy court awarding all proceeds from the sale of the company relating to the $1.4 million commercial and industrial doubtful loan as of December 31, 2009.  Currently, there is $1.5 million on deposit to fund this judgment.

·
The Bank’s 2008 loans classified as doubtful were subsequently charged-off in 2009.

·
The Bank saw its construction and development customer base deteriorate during 2009 especially in land development.   Of the $13.7 million classified as substandard as of December 31, 2009, approximately $12.9 million is represented by six developments.  As of December 31, 2009, all of the classified land development loans had sufficient collateral to require only minor impairment.

·
The Bank’s commercial real estate saw broad based deterioration due to the prolonged economic recession; highlighted as the hardest hit by the recession is the low income economic class.  Loans that have deteriorated the most associated with this group have been two churches totaling approximately $3.0 million of exposure, customers with mini warehouses and low income multifamily housing.

·
The Bank has revised its appraisal policy to require all loans graded substandard or worse to have annual appraisals on all real estate pledged as collateral with a value of $500,000 or greater.  These appraisals are used by the Bank’s Loan Review department to verify appropriate real estate impairment levels during this period of unstable property values.

Table 18 presents Cornerstone’s allocation of the allowance for loan losses as of December 31, 2009, 2008, 2007, 2006 and 2005.

TABLE 18
 
Allowance for Loan Losses
Years Ended December 31,
   
2009
  
2008
    
2007
  
(In thousands)
Balance at end of period applicable to
  
Amount
    
Percent of loans by category to total loans
    
Amount
    
Percent of loans by category to total loans
    
 
Amount
    
Percent of loans by category to total loans
  
Commercial, financial and agricultural
   $ 1,607       17.99 %   $ 4,955       21.42 %   $ 9,482       25.57 %
Real estate – construction
     595       14.15 %     1,433       18.15 %     2,447       20.03 %
Real estate – mortgage
     1,861       21.08 %     1,532       18.74 %     101       16.84 %
Real estate – commercial
     1,768       45.53 %     1,376       40.13 %     1,434       35.99 %
Consumer
     74       1.25 %     322       1.56 %     246       1.57 %
Totals
   $ 5,905       100.00 %   $ 9,618       100.00 %   $ 13,710       100.00 %
                           
   
2006
  
2005
                  
(In thousands)
Balance at end of period applicable to
  
 
Amount
    
Percent of loans by category to total loans
    
 
Amount
    
Percent of loans by category to total loans
                  
Commercial, financial and agricultural
   $ 1,686       31.77 %   $ 1,438       32.40 %                
Real estate – construction
     1,581       18.57 %     1,253       17.72 %                
Real estate – mortgage
     77       15.70 %     79       17.19 %                
Real estate – commercial
     703       31.98 %     535       29.98 %                
Consumer
     211       1.98 %     240       2.71 %                
Totals
   $ 4,258       100.00 %   $ 3,545       100.00 %                

35
 
·
In recent years Cornerstone has refined its loan loss allowance to include measurements such as environmental factors for growth, environmental factors for real estate values, historical metrics and specific loan products with increased levels of risk, such as asset based lending.  This process enables Cornerstone to support and estimate the necessary allowance needed to protect Cornerstone against possible losses.  The allowance as of December 31, 2009 totaled $5.9 million compared to $9.6 million as of December 31, 2008.  The most significant events occurring in the loan loss allowance during 2009 were provisions totaling $14.9 million and net charge-offs $18.6 million.

·
Of the Bank’s $5.9 million loan loss allowance, the Bank has specifically assigned approximately $2.1 million to cover specific impairments for loans the Bank has identified as classified loans.  The remaining $3.8 million is a general reserve derived from historical and economic factors mentioned above.

·
The primary difference between the 2009 allowance and the 2008 allowance is the proactive stance the Bank took during 2009 which resulted in several loans being charged-off.  At the end of 2008, several large loans had specific reserves but were not charged-off until 2009.  One example of the distorted level of allowance was a loan relationship in the commercial and industrial classification totaling approximately $5.2 million with a specific impairment of approximately $3.0 million.  As of December 31, 2008, the Bank had performed its loan impairment analysis and recorded the proper amount of allowance needed.  During 2009, the loan relationship was charged-off which resulted in a significant decline in the allowance for loan loss amount as of December 31, 2009.

Table 19 presents Cornerstone’s delinquent and non-performing assets as of December 31, 2009 and 2008.

TABLE 19
 
Delinquent and Non-Performing Assets
Actual for Years Ended December 31,
(In thousands)
  
2009
    
2008
  
Accruing loans that are contractually
            
past due 90-days or more:
            
             
Commercial, financial and agricultural
   $ 0     $ 0  
Real estate – construction
     0       0  
Real estate – mortgage
     0       0  
Real estate- commercial
     0       0  
Consumer
     0       0  
Total Loans
   $ 0     $ 0  
                 
Non-accruing loans 90-days or more:
                
                 
Commercial, financial and agricultural
   $ 1,498     $ 0  
Real estate – construction
     2,770       1,180  
Real estate – mortgage
     842       720  
Real estate – commercial
     2,250       2,352  
Consumer
     0       0  
Total Loans
   $ 7,360     $ 4,252  
                 
Real estate acquired through foreclosure
   $ 10,327     $ 2,459  
Property acquired through repossession
     217       257  
Total acquired
   $ 10,544     $ 2,716  
Total Loans
   $ 336,692     $ 388,090  
                 
Ratio of non-performing assets to total loans
     5.32 %     1.80 %
Ratio of delinquent (30-days or more) but accruing loans to:
                
Total loans
     1.80 %     2.08 %
Total assets
     1.20 %     1.71 %
 
·
Adverse economic conditions over the past two years have negatively impacted the Bank’s loan portfolio.  Real estate loans in all three classifications were negatively impacted during 2009.  The Bank continues to monitor its real estate loan portfolio closely in an attempt to identify potential problem loans as soon as possible.  However, as of December 31, 2009, the Bank had foreclosed on residential properties totaling approximately $4.4 million, commercial properties totaling approximately $4.0 million and real estate land totaling approximately $1.9 million.

In addition to the Bank’s loan rating system for problem assets described above (see “Problem Loans,” above), the Bank has established a loan rating system for all categories of loans which assists management and the Board of Directors in determining the adequacy of the Bank’s allowance for loan losses.  Each loan in the Bank’s portfolio is assigned a rating which is reviewed by management periodically to ensure its continued suitability.  An exception is made in the case of (i) monthly installment loans which are grouped together by delinquency status such as over 10, 30, 60, or 90 days past due and (ii) problem assets which are rated as substandard, doubtful, or loss as discussed above.  All other loans are assigned a rating of excellent, good, or average.

·
The Bank has developed an internal loan watchlist that identifies classified loans and assists management to monitor their potential risk to Bank earnings.  As of December 31, 2009, the Bank had approximately $1.3 million in loans graded as doubtful, approximately $37.9 million in loans graded substandard and approximately $31.7 million graded as special mention.

36
 
Table 20 presents Cornerstone’s loan loss experience for the periods indicated.

TABLE 20
 
Loan Loss Reserve Analysis
Years Ending December 31,
(in thousands)
  
2009
    
2008
    
2007
    
2006
    
2005
  
Average loans
   $ 363,146     $ 385,957     $ 353,278     $ 284,105     $ 236,265  
                                         
Allowance for possible loan losses,
                                        
Beginning of the period
   $ 9,618     $ 13,710     $ 4,258     $ 3,545     $ 2,658  
                                         
Charge-offs for the period:
                                        
Commercial, financial and agricultural
     10,811       6,991       737       307       275  
Real estate – construction
     6,005       434       84       0       48  
Real estate – mortgage
     692       193       0       104       50  
Real estate - commercial
     1,248       210       180       0       78  
Consumer
     340       151       74       70       111  
                                         
Total charge-offs
     19,096       7,979       1,075       481       562  
                                         
Recoveries for the period:
                                        
Commercial, financial and agricultural
     358       362       114       66       12  
Real estate – construction
     4       14       0       0       1  
Real estate – mortgage
     64       1       4       7       6  
Real estate – commercial
     43       0       0       0       0  
Consumer
     15       12       0       15       28  
                                         
Total recoveries
     484       389       118       88       47  
                                         
Net charge-offs for the period
     18,612       7,590       957       393       515  
                                         
Provision for loan losses
     14,899       3,498       10,409       1,106       1,402  
Adjustments
     0       0       0       0       0  
                                         
Allowance for possible loan losses, end of period
   $ 5,905     $ 9,618     $ 13,710     $ 4,258     $ 3,545  
                                         
Ratio of allowance for loan losses to total average loans outstanding
     1.63 %     2.49 %     3.88 %     1.50 %     1.50 %
                                         
Ratio of net charge-offs during the period to average loans outstanding during the period
     5.13 %     1.97 %     0.27 %     0.14 %     0.22 %

Intangibles-Cornerstone follows the provisions of Accounting Standards Codification Topic 350, “Intangibles-Goodwill and Other” concerning approximately $2.5 million in goodwill created by the merger with the Bank of East Ridge.  Goodwill is tested annually for impairment.  If the carrying value of goodwill exceeds the fair value, a write-down is recorded.  No impairment loss was recognized during 2009, 2008 or 2007.  In December, 2005, Cornerstone completed the purchase of Eagle Financial, Inc. and recorded an intangible asset of $848,916. Prior to June 2009, Eagle amortized a portion of the intangible each month.  However, on June 30, 2009 the Bank purchased Eagle from the holding company.  The transaction resulted in a write-off of the remaining intangible balance of approximately $229 thousand based on an appraisal of the business performed in conjunction with that transaction.

37
 
Sources of Funds

Overview-Time, money market, savings and demand deposits are the major source of the Bank’s funds for lending and other investment purposes.  All deposits are held by the Bank.  In addition, the Bank obtains funds from loan principal repayments and proceeds from sales of loan participations and investment securities.  Loan repayments are a relatively stable source of funds, while deposit inflows and outflows and sales of loan participations and investment securities are significantly influenced by prevailing interest rates, economic conditions and the Bank’s asset and liability management strategies.  Borrowings are used on either a short-term basis to compensate for reductions in the availability of other sources of funds or on a longer-term basis to reduce interest rate risk.

Part of the banking industries lexicon is core and non-core funding.   Core funding includes all deposits except time deposits issued in denominations of $100,000 or greater.  All other funding is classified as non-core funding.  The Bank attempts to minimize its reliance on non-core funding by attracting local deposit accounts.   However, local market competition or advantageous interest rate positions can influence the Bank to select non-core funding.

Table 21 presents the Bank’s core vs. non-core funding as of December 31, 2009 and 2008 (in thousands).

TABLE 21

Core and Non-Core Funding
           
(In thousands)
  
December 31, 2009
    
December 31, 2008
  
Core funding:
  
Amount
    
Percent
    
Amount
    
Percent
  
Noninterest bearing demand deposits
   $ 41,972       8.4 %   $ 40,078       9.3 %
Interest-bearing demand deposits
     26,533       5.3 %     26,909       6.3 %
Savings & money market accounts
     31,030       6.2 %     35,848       8.3 %
Time deposits under $100,000
     214,143       43.0 %     147,928       34.5 %
Total core funding
     313,678       62.9 %     250,763       58.4 %
                                 
Non-core funding:
                                
Brokered deposits
     5,852       1.29 %     16,763       3.9 %
Time deposits greater than $100,000
     85,212       17.19 %     59,057       13.8 %
Securities sold under agreements to repurchase
     26,322       5.3 %     35,790       8.3 %
Federal Home Loan Bank advances
     67,000       13.5 %     67,000       15.6 %
Total non-core funding
     184,386       37.1 %     178,610       41.6 %
                                 
Total
   $ 498,064       100.0 %   $ 429,373       100.0 %
 
·
During 2009, the Bank materially increased its time deposits to fund an increase in the Bank’s investment portfolio.  The increase in the investment portfolio was needed for pledging and liquidity purposes.  The time deposits represent a more stable funding source for the Bank when compared to other sources such as brokered deposits.  Management anticipates the time deposits to remain at this level during 2010.

·
During 2010, the Bank is contractually obligated to pay off $17 million of Federal Home Loan Bank advances.

Deposits-The Bank offers several types of deposit accounts, with the principal differences relating to the minimum balances required, the time period the funds must remain on deposit and the interest rate.  Deposits are obtained primarily from the Bank’s Chattanooga, Tennessee MSA.  The Bank does advertise for deposits outside of this area and has had moderate success attracting deposits from credit unions around the United States.  The Bank does not rely upon any single person or group of related persons for a material portion of its deposits. However, the Bank has a large depositor related to its ACH business line that leaves a large amount of money for the Bank to use as it passes through the Bank to its final destination.  A principal source of deposits for the Bank consists of short-term money market and other accounts, which are highly responsive to changes in market interest rates.  Accordingly, the Bank, like all financial institutions, is subject to short-term fluctuations in deposits in response to customer actions due to changing short-term market interest rates.  The ability of the Bank to attract and maintain deposits and the Bank’s cost of funds has been and will continue to be significantly affected by money market conditions.

38
 
Table 22 presents the composition of deposits for the Bank, excluding accrued interest payable, by type for the years ended December 31, 2009, 2008 and 2007 (in thousands).

TABLE 22
 
Deposit Composition
Years Ended December 31,
(In thousands)
  
2009
    
2008
    
2007
  
Demand deposits
   $ 41,972     $ 40,078     $ 45,285  
NOW deposits
     26,533       26,909       31,985  
Savings & money market deposits
     31,030       35,848       49,970  
Time deposits $100,000 and over
     91,064       59,057       58,250  
Time deposits under $100,000
     214,143       164,692       127,760  
     Total Deposits
   $ 404,742     $ 326,584     $ 313,250  

·
On October 3, 2008, the Emergency Economic Stabilization Act of 2008 (“EESA”) became law.  The EESA enabled the FDIC to temporarily increase the amount of FDIC deposit insurance coverage from $100,000 to $250,000 per qualified depositor through December 31, 2013.  Also during the fourth quarter of 2008, the FDIC’s Temporary Liquidity Guarantee Program (“TLGP”) extended unlimited deposit insurance coverage for non-interest bearing transaction accounts at participating FDIC insured banks.  The FDIC also offered coverage regarding debt obligation coverage.  These services were offered by the FDIC with a fee structure for each product.  The Bank chose to accept the unlimited transaction account coverage but refused the debt obligation coverage.  The TLGP currently has an expiration date of June 30, 2010.

·
Time deposits annual percentage yields decreased materially throughout 2009, which allowed the Bank to increase its deposit base at a lower cost of funds than incurred in 2008.  In November 2009, the FDIC downgraded the Bank to “adequately capitalized” status, thereby restricting the interest rates payable by the Bank for time deposits.  However, as of March 2010, the restriction has not affected deposit growth.

Table 23 presents a breakdown by category of the average amount of deposits and the average rate paid on deposits for the periods indicated:

TABLE 23
 
Average Amount and Average Rate Paid on Deposits
Years Ending December 31,
   
2009
    
2008
    
2007
  
(In thousands)
  
Amount
    
Rate
    
Amount
    
Rate
    
Amount
    
Rate
  
Demand deposits
   $ 40,816           $ 42,915           $ 41,503        
NOW deposits
     27,864       0.35 %     30,106       0.70 %     36,327       2.21 %
Savings & money market deposits
     35,269       0.86 %     51,600       1.60 %     55,808       3.61 %
Time deposits $100,000 and over
     61,533       3.33 %     59,083       4.01 %     61,172       5.12 %
Time deposits under $100,000
     195,018       2.85 %     131,138       4.49 %     107,498       5.01 %
Total Deposits
   $ 360,500       2.51 %   $ 314,842       3.42 %   $ 302,308       4.35 %

Borrowings-The Bank joined the Federal Home Loan Bank of Cincinnati in October 2000.  The Federal Home Loan Bank (the “FHLB”) allows the Bank to borrow funds on a contractual basis many times at rates lower than the costs of local certificates of deposit.   In addition, the FHLB has the ability to provide structured advances that best reduce or leverage the interest rate risk of the Bank.  The Bank as of December 31, 2009, had $67 million outstanding with the FHLB.  The FHLB offers multiple products to assist banks in their funding needs.  The advances from the FHLB as of December 31, 2009 are structured as an obligation with a fixed rate with the majority of loans incorporating an optional conversion to a floating rate after a stated period of time.  The loans have maturities ranging from May 2010 to January 2017.  As of December 31, 2009, the interest rates on these loans ranged from 3.52% to 5.00%.  The Bank has two Federal Funds lines of credit available with correspondent banks with a total availability of $9 million as of December 31, 2009.  In addition, the Bank has the right to borrow from the Federal Reserve Bank if necessary to supplement its supply of funds available for lending and to meet deposit withdrawal requirements.  As of December 31, 2009, Cornerstone had two loans totaling approximately $5.4 million priced at New York Prime Rate plus 300 basis points with a floor of 6.25%.  The loans were established to insert capital infusions to the Bank to fund growth or retire treasury stock, if any, as needed.  See Note 9 of our audited consolidated financial statements for additional information.

39
 
Capital

Capital Resources-Stockholder’s average equity for 2009 and 2008 totaled $33.6 million and $37.4 million, respectively.  As of December 31, 2009, Cornerstone’s actual stockholder equity totaled $27.8 million compared to $36.5 million as of December 31, 2008.  The number of common shares outstanding increased to 6,500,396 as of December 31, 2009 from 6,319,718 as of December 31, 2008.  Changes in the number of common shares outstanding resulted from Cornerstone’s two stock dividends totaling 0.8421% of the shares outstanding as of June 12, 2009 and 2.0% of the shares outstanding as of September 18, 2009.

Capital Adequacy-Capital adequacy refers to the level of capital required to sustain asset growth and to absorb losses.  The objective of Cornerstone’s management is to maintain a level of capitalization that is sufficient to take advantage of profitable growth opportunities while meeting regulatory requirements.  This is achieved by improving profitability by effectively allocating resources to more profitable business, improving asset quality, strengthening service quality, and streamlining costs.  The primary measures used by management to monitor the results of these efforts are the ratios of actual equity to average assets and actual equity to risk-adjusted assets.

The FDIC has adopted capital guidelines governing the activities of banks.  These guidelines require the maintenance of an amount of capital based on risk-adjusted assets so that categories of assets with potentially higher credit risk will require more capital backing than assets with lower risk.  In addition, banks are required to maintain capital to support, on a risk-adjusted basis, certain off-balance sheet activities such as loan commitments.  The capital guidelines classify capital into two tiers, referred to as Tier I and Tier II.  Under risk-based capital requirements, total capital consists of Tier I capital, which is generally common shareholder’s equity less goodwill, and Tier II, which is primarily Tier I capital plus a portion of the loan loss allowance.  In determining risk-based capital requirements, assets are assigned risk-weights of 0% to 100%, depending primarily on the regulatory assigned levels of credit risk associated with such assets.  Off-balance sheet items are considered in the calculation of risk-adjusted assets through conversion factors established by regulators.  The framework for calculating risk-based capital requires banks to meet the regulatory minimums of 4% Tier I and 8% total risk based capital.  In 1990, regulators added a leverage computation to the capital requirements, comparing Tier I capital to total average assets less goodwill.

The Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”) established five capital categories for banks.  Under the regulation defining these five capital categories, each bank is classified into one of the five categories based on its level of risk-based capital as measured by Tier I capital, total risk-based capital, and Tier I leverage ratios and its supervisory ratings.  Table 24 lists the five categories of capital and each of the minimum requirements for the three risk-based ratios.

TABLE 24
 
Minimum Requirements for Risk-Based Capital Ratios
   
Total Risk-Based
Capital Ratio
  
Tier I Risk-Based
Capital Ratio
  
 
Leverage Ratio
Well capitalized
  
10% or above
  
6% or above
  
5% or above
Adequately capitalized
  
8% or above
  
4% or above
  
4% or above
Under Capitalized
  
Less than 8%
  
Less than 4%
  
Less than 4%
Significantly undercapitalized
  
Less than 6%
  
Less than 3%
  
Less than 3%
Critically undercapitalized
          
2% or less

·
As of December 31, 2009, the Bank exceeded the regulatory minimums and qualified as an adequately-capitalized institution under the regulations.  The Bank had Tier 1 capital of $29.5 million or 6.1% of average assets as of December 31, 2009, compared to Tier 1 capital of $36.3 million or 7.9% of average assets as of December 31, 2008.  The Bank had total capital of $34.0 million or 9.5% of risk weighted assets as of December 31, 2009, compared to total capital of $41.4 million or 10.3% of risk weighted assets as of December 31, 2008.

·
To provide sufficient capital to restore the Bank’s status as a “well capitalized” institution and to pay off Cornerstone’s holding company loans, Cornerstone is actively considering strategic alternatives, which may include a capital infusion through the issuance and sale shares of common stock, preferred stock or other securities (including securities convertible into shares of common stock) in public or private offerings.

Liquidity-Of primary importance to depositors, creditors and regulators is the ability to have readily available funds sufficient to repay fully maturing liabilities.  Cornerstone’s liquidity, represented by cash and cash from banks, is a result of its operating, investing and financing activities.  In order to ensure funds are available at all times, Cornerstone devotes resources to projecting on a monthly basis the amount of funds accessible.  Liquidity requirements can also be met through short-term borrowing or the disposition of short-term assets, which are generally matched to correspond to the maturity of liabilities.

40
 
The Bank’s liquidity target is measured by adding net cash, short term and marketable securities not pledged and dividing this number by total deposits and short-term liabilities not secured by assets pledged.  The Bank’s liquidity ratio at December 31, 2009 was 9.1% compared to 10.4% at December 31, 2008.  The Bank is not subject to any specific liquidity requirements imposed by regulatory orders.  The Bank is subject however, to general FDIC guidelines which are concerned with funding sources and dependence on noncore deposits and does not require a specific minimum level of liquidity.  Management believes its liquidity ratios and funding sources meet or exceed these guidelines.

Cornerstone’s liquidity is dependent on dividends from its subsidiary and capital contributions from its stockholders.  Currently, the holding company’s expenses are tied to debt service on two holding company loans totaling $5.4 million and shareholder and related Securities and Exchange Commission required filings expense.  The Bank is presently restricted from passing up any dividends to the holding company unless the Bank receives prior approval from the FDIC.

As previously reported, after initially applying in December 2008 for funding of up to $12 million under the U.S. Treasury’s Capital Purchase Program, instituted as part of the Troubled Asset Relief Program established under the EESA, Cornerstone notified the FDIC of its decision to withdraw its application on October 15, 2009.

Management does not know of any other trends, demands, commitments, events or uncertainties that will result in or are reasonably likely to result in liquidity increasing or decreasing in any material manner.

Table 25 presents the average loan to deposit ratios, a liquidity measure, for periods indicated:

TABLE 25
 
   
December 31, 2009
    
December 31, 2008
  
Average loans to average deposits
     100.73 %     122.59 %
 
ITEM 7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Cornerstone’s Asset/Liability Committee (“ALCO”) actively measures and manages interest rate risk using a process developed by the Bank. The ALCO is also responsible for approving Cornerstone’s asset/liability management policies, overseeing the formulation and implementation of strategies to improve balance sheet positioning and earnings, and reviewing Cornerstone’s interest rate sensitivity position.
 
The primary tool that management uses to measure short-term interest rate risk is a net interest income simulation model prepared by an independent national consulting firm and reviewed by another separate and independent national consulting firm. These simulations estimate the impact that various changes in the overall level of interest rates over one- and two-year time horizons would have on net interest income. The results help Cornerstone develop strategies for managing exposure to interest rate risk.
 
Like any forecasting technique, interest rate simulation modeling is based on a large number of assumptions. In this case, the assumptions relate primarily to loan and deposit growth, asset and liability prepayments, interest rates and balance sheet management strategies. Management believes that both individually and in the aggregate the assumptions are reasonable. Nevertheless, the simulation modeling process produces only a sophisticated estimate, not a precise calculation of exposure.

Table 26 presents the re-pricing of the Bank’s interest earning assets and interest-bearing liabilities as of December 31, 2009.  This interest sensitivity gap table is designed to monitor the Bank’s interest rate risk exposure within the designated time period.  In order to control interest rate risk, management regularly monitors the volume of interest sensitive assets relative to interest sensitive liabilities over specific time intervals.  The Bank’s interest rate management policy is to attempt to maintain a relatively stable net interest margin in periods of interest rate fluctuations.   The Bank’s policy is to attempt to maintain a ratio of cumulative gap to total interest sensitive assets of negative 15.00% to positive 15.00% in the time period of one year or less.  The information set forth below is based on the following assumptions of management:  (i) savings and money market and NOW accounts will be less interest rate sensitive and the re-pricing on these accounts will be spread out over a five-year period; and (ii) securities other than mortgage-backed securities have been scheduled by maturity date while mortgages have been amortized over the life of the mortgage.   Table 26 excludes the interest sensitive assets and liabilities of Eagle and the Bank’s holding company, Cornerstone Bancshares, Inc.  The exclusion for Eagle is an interest sensitive asset, consisting of accounts receivable, totaling $2.0 million.  The exclusion for the holding company is an interest sensitive liability, which consists of two loans with approximately $5.4 million outstanding.  The interest sensitive asset of Eagle would be accounted for in the less than one year analysis.  With respect to the interest sensitive liability of the holding company $1.0 million would be accounted for in the less than one year analysis and $4.4 million would be accounted for the one to five year analysis.
 
41
 
TABLE 26
 
Re-pricing of Interest Sensitive Assets and Liabilities
Year-end balance as of December 31, 2009
  
(In thousands)
  
Less than
 One Year
    
1 to
 5 Years (3)
    
Over
 5 Years (3)
    
Total
  
Interest Sensitive Assets:
                        
Investment securities
                        
Taxable (1)
   $ 47,062     $ 61,377     $ 639     $ 109,078  
Tax-exempt (1)
     -       599       14,873       15,472  
Loans (2)
                                
Fixed rate and adjustable rate 1-4 family mortgage
     18,408       29,727       10,071       58,206  
Scheduled payments
     125,822       137,871       14,793       278,486  
Other
     42,094       -       -       42,094  
Total Interest Sensitive Assets
   $ 233,386     $ 229,574     $ 40,376     $ 503,336  
                                 
Interest Sensitive Liabilities:
                                
NOW accounts
   $ 10,622     $ 15,911     $ -     $ 26,533  
Money market and savings accounts
     14,640       16,390       -       31,030  
Time deposits
     242,982       62,225       -       305,207  
Other interest bearing liabilities
     78,322       15,000               93,322  
Total Interest Sensitive Liabilities
   $ 346,566     $ 109,526     $ -     $ 456,092  
                                 
Interest Sensitive Gap
     (113,180 )     120,048       40,376       47,244  
Cumulative Interest Sensitive Gap
     (113,180 )     6,868       47,244          
                                 
Ratio of cumulative gap to total Interest Sensitive Assets
     (22.49 )%     1.36 %     9.39 %        
 
(1) All AFS securities are shown at the market value and HTM are shown at book value.
 
(2) Non-performing loans are included as interest-earning assets.
 
(3) All assets and liabilities in these categories are fixed rates.

·
The majority of the Bank’s loans are indexed to the Prime rate as published in The Wall Street Journal.  These variable rate loans contain a provision stating that an interest rate floor ranging from 4.0% to 7.5% exists.  Almost all of the Bank’s variable rate loans have repriced to the interest rate floors.  The Bank’s interest rate model estimates the most likely rate adjustment scenario.

Impact of Inflation and Changing Price- The financial statements and related financial data presented herein have been prepared in accordance with U.S. generally accepted accounting principles, which require the measurement of the financial position and operating results in terms of historical dollars without considering the changes in the relative purchasing power of money over time and due to inflation.  Management is primarily concerned with two inflationary factors; The first and most common factor is the general impact of inflation on the operations of Cornerstone and is reflected in increased operating costs.  The second, and more material to the Bank’s profitability, factor is interest rate adjustments by the Federal Reserve and the general fixed income market in reaction to inflation.  In other words, interest rate risk, unlike most industrial companies, substantially impacts Cornerstone because virtually all of the assets and liabilities of Cornerstone are monetary in nature.  As a result, interest rates may have a more significant impact on Cornerstone’s performance than the effects of general levels of inflation.  Interest rate fluctuations do not necessarily move in the same direction or in the same magnitude as the price of goods and services and each issue must be dealt with independently.

42
 
ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY

Consolidated Financial Statements and Footnotes

Table of Contents
 
   
Page No.
Management’s Report on Internal Control over Financial Reporting
  
44
Report of Independent Registered Public Accounting Firm – Financial Statements
  
45
Consolidated Financial Statements
  
46
Consolidated balance sheets
  
46
Consolidated statements of operations
  
47
Consolidated statements of changes in stockholders’ equity
  
48
Consolidated statements of cash flows
  
50
Notes to consolidated financial statements
  
51
 
43

MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

The management of Cornerstone is responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting is defined in Rule 13a-15(f) or 15d-15(f) promulgated under the Exchange Act as a process designed by, or under the supervision of, Cornerstone’s principal executive and principal financial officers and effected by Cornerstone’s board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those polices and procedures that:

 
·
Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of Cornerstone’s assets;
     
 
·
Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that Cornerstone’s receipts and expenditures are being made only in accordance with authorizations of Cornerstone’s management and directors; and
     
 
·
Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of Cornerstone’s assets that could have a material effect on the financial statements.

All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.

Cornerstone’s management has assessed the effectiveness of internal controls over financial reporting as of December 31, 2009. In making this assessment, it used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in “Internal Control-Integrated Framework.”

Based on this assessment management believes that, as of December 31, 2009, Cornerstone’s internal control over financial reporting was effective based on those criteria.

This annual report does not include an attestation report of Cornerstone’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by Cornerstone’s registered public accounting firm pursuant to transitional rules of the Securities and Exchange Commission that permit Cornerstone to provide only management’s report in this annual report.

44
 
Report of Independent Registered Public Accounting Firm

To the Stockholders and
Board of Directors
Cornerstone Bancshares, Inc.
Chattanooga, Tennessee

We have audited the accompanying consolidated balance sheets of Cornerstone Bancshares, Inc. and subsidiary (Company) as of December 31, 2009 and 2008, 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, 2009.  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 financial position of Cornerstone Bancshares, Inc. and subsidiary as of December 31, 2009 and 2008, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2009, in conformity with United States generally accepted accounting principles.

The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern.  As discussed in Note 2 to the consolidated financial statements, the Company was not in compliance with certain of its debt covenants at December 31, 2009, due to recent operating losses and reduced capital levels.  The uncertainty of the Company’s ability to repay or replace certain of the Company’s debt or to mitigate actions by its lender if the lender declares an event of default, accelerates the repayment terms of the debt or attempts to foreclose on the stock of the subsidiary that is pledged as collateral, raises substantial doubt about the Company’s ability to continue as a going concern.  Management’s plans in regard to these matters are also described in Note 2.  The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.

We were not engaged to examine management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2009, included in Management’s Report on Internal Control Over Financial Reporting found in Item 9A(T) of Form 10-K for the year ended December 31, 2009, and, accordingly, we do not express an opinion thereon.

/s/ HAZLETT, LEWIS & BIETER, PLLC

Chattanooga, Tennessee
March 29, 2010
 
45
 
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
  
CONSOLIDATED BALANCE SHEETS
  
December 31, 2009 and 2008
  
             
   
2009
    
2008
  
             
ASSETS
            
             
Cash and due from banks
  
$
38,202,205
    
$
10,872,390
  
Federal funds sold
    
-
      
11,025,000
  
                 
  Cash and cash equivalents
    
38,202,205
      
21,897,390
  
                 
Securities available for sale
    
124,415,318
      
44,056,559
  
Securities held to maturity (fair value approximates
                
$136,062 at 2009 and $169,759 at 2008)
    
135,246
      
169,284
  
Federal Home Loan Bank stock, at cost
    
2,229,200
      
2,187,500
  
Loans, net of allowance for loan losses of
                
$5,905,054 in 2009 and $9,618,265 in 2008
    
330,787,382
      
378,471,619
  
Bank premises and equipment, net
    
8,098,059
      
8,471,955
  
Accrued interest receivable
    
1,520,699
      
1,771,091
  
Goodwill and amortizable intangibles
    
2,579,211
      
2,840,773
  
Foreclosed assets
    
10,327,297
      
2,458,821
  
Other assets
    
14,109,769
      
9,478,183
  
                 
Total assets
  
$
532,404,386
    
$
471,803,175
  
                 
LIABILITIES AND STOCKHOLDERS' EQUITY
                
                 
Deposits:
                
Noninterest-bearing demand deposits
  
$
41,971,956
    
$
40,077,977
  
Interest-bearing demand deposits
    
26,533,329
      
26,908,572
  
Savings deposits and money market accounts
    
31,029,587
      
35,847,667
  
Time deposits of $100,000 or more
    
91,064,094
      
59,056,590
  
Time deposits under $100,000
    
214,143,147
      
164,692,417
  
                 
Total deposits
    
404,742,113
      
326,583,223
  
                 
Accrued interest payable
    
351,360
      
469,586
  
Federal funds purchased and securities sold under
                
agreements to repurchase
    
26,321,885
      
35,790,246
  
Federal Home Loan Bank advances and other borrowings
    
72,350,000
      
71,250,000
  
Other liabilities
    
801,549
      
1,208,611
  
                 
Total liabilities
    
504,566,907
      
435,301,666
  
                 
Stockholders' equity:
                
Preferred stock - no par value; 2,000,000 shares
                
authorized; no shares issued
    
-
      
-
  
Common stock - $1.00 par value; 10,000,000 shares authorized;
                
6,709,199 and 6,522,718 shares issued in 2009 and 2008
                
6,500,396 and 6,319,718 shares outstanding in 2009 and 2008
    
6,500,396
      
6,319,718
  
Additional paid-in capital
    
21,162,686
      
20,311,638
  
Retained earnings
    
424,854
      
10,056,680
  
Accumulated other comprehensive income
    
(250,457
)
    
(186,527
)
                 
Total stockholders' equity
    
27,837,479
      
36,501,509
  
                 
Total liabilities and stockholders' equity
  
$
532,404,386
    
$
471,803,175
  
                 
The Notes to Consolidated Financial Statements are an integral part of these statements.
          
 
46
 
CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
CONSOLIDATED  STATEMENTS  OF  OPERATIONS
Years Ended December 31, 2009, 2008 and 2007
 
   
2009
    
2008
    
2007
  
                   
INTEREST INCOME
                  
Loans, including fees
   $ 24,402,101     $ 28,660,491     $ 32,981,334  
Securities and interest-bearing deposits in other banks
     1,895,228       1,996,228       1,750,023  
Federal funds sold
     11,098       23,455       52,161  
                         
Total interest income
     26,308,427       30,680,174       34,783,518  
                         
INTEREST EXPENSE
                        
Time deposits of $100,000 or more
     2,049,063       2,370,873       3,134,084  
Other deposits
     5,960,079       6,928,475       8,206,843  
Federal funds purchased and securities
                        
sold under agreements to repurchase
     173,648       600,163       857,161  
Federal Home Loan Bank advances and other borrowings
     3,006,593       2,798,563       2,215,517  
                         
Total interest expense
     11,189,383       12,698,074       14,413,605  
                         
Net interest income before provision for loan losses
     15,119,044       17,982,100       20,369,913  
                         
Provision for loan losses
     14,898,898       3,498,000       10,409,365  
                         
Net interest income after provision for loan losses
     220,146       14,484,100       9,960,548  
                         
NONINTEREST INCOME
                        
Customer service fees
     1,630,387       1,726,681       1,425,822  
Other noninterest income
     138,244       107,522       165,495  
Net (loss) gain from sale of loans and other assets
     (1,227,414 )     57,828       103,773  
                         
Total noninterest income
     541,217       1,892,031       1,695,090  
                         
NONINTEREST EXPENSES
                        
Salaries and employee benefits
     6,970,282       7,139,594       6,608,808  
Net occupancy and equipment expense
     1,547,630       1,520,378       1,354,642  
Depository insurance
     1,198,937       321,164       105,550  
Other operating expenses
     4,559,193       3,586,629       2,856,601  
                         
Total noninterest expenses
     14,276,042       12,567,765       10,925,601  
                         
(Loss) income before income tax expense
     (13,514,679 )     3,808,366       730,037  
                         
Income tax (benefit) expense
     (5,336,040 )     1,296,542       (141,115 )
                         
Net (loss) income
   $ (8,178,639 )   $ 2,511,824     $ 871,152  
                         
EARNINGS (LOSS) PER COMMON SHARE
                        
Basic
   $ (1.26 )   $ .39     $ .13  
Diluted
     (1.26 )     .38       .12  
                         
The Notes to Consolidated Financial Statements are an integral part of these statements.
          
 
47
 
CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
CONSOLIDATED  STATEMENTS  OF  CHANGES  IN  STOCKHOLDERS'  EQUITY
Years Ended December 31, 2009, 2008 and 2007
 
                           
Accumulated
        
               
Additional
          
Other
    
Total
  
   
Comprehensive
    
Common
    
Paid-in
    
Retained
    
Comprehensive
    
Stockholders'
  
   
Income
    
Stock
    
Capital
    
Earnings
    
Income
    
Equity
  
                                     
BALANCE, December 31, 2006
         $ 6,511,848     $ 21,849,006     $ 9,881,029     $ (58,618 )   $ 38,183,265  
                                               
Issuance of common stock
           5,870       20,446       -       -       26,316  
                                               
Issuance of common stock under Director's stock option plan
           5,000       41,610       -       -       46,610  
                                               
Stock compensation expense
           -       220,016       -       -       220,016  
                                               
Dividends - $.22 per share
           -       -       (1,434,303 )     -       (1,434,303 )
                                               
Repurchase of common stock
           (153,000 )     (1,598,291 )     -       -       (1,751,291 )
                                               
Comprehensive income:
                                              
Net income
   $ 871,152       -       -       871,152       -       871,152  
                                                 
Other comprehensive income, net of tax:
                                                
Unrealized holding gains (losses) on securities available for sale,
                                                
net of reclassification adjustment
     165,585       -       -       -       165,585       165,585  
                                                 
Total comprehensive income
   $ 1,036,737                                          
                                                 
BALANCE, December 31, 2007
             6,369,718       20,532,787       9,317,878       106,967       36,327,350  
                                                 
Issuance of common stock
             22,000       60,500       -       -       82,500  
                                                 
Stock compensation expense
             -       279,400       -       -       279,400  
                                                 
Dividends - $.28 per share
             -       -       (1,773,022 )     -       (1,773,022 )
                                                 
Repurchase of common stock
             (72,000 )     (561,049 )     -       -       (633,049 )
                                                 
Comprehensive income:
                                                
Net income
   $ 2,511,824       -       -       2,511,824       -       2,511,824  
                                                 
Other comprehensive income, net of tax:
                                                
Unrealized holding gains (losses) on securities available for sale,
                                                
net of reclassification adjustment
     (293,494 )     -       -       -       (293,494 )     (293,494 )
                                                 
Total comprehensive income
   $ 2,218,330                                          
                                                 
BALANCE, December 31, 2008
           $ 6,319,718     $ 20,311,638     $ 10,056,680     $ (186,527 )   $ 36,501,509  
                                                 
(continued on next page)
 
48
 
CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
Years Ended December 31, 2009, 2008 and 2007
 
(continued from previous page)
 
                           
Accumulated
        
               
Additional
          
Other
    
Total
  
   
Comprehensive
    
Common
    
Paid-in
    
Retained
    
Comprehensive
    
Stockholders'
  
   
Income
    
Stock
    
Capital
    
Earnings
    
Income
    
Equity
  
                                     
BALANCE, December 31, 2008
         $ 6,319,718     $ 20,311,638     $ 10,056,680     $ (186,527
)
   $ 36,501,509  
                                               
Stock compensation expense
           -       216,600       -       -       216,600  
                                               
Dividends - $0.10 per share
           -       -      
(638,061
)
     -       (638,061
)
 
                                             
Stock dividends
 
         180,678       634,448       (815,126
)
     -       -  
   
 
                                          
Comprehensive loss:
                                              
Net loss
   $ (8,178,639 )     -       -       (8,178,639
)
     -       (8,178,639
)
                                                 
Other comprehensive loss net of tax:
                                                
 
                                                
Unrealized holding gains (losses) on securities available for sale, net of reclassification adjustment
     (63,930 )     -       -       -       (63,930
)
     (63,930
)
                                                 
Total comprehensive loss
   $ (8,242,569 )                                        
                                                 
BALANCE, December 31, 2009
           $ 6,500,396     $ 21,162,686     $ 424,854     $ (250,457
)
   $ 27,837,479  
                                                 
The Notes to Consolidated Financial Statements are an integral part of these statements.
 
49
 
CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
CONSOLIDATED  STATEMENTS  OF  CASH  FLOWS
Years Ended December 31, 2009, 2008 and 2007
 
   
2009
    
2008
    
2007
  
CASH FLOWS FROM OPERATING ACTIVITIES
                  
Net (loss) income
   $ (8,178,639
)
   $ 2,511,824     $ 871,152  
Adjustments to reconcile net (loss) income to net cash
                        
provided by operating activities:
                        
Depreciation and amortization
     958,438       694,499       605,062  
Provision for loan losses
     14,898,898       3,498,000       10,409,365  
Stock compensation expense
     216,600       279,400       220,016  
Loss (gain) on sales of loans and other assets
     1,227,414       (57,828
)
     (103,773
)
Deferred income taxes
     1,301,148       3,302,186       (3,478,707
)
Changes in other operating assets and liabilities:
                        
Net change in loans held for sale
     582,000       (112,000
)
     484,900  
Accrued interest receivable
     250,392       636,886       (287,199
)
Accrued interest payable
     (118,226
)
     253,500       (92,306
)
Other assets and liabilities
     (5,089,681
)
     (7,509,166
)
     3,154,062  
 
                       
Net cash provided by operating activities
 
   6,048,344       3,497,301       11,782,572  
 
                       
CASH FLOWS FROM INVESTING ACTIVITIES
 
                      
Proceeds from security transactions:
  
 
                    
Securities available for sale
    
36,851,917
       23,596,577       13,008,453  
Securities held to maturity
     33,532
 
     30,594       36,467  
Purchase of securities available for sale
     (117,340,105
)
 
   (33,350,455
)
     (15,037,296
)
Purchase of Federal Home Loan Bank stock
     (41,700
)
     (275,900
)
     (559,400
)
Loan originations and principal collections, net
     18,247,178       (14,691,368
)
     (76,239,255
)
Purchase of bank premises and equipment
     (310,113
)
     (2,589,553
)
     (840,644
)
Proceeds from sale of other real estate and other assets
     4,119,884       1,357,027       784,592  
 
                       
Net cash used in investing activities
    
(58,439,407
)
     (25,923,078
)
     (78,847,083
)
 
                       
CASH FLOWS FROM FINANCING ACTIVITIES
 
                      
Net increase in deposits
  
 
 78,158,890       13,333,498       37,433,192  
(Decrease) increase in federal funds purchased and
    
 
                  
securities sold under agreements to repurchase
     (9,468,361
)
     (5,770,109
)
     22,310,654  
Proceeds from Federal Home Loan Bank advances
     -       20,000,000       35,000,000  
Repayment of Federal Home Loan Bank advances
     -       -       (27,000,000
)
Net borrowings (repayments) under line of credit
     1,100,000       4,150,000
 
     (400,000
)
Purchase of common stock
     -       (633,049
)
     (1,751,291
)
Payment of dividends
     (1,094,651
)
     (1,773,022
)
     (1,303,577
)
Issuance of common stock
     -       82,500       72,926  
                         
Net cash provided by financing activities
     68,695,878       29,389,818       64,361,904  
 
                       
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
 
   16,304,815       6,964,041       (2,702,607
)
                         
CASH AND CASH EQUIVALENTS, beginning of year
     21,897,390       14,933,349       17,635,956  
                         
CASH AND CASH EQUIVALENTS, end of year
   $ 38,202,205     $ 21,897,390     $ 14,933,349  
                         
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
                        
Cash paid during the period for interest
   $ 11,307,609     $ 12,444,574     $ 14,505,911  
Cash paid during the period for taxes
     180,350       738,886       4,092,910  
 
                       
NONCASH INVESTING AND FINANCING ACTIVITIES
                        
Acquisition of real estate through foreclosure
   $ 14,156,244     $ 2,915,414     $ 1,518,329  
                         
The Notes to Consolidated Financial Statements are an integral part of these statements.
 
50
 
CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
December 31, 2009, 2008 and 2007

Note 1.
Summary of Significant Accounting Policies

The accounting and reporting policies of Cornerstone Bancshares, Inc. and subsidiary (Cornerstone) conform with United States generally accepted accounting principles (GAAP) and practices within the banking industry.  The policies that materially affect financial position and results of operations are summarized as follows:

Nature of operations:

Cornerstone is a bank-holding company which owns all of the outstanding common stock of Cornerstone Community Bank (the Bank). The Bank provides a variety of financial services through five full service branch locations in Chattanooga, Tennessee and a loan production office in Dalton, Georgia.  The Bank’s primary deposit products are demand deposits, savings accounts, and certificates of deposit.  Its primary lending products are commercial loans, real estate loans, and installment loans.  In addition, the Bank owns Eagle Financial, Inc. (Eagle) which is a finance and factoring company located in Chattanooga, Tennessee.

Principles of consolidation:

The consolidated financial statements include the accounts of Cornerstone, the Bank and Eagle.  All material intercompany accounts and transactions have been eliminated in consolidation.

Goodwill:

Goodwill represents the excess of the cost of Cornerstone’s 1997 purchase of the net assets of the Bank of East Ridge over the underlying fair value of such net assets at the date of acquisition.  Cornerstone applies the provisions of Accounting Standard Codification (ASC) Topic 350 “Intangibles-Goodwill and Other” which requires that goodwill and other intangible assets deemed to have an indefinite life not be amortized.  Goodwill is tested annually for impairment.  If the carrying value of goodwill exceeds the fair value, a write-down is recorded.  There was no impairment in any of the years ending December 31, 2009, 2008 or 2007.

Use of estimates:

In preparing financial statements in conformity with accounting principles generally accepted in the United States of America, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and reported amounts of revenues and expenses during the reporting period.  Actual results could differ from those estimates.  Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, the valuation of deferred tax assets, other-than-temporary impairments of securities, and the fair value of financial instruments.

Significant group concentrations of credit risk:

Most of Cornerstone’s activities are with customers located in middle and eastern Tennessee.  The types of securities that Cornerstone invests in are included in Note 4.  The types of lending Cornerstone engages in are included in Note 5.  Cornerstone does not have any significant concentrations to any one industry or customer.

Commercial real estate, including commercial construction loans, represented 57 percent of the loan portfolio at December 31, 2009, and 54 percent of the loan portfolio at December 31, 2008.

Securities:

Debt securities are classified as held to maturity when the Bank has the intent and ability to hold the securities to maturity.  Securities held to maturity are carried at amortized cost.  The amortization of premiums and accretion of discounts are recognized in interest income using methods approximating the interest method over the period to maturity.

Debt securities not classified as held to maturity are classified as available for sale. Securities available for sale are carried at fair value with unrealized gains and losses reported in other comprehensive income.  Realized gains and losses on securities available for sale are included in other income and, when applicable, are reported as a reclassification adjustment, net of tax, in other comprehensive income.

51
 
CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
December 31, 2009, 2008 and 2007

Note 1.
Summary of Significant Accounting Policies (continued)

Securities: (continued)

Gains and losses on sales of securities are determined on the specific-identification method.  Purchase premiums and discounts are recognized in interest income using the interest method over the terms of the securities.

Prior to a change in accounting guidance on April 1, 2009, in determining whether other-than-temporary impairment existed, management considered (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of Cornerstone to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value.  Declines in the fair value of individual securities below their cost that are deemed to be other-than-temporary are reflected in earnings as realized losses.

Effective April 1, 2009, Cornerstone adopted new accounting guidance related to other-than-temporary impairment of securities.  The new guidance amended the criteria for recognizing other-than-temporary impairments of debt securities and expanded the disclosure requirements for impairment losses on debt and equity securities.  The new guidance specifies that (1) if a company does not have the intent to sell a debt security prior to recovery and (2) it is more likely than not that it will not have to sell the debt security prior to recovery, the security would not be considered other-than-temporarily impaired unless there is a credit loss.  The credit loss component is the amount of principal cash flows not expected to be received over the remaining term of the security based on cash flow projections.  For debt securities that management has no intent to sell and believes that it more-likely-than-not will not be required to sell prior to recovery, only the credit loss component of the impairment is recognized in earnings, while the non-credit loss is included in accumulated other comprehensive income.

Federal Home Loan Bank stock:

Cornerstone, as a member of the Federal Home Loan Bank (FHLB) system, is required to maintain an investment in capital stock of the FHLB.  Based on redemption provisions of the FHLB, the stock has no quoted market value and is carried at cost.  At its discretion, the FHLB may declare dividends on the stock.  Management reviews for impairment based on the ultimate recoverability of the cost basis in the FHLB stock.

Loans:

Cornerstone grants mortgage, commercial and consumer loans to customers.  A substantial portion of the loan portfolio is represented by real estate loans secured by properties located in Chattanooga, Tennessee and surrounding areas.  The ability of Cornerstone’s debtors to honor their contracts is somewhat dependent on the real estate and economic conditions in these areas.

Loans that management has the intent and ability to hold for the foreseeable future or until maturity are stated at unpaid principal balances, less the allowance for loan losses and net deferred loan fees and costs.  Mortgage loans originated and intended for sale in the secondary market are carried at the lower of cost or estimated market value in the aggregate.

Interest income is accrued based on the unpaid principal balance.  Loan origination and commitment fees, as well as certain direct origination costs, are deferred and amortized as a yield adjustment over the lives of the related loans using the interest method.  Amortization of deferred loan fees is discontinued when a loan is placed on nonaccrual status.

The accrual of interest on mortgage and commercial loans is discontinued at the time the loan is 90 days past due unless the credit is well-secured and in process of collection.  Credit card loans and other consumer loans are typically charged off no later than 120 days past due.  Past due status is based on contractual terms of the loan.  In all cases, loans are placed on nonaccrual or charged off at an earlier date if collection of principal or interest is considered doubtful.

All interest accrued but not collected for loans that are charged off is reversed against interest income.  The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual.  Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.

52
 
CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
December 31, 2009, 2008 and 2007

Note 1.
Summary of Significant Accounting Policies (continued)

Allowance for loan losses:

The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings.  Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.

The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectibility of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.

The allowance consists of allocated and general components.  The allocated component relates to loans that are classified as impaired. For those loans that are classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan.  The general component covers non-classified loans and is based on historical charge-off experience and expected loss given default derived from the Bank’s internal risk rating process. Other adjustments may be made to the allowance for pools of loans after an assessment of internal or external influences on credit quality that are not fully reflected on the historical loss or risk rating data.

A loan is considered impaired when, based on current information and events, it is probable that Cornerstone will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement.  Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due.  Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired.  Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed.  Impairment is measured on a loan by loan basis for commercial and construction loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent.

Large groups of smaller balance homogeneous loans are collectively evaluated for impairment.  Accordingly, Cornerstone does not separately identify individual consumer and residential loans for impairment disclosures, unless such loans are the subject of a restructuring agreement due to financial difficulties of the borrower.

Derivative loan commitments:

Mortgage loan commitments are referred to as derivative loan commitments if the loan that will result from exercise of the commitment will be held for sale upon funding.  Loan commitments that are derivatives are recognized at fair value on the consolidated balance sheet in derivative assets or derivative liabilities with changes in their fair values recorded in net gains on sales of loans.

Cornerstone records a zero value for the loan commitment at inception, when the commitment is issued to a borrower.  Subsequent to inception, changes in the fair value of the loan commitment are recognized based on changes in the fair value of the underlying mortgage loan due to interest rate changes, changes in the probability the derivative loan commitment will be exercised, and the passage of time.  In estimating fair value, Cornerstone assigns a probability to a loan commitment based on an expectation that it will be exercised and the loan will be funded.

53
 
CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
December 31, 2009, 2008 and 2007

Note 1.
Summary of Significant Accounting Policies (continued)

Premises and equipment:

Land is carried at cost.  Buildings and equipment are carried at cost, less accumulated depreciation and amortization computed on the straight-line and declining balance methods over the estimated useful lives of the assets.  Maintenance and repairs are expensed as incurred while major additions and improvements are capitalized.  Gains and losses on dispositions are included in current operations.

Investment in partnership:

Cornerstone’s investment in a partnership consists of an equity interest in a lending partnership for the purposes of investing in the New Market Tax Credit Program.  This program permits taxpayers to claim a credit against federal income taxes for Qualified Equity Investments made to acquire stock or a capital interest in designated Community Development Entities (CDEs).  These designated CDEs must use substantially all (defined as 85 percent) of these proceeds to make qualified low-income community investments.

Cornerstone uses the equity method when it owns an interest in a partnership and can exert significant influence over the partnership’s operations but cannot control the partnership’s operations.  Under the equity method, Cornerstone’s ownership interest in the partnership’s capital is reported as an investment on its consolidated balance sheets and Cornerstone’s allocable share of the income or loss from the partnership is reported in noninterest income or expense in the consolidated statements of income.  Cornerstone ceases recording losses on an investment in partnership when the cumulative losses and distributions from the partnership exceed the carrying amount of the investment and any advances made by Cornerstone.  After Cornerstone’s investment in such partnership reaches zero, cash distributions received from these investments are recorded as income.

Foreclosed assets:

Assets acquired through, or in lieu of, loan foreclosure are held for sale and are initially recorded at fair value less cost to sell at the date of foreclosure, establishing a new cost basis.  Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or fair value less cost to sell.  Revenues and expenses from operations and changes in the valuation allowance are included in net expenses from foreclosed assets.

Securities sold under agreements to repurchase:

Cornerstone enters into sales of securities under agreements to repurchase identical securities the next day.  Securities sold under agreements to repurchase amounted to $26,321,885 at December 31, 2009, mature on a daily basis and are secured by securities available for sale with a fair value of $47,002,088.

Income taxes:

Cornerstone accounts for income taxes in accordance with income tax accounting guidance in ASC Topic 740.  The income tax accounting guidance results in two components of income tax expense – current and deferred.  Current income tax expense reflects taxes to be paid or refunded for the current period by applying the provisions of the enacted tax law to taxable income or loss.  Cornerstone determines deferred income taxes using the liability method.  Under this method, the net deferred tax asset or liability is based on the tax effects of the differences between the book and tax bases of assets and liabilities.  Cornerstone’s deferred taxes relate primarily to differences between the basis of the allowance for loan losses and accumulated depreciation.  Deferred tax assets and liabilities are reflected at income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled.  As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes.  Cornerstone files consolidated income tax returns with its subsidiary.

54
 
CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
December 31, 2009, 2008 and 2007

Note 1.
Summary of Significant Accounting Policies (continued)

Income taxes: (continued)

Cornerstone recognizes deferred tax assets if it is more likely than not, based on the technical merits, that the tax position will be realized or sustained upon examination.  Cornerstone follows the statutory requirements for its income tax accounting and generally avoids risks associated with potentially problematic tax positions that may be challenged upon examination.

Transfers of financial assets:

Transfers of financial assets are accounted for as sales, when control over the assets has been surrendered.  Control over assets is deemed to be surrendered when (1) the assets have been isolated from Cornerstone, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) Cornerstone does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity, or the ability to unilaterally cause the holder to return specific assets.

Advertising costs:

Cornerstone expenses all advertising costs as incurred.  Advertising expense was $97,734, $92,252, and $83,632, for the years ended December 31, 2009, 2008 and 2007, respectively.

Statements of cash flows:

Cornerstone considers all cash and amounts due from depository institutions, interest-bearing deposits in other banks, and federal funds sold to be cash equivalents for purposes of the statements of cash flows.

Stock option plan:

Cornerstone recognizes compensation cost relating to share-based payment transactions in accordance with ASC Topic 718.  Compensation cost has been measured based on the grant date fair value of the equity or liability instruments issued.  Compensation cost is calculated and recognized over the employee service period, generally defined as the vesting period.  Cornerstone uses a stock option pricing model to determine the fair value of the award on the grant date.

Segment reporting:

Accounting Standards Codification Topic 280, “Segment Reporting,” provides for the identification of reportable segments on the basis of distinct business units and their financial information to the extent such units are reviewed by an entity’s chief decision maker (which can be an individual or group of management persons).  ASC Topic 280 permits aggregation or combination of segments that have similar characteristics.  In Cornerstone’s operations, each bank branch is viewed by management as being a separately identifiable business or segment from the perspective of monitoring performance and allocation of financial resources.  Although the branches operate independently and are managed and monitored separately, each is substantially similar in terms of business focus, type of customers, products and services.  Further, the results of Eagle for 2009, 2008 and 2007 were not significant for separate disclosure.  Accordingly, Cornerstone’s consolidated financial statements reflect the presentation of segment information on an aggregated basis in one reportable segment.

55
 
CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
December 31, 2009, 2008 and 2007

Note 1.
Summary of Significant Accounting Policies (continued)

Earnings per share:

Basic earnings per share represents income available to common stockholders divided by the weighted-average number of common shares outstanding during the period.  Diluted earnings per share reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income that would result from the assumed issuance.  Potential common shares that may be issued by Cornerstone relate solely to outstanding stock options, and are determined using the treasury stock method.

Variable interest entities:

An entity is referred to as a variable interest entity (VIE) if it meets the criteria outlined in ASC Topic 810, which are: (1) the entity has equity that is insufficient to permit the entity to finance its activities without additional subordinated financial support from other parties, or (2) the entity has equity investors that cannot make significant decisions about the entity’s operations or that do not absorb the expected losses or receive the expected returns of the entity.  A VIE must be consolidated by Cornerstone if it is deemed to be the primary beneficiary of the VIE, which is the party involved with the VIE that has a majority of the expected losses, expected residual returns, or both.  At December 31, 2009, Cornerstone has an investment in Appalachian Fund for Growth II Partnership that qualifies as an unconsolidated VIE.

Comprehensive income:

Comprehensive income consists of net income and other comprehensive income.  Other comprehensive income includes unrealized gains on securities available for sale, and unrealized losses related to factors other than credit losses on debt securities.

Reclassification:

Certain amounts in the prior consolidated financial statements have been reclassified to conform to the current year presentation.  The reclassifications had no effect on net income or stockholders’ equity as previously reported.

Off-balance sheet credit related financial instruments:

In the ordinary course of business, Cornerstone has entered into commitments to extend credit, including commitments under credit card arrangements, commercial letters of credit, and standby letters of credit.  Such financial instruments are recorded when they are funded.

Subsequent events:

Cornerstone has evaluated subsequent events for potential recognition and/or disclosures in the consolidated financial statements and accompanying notes included in this Annual Report on Form 10-K.

Note 2.
Going Concern Considerations

The going concern assumption is a fundamental principle in the preparation of financial statements.  It is the responsibility of management to assess our ability to continue as a going concern.  In assessing this assumption, we have taken into account all available information we have deemed relevant about our foreseeable future, which is at least, but is not limited to, twelve months from the balance sheet date of December 31, 2009.  

56
 
CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
December 31, 2009, 2008 and 2007
 
Note 2.
Going Concern Considerations (continued)

Prior to 2009, the Bank had a history of profitable operations and sufficient sources of liquidity to meet its funding needs.  However, the Bank’s parent holding company, Cornerstone Bancshares, Inc., primarily relies on dividends from the Bank to meet its funding needs.  The holding company’s funding needs as of December 31, 2009, primarily consisted of principal and interest payments on two holding company loans totaling $5,350,000 secured by 100% of the subsidiary Bank’s common stock.  The loans were renewed in January 2010, with Cornerstone subsequently receiving a waiver regarding previous covenant violations through December 31, 2009.  As of December 31, 2009, the Bank was restricted from paying dividends to the holding company due to recent operating losses and the Bank’s capital position of less than well capitalized under the regulatory framework for prompt corrective action, as further described in Note 16.  This restriction, coupled with the holding company’s failure to meet certain loan covenants as of December 31, 2009, as further described in Note 9, has prompted management to perform an assessment of the Cornerstone’s ability to continue as a going concern.  

Management’s business plan for 2010 projects a return to profitability and a well capitalized position; however, covenant compliance is determined on a quarterly basis with certain of the covenants being based on rolling quarterly averages; thus, management’s projections are not anticipating full compliance with the covenants during 2010. The uncertainty surrounding the lender’s intention to continue granting quarterly waivers of the covenant defaults on the loans through December 31, 2010, combined with the lender’s unwillingness to amend the loan covenants, raises substantial doubt about the ability of Cornerstone to continue as a going concern.  Should the lender not grant a waiver of the covenant defaults for a future quarter, the lender would have the ability to call the loans and require the holding company to secure an alternate source of financing to repay the outstanding balance on the loans within a short period of time.  Management has assessed the potential consequences of this action and believes that its current strategy to raise additional capital to allow repayment of this debt and further enhance the capital position of the Bank will enable the holding company to deal with this event.  As an alternative, management will continue looking for suitable alternative sources of financing to cure this situation. If management is unable to raise sufficient capital or find an alternative source of financing, the lender could take steps to foreclose on the Bank stock serving as collateral for the loans.   The impact of this condition would negatively impact the shareholders of Cornerstone since the condition would result in a material decrease in the holding company’s assets and therefore the going concern ability of Cornerstone.

As a result of management’s assessment of Cornerstone’s ability to continue as a going concern, the accompanying consolidated financial statements for Cornerstone have been prepared on a going concern basis, which contemplates the realization of assets and the discharge of liabilities in the normal course of business for the foreseeable future, and does not include any adjustments to reflect the possible future effects on the recoverability or classification of assets, and the amounts or classification of liabilities that may result from the outcome of a potential future default due to noncompliance with covenants on the debt, which could affect Cornerstone’s ability to continue as a going concern.
 
Note 3.
Restrictions on Cash and Due From Banks

The Bank is required to maintain balances on hand or with the Federal Reserve Bank based on a percentage of deposits.  At December 31, 2009 and 2008, these reserve balances were approximately $1,011,000 and $2,321,000, respectively.
 
57
 
CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
December 31, 2009, 2008 and 2007

Note 4.
Securities

Securities have been classified in the balance sheet according to management’s intent as either securities held to maturity or securities available for sale.  The amortized cost and approximate fair value of securities at December 31, 2009 and 2008, are as follows:

   
December 31, 2009
  
         
Gross
    
Gross
        
   
Amortized
    
Unrealized
    
Unrealized
    
Fair
  
   
Cost
    
Gains
    
Loss
    
Value
  
Debt securities available for sale:
                        
   U.S. Government agencies
   $ 4,772,461     $ 4,703     $ (3,144 )   $ 4,774,020  
                                 
   State and municipal securities
     16,660,518       268,343       (173,221 )     16,755,640  
                                 
   Mortgage-backed securities:
                                
       Residential mortgage
                                
          guaranteed by GNMA
     53,207,225       217,897       (698,355 )     52,726,767  
                                 
       Collateralized mortgage
                                
          obligations issued or
                                
          guaranteed by U.S.
                                
          Government agencies or
                                
          sponsored agencies
     49,956,882       77,852       (74,286 )     49,960,448  
                                 
        Other
     203,961       -       (5,518 )     198,443  
                                 
    $ 124,801,047     $ 568,795     $ (954,524 )   $ 124,415,318  
                                 
Debt securities held to maturity:
                                
   Mortgage-backed securities:
                                
       Residential mortgage
                                
          guaranteed by GNMA
   $ 135,246     $ 1,193     $ (377 )   $ 136,062  

U.S. Government sponsored agencies include entities such as Federal National Mortgage Association, Federal Home Loan Mortgage Corporation, and Federal Home Loan Banks.

   
December 31, 2008
  
         
Gross
    
Gross
        
   
Amortized
    
Unrealized
    
Unrealized
    
Fair
  
   
Cost
    
Gains
    
Loss
    
Value
  
Debt securities available for sale:
                        
   U.S. Government securities
   $ 7,976,040     $ 275,731     $ -     $ 8,251,771  
                                 
   State and municipal securities
     4,609,632       82,013       (68,830 )     4,622,815  
                                 
   Mortgage-backed securities
     31,753,504       160,387       (731,918 )     31,181,973  
                                 
    $ 44,339,176     $ 518,131     $ (800,748 )   $ 44,056,559  
                                 
Debt securities held to maturity:
                                
   Mortgage-backed securities
   $ 169,284     $ 1,158     $ (683 )   $ 169,759  


58
 
CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
December 31, 2009, 2008 and 2007

Note 4.
Securities (continued)

At December 31, 2009 and 2008, securities with a carrying value of approximately $22,835,000 and $11,262,000, respectively, were pledged to secure public deposits and for other purposes required or permitted by law.

At December 31, 2009 and 2008, the carrying amount of securities pledged to secure repurchase agreements was approximately $47,002,000 and $32,516,000, respectively.

At December 31, 2009, the Bank had pledged securities with a carrying amount of approximately $54,380,000 to the Federal Home Loan Bank as collateral for the Bank’s borrowings.  At December 31, 2008, the Bank had no securities pledged to the Federal Home Loan Bank as collateral for the Bank’s borrowings.

The amortized cost and fair value of securities at December 31, 2009, by contractual maturity, are shown below.  Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
 
   
Securities Available for Sale
    
Securities Held to Maturity
  
   
Amortized
    
Fair
    
Amortized
    
Fair
  
   
Cost
    
Value
    
Cost
    
Value
  
                         
Due in one year or less
   $ -     $ -     $ -     $ -  
Due from one year to five years
     599,132       626,059       -       -  
Due from five years to ten years
     2,468,408       2,553,683       -       -  
Due after ten years
     18,365,439       18,349,918       -       -  
                                 
      21,432,979       21,529,660       -       -  
                                 
Mortgage-backed securities
     103,368,068       102,885,658       135,246       136,062  
    $ 124,801,047     $ 124,415,318     $ 135,246     $ 136,062  
 
For the year ended December 31, 2009, there were available for sale securities sold with proceeds totaling $18,951,608 which resulted in gross gains and losses realized of $414,193 and $14,439, respectively.  There were no sales of securities available for sale for the years ended December 31, 2008 and 2007.
 
59
 
CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
December 31, 2009, 2008 and 2007

Note 4.
Securities (continued)

The following tables present gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities available for sale have been in a continuous unrealized loss position, at December 31, 2009 and 2008:
 
   
As of December 31, 2009
  
   
Less than 12 Months
    
12 Months or Greater
    
Total
  
   
Fair
Value
    
Gross Unrealized Losses
    
Fair
Value
    
Gross
Unrealized
Losses
    
Fair
Value
    
Gross
Unrealized
Losses
  
Debt securities available for sale:
                                    
U.S. Governmental agencies
   $ 971,400     $ (3,144 )   $ -     $ -     $ 971,400     $ (3,144 )
State and municipal securities
     8,222,297       (159,907 )     734,848       (13,314 )     8,957,145       (173,221 )
Mortgage-backed securities:
                                                
Residential mortgage guaranteed by GNMA
     40,492,722       (698,343 )     5,516       (12 )     40,498,238       (698,355 )
Collateralized mortgage obligations issued or guaranteed by U.S. Government agencies or sponsored agencies
     22,538,122       (74,286 )     -       -       22,538,122       (74,286 )
Other
     -       -       198,443       (5,518 )     198,443       (5,518 )
    $ 72,224,541     $ (935,680 )   $ 938,807     $ (18,844 )   $ 73,163,348     $ (954,524 )
                                                 
Debt securities held to maturity:
                                                
Mortgage-backed securities:
                                                
Residential mortgage guaranteed by GNMA
   $ 48,767     $ (70 )   $ 25,594     $ (307 )   $ 74,361     $ (377 )
 
   
As of December 31, 2008
  
   
Less than 12 Months
    
12 Months or Greater
    
Total
  
   
Fair Value
    
Gross Unrealized Losses
    
Fair Value
    
Gross Unrealized Losses
    
Fair Value
    
Gross Unrealized Losses
  
Debt securities available for sale:
                                    
State and municipal securities
  $ 1,125,144     $ (48,772 )   $ 206,650     $ (20,058 )   $ 1,331,794      $ (68,830 )
Mortgage-backed securities
     19,234,621       (719,051 )     642,457       (12,867 )     19,877,078       (731,918 )
                                                 
    $ 20,359,765     $ (767,823 )   $ 849,107     $ (32,925 )   $ 21,208,872     $ (800,748 )
                                                 
Debt securities held to maturity:
                                                
Mortgage-backed securities
   $ 26,405     $ (289 )   $ 30,897     $ (394 )   $ 57,302     $ (683 )
 
60
 
CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
December 31, 2009, 2008 and 2007

Note 4.
Securities (continued)
 
Upon acquisition of a security, Cornerstone determines the appropriate impairment model that is applicable.  If the security is a beneficial interest in securitized financial assets, Cornerstone uses the beneficial interests in securitized financial assets impairment model.  If the security is not a beneficial interest in securitized financial assets, Cornerstone uses the debt and equity securities impairment model.  Cornerstone conducts periodic reviews to evaluate each security to determine whether an other-than-temporary impairment has occurred.  Cornerstone does not have any securities that have been classified as other-than-temporarily-impaired at December 31, 2009.

At December 31, 2009, the significant categories of temporarily impaired securities, and management’s evaluation of those securities are as follows:

State and municipal securities:  At December 31, 2009, 20 investments in obligations of state and municipal securities had unrealized losses.  Cornerstone believes the unrealized losses on those investments were caused by the interest rate environment and does not relate to the underlying credit quality of the issuers.  Because the Company has the intent and ability to hold those investments for a time necessary to recover their amortized cost bases, which may be maturity, the Company does not consider those investments to be other-than-temporarily impaired at December 31, 2009.

Mortgage-backed securities issued or guaranteed by FNMA, FHLMC, or GNMA: At December 31, 2009, 17 investments in residential mortgage-backed securities issued or guaranteed by FNMA, FHLMC, or GNMA had unrealized losses.  This impairment is believed to be caused by the current interest rate environment.  The contractual cash flows of those investments are guaranteed or issued by an agency of the U.S. Government.  Because the decline in market value is attributable to the current interest rate environment and not credit quality, and because Cornerstone does not intend to sell the investments and it is not more likely than not that Cornerstone will be required to sell the investments before recovery of their amortized cost bases, which may be maturity, Cornerstone does not deem those investments to be other-than-temporarily impaired at December 31, 2009.

61
 
CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
December 31, 2009, 2008 and 2007
 
Note 5.
Loans and Allowance for Loan Losses

At December 31, 2009 and 2008, the Bank’s loans consist of the following (in thousands):
 
   
2009
    
2008
  
Mortgage loans on real estate:
            
Residential 1-4 family
   $ 43,249     $ 42,136  
Residential multifamily (5 or more)
     12,770       14,747  
Held for sale
     686       104  
Commercial
     153,310       155,728  
Construction
     47,651       70,456  
Second mortgages
     3,798       3,030  
Equity lines of credit
     10,473       12,720  
      271,937       298,921  
Commercial loans
     60,560       83,140  
Consumer installment loans:
                
Personal
     3,630       5,486  
Credit cards
     565       543  
      4,195       6,029  
Total loans
     336,692       388,090  
Less: Allowance for loan losses
     (5,905 )     (9,618 )
Loans, net
   $ 330,787     $ 378,472  
 
   
2009
    
2008
    
2007
  
An analysis of the allowance for loan losses follows:
                  
                   
Balance, beginning of year
   $ 9,618,265     $ 13,710,109     $ 4,258,352  
Provision charged to operations
     14,898,898       3,498,000       10,409,365  
Charge-offs
     (19,095,793 )     (7,978,767 )     (1,075,670 )
Recoveries
     483,684       388,923       118,062  
Balance, end of year
   $ 5,905,054     $ 9,618,265     $ 13,710,109  
 
Cornerstone follows the loan impairment accounting guidance in ASC Topic 310.  A loan is considered impaired when, based on current information and events, it is probable that Cornerstone will be unable to collect all amounts due from the borrower in accordance with the contractual terms of the loan.  Impaired loans include nonperforming commercial loans and loans modified in troubled debt restructurings where concessions have been granted to borrowers experiencing financial difficulties.  These concessions could include a reduction in interest rates, payment extensions, forgiveness of principal, forbearance or other actions intended to maximize collections.

Included in impaired loans are troubled debt restructurings that are classified as impaired.  At December 31, 2009, the Bank has loans of approximately $2,312,000 that were modified in troubled debt restructurings and impaired.

62
 
CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
December 31, 2009, 2008 and 2007
 
Note 5.
Loans and Allowance for Loan Losses (continued)

At December 31, 2009 and 2008, information pertaining to impaired loans is as follows:
 
   
December 31,
  
   
2009
    
2008
  
Impaired loans without a valuation allowance
   $ 7,138,077     $ 2,543,320  
Impaired loans with a valuation allowance
     23,956,594       17,375,043  
                 
Total impaired loans
   $ 31,094,671     $ 19,918,363  
                 
Valuation allowance related to impaired loans
   $ 2,145,383     $ 5,872,373  
 
   
Years Ended December 31,
  
   
2009
    
2008
    
2007
  
Average investment in impaired loans
   $ 28,555,483     $ 10,891,357     $ 3,348,873  
                         
Interest income recognized on impaired loans
   $ 2,900,652     $ 966,011     $ 1,182,407  
                         
Interest income recognized on a cash basis on
                        
impaired loans
   $ -     $ -     $ 28,900  
 
At December 31, 2009 and 2008, information pertaining to nonperforming loans is as follows:
 
   
December 31,
  
   
2009
    
2008
  
Loans past due over 90 days still on accrual
   $ -     $ -  
Loans on nonaccrual
     7,359,542       4,252,791  
                 
Total nonperforming loans
   $ 7,359,542     $ 4,252,791  

Nonperforming loans include both smaller balance homogeneous loans that are collectively evaluated for impairment and individually classified impaired loans.

In the ordinary course of business, the Bank has granted loans to principal officers and directors and their affiliates. Annual activity of these related party loans were as follows:
 
   
2009
    
2008
  
Beginning balance
   $ 189,673     $ 772,942  
New loans
     65,196       65,177  
Repayments
     (64,828 )     (648,446 )
                 
Ending balance
   $ 190,041     $ 189,673  
 
63
 
CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
December 31, 2009, 2008 and 2007
 
Note 6.
Bank Premises and Equipment

A summary of bank premises and equipment at December 31, 2009 and 2008, is as follows:
 
   
2009
    
2008
  
Land
   $ 3,315,050     $ 3,338,413  
Buildings and improvements
     4,578,792       4,537,349  
Furniture, fixtures and equipment
     4,414,075       4,255,237  
      12,307,917       12,130,999  
Accumulated depreciation
     (4,209,858 )     (3,659,044 )
    $ 8,098,059     $ 8,471,955  

Depreciation expense for the years ended December 31, 2009, 2008 and 2007, amounted to $670,054, $588,490, and $500,573, respectively.

Certain bank facilities and equipment are leased under various operating leases.  Total rent expense on these leases for the years ended December 31, 2009, 2008 and 2007, was $426,861, $386,714, and $384,004, respectively.

Future minimum rental commitments under non-cancelable leases are as follows:
 
2010
   $ 367,427  
2011
     350,998  
2012
     344,237  
2013
     341,003  
2014
     341,003  
Thereafter
     533,911  
Total
   $ 2,278,579  
 
Note 7.
Time and Related-Party Deposits

At December 31, 2009, the scheduled maturities of time deposits are as follows:
 
2010
   $ 242,982  
2011
     43,655  
2012
     14,493  
2013
     2,286  
2014
     1,687  
Thereafter
     104  
Total
   $ 305,207  
 
Deposits from related parties held by the Bank at December 31, 2009 and 2008, amounted to approximately $564,000, and $1,007,000, respectively.
 
64
 
CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
December 31, 2009, 2008 and 2007

Note 8.
Income Taxes

Cornerstone files consolidated income tax returns with its subsidiary.  Under the terms of a tax-sharing agreement, the subsidiary’s allocated portion of the consolidated tax liability is computed as if they were reporting income and expenses to the Internal Revenue Service as a separate entity.

Income tax expense in the consolidated statements of income for the years ended December 31, 2009, 2008 and 2007, consists of the following:
 
   
2009
    
2008
    
2007
  
                   
Current tax expense (benefit)
   $ (6,637,188 )   $ (2,005,644 )   $ 3,337,592  
Deferred tax expense (benefit) related to:
                        
Allowance for loan losses
     1,241,231       3,158,858       (3,623,934 )
Other
     59,917       143,328       145,227  
Income tax expense (benefit)
   $ (5,336,040 )   $ 1,296,542     $ (141,115 )

The income tax expense is different from the expected tax expense computed by multiplying income before income tax expense by the statutory federal income tax rates. These differences are reconciled as follows:
   
2009
    
2008
    
2007
  
Expected tax at statutory rates
   $ (4,594,991 )   $ 1,294,844     $ 248,213  
(Decrease) increase resulting from tax effect of:
                        
State income taxes, net of federal tax benefit
     (579,780 )     163,379       31,318  
New market tax credits
     (150,000 )     (150,000 )     (300,000 )
Other
     (11,269 )     (11,681 )     (120,646 )
Income tax expense (benefit)
   $ (5,336,040 )   $ 1,296,542     $ (141,115 )

The components of the net deferred tax asset, included in other assets, are as follows:

   
2009
    
2008
  
Deferred tax assets:
            
Deferred compensation
   $ 118,724     $ 124,583  
Deferred loan fees
     29,866       52,150  
Allowance for loan losses
     694,702       1,935,933  
Net unrealized loss on securities available for sale
     39,183       151,194  
Other
     -       28,334  
                 
      882,475       2,292,194  
                 
Deferred tax liabilities:
                
Depreciation
     121,420       126,979  
Life insurance
     199,077       186,721  
Other
     10,808       14,165  
                 
      331,305       327,865  
                 
Net deferred tax asset
   $ 551,170     $ 1,964,329  

ASC Topic 740, “Income Taxes,” clarifies the accounting for uncertainty in tax positions. ASC Topic 740 requires that Cornerstone recognize in its financial statements, the impact of a tax position, if that position is more likely than not of being sustained on audit, based on the technical merits of the position.  Cornerstone recognized no interest and penalties assessed by taxing authorities on any underpayment of income tax for 2009, 2008 or 2007.
 
65
 
CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
December 31, 2009, 2008 and 2007

Note 9.
Federal Home Loan Bank Advances and Other Borrowings

The Bank has agreements with the Federal Home Loan Bank of Cincinnati (FHLB) that can provide advances to the Bank in an amount up to approximately $71,000,000.  All of the Bank’s loans secured by first mortgages on 1-4 family residential, multi-family properties and commercial properties are pledged as collateral for these advances.  Additionally, the Bank has pledged securities with a carrying amount of approximately $54,380,000 as of December 31, 2009.

At December 31, 2009 and 2008, FHLB advances consist of the following:
 
   
2009
    
2008
  
Long-term advance dated December 27, 2000, requiring monthly interest payments, fixed at 5.00% until conversion option is exercised, principal due in December 2010
   $ 2,000,000     $ 2,000,000  
Long-term advance dated February 9, 2005, requiring monthly interest payments, fixed at 3.86%, convertible on February 2010, principal due in February 2015
     5,000,000       5,000,000  
Long-term advance dated May 14, 2007, requiring monthly interest payments, fixed at 4.78%, with a put option exercisable in November 2007 and then quarterly thereafter, principal due in May 2010
     5,000,000       5,000,000  
Long-term advance dated December 6, 2007, requiring monthly interest payments, fixed at 3.87%, until maturity, principal due in December 2010
     5,000,000       5,000,000  
Long-term advance dated June 26, 2008, requiring monthly interest payments, fixed at 3.64%, until maturity, principal due in July 2010
     5,000,000       5,000,000  
Long-term advance dated July 2, 2008, requiring monthly interest payments, fixed at 3.85%, until maturity, principal due in July 2011
     5,000,000       5,000,000  
Long-term advance dated January 18, 2008, requiring monthly interest payments, fixed at 3.59%, until maturity, principal due in January 2013
     5,000,000       5,000,000  
Long-term advance dated May 11, 2007, requiring monthly interest payments, fixed at 4.66%, with a put option exercisable in February 2008 and then quarterly thereafter, principal due in May 2011
     5,000,000       5,000,000  
Long-term advance dated May 15, 2007, requiring monthly interest payments, fixed at 4.58%, with a put option exercisable in May 2008 and then quarterly thereafter, principal due in May 2012
     5,000,000       5,000,000  
Long-term advance dated July 31, 2007, requiring monthly interest payments, fixed at 4.50%, with a put option exercisable in July 2008 and then quarterly thereafter, principal due in July 2013
     5,000,000       5,000,000  

66
 
CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
December 31, 2009, 2008 and 2007

Note 9.
Federal Home Loan Bank Advances and Other Borrowings (continued)
 
   
2009
    
2008
  
Long-term advance dated August 7, 2007, requiring monthly interest payments, fixed at 4.43%, with a put option exercisable in February 2009 and then quarterly thereafter, principal due in August 2014
   $ 5,000,000     $ 5,000,000  
Long-term advance dated January 2, 2008, requiring monthly interest payments, fixed at 3.52% with a put option exercisable in January 2011 and the quarterly thereafter, principal due in January 2015
     5,000,000       5,000,000  
Long-term advance dated January 20, 2006, requiring monthly interest payments, fixed at 4.18%, with a put option exercisable in January 2009 and then quarterly thereafter, principal due in January 2016
     5,000,000       5,000,000  
Long-term advance dated January 10, 2007, requiring monthly interest payments, fixed at 4.25%, with a put option exercisable in January 2008 and then quarterly thereafter, principal due in January 2017
     5,000,000       5,000,000  
    $ 67,000,000     $ 67,000,000  
 
During the fixed rate term, the advances may be prepaid subject to a prepayment penalty as defined in the agreements.  On convertible agreements, the FHLB has the right to convert the fixed rate on the above advances at the end of the initial fixed rate period and on a quarterly basis thereafter.  If the conversion option is exercised, the advances will bear interest at the three-month London Interbank Offered Rate (LIBOR) adjusted quarterly at a spread of zero basis points to the LIBOR index.  Subsequent to any conversion, the Bank has the option to prepay the advances, in full or in part, without penalty on the conversion date or any subsequent quarterly repricing date.  On agreements with put options, the FHLB has the right, at its discretion, to terminate only the entire advance prior to the stated maturity date.  The termination option may only be exercised on the expiration date of the predetermined lockout period and on a quarterly basis thereafter.

Cornerstone had an $8,500,000 line of credit with Silverton Bank (now known as Silverton Bridge Bank, N.A.) that was secured by 100% of the Bank’s common stock with borrowings outstanding of $4,250,000 at December 31, 2008.  During March 2009, the line of credit matured and was reworked into two loans, a $4,350,000 amortizing term loan and a $1,000,000 revolving line of credit.  Borrowings outstanding under these agreements were $5,350,000 at December 31, 2009.

In January 2010 these loans were modified with Silverton Bridge Bank, N.A.  These loans continue to be secured by 100% of the Bank’s common stock and bear interest at the greater of Prime plus 3% or 6.25%.  The first loan has an original principal balance of $4,350,000 with semi-annual principal payments of $435,000 beginning July 2010, quarterly interest payments beginning April 2010, and final payment of outstanding principal and accrued interest due July 2014.   The second loan has an original principal balance of $1,000,000 with a quarterly payment of principal of $50,000 plus accrued interest beginning January 2010 and final payment of outstanding principal and accrued interest due April 1, 2011.

Both of these loans with Silverton Bridge Bank, N.A. contain certain compliance covenants which have been waived through December 31, 2009.  However, due to the increased nonperforming assets of the Bank and capital reductions due to net losses of both Cornerstone and the Bank, Cornerstone was not in compliance with several of the covenants on the loans at December 31, 2009.  The covenants include stated minimum or maximum target amounts for Cornerstone’s capital levels, the Bank’s capital levels, nonperforming asset

67
 
CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
December 31, 2009, 2008 and 2007

Note 9.
Federal Home Loan Bank Advances and Other Borrowings (continued)

levels at the Bank and the ability of Cornerstone to meet the required annual debt service requirements, which are computed on a rolling quarter average.  Cornerstone has been unable to receive covenant modifications for 2010 which would enable compliance in future quarters.  Covenant violations are considered an “Event of Default” which, at Silverton Bridge Bank, N.A.’s option, could cause these two loans to become due and payable in full.

The primary source of liquidity for Cornerstone is the payment of dividends from the Bank.  As of December 31, 2009, the Bank was under a dividend restriction that requires regulatory approval prior to the payment of a dividend from the Bank to Cornerstone.

At December 31, 2009, scheduled maturities of the Federal Home Loan Bank advances and other borrowings are as follows:
 
2010
   $ 17,635,000  
2011
     11,670,000  
2012
     5,870,000  
2013
     10,870,000  
2014
     6,305,000  
Thereafter
     20,000,000  
Total
   $ 72,350,000  

Note 10.
Employee Benefit Plans

401(k) plan:

Cornerstone has a 401(k) employee benefit plan covering substantially all employees that have completed at least 30 days of service and met minimum age requirements.  Cornerstone’s contribution to the plan is discretionary.  Cornerstone elected not to make a contribution to the plan for 2009.  Cornerstone’s contribution to the plan was $87,408 for 2008 and $230,732 for 2007.

Employee Stock Ownership Plan:

Cornerstone has a non-leveraged employee stock ownership plan (ESOP) to which Cornerstone makes 100% of the contributions for purchasing Cornerstone’s common stock, and allocates the contributions among the participants based on regulatory guidelines.  Cornerstone’s contribution is discretionary, as determined by the Compensation Committee. Employer contributions are available to all employees after 1,000 hours of service.  There are certain age and years-of-service requirements before contributions can be made for the benefit of the employee.  The ESOP plan also provides for a three year 100% vesting requirement; therefore, employees terminating employment before their third anniversary date will forfeit their accrued benefit under the ESOP.  The forfeiture will be re-allocated among the remaining ESOP participants.  No contributions were made to the ESOP in 2009 or 2007.Cornerstone made a contribution of $166,347 in 2008.

Note 11.
Financial Instruments With Off-Balance-Sheet Risk

In the normal course of business, the Bank has outstanding commitments and contingent liabilities, such as commitments to extend credit and standby letters of credit, which are not included in the accompanying financial statements.  The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit and standby letters of credit is represented by the contractual or notional amount of those instruments.  The Bank uses the same credit policies in making such commitments as it does for instruments that are included in the balance sheet.  At December 31, 2009 and 2008, undisbursed loan commitments aggregated $42,287,000, and $63,426,000, respectively.  In addition, there were outstanding standby letters of credit totaling $3,708,000 and $3,983,000, respectively.
 
68
 
CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
December 31, 2009, 2008 and 2007

Note 11.
Financial Instruments With Off-Balance-Sheet Risk (Continued)

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.  Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.  The Bank evaluates each customer’s creditworthiness on a case-by-case basis.  The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on management’s credit evaluation.  Collateral held varies but may include accounts receivable, inventory, property and equipment, and income-producing commercial properties.

Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party.  Standby letters of credit generally have fixed expiration dates or other termination clauses and may require payment of a fee.  The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.  The Bank’s policy for obtaining collateral, and the nature of such collateral, is essentially the same as that involved in making commitments to extend credit.

The Bank incurred insignificant losses on its commitments during 2009, 2008 and 2007.

Note 12.
Fair Value Disclosures

Cornerstone uses fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures.  In accordance with the “Fair Value Measurements and Disclosures” ASC Topic 820, the fair value of a financial instrument is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.  Fair value is best determined based upon quoted market prices.  In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques.  Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows.  Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument.

ASC Topic 820 provides a consistent definition of fair value, which focuses on exit price in an orderly transaction between market participants at the measurement date under current market conditions.  If there has been a significant decrease in the volume and level of activity for the asset or liability, a change in valuation technique or the use of multiple valuation techniques may be appropriate.  In such instances, determining the price at which willing market participants would transact at the measurement date under current market conditions depends on the facts and circumstances and requires the use of significant judgment.  The fair value is a reasonable point within the range that is most representative of fair value under current market conditions.

ASC Topic 820 also establishes a three-tier fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value, as follows:

Level 1 - Quoted prices (unadjusted) in active markets for identical assets or liabilities that Cornerstone has the ability to access.

Level 2 - Significant other observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities in active markets, quoted prices in markets that are not active and other inputs that are observable or can be corroborated by observable market data.

Level 3 - Significant unobservable inputs that reflect a company’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

A financial instrument’s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement.

69
 
CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
December 31, 2009, 2008 and 2007

Note 12.
Fair Value Disclosures (continued)

The following methods and assumptions were used by Cornerstone in estimating fair value disclosures for financial instruments:

Cash and cash equivalents:

The carrying amounts of cash and cash equivalents approximate fair values based on the short-term nature of the assets.

Securities:

Fair values are estimated using pricing models and discounted cash flows that consider standard input factors such as observable market data, benchmark yields, interest rate volatilities, broker/dealer quotes, and credit spreads.  Securities classified as available for sale are reported at fair value utilizing Level 2 inputs.

The carrying value of Federal Home Loan Bank stock approximates fair value based on the redemption provisions of the Federal Home Loan Bank.

Loans:

For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values.  Fair values for fixed-rate loans are estimated using discounted cash flow analyses, using market interest rates for comparable loans.  Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired.  Once a loan is identified as individually impaired, management measures impairment in accordance with ASC Topic 310, “Accounting by Creditors for Impairment of a Loan”.  The fair value of impaired loans is estimated using several methods including collateral value, liquidation value and discounted cash flows.

Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans.  At December 31, 2009 and 2008, substantially all of the total impaired loans were evaluated based on the fair value of collateral.  In accordance with ASC Topic 820, impaired loans where an allowance is established based on the fair value of collateral require classification in the fair value hierarchy.  When the fair value of the collateral is based on an observable market price or a current appraised value, Cornerstone records the impaired loan as nonrecurring Level 2.  When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, Cornerstone records the impaired loan as nonrecurring Level 3.

Cash surrender value of life insurance:

The carrying amounts of cash surrender value of life insurance approximate their fair value.  The carrying amount is based on information received from the insurance carriers indicating the financial performance of the policies and the amount Cornerstone would receive should the policies be surrendered.  Cornerstone reflects these assets within Level 2 of the valuation hierarchy.

Foreclosed assets:

Foreclosed assets, consisting of properties obtained through foreclosure or in satisfaction of loans, is initially recorded at fair value, determined on the basis of current appraisals, comparable sales, and other estimates of value obtained principally from independent sources, adjusted for estimated selling costs.  At the time of foreclosure, any excess of the loan balance over the fair value of the real estate held as collateral is treated as a charge against the allowance for loan losses.  Gains or losses on sale and any subsequent adjustment to the fair value are recorded as a component of foreclosed real estate expense.  Foreclosed assets are included in Level 2 of the valuation hierarchy.
 
70
 
CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
December 31, 2009, 2008 and 2007

Note 12.
Fair Value Disclosures (continued)
 
Deposits:

The fair value of deposits with no stated maturity, such as noninterest-bearing and interest-bearing demand deposits, savings deposits, and money market accounts, is equal to the amount payable on demand at the reporting date.  The carrying amounts of variable-rate, fixed-term certificates of deposit approximate their fair values at the reporting date.  Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies market interest rates on comparable instruments to a schedule of aggregated expected monthly maturities on time deposits.

Securities sold under agreements to repurchase:

The estimated fair value of these liabilities approximates their carrying value.

Federal Home Loan Bank advances and other borrowings:

The carrying amounts of FHLB advances and other borrowings approximate their fair value.

Accrued interest:

The carrying amounts of accrued interest approximate fair value.

Commitments to extend credit, letters of credit and lines of credit:

The fair value of commitments is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties.  For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates.

The tables below present the recorded amount of assets and liabilities measured at fair value on a recurring basis.
 
   
Balance as of
December 31,
2009
    
Quoted Prices in
Active Markets
for Identical
Assets
(Level 1)
    
Significant
Other
Observable
Inputs
(Level 2)
    
Significant
Other
Unobservable
Inputs
(Level 3)
  
Debt securities available for sale:
                        
                         
U.S. Government agencies
   $ 4,774,020     $ -     $ 4,774,020     $ -  
State and municipal securities
     16,755,640       -       16,755,640       -  
Mortgage-backed securities:
                                
Residential mortgage guaranteed by GNMA
     52,726,767       -       52,726,767       -  
Collateralized mortgage obligations issued or guaranteed by U.S.
                                
Government agencies or sponsored agencies
     49,960,448       -       49,960,448       -  
Other
     198,443       -       198,443       -  
Total securities available for sale
   $ 124,415,318     $ -     $ 124,415,318     $ -  
                                 
Cash surrender value of life insurance
   $ 1,100,874     $ -     $ 1,100,874     $ -  
 
71
 
CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
December 31, 2009, 2008 and 2007

Note 12.
Fair Value Disclosures (continued)
 
   
Balance as of
December 31,
2008
    
Quoted Prices in
Active Markets
for Identical
Assets
(Level 1)
    
Significant
Other
Observable
Inputs
(Level 2)
    
Significant
Other
Unobservable
Inputs
(Level 3)
  
                         
Debt securities available for sale:
                        
U.S. Government securities
   $ 8,251,771     $ -     $ 8,251,771     $ -  
State and municipal securities
     4,622,815       -       4,622,815       -  
Mortgage-backed securities
     31,181,973       -       31,181,973       -  
Total securities available for sale
   $ 44,056,559     $ -     $ 44,056,559     $ -  
                                 
Cash surrender value of life insurance
   $ 1,067,924     $ -     $ 1,067,924     $ -  
 
Cornerstone has no assets or liabilities whose fair values are measured using Level 3 inputs.

Certain assets and liabilities are measured at fair value on a nonrecurring basis, which means the assets and liabilities are not measured at fair value on an ongoing basis but are subject to fair value adjustments in certain circumstances (for example, when there is evidence of impairment).  The tables below present information about assets and liabilities on the balance sheet at December 31, 2009 and 2008, for which a nonrecurring change in fair value was recorded.
 
   
Balance as of
December 31,
2009
    
Quoted Prices in
Active Markets
for Identical
Assets
(Level 1)
    
Significant
Other
Observable
Inputs
(Level 2)
    
Significant
Other
Unobservable
Inputs
(Level 3)
  
                         
Impaired loans
   $ 21,811,211     $ -     $ 21,811,211     $ -  
Foreclosed assets
     10,327,297       -       10,327,297       -  
 
   
Balance as of
December 31,
2008
    
Quoted Prices in
Active Markets
for Identical
Assets
(Level 1)
    
Significant
Other
Observable
Inputs
(Level 2)
    
Significant
Other
Unobservable
Inputs
(Level 3)
  
Impaired loans
   $ 11,502,670     $ -     $ 11,502,670     $ -  
 
Loans include impaired loans held for investment for which an allowance for loan losses has been calculated based upon the fair value of the loans at December 31, 2009 and 2008.  Losses derived from Level 2 inputs were calculated by models incorporating significant observable market data.

72
 
CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
December 31, 2009, 2008 and 2007
 

Note 12.
Fair Value Disclosures (continued)
 
The carrying amount and estimated fair value of the Cornerstone’s financial instruments at December 31, 2009 and 2008, are as follows (in thousands):
 
   
2009
    
2008
  
   
Carrying
Amount
    
Estimated
Fair Value
    
Carrying
Amount
    
Estimated
Fair Value
  
Assets:
                        
Cash and cash equivalents
   $ 38,202     $ 38,202     $ 21,897     $ 21,897  
Securities
     124,551       124,551       44,226       44,226  
Federal Home Loan Bank stock
     2,229       2,229       2,188       2,188  
Loans, net
     330,787       331,456       378,472       380,394  
Cash surrender value of life insurance
     1,101       1,101       1,068       1,068  
Accrued interest receivable
     1,521       1,521       1,771       1,771  
                                 
Liabilities:
                                
Noninterest-bearing demand deposits
     41,972       41,972       40,078       40,078  
Interest-bearing demand deposits
     26,533       26,533       26,909       26,909  
Savings deposits and money market accounts
     31,030       31,030       35,848       35,848  
Time deposits
     305,207       307,596       223,749       225,882  
Federal funds purchased and securities sold under agreements to repurchase
     26,322       26,322       35,790       35,790  
Federal Home Loan Bank advances and other borrowings
     72,350       72,350       71,250       71,250  
Accrued interest payable
     351       351       470       470  
Unrecognized financial instruments (net of contract amount):
                                
Commitments to extend credit
     -       -       -       -  
Letters of credit
     -       -       -       -  
Lines of credit
     -       -       -       -  
 
Note 13.
Contingencies
 
The Bank is involved in certain claims arising from normal business activities.  Management believes that the impact of those claims are without merit and that the ultimate liability, if any, resulting from them will not materially affect the Bank’s financial condition or Cornerstone’s consolidated financial position, results of operations or cash flows.

Note 14.
Stock Option Plans
 
Cornerstone has stock option plans which are more fully described below.  For the years ended December 31, 2009, 2008 and 2007, Cornerstone recognized $216,600, $279,400 and $220,016, respectively, in compensation expense for all stock options.

The fair value of each option granted is estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions:
 
   
Years Ended December 31,
  
   
2009
    
2008
    
2007
  
Dividend yield
     2.97 %     1.47 %     1.33 %
Expected life
  
7.0 years
    
8.0 years
    
7.0 years
  
Expected volatility
     38.74 %     20.27 %     12.22 %
Risk-free interest rate
     2.69 %     4.22 %     4.51 %
 
73
 
CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
December 31, 2009, 2008 and 2007

Note 14.
Stock Option Plans (continued)
 
The expected volatility is based upon historical volatility.  The risk-free interest rates for periods within the contractual life of the awards are based on the U.S. Treasury yield curve in effect at the time of the grant.  The expected life is based on historical exercise experience.   The dividend yield assumption is based on Cornerstone’s history and expectation of dividend payouts.

Board of Directors plan:

Cornerstone has a stock option plan under which members of the Board of Directors, at the formation of the Bank, were granted options to purchase a total of up to 600,000 shares of common stock.  Only non-qualified stock options may be granted under the Plan.  In addition, members of the Board of Directors can be issued options under the Cornerstone 2002 Long-Term Incentive Plan to purchase up to 1,200,000 shares of Cornerstone stock.  The options available for issuance to Board members under the 2002 Long-Term Incentive Plan are shared with officers and employees of Cornerstone.  The exercise price of each option equals the market price of Cornerstone’s stock on the date of grant and the option’s maximum term is ten years, at which point they expire.  Vesting for options granted during 2007, 2008 and 2009, are 50% on each of the first and second anniversary of the grant date with full vesting occurring at the second anniversary date.  At December 31, 2009, the total remaining compensation cost to be recognized on non-vested options is approximately $37,000.  An analysis of this stock option plan is presented in the following table:
 
   
Years Ended December 31,
  
   
2009
    
2008
    
2007
  
   
Shares
    
Average
Exercise
Price
    
Aggregate
Intrinsic
Value(1)
    
Shares
    
Average
Exercise
Price
    
Shares
    
Average
Exercise
Price
  
                                           
Outstanding at beginning of year
     81,800     $ 10.73             69,000     $ 11.23       67,000     $ 10.61  
                                                       
Granted
     20,500       3.65             12,800       7.99       9,000       15.25  
                                                       
Exercised
     -       -             -       -       (5,000 )     9.32  
                                                       
Forfeited
     (2,050 )     3.65             -       -       (2,000 )     13.25  
                                                       
Outstanding at end of year
     100,250     $ 9.42     $ -       81,800     $ 10.73       69,000     $ 11.23  
                                                         
Options exercisable at year-end
     75,400     $ 10.96     $ -       64,500     $ 10.95       42,000     $ 9.51  
                                                         
Weighted-average fair value of options granted during the year
   $ 1.13                     $ 2.23             $ 3.33          
 
74
 
CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
December 31, 2009, 2008 and 2007

Note 14.
Stock Option Plans (continued)
 
 
(1)
The aggregate intrinsic value of a stock option in the table above represents the total pre-tax intrinsic value (the amount by which the current market value of the underlying stock exceeds the exercise price of the option) that would have been received by the option holders had all option holders exercised their options on December 31, 2009. This amount changes based on changes in the market value of the Cornerstone’s stock. The fair value (present value of the estimated future benefit to the option holder) of each option grant is estimated on the date of grant using the Black-Scholes option pricing model.

Information pertaining to options outstanding at December 31, 2009, is as follows:
 
     
Options Outstanding
    
Options Exercisable
  
Exercise Prices
    
Number Outstanding
  
Weighted Average Remaining Life
  
Weighted Average Exercise Price
    
Number Exercisable
    
Weighted Average Exercise Price
  
$5.44       16,000  
4.2 Years
   $ 5.44       16,000     $ 5.44  
 9.23       8,000  
5.2 Years
     9.23       8,000       9.23  
 13.25       36,000  
6.2 Years
     13.25       36,000       13.25  
 15.25       9,000  
7.2 Years
     15.25       9,000       15.25  
 7.99       12,800  
8.2 Years
     7.99       6,400       7.99  
 3.65       18,450  
9.2 Years
     3.65       -       -  
Outstanding at end of year
       100,250  
6.7 Years
   $ 9.42       75,400     $ 10.96  
 
Information pertaining to non-vested options for the year ended December 31, 2009, is as follows:
 
   
Number of Shares
    
Weighted Average Grant Date Fair Value
  
Non-vested options, December 31, 2008
     17,300     $ 9.88  
Granted
     20,500       3.65  
Vested
     (10,900 )     10.99  
Forfeited
     (2,050 )     3.65  
                 
Non-vested options, December 31, 2009
     24,850     $ 4.77  
 
The total fair value of shares vested during 2009 was approximately $45,000.
 
Officer and Employee Plans:
 
Cornerstone has two stock option plans, the 1996 Cornerstone Statutory and Non-statutory Option Plan and the Cornerstone 2002 Long-Term Incentive Plan, under which officers and employees can be granted incentive stock options or non-qualified stock options to purchase a total of up to 220,000 and 1,200,000 shares, respectively, of Cornerstone’s common stock.  The option price for incentive stock options shall be not less than 100 percent of the fair market value of the common stock on the date of the grant.  The non-qualified stock options may be equal to or more or less than the fair market value of the common stock on the date of the grant.  The stock options vest at 30 percent on the second and third anniversaries of the grant date and 40 percent on the fourth anniversary of the grant date.  These options expire ten years from the grant date.  At December 31, 2009, the total remaining compensation cost to be recognized on non-vested options is approximately $500,000.  An analysis of the activity for each of the years ending December 31, 2009, 2008 and 2007, for this stock option plan follows:
 
75
 
CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
December 31, 2009, 2008 and 2007
 
Note 14.
Stock Option Plans (continued)
 
Officer and Employee Plans: (continued)
 
   
Years Ended December 31,
  
   
2009
    
2008
    
2007
  
   
Shares
    
Average
Exercise
Price
    
Aggregate
Intrinsic
Value(1)
    
Shares
    
Average
Exercise
Price
    
Shares
    
Average
Exercise
Price
  
                                           
Outstanding at beginning of year
     755,425     $ 6.63             715,075     $ 6.52       669,120     $ 5.79  
                                                       
Granted
     115,850       3.65             71,500       7.99       53,800       15.25  
                                                       
Exercised
     -       -             (22,000 )     3.75       (5,870 )     4.48  
                                                       
Forfeited
     (71,600 )     6.77             (9,150 )     13.34       (1,975 )     14.03  
                                                       
Outstanding at end of year
     799,675     $ 6.18     $ -       755,425     $ 6.63       715,075     $ 6.52  
                                                         
Options exercisable at year-end
     592,648     $ 5.69     $ -       549,516     $ 4.87       470,990     $ 4.06  
                                                         
Weighted-average fair value of options granted during the year
   $ 1.13                     $ 2.23             $ 3.33          
 
 
(1)
The aggregate intrinsic value of a stock option in the table above represents the total pre-tax intrinsic value (the amount by which the current market value of the underlying stock exceeds the exercise price of the option) that would have been received by the option holders had all option holders exercised their options on December 31, 2009.  This amount changes based on changes in the market value of the Cornerstone’s stock. The fair value (present value of the estimated future benefit to the option holder) of each option grant is estimated on the date of grant using the Black-Scholes option pricing model.

Information pertaining to options outstanding at December 31, 2009, is as follows:
 
     
Options Outstanding
    
Options Exercisable
  
Exercise Prices
    
Number Outstanding
  
Weighted Average Remaining Life
  
Weighted Average Exercise Price
    
Number Exercisable
    
Weighted Average Exercise Price
  
$3.25 - $3.75
       324,600  
1.8 Years
   $ 3.48       324,600     $ 3.48  
 5.44
       131,440  
4.2 Years
     5.44       131,440       5.44  
 9.23
       77,410  
5.2 Years
     9.23       77,410       9.23  
 13.25
       70,000  
6.2 Years
     13.25       45,120       13.25  
 15.25
       38,925  
7.2 Years
     15.25       13,253       15.25  
 15.20
       2,750  
7.3 Years
     15.20       825       15.20  
 7.99
       59,000  
8.2 Years
     7.99       -       -  
 3.65
       95,550  
9.2 Years
     3.65       -       -  
                                     
Outstanding at end of year
       799,675  
4.5 Years
   $ 6.18       592,648     $ 5.69  
 
76
 
CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
December 31, 2009, 2008 and 2007

Note 14.
Stock Option Plans (continued)
 
Information pertaining to non-vested options for the year ended December 31, 2009, is as follows:
 
   
Number of Shares
    
Weighted Average Grant Date Fair Value
  
Non-vested options, December 31, 2008
     205,909     $ 11.31  
Granted
     115,850       3.65  
Vested
     (69,582 )     11.92  
Forfeited
     (45,150 )     7.88  
Non-vested options, December 31, 2009
     207,027     $ 7.57  
 
The total fair value of shares vested during 2009 was approximately $288,000.

Note 15.
Liquidity and Capital Resources
 
Cornerstone’s primary source of funds with which to pay its future obligations is the receipt of dividends from its subsidiary Bank.  Banking regulations provide that the Bank must maintain capital sufficient to enable it to operate as a viable institution and, as a result, has limited the amount of dividends the Bank may pay without prior approval.

Note 16.
Minimum Regulatory Capital Requirements
 
Cornerstone (on a consolidated basis) and the Bank are subject to various regulatory capital requirements administered by the Tennessee Department of Financial Institutions and the federal banking agencies.  Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on Cornerstone’s and the Bank’s financial statements.  Under capital adequacy guidelines and the regulatory framework for prompt corrective action, Cornerstone and the Bank must meet specific capital guidelines that involve quantitative measures of Cornerstone’s and the Bank’s assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices.  Cornerstone’s and the Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.  Prompt corrective action provisions are not applicable to bank holding companies.

Quantitative measures established by regulation to ensure capital adequacy require Cornerstone and the Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital (as defined) to average assets (as defined).

As of December 31, 2009, the most recent notification from the Federal Deposit Insurance Corporation (FDIC) categorized the Bank as adequately capitalized under the regulatory framework for prompt corrective action.  To be categorized as well capitalized, an institution must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in the following tables.  There are no conditions or events since that notification that management believes have changed the Bank’s prompt corrective action category for bank capital.

In situations similar to the Bank’s, the FDIC has been known to issue Consent Orders that have contained one or more of the following provisions: a requirement to augment capital; a requirement to closely monitor criticized assets; a requirement to closely monitor and manage liquidity; and other similar requirements.  If the Bank were to be presented with such a supervisory agreement, the Bank’s Board of Directors would likely consent to its terms.

77
 
CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
December 31, 2009, 2008 and 2007

Note 16.
Minimum Regulatory Capital Requirements (continued)
 
Cornerstone’s and the Bank’s actual capital amounts and ratios are also presented in the table.  Dollar amounts are presented in thousands.
 
   
Actual
    
Minimum Capital Requirements
    
Minimum To Be
Well Capitalized
  
   
Amount
    
Ratio
      
Amount
    
Ratio
    
Amount
    
Ratio
  
                                       
As of December 31, 2009:
                                      
Total capital to risk-weighted assets:
                                      
Consolidated
   $ 29,472       8.3 %   $
 28,556
      8.0 %     N/A       N/A  
Cornerstone Community Bank
     33,963       9.5 %    
 28,532
        8.0 %   $ 35,666       10.0 %
Tier 1 capital to risk-weighted assets:
                                                
Consolidated
     24,992       7.0 %    
 14,278
       4.0 %     N/A       N/A  
Cornerstone Community Bank
     29,487       8.3 %    
 14,266
        4.0 %     21,399       6.0 %
Tier 1 capital to average assets:
                                                
Consolidated
     24,992       5.2 %    
 19,241
        4.0 %     N/A       N/A  
Cornerstone Community Bank
     29,487       6.1 %    
 19,216
       4.0 %     24,020       5.0 %
                                                 
As of December 31, 2008:
                                                
Total capital to risk-weighted assets:
                                                
Consolidated
   $ 38,974       9.7 %   $
 32,282
        8.0 %     N/A       N/A  
Cornerstone Community Bank
     41,410       10.3 %    
 32,130
       8.0 %   $ 40,163       10.0 %
Tier 1 capital to risk-weighted assets:
                                                
Consolidated
     33,873       8.4 %    
 16,141
        4.0 %     N/A       N/A  
Cornerstone Community Bank
     36,336       9.1 %    
 16,065
       4.0 %     24,098       6.0 %
Tier 1 capital to average assets:
                                                
Consolidated
     33,873       7.4 %    
 18,390
 
      4.0 %     N/A       N/A  
Cornerstone Community Bank
     36,336       7.9 %    
 18,339
       4.0 %     22,924       5.0 %
 
78
 
CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
December 31, 2009, 2008 and 2007

Note 17.
Other Comprehensive Income
 
Other comprehensive income consists of unrealized holding gains and losses on securities available for sale.  A summary of other comprehensive income and the related tax effects for the years ended December 31, 2009, 2008 and 2007, is as follows:
 
   
Before-Tax
Amount
    
(Expense)
Benefit
    
Tax Net-of-Tax
Amount
  
                   
Year ended December 31, 2009:
                  
Unrealized holding gains and losses arising during the period
   $ 262,642     $ (113,884 )   $ 182,758  
Less reclassification adjustment for gains realized in net income
     399,754       (153,066 )     246,688  
    $ (103,112 )   $ 39,182     $ (63,930 )
                         
Year ended December 31, 2008:
                        
Unrealized holding gains and losses arising during the period
   $ (444,690 )   $ 151,196     $ (293,494 )
Less reclassification adjustment for gains realized in net income
     -       -       -  
    $ (444,690 )   $ 151,196     $ (293,494 )
                         
Year ended December 31, 2007:
                        
Unrealized holding gains and losses arising during the period
   $ 250,886     $ (85,301 )   $ 165,585  
Less reclassification adjustment for gains realized in net income
     -       -       -  
    $ 250,886     $ (85,301 )   $ 165,585  
 
Note 18.
Earnings (Loss) Per Common Share
 
Basic earnings (loss) per share represents income (loss) available to common stockholders divided by the weighted-average number of common shares outstanding during the period.  Diluted earnings (loss) per share reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income that would result from the assumed issuance.

Potential common shares that may be issued by Cornerstone relate to outstanding stock options, determined using the treasury stock method.

79
 
CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
December 31, 2009, 2008 and 2007
 
Note 18.
Earnings (Loss) Per Common Share (continued)
 
Earnings (loss) per common share have been computed based on the following:
 
   
2009
    
2008
    
2007
  
Net (loss) income
   $ (8,178,639 )   $ 2,511,824     $ 871,152  
Less: Preferred stock dividends
     -       -       -  
Net (loss) income applicable to common stock
   $ (8,178,639 )   $ 2,511,824     $ 871,152  
Average number of common shares outstanding
     6,500,396       6,508,631       6,685,275  
Effect of dilutive stock options
     -       136,826       339,346  
Average number of common shares outstanding used to calculate diluted earnings (loss) per common share
     6,500,396       6,645,457       7,024,621  
 
The effects of outstanding antidilutive stock options are excluded from the computation of diluted earnings (loss) per share.  There were 933,725, 329,526 and 62,150 antidilutive stock options for 2009, 2008 and 2007, respectively.  The average number of common shares outstanding and the effect of dilutive stock options for 2008 and 2007 have been retroactively adjusted to reflect two stock dividends that occurred during 2009.
 
Note 19.
Recent Accounting Pronouncements
 
On July 1, 2009, the FASB Accounting Standards Codification became the officially recognized source of authoritative U.S. generally accepted accounting principles applicable to all public and non-public, non-governmental entities, superseding existing FASB, AICPA, EITF and related literature.  Rules and interpretive releases of the SEC under the authority of federal securities laws are also sources of authoritative GAAP for SEC registrants.  All other accounting literature is considered non-authoritative.  The switch to the ASC affects the way companies refer to U.S. GAAP in financial statements and accounting policies.  The Codification is not intended to change U.S. GAAP, but rather is expected to simplify accounting research by reorganizing current GAAP into approximately 90 accounting topics.

ASC Topic 820, “Fair Value Measurements and Disclosures”, defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. The provisions of ASC Topic 820 became effective for periods beginning after November 15, 2007. Cornerstone adopted these provisions on January 1, 2008 for financial assets and financial liabilities and on January 1, 2009 for non-financial assets and non-financial liabilities.

Additional new authoritative accounting guidance under ASC Topic 820 affirms that the objective of fair value when the market for an asset is not active is the price that would be received to sell the asset in an orderly transaction, and clarifies and includes additional factors for determining whether there has been a significant decrease in market activity for an asset when the market for that asset is not active. ASC Topic 820 requires an entity to base its conclusion about whether a transaction was not orderly on the weight of the evidence. The new accounting guidance amended prior guidance to expand certain disclosure requirements. Cornerstone adopted the new authoritative accounting guidance under ASC Topic 820 during the first quarter of 2009. Adoption of the new guidance did not significantly impact the financial statements.

80
 
CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
December 31, 2009, 2008 and 2007
 
Note 19.
Recent Accounting Pronouncements (Continued)
 
Further new authoritative accounting guidance, Accounting Standards Update (ASU) No. 2009-5, provides guidance for measuring the fair value of a liability in circumstances in which a quoted price in an active market for the identical liability is not available. In such instances, a reporting entity is required to measure fair value utilizing a valuation technique that uses (i) the quoted price of the identical liability when traded as an asset, (ii) quoted prices for similar liabilities or similar liabilities when traded as assets, or (iii) another valuation technique that is consistent with the existing principles of ASC Topic 820, such as an income approach or market approach. The new authoritative accounting guidance also clarifies that when estimating the fair value of a liability, a reporting entity is not required to include a separate input or adjustment to other inputs relating to the existence of a restriction that prevents the transfer of the liability. The forgoing new authoritative accounting guidance under ASC Topic 820 became effective for periods ending after October 1, 2009 and did not have a significant impact on Cornerstone’s financial statements.

ASC Topic 825, “Financial Instruments”, permits entities to choose to measure eligible financial instruments at fair value at specified election dates. The fair value measurement option (i) may be applied instrument by instrument, with certain exceptions, (ii) is generally irrevocable and (iii) is applied only to entire instruments and not to portions of instruments. Unrealized gains and losses on items for which the fair value measurement option has been elected must be reported in earnings at each subsequent reporting date. The forgoing provisions of ASC Topic 825 became effective for Cornerstone on January 1, 2008.  However, it had no impact on the consolidated financial statements of Cornerstone as the Company did not elect the fair value option for any financial instrument not presently being accounted for at fair value.

ASC Topic 715-60, “Defined Benefit Plans – Other Postretirement”, covers postretirement benefit aspects of endorsement split-dollar life insurance arrangements.  This topic concluded that deferred compensation or postretirement benefit aspects of an endorsement split-dollar life insurance arrangement should be recognized as a liability by the employer and the obligation is not effectively settled by the purchase of a life insurance policy. The effective date for this topic was for fiscal years beginning after December 15, 2007. Adoption of this topic on January 1, 2008 did not have a material impact on Cornerstone’s consolidated financial statements.

ASC Topic 855, “Subsequent Events”, establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued. Cornerstone adopted the provisions of ASC Topic 855 during the period ended June 30, 2009. The adoption of ASC Topic 855 did not impact our financial statements.

ASC Topic 815, “Derivatives and Hedging”, amends prior guidance to expand the disclosure requirements for derivatives and hedging activities to provide greater transparency about (i) how and why an entity uses derivative instruments, (ii) how derivative instruments and related hedge items are accounted for under ASC Topic 815, and (iii) how derivative instruments and related hedged items affect an entity’s financial position, results of operations and cash flows. To meet those objectives, the new authoritative accounting guidance requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of gains and losses on derivative instruments and disclosures about credit-risk-related contingent features in derivative agreements. ASC Topic 815 was effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008.

ASC Topic 320, “Investments—Debt and Equity Securities”, (i) changes existing guidance for determining whether an impairment is other than temporary to debt securities and (ii) replaces the existing requirement that the entity’s management assert it has both the intent and ability to hold an impaired security until recovery with a requirement that management assert: (a) it does not have the intent to sell the security; and (b) it is more likely than not it will not have to sell the security before recovery of its cost basis. Under ASC Topic 320, declines in the fair value of held-to-maturity and available-for-sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses to the extent the impairment is related to credit losses. The amount of the impairment related to other factors is recognized in other comprehensive income. We adopted the provisions of the new authoritative accounting guidance under ASC Topic 320 during the second quarter of 2009. There was no impact from the adoption of this new guidance.

81
 
CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
December 31, 2009, 2008 and 2007
 
Note 19.
Recent Accounting Pronouncements (Continued)
 
ASC Topic 860, “Transfers and Servicing”, amended previous guidance on accounting for transfers of financial assets. The amended guidance eliminates the concept of qualifying special-purpose entities and requires that these entities be evaluated for consolidation under applicable accounting guidance, and it also removes the exception that permitted sale accounting for certain mortgage securitizations when control over the transferred assets had not been surrendered. Based on this new standard, many types of transferred financial assets that would previously have been derecognized will now remain on the transferor’s financial statements. The guidance also requires enhanced disclosures about transfers of financial assets and the transferor’s continuing involvement with those assets and related risk exposure. The new guidance is effective for Cornerstone beginning January 1, 2010. Adoption of this new guidance is not expected to have a significant impact on Cornerstone’s financial condition or results of operations, given Cornerstone’s current involvement in financial asset transfer activities.

Also in June 2009, the FASB issued amended guidance on accounting for variable interest entities (VIEs). This guidance replaces the quantitative-based risks and rewards calculation for determining which enterprise might have a controlling financial interest in a VIE. The new, more qualitative evaluation focuses on who has the power to direct the significant economic activities of the VIE and also has the obligation to absorb losses or rights to receive benefits from the VIE. It also requires an ongoing reassessment of whether an enterprise is the primary beneficiary of a VIE and calls for certain expanded disclosures about an enterprise’s involvement with variable interest entities. The new guidance is effective for Cornerstone in 2010. Management does not expect the new guidance to have a material effect, if any, on the Cornerstone’s financial position or results of operations.

Other than disclosures contained within these statements, Cornerstone has determined that all other recently issued accounting pronouncements will not have a material impact on its consolidated financial statements or do not apply to its operations.
 
Note 20.
Equity Investment
 
During 2006, Cornerstone invested $3,000,000 for a 25% share of the Appalachian Fund for Growth II Partnership (AFG), which is managed by the Southeast Local Development Corporation (General Partner).   AFG is targeting high job creation and retention businesses and businesses providing important community services.  The funds are being deployed to help:  1) attract new businesses to under-served service areas by offering creative financing; 2) supply creative financing for businesses to rehabilitate existing distressed properties to facilitate community development; and 3) leverage other private investment into its targeted communities.  In return for its investment in AFG, Cornerstone and other investors will receive new market tax credits.  For 2009, 2008 and 2007 Cornerstone received approximately $150,000, $150,000 and $300,000, respectively, in new market tax credits.

AFG meets the criteria of a VIE outlined in ASC Topic 810 “Consolidation”.  AFG has not been consolidated by Cornerstone as Cornerstone is not the primary beneficiary.

82
 
CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
December 31, 2009, 2008 and 2007
 
Note 21.
Condensed Parent Information
 
BALANCE SHEETS
            
             
   
December 31,
    
December 31,
  
   
2009
    
2008
  
             
ASSETS
            
Cash
   $ 620,471     $ 439,440  
Investment in subsidiary
     29,790,633       37,295,042  
Loan to subsidiary
     -       450,000  
Goodwill
     2,541,476       2,541,476  
Other assets
     294,899       513,738  
Total assets
   $ 33,247,479     $ 41,239,696  
                 
LIABILITIES AND STOCKHOLDERS’ EQUITY
                
Other liabilities
   $ 60,000     $ 488,187  
Other borrowings
     5,350,000       4,250,000  
Total liabilities
     5,410,000       4,738,187  
Stockholders’ equity
     27,837,479       36,501,509  
Total liabilities and stockholders’ equity
   $ 33,247,479     $ 41,239,696  
 
STATEMENTS OF INCOME
                  
       
   
Years Ended December 31,
  
   
2009
    
2008
    
2007
  
                   
INCOME
                  
Dividends
   $ 1,180,260     $ 1,475,325     $ 1,280,260  
Interest income
     4,110       33,336       158,039  
      1,184,370       1,508,661       1,438,299  
                         
EXPENSES
                        
Interest expense
     221,093       137,421       24,882  
Other operating expenses
     802,084       1,225,402       623,405  
                         
Income before equity in undistributed (loss) earnings
     161,193       145,838       790,012  
                         
Equity in undistributed (loss) earnings of subsidiary
     (8,740,480 )     1,830,862       (228,170 )
                         
Income tax benefit
     400,648       535,124       309,310  
Net (loss) income
   $ (8,178,639 )   $ 2,511,824     $ 871,152  

83
 
CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
December 31, 2009, 2008 and 2007
 
Note 21.
Condensed Parent Information (continued)
 
   
2009
    
2008
    
2007
  
STATEMENTS OF CASH FLOWS
                  
                   
CASH FLOWS FROM OPERATING ACTIVITIES
                  
Net (loss) income
   $ (8,178,639 )   $ 2,511,824     $ 871,152  
Adjustments to reconcile net (loss) income to net cash provided by operating activities:
                        
Stock compensation expense
     216,600       279,400       220,016  
Equity in undistributed (loss) income of subsidiary
     8,740,480       (1,830,862 )     228,170  
Other
     247,241       (534,415 )     19,095  
Net cash provided by operating activities
     1,025,682       425,947       1,338,433  
                         
CASH FLOWS FROM INVESTING ACTIVITIES
                        
Repayment from subsidiary
     450,000       300,000       2,119,500  
Capital contribution to subsidiary
     (1,300,000 )     (2,500,000 )     -  
Net cash (used in) provided by investing activities
     (850,000 )     (2,200,000 )     2,119,500  
                         
CASH FLOWS FROM FINANCING ACTIVITIES
                        
Net borrowings (repayments) under other borrowings
     1,100,000       4,150,000       (400,000 )
Purchase of common stock
     -       (633,049 )     (1,751,291 )
Payment of dividends
     (1,094,651 )     (1,773,022 )     (1,303,577 )
Issuance of common stock
     -       82,500       72,926  
Net cash provided by (used in) financing activities
     5,349       1,826,429       (3,381,942 )
                         
NET INCREASE IN CASH AND CASH EQUIVALENTS
     181,031       52,376       75,991  
                         
CASH AND CASH EQUIVALENTS, beginning of year
     439,440       387,064       311,073  
                         
CASH AND CASH EQUIVALENTS, end of year
   $ 620,471     $ 439,440     $ 387,064  
                         
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
                        
Cash paid during the year for:
                        
Interest
   $ 221,093     $ 137,421     $ 24,882  
Income taxes
     -       -       3,592,300  

84
 
CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
December 31, 2009, 2008 and 2007
 
Note 22.
Quarterly Data (unaudited)
 
   
Years Ended December 31,
  
   
2009
    
2008
  
   
Fourth
    
Third
    
Second
    
First
    
Fourth
    
Third
    
Second
    
First
  
   
Quarter
    
Quarter
    
Quarter
    
Quarter
    
Quarter
    
Quarter
    
Quarter
    
Quarter
  
                                                 
Interest income
   $ 6,609,921     $ 6,406,525     $ 6,427,866     $ 6,864,115     $ 7,400,732     $ 7,462,473     $ 7,756,905     $ 8,060,064  
Interest expense
     2,761,685       2,765,954       2,791,068       2,870,676       2,977,990       3,026,759       3,223,449       3,469,876  
                                                                 
Net interest income, before provision for loan losses
     3,848,236       3,640,571       3,636,798       3,993,439       4,422,742       4,435,714       4,533,456       4,590,188  
                                                                 
Provision for loan losses
     4,150,000       3,390,000       1,633,898       5,725,000       2,571,000       440,000       170,000       317,000  
                                                                 
Net interest (loss) income, after provision for loan losses
     (301,764 )     250,571       2,002,900       (1,731,561 )     1,851,742       3,995,714       4,363,456       4,273,188  
                                                                 
Noninterest income (charges)
     (636,420 )     184,232       730,291       263,114       496,420       476,733       524,572       394,306  
Noninterest expenses
     3,930,984       3,278,956       3,773,359       3,292,743       3,104,109       3,151,037       3,215,991       3,096,628  
                                                                 
(Loss) income before income taxes
     (4,869,168 )     (2,844,153 )     (1,040,168 )     (4,761,190 )     (755,947 )     1,321,410       1,672,037       1,570,866  
Income tax (benefit) expense
     (1,904,367 )     (1,144,617 )     (437,369 )     (1,849,687 )     (319,640 )     461,194       598,981       556,007  
                                                                 
Net (loss) income
   $ (2,964,801 )   $ (1,699,536 )   $ (602,799 )   $ (2,911,503 )   $ (436,307 )   $ 860,216     $ 1,073,056     $ 1,014,859  
                                                                 
Earnings (loss) per common share:
                                                                
Basic
   $ (0.46 )   $ (0.26 )   $ (0.09 )   $ (0.45 )   $ (0.07 )   $ 0.14     $ 0.16     $ 0.16  
Diluted
   $ (0.46 )   $ (0.26 )   $ (0.09 )   $ (0.45 )   $ (0.07 )   $ 0.14     $ 0.16     $ 0.15  
 
85

ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

Cornerstone has not had any change in accountants or disagreements with accountants on accounting and financial disclosure during the two most recent fiscal years or subsequently.

ITEM 9A(T).  CONTROLS AND PROCEDURES

Disclosure Controls and Procedures

Cornerstone maintains disclosure controls and procedures, as defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934 (the “Exchange Act”), that are designed to ensure that information required to be disclosed by it in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Commission’s rules and forms and that such information is accumulated and communicated to Cornerstone’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. Cornerstone carried out an evaluation, under the supervision and with the participation of its management, including its Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of its disclosure controls and procedures as of the end of December 31, 2009.  Based on the evaluation of these disclosure controls and procedures, the Chief Executive Officer and Chief Financial Officer have concluded that as of December 31, 2009, Cornerstone’s disclosure controls and procedures were effective.

Management’s Report on Internal Control over Financial Reporting

The report of Cornerstone’s management on internal control over financial reporting is set forth in Item 8 of this Annual Report on Form 10-K and incorporated herein by reference.

Changes in Internal Controls

There were no changes in Cornerstone’s internal control over financial reporting during Cornerstone’s fiscal quarter ended December 31, 2009 that have materially affected, or are reasonably likely to materially affect, Cornerstone’s internal control over financial reporting.

ITEM 9B. OTHER INFORMATION

None

PART III

ITEM 10.  DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

Information relating to the directors and executive officers of Cornerstone is set forth under the caption “Proposals—Election of Directors” in Cornerstone’s 2010 Proxy Statement. Such information is incorporated into this report by reference.

Information relating to Cornerstone’s audit committee and audit committee financial experts is set forth under the caption “Corporate Governance and the Board of Directors—Audit Committee” in Cornerstone’s 2010 Proxy Statement. Such information is incorporated into this report by reference.

Information relating to compliance with the reporting requirements of Section 16(a) of the Exchange Act by Cornerstone’s executive officers and directors, persons who beneficially own more than ten percent of Cornerstone’s common stock and their affiliates who are required to comply with such reporting requirements is set forth under the caption “Other Matters—Section 16(a) Beneficial Ownership Reporting Compliance” in Cornerstone’s 2010 Proxy Statement. Such information is incorporated into this report by reference.

Cornerstone has adopted a code of business conduct and ethics that applies to its directors, officers and employees, including its principal executive officers, principal financial officer, principal accounting officer, controller or persons performing similar functions.
 
86
 
ITEM 11.
EXECUTIVE COMPENSATION

Information relating to executive compensation is set forth under the captions “Executive Compensation” and “Director Compensation” in Cornerstone’s 2010 Proxy Statement. Such information is incorporated into this report by reference.

ITEM 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

Information relating to beneficial ownership of Cornerstone’s common stock by certain persons is set forth under the caption “Security Ownership of Certain Beneficial Owners and Management” in Cornerstone’s 2010 Proxy Statement. Such information is incorporated into this report by reference.

Information relating to Cornerstone’s equity compensation plans is set forth under the caption “The Company’s Long-Term Equity and Qualified Retirements Plans—Equity Compensation Plan Information as of December 31, 2009” in Cornerstone’s 2010 Proxy Statement. Such information is incorporated into this report by reference.

ITEM 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

Information relating to certain transactions between Cornerstone and its affiliates and certain other persons and to Cornerstone’s policies and procedures for approval of such transactions is set forth under the captions “Certain Relationships and Related Transactions” and “Corporate Governance and the Board of Directors—Policies and Procedures for Approval of Related Person Transactions” in Cornerstone’s 2010 Proxy Statement. Such information is incorporated into this report by reference.

Information relating to director independence is set forth under the caption “Corporate Governance and the Board of Directors—Board Composition and Director Independence” in Cornerstone’s 2010 Proxy Statement. Such information is incorporated into this report by reference.

ITEM 14.
PRINCIPAL ACCOUNTANT FEES AND SERVICES

Information relating to principal accountant fees and services is set forth under the caption “Audit Committee—Audit and Non-Audit Fees” in Cornerstone’s 2010 Proxy Statement. Such information is incorporated into this report by reference.
 
87
 
ITEM 15.
EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
         
  (a) The following documents are filed as part of this report:
     
 
(1)
Financial Statements
     
   
The following report and consolidated financial statements of Cornerstone and Subsidiaries are included in Item 8:
     
   
Report of Independent Registered Public Accounting Firm
   
Consolidated Balance Sheets as of December 31, 2009 and 2008
   
Consolidated Statements of Income for the years ended December 31, 2009, 2008 and 2007
   
Consolidated Statement of Changes in Stockholders’ Equity for the years ended December 31, 2009, 2008 and 2007
   
Consolidated Statements of Cash Flows for the years ended December 31, 2009, 2008 and 2007
   
Notes to Consolidated Financial Statements
     
 
(2)
Financial Statement Schedules:
     
   
Schedule II: Valuation and Qualifying Accounts
     
   
All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and therefore have been omitted.
     
 
(3)
The following documents are filed or incorporated by reference as exhibits to this report:

 
Exhibit No.
Description

 
3.1
Amended and Restated Charter of Cornerstone Bancshares, Inc. (1)
 
3.2
First Amendment to Amended and Restated Charter of Cornerstone Bancshares, Inc. (2)
 
3.3
Amended and Restated Bylaws of Cornerstone Bancshares, Inc. (3)
 
4
The right of securities holders are defined in the Charter and Bylaws provided in exhibits 3.1, 3.2 and 3.3 respectively.
 
10.1*
Cornerstone Bancshares, Inc. Statutory and Nonstatutory Stock Option Plan. (4)
 
10.2*
Cornerstone Bancshares, Inc. 2002 Long-Term Incentive Plan. (5)
 
10.3*
Cornerstone Bancshares, Inc. 2004 Non-Employee Director Plan. (6)
 
10.4*
Cornerstone Community Bank Employee Stock Ownership Plan. (7)
 
10.5*
Key Executive and Employment Agreement with Nathaniel F. Hughes, as amended. (8)
 
10.6*
Key Executive and Employment Agreement with Jerry D. Lee, as amended. (9)
 
10.7*
Separation Agreement dated November 12, 2009, by and among Gregory B. Jones, Cornerstone Community Bank and Cornerstone Bancshares, Inc.
 
14
Code of Ethics. (10)
 
21
Subsidiaries of the registrant.
 
31.1
Certification of principal executive officer.
 
31.2
Certification of principal financial officer.
 
32
Section 906 certifications of chief executive officer and chief financial officer.
 
 
*
This item is a management contract or compensatory plan or arrangement required to be filed as an exhibit to this Form 10-K pursuant to Item 15(b) of this report.
 
(1)
Incorporated by reference to Exhibit 3.1 of the registrant’s Form 10-KSB filed on March 24, 2004.
 
(2)
Incorporated by reference to Exhibit 3 of the registrant’s Form 10-Q filed on May 14, 2004.
 
(3)
Incorporated by reference to Exhibit 3.2 of the registrant’s Form 10-KSB filed on March 24, 2004.
 
(4)
Incorporated by reference to Exhibit 10.1 of the registrant’s Registration Statement on Form S-1 filed on February 4, 2000, as amended (File No. 333-96185).
 
(5)
Incorporated by reference to Exhibit 99.1 of the registrant’s Registration Statement on Form S-8 filed March 5, 2004 (File No. 333-113314).
 
(6)
Incorporated by reference to Exhibit 99.3 of the registrant’s Registration Statement on Form S-8 filed March 5, 2004 (File No. 333-113314).
 
(7)
Incorporated by reference to Exhibit 10.1 of the registrant’s Form 8-K filed on July 19, 2005.
 
(8)
Incorporated by reference to Exhibit 10.3 of the registrant’s Registration Statement on Form S-1 filed on February 4, 2000 (File No. 333-96185).
 
(9)
Incorporated by reference to Exhibit 10.4 of the registrant’s Registration Statement on Form S-1 filed on February 4, 2000 (File No. 333-96185).
 
(10)
Incorporated by reference to Exhibit 14 of the registrant’s Form 10-KSB filed on March 24, 2004.
 
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SIGNATURES
 
In accordance with Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
 
 
CORNERSTONE BANCSHARES, INC.
  
       
Date: March 30, 2010
By:
/s/  Nathaniel F. Hughes  
    Nathaniel F. Hughes  
    President & Chief Executive Officer  
    (principal executive officer)  

By:
/s/  Gary W. Petty, Jr.    
    Gary W. Petty, Jr.  
    Senior Vice President and Chief Financial Officer  
    (principal financial officer and accounting officer)  
 
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In accordance with the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on March 30, 2010.
 
Signature
    
Title
  
         
/s/  W. Miller Welborn
     Chairman of the Board of Directors  
W. Miller Welborn
      
     
/s/  Nathaniel F. Hughes     President and Chief Executive Officer  
Nathaniel F. Hughes      (principal executive officer) and Director  
         
/s/  B. Kenneth Driver     Director  
B. Kenneth Driver        
         
/s/  Karl Fillauer     Director  
Karl Fillauer        
         
/s/  David Fussell     Director  
David Fussell        
         
/s/  Jerry D. Lee     Executive Vice President and Senior Lender  
Jerry D. Lee     and Director  
         
/s/  Lawrence D. Levine     Director  
Lawrence D. Levine        
         
/s/ Frank S. McDonald     Director  
Frank S. McDonald        
         
/s/  Doyce G. Payne     Director  
Doyce G. Payne        
         
/s/  Billy O. Wiggins     Director  
Billy O. Wiggins        
         
/s/  Marsha Yessick     Director  
Marsha Yessick        
         
/s/  Gary W. Petty, Jr.     Senior Vice President and Chief Financial Officer  
Gary W. Petty, Jr.     (principal financial officer and accounting officer)  

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INDEX OF EXHIBITS

Exhibit No.
Description

3.1
Amended and Restated Charter of Cornerstone Bancshares, Inc. (1)
3.2
First Amendment to Amended and Restated Charter of Cornerstone Bancshares, Inc. (2)
3.3
Amended and Restated Bylaws of Cornerstone Bancshares, Inc. (3)
4
The right of securities holders are defined in the Charter and Bylaws provided in exhibits 3.1, 3.2 and 3.3 respectively.
10.1*
Cornerstone Bancshares, Inc. Statutory and Nonstatutory Stock Option Plan. (4)
10.2*
Cornerstone Bancshares, Inc. 2002 Long-Term Incentive Plan. (5)
10.3*
Cornerstone Bancshares, Inc. 2004 Non-Employee Director Plan. (6)
10.4*
Cornerstone Community Bank Employee Stock Ownership Plan. (7)
10.5*
Key Executive and Employment Agreement with Nathaniel F. Hughes, as amended. (8)
10.6*
Key Executive and Employment Agreement with Jerry D. Lee, as amended. (9)
10.7*
Separation Agreement dated November 12, 2009, by and among Gregory B. Jones, Cornerstone Community Bank and Cornerstone Bancshares, Inc.
14
Code of Ethics. (10)
21
Subsidiaries of the registrant.
31.1
Certification of principal executive officer.
31.2
Certification of principal financial officer.
32
Section 906 certifications of chief executive officer and chief financial officer.
 
*
This item is a management contract or compensatory plan or arrangement required to be filed as an exhibit to this Form 10-K pursuant to Item 15(b) of this report.
(1)
Incorporated by reference to Exhibit 3.1 of the registrant’s Form 10-KSB filed on March 24, 2004.
(2)
Incorporated by reference to Exhibit 3 of the registrant’s Form 10-Q filed on May 14, 2004.
(3)
Incorporated by reference to Exhibit 3.2 of the registrant’s Form 10-KSB filed on March 24, 2004.
(4)
Incorporated by reference to Exhibit 10.1 of the registrant’s Registration Statement on Form S-1 filed on February 4, 2000, as amended (File No. 333-96185).
(5)
Incorporated by reference to Exhibit 99.1 of the registrant’s Registration Statement on Form S-8 filed March 5, 2004 (File No. 333-113314).
(6)
Incorporated by reference to Exhibit 99.3 of the registrant’s Registration Statement on Form S-8 filed March 5, 2004 (File No. 333-113314).
(7)
Incorporated by reference to Exhibit 10.1 of the registrant’s Form 8-K filed on July 19, 2005.
(8)
Incorporated by reference to Exhibit 10.3 of the registrant’s Registration Statement on Form S-1 filed on February 4, 2000 (File No. 333-96185).
(9)
Incorporated by reference to Exhibit 10.4 of the registrant’s Registration Statement on Form S-1 filed on February 4, 2000 (File No. 333-96185).
(10)
Incorporated by reference to Exhibit 14 of the registrant’s Form 10-KSB filed on March 24, 2004.
 
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