<PAGE> 1
FORM 10-K
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
[ X ] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 1998
Commission file number 333-26699
CORNERSTONE BANCSHARES, INC.
(Exact name of registrant as specified in its charter)
<TABLE>
<S> <C>
TENNESSEE 62-1173944
(State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.)
</TABLE>
5319 HIGHWAY 153
CHATTANOOGA, TENNESSEE 37343
(Address of principal executive offices and Zip Code)
(423) 877-8181
(Registrant's telephone number)
Securities registered under Section 12(b) of the Exchange Act: NONE
Securities registered under Section 12(g) of the Exchange Act: NONE
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Exchange Act during the past
12 months (or for such shorter period that the registrant was required to file
such reports), and (2) has been subject to such filing requirements for the past
90 days. Yes X No
--- ---
THE AGGREGATE MARKET VALUE OF THE SHARES OF COMMON STOCK HELD BY
NONAFFILIATES OF THE REGISTRANT AS OF MARCH 31, 1999 IS APPROXIMATELY
$13,124,293. (For purposes of this calculation only, all executive officers and
directors are classified as affiliates.)
Indicate the number of shares outstanding of each of the registrant's classes of
common stock, as of the latest practicable date. OUTSTANDING AT MARCH 31, 1999,
COMMON STOCK, $1.00 PAR VALUE, 1,009,561.
Documents Incorporated by Reference: NONE
<PAGE> 2
PART I
ITEM 1. DESCRIPTION OF BUSINESS
GENERAL
Cornerstone Bancshares, Inc. ("Cornerstone"), a Tennessee corporation,
is a bank holding company registered under the Bank Holding Company Act of 1956,
as amended, and was formerly known as East Ridge Bancshares, Inc. Its
wholly-owned subsidiary, Cornerstone Community Bank, a Tennessee banking
corporation (the "Bank"), resulted from the merger of The Bank of East Ridge and
Cornerstone Community Bank effective October 15, 1997. Cornerstone provides a
variety of banking and financial services to businesses and individuals.
Cornerstone's headquarters and principal banking office is located at 5319
Highway 153, Chattanooga, Tennessee. It has branches located at 4154 Ringgold
Road (formerly the main office of The Bank of East Ridge) and 610 Georgia
Avenue, Chattanooga, Tennessee. It also leases space in which it operates two
branches in Albertson's Supermarkets. Cornerstone conducts its business as a
commercial bank, with special emphasis in retail banking, including the
acceptance of checking and saving deposits, and the making of commercial, real
estate, personal, home improvement, automobile and other installment and term
loans. It also offers collections, notary public services, escrow service and
other customary bank services to its customers.
The 1997 statistical disclosures of Cornerstone under Guide 3 represent
historical financial information presented on a pro forma basis as if the merger
of The Bank of East Ridge and Cornerstone Community Bank occurred as of January
1, 1997. Guide 3 financial information presented on the pro forma basis provides
comparable data that is reasonable and meaningful to the combined banking
operations that began on the merger date of October 15, 1997.
EMPLOYEES
As of March 1, 1999, Cornerstone had approximately 52 full-time
employees. The employees are not represented by a collective bargaining unit.
Cornerstone believes its relationship with its employees to be good.
CUSTOMERS
It is the opinion of management that there is no single customer or
affiliated group of customers whose deposits, if withdrawn, would have a
materially adverse effect on the business of Cornerstone.
COMPETITION
All phases of Cornerstone's banking activities are highly competitive.
Cornerstone competes actively with nine commercial banks, as well as finance
companies, credit unions and other financial institutions located in its service
area, which includes Hamilton County, Tennessee.
SUPERVISION AND REGULATION
Cornerstone is a bank holding company within the meaning of the Federal
Bank Holding Company Act of 1956, as amended (the "Act"), and is registered with
the Board of Governors of the Federal Reserve System (the "Board"). Cornerstone
is required to file with the Board annual reports and such additional
information as the Board may require pursuant to the Act. The Board may also
make examinations of Cornerstone and its subsidiaries. The following summary of
the Act and of the other acts described herein is qualified in its entirety by
express reference to each of the particular acts.
The Act requires every bank holding company to obtain the prior
approval of the Board before acquiring direct or indirect ownership or control
of more than 5% of the voting shares of any bank which is not majority owned by
Cornerstone. The Act prohibits a bank holding company, with certain exceptions,
from acquiring direct or indirect ownership or control of more than 5% of the
outstanding voting shares of any company which is not a bank and from engaging
in any business other than banking or furnishing services to or performing
services for its subsidiaries. The 5% limitation is not applicable to
<PAGE> 3
ownership of shares in any company the activities of which the Board has
determined to be so closely related to banking or managing or controlling banks
as to be a proper incident thereto.
Subject to limited exceptions, the Act prohibits the direct or indirect
acquisition by a bank holding company or any of its subsidiaries of more than
five percent of the voting shares or substantially all of the assets of a bank
located outside the state in which the operations of its banking subsidiaries
are principally conducted, unless the acquisition is specifically authorized by
a statute of the state in which the bank to be acquired is located. The
Tennessee Reciprocal Banking Act was amended, effective January 1, 1991,
generally to permit nationwide reciprocal interstate banking.
The Bank is an "affiliate" of Cornerstone within the meaning of the
Federal Reserve Act. This act places restrictions on a bank's loans or
extensions of credit to, purchases of or investments in the securities of, and
purchases of assets from an affiliate, a bank's loans or extensions of credit to
third parties collateralized by the securities or obligations of an affiliate,
the issuance of guarantees, acceptances, and letters of credit on behalf of an
affiliate, and certain bank transactions with an affiliate, or with respect to
which an affiliate acts as agent, participates, or has a financial interest.
Furthermore, a bank holding company and its subsidiaries are prohibited from
engaging in certain tie-in arrangements in connection with any extension of
credit, lease or sale of property or furnishing of services.
Under Federal Reserve Board policy, Cornerstone is expected to act as a
source of financial strength to its subsidiary bank and to commit resources to
support its subsidiary. This support may be required at times when, absent such
Federal Reserve Board policy, Cornerstone may not be inclined to provide it.
Under the Financial Institutions Reform, Recovery, and Enforcement Act of 1989
("FIRREA"), a depository institution insured by the FDIC can be held liable for
any loss incurred by, or reasonably expected to be incurred by, the FDIC after
August 9, 1989 in connection with (a) the default of a commonly controlled
FDIC-insured depository institution or (b) any assistance provided by the FDIC
to any commonly controlled FDIC-insured depository institution "in danger of
default." "Default" is defined generally as the appointment of a conservator or
receiver and "in danger of default" is defined generally as the existence of
certain conditions indicating that a default is likely to occur in the absence
of regulatory assistance. Under FDICIA (see discussion below) a bank holding
company may be required to guarantee the capital plan of an undercapitalized
depository institution. Any capital loans by a bank holding company to any of
its subsidiary banks are subordinate in right of payment to deposits and to
certain other indebtedness of such subsidiary bank. In the event of a bank
holding company's bankruptcy, any commitment by the bank holding company to a
federal bank regulatory agency to maintain the capital of a subsidiary bank will
be assumed by the bankruptcy trustee and entitled to a priority of payment.
The Bank is a member of the FDIC and is subject to examination and
regulation by that authority. The Bank is chartered under the banking laws of
the State of Tennessee and is subject to the supervision of, and regular
examination by, the TDFI.
The Tennessee Reciprocal Banking Act requires the filing of an
application with and the approval of the Tennessee Commissioner of Financial
Institutions to acquire a Tennessee bank or bank holding company.
Tennessee law was amended in 1990 to permit branch banking in any
county in the state. Prior to the amendment, statewide branching was possible
pursuant to a May 1988 federal court decision.
In December 1991, a major banking bill entitled the Federal Deposit
Insurance Corporation Improvement Act of 1991 ("FDICIA") was enacted, which
substantially revises the bank regulatory and funding provisions of the Federal
Deposit Insurance Act and makes revisions to several other federal banking
statutes. Among other things, FDICIA requires the federal banking regulators to
take "prompt corrective action" in respect of depository institutions that do
not meet minimum capital requirements. The Bank has capital levels well above
the minimum requirements. In addition, an institution that is not well
capitalized is generally prohibited from accepting brokered deposits and
offering interest rates on deposits higher than the prevailing rate in its
market and also may not be able to "pass through" insurance coverage for certain
employee benefit accounts. FDICIA also requires the holding company of any
undercapitalized depository institution to guarantee, in part, certain aspects
of such depository institution's
<PAGE> 4
capital plan for such plan to be acceptable. FDICIA contains numerous other
provisions, including new accounting, audit and reporting requirements,
termination of the "too big to fail" doctrine except in special cases,
limitations on the FDIC's payment of deposits at foreign branches, new
regulatory standards in such areas as asset quality, earnings and compensation
and revised regulatory standards for, among other things, powers of state banks,
real estate lending and capital adequacy. FDICIA also requires that a depository
institution provide 90 days prior notice of the closing of any branches.
EFFECT OF GOVERNMENTAL POLICIES
Cornerstone and the Bank are affected by the policies of regulatory
authorities, including the Federal Reserve System. An important function of the
Federal Reserve System is to regulate the national money supply. Among the
instruments of monetary policy used by the Federal Reserve are: purchases and
sales of U.S. Government securities in the marketplace; changes in the discount
rate, which is the rate any depository institution must pay to borrow from the
Federal Reserve; and changes in the reserve requirements of depository
institutions. These instruments are effective in influencing economic and
monetary growth, interest rate levels and inflation.
The monetary policies of the Federal Reserve System and other
governmental policies have had a significant effect on the operating results of
commercial banks in the past and are expected to continue to do so in the
future. Because of changing conditions in the national economy and in the money
market, as well as the result of actions by monetary and fiscal authorities, it
is not possible to predict with certainty future changes in interest rates,
deposit levels, loan demand or the business and earnings of Cornerstone or
whether the changing economic conditions will have a positive or negative effect
on operations and earnings.
Bills are pending before the United States Congress and the Tennessee
General Assembly which could affect the business of Cornerstone and the Bank,
and there are indications that other similar bills may be introduced in the
future. It cannot be predicted whether or in what form any of these proposals
will be adopted or the extent to which the business of Cornerstone and the Bank
may be affected thereby.
NET INTEREST INCOME
The following table sets forth weighted yields earned by Cornerstone on
its earning assets and the weighted average rates paid on its deposits and other
interest-bearing liabilities for the years ended December 31, 1998 and 1997.
<PAGE> 5
<TABLE>
<CAPTION>
December 31, 1998 December 31, 1997
-------------------------------------- ------------------------------------
(Fully taxable equivalent) (Dollars in
thousands) Interest Average Interest Average
Average Income/ Yields/ Average Income/ Yields/
Balance Expense Rates Balance Expense Rates
--------- -------- ------- -------- -------- --------
<S> <C> <C> <C> <C> <C> <C>
ASSETS:
Interest-earning assets:
Loans net of unearned income $ 69,356 $6,738 9.72% $ 50,120 $5,292 10.56%
Other investments 20,269 1,297 6.40% 19,207 1,317 6.86%
Interest-bearing deposits with banks 16 1 3.70% 713 39 5.47%
Federal funds sold 3,289 175 5.32% 3,447 189 5.48%
--------- ------ -------- ------
Total interest-earning 92,930 8,211 8.83% 73,487 6,837 9.30%
--------- ------ -------- ------
assets/interest income
Cash and due from banks 6,976 2,859
Other assets 6,757 5,413
Allowance for loan losses (900) (706)
--------- --------
Total $ 105,763 $ 81,053
========= ========
LIABILITIES AND SHAREHOLDERS' EQUITY:
Interest-bearing liabilities:
Demand deposits $ 12,287 $ 260 2.12% $ 11,104 $ 247 2.22%
Savings 10,195 374 3.67% 9,430 363 3.85%
Time certificates 60,234 3,507 5.82% 43,705 2,703 6.18%
Other borrowings 1,200 89 7.42% -0- -0-
--------- ------ -------- ------
Total interest-bearing 83,916 4,230 5.04% 64,239 3,313 5.16%
--------- ------ -------- ------
liabilities/interest expense
Non interest-bearing demand deposits 10,490 7,896
Other liabilities 1,079 2,654
Shareholders' equity 10,278 6,264
--------- --------
Total $ 105,763 $ 81,053
========= ========
Net interest earnings $3,981 $3,524
====== ======
Net interest on interest-earning assets 4.28% 4.80%
</TABLE>
LIABILITY AND ASSET MANAGEMENT
The matching of assets and liabilities may be analyzed by examining the
extent to which such assets and liabilities are "interest rate sensitive" and by
monitoring an institution's interest rate sensitivity "gap." An asset or
liability is said to be interest rate sensitive within a specific time period if
it will mature or reprice within that time period. The interest rate sensitivity
gap is defined as the difference between the amount of interest-earning assets
maturing or repricing within a specific time period and the amount of
interest-bearing liabilities maturing or repricing within that time period. A
gap is considered positive when the amount of interest rate sensitive assets
exceeds the amount of interest rate sensitive liabilities. A gap is considered
negative when the amount of interest rate sensitive liabilities exceeds the
amount of interest rate sensitive assets. During a period of rising interest
rates, a negative gap would tend to adversely affect net interest income while a
positive gap would tend to result in an increase in net interest income. During
a period of falling interest rates, a negative gap would tend to result in an
increase in net interest income while a positive gap would tend to adversely
affect net interest income.
The asset/liability committee, which consists of the chief executive
officer, chief financial officer, and four other directors are charged with
monitoring the liquidity and funds position of Cornerstone. The committee
regularly reviews (a) the rate sensitivity position on a three-month, six-month,
and one-year time horizon; (b) loans to deposit ratios; and (c) average maturity
for certain categories of liabilities.
<PAGE> 6
Cornerstone operates an external asset/liability management model. No
estimates of the impact of changing interest rates on historical or projected
earnings are available. The current level of interest rate risk can, however, be
inferred from maturity and repricing data. At December 31, 1998, Cornerstone had
a negative cumulative repricing gap within one year of approximately $3.2
million, or approximately 3.2% of total assets. This negative repricing gap
indicates that Cornerstone's future earnings may be adversely impacted by a rise
in market interest rates. Such an impact would primarily be felt in the
twelve-month period after a rise in rates.
The following tables represent an interest sensitivity profile for
Cornerstone as of December 31, 1998 and 1997. The tables represent a static
point in time and do not consider other variables, such as changing spread
relationships or interest rate levels. "Net repricing gap" is the difference
between total earning assets and total interest bearing liabilities repricing in
any given period and "cumulative gap" is the sum of the net repricing gap from
period to period. Interest-bearing demand, savings and money market account
deposits are presented as repricing in the earliest period presented.
<TABLE>
<CAPTION>
December 31, 1998
-----------------
Within After 3 months After 12 months
3 months Within 12months Within 5 years After 5 years Total
-------- --------------- ---------------- ------------- --------
<S> <C> <C> <C> <C> <C>
(Dollars in thousands)
EARNING ASSETS:
Loans $27,629 $ 10,686 $32,814 $ 2,764 $ 73,893
Investment securities 1,606 4,313 8,681 3,758 18,358
Other earning assets 11 0 11
Federal funds sold 8,425 0 0 0 8,425
------- -------- ------- ------- --------
Total earning assets $37,671 $ 14,999 $41,495 $ 6,522 $100,687
------- -------- ------- ------- --------
INTEREST-BEARING LIABILITIES:
Interest-bearing deposits $18,496 $ 36,107 $29,257 $ 0 $ 83,860
Other borrowed funds 1,250 0 0 0 1,250
------- -------- ------- ------- --------
Total interest-bearing liabilities $19,746 $ 36,107 $29,257 $ 0 $ 85,110
------- -------- ------- ------- --------
RATE SENSITIVITY GAP:
Net repricing gap $17,925 $(21,108) $12,238 $ 6,522 $ 15,577
Net repricing gap as a percentage of
total earning assets 17.80% (20.96)% 12.15% 6.48%
Cumulative gap $17,925 $ (3,183) $ 9,055 $15,577
Cumulative gap as a percentage of
total earning assets 17.80% (3.16)% 8.99% 15.67%
</TABLE>
<PAGE> 7
<TABLE>
<CAPTION>
December 31, 1997
-----------------
Within After 3 months After 12 months
3 months Within 12 Months Within 5 years After 5 years Total
-------- ---------------- ---------------- ------------- -------
<S> <C> <C> <C> <C> <C>
(Dollars in thousands)
EARNING ASSETS:
Loans $ 21,748 $ 9,077 $25,525 $5,155 $61,505
Investment securities 1,424 5,249 10,004 1,579 18,256
Other earning assets 55 -- -- -- 55
Federal funds sold 1,130 -- -- -- 1,130
-------- -------- ------- ------ -------
Total earning assets $ 24,357 $ 14,326 $35,529 $6,734 $80,946
======== ======== ======= ====== =======
INTEREST-BEARING LIABILITIES:
Interest-bearing deposits $ 39,232 $ 21,020 $12,324 $ -- $72,576
-------- -------- ------- ------ -------
Total interest-bearing liabilities $ 39,232 $ 21,020 $12,324 $ -- $72,576
======== ======== ======= ====== =======
RATE SENSITIVITY GAP:
Net repricing gap $(14,875) $ (6,694) $23,205 $6,734 $ 8,370
Net repricing gap as a percentage of
total earning assets (18.38)% (8.27)% 28.67% 8.32% 10.34%
Cumulative gap $(14,875) $(21,569) $ 1,636 $8,370
Cumulative gap as a percentage of
total earning assets (18.38)% (26.65)% 2.02% 10.34%
</TABLE>
Management has made the following assumptions in the above analysis: (i) Assets
and liabilities are generally assigned to a period based upon their earliest
repricing period when the repricing is less than the contractual maturity; (ii)
Investment securities available for sale are currently treated in the same
manner as comparable securities in the investment securities held to maturity
portfolio in that they are scheduled according to the earlier of their
contractual maturities or earliest repricing dates; and (iii) Interest-bearing
demand deposits, money market deposits and savings deposits that have no
contractual maturities are scheduled 50% in the within 3 months to 12 months
category and 50% in the 12 months to 5 year category.
DEPOSITS
Cornerstone's primary sources of funds are interest bearing deposits.
The following table sets forth Cornerstone's deposit structure at December 31,
1998 and 1997.
<TABLE>
<CAPTION>
(In thousands) December 31, 1998 December 31, 1997
----------------- -----------------
<S> <C> <C>
Non interest-bearing deposits:
Individuals, partnerships and corporations $13,798 $ 9,184
Certified and official checks 357 89
------- -------
Total non interest-bearing deposits 14,152 9,273
Interest-bearing deposits:
Interest-bearing demand accounts 12,998 13,009
Savings accounts 10,283 9,879
Certificates of deposit, less than $100,000 43,089 35,736
Certificates of deposit, $100,000 or more 17,490 13,952
------- -------
Total interest-bearing deposits 83,860 72,576
------- -------
Total deposits $98,012 $81,849
======= =======
</TABLE>
The following table presents a breakdown by category of the average
amount of deposits and the average rate paid on deposits for the periods
indicated:
<TABLE>
<CAPTION>
(In thousands) December 31, 1998 December 31, 1997
------------------------ ------------------------
<S> <C> <C> <C> <C>
Non interest-bearing deposits $10,490 $ 7,896
Savings deposits 10,195 3.67% 9,430 3.85%
Time deposits 60,234 5.82% 43,705 6.18%
Interest-bearing demand deposits 12,287 2.12% 11,104 2.22%
------- -------
Total deposits $93,206 $72,135
======= =======
</TABLE>
<PAGE> 8
At December 31, 1998 and 1997, time deposits of $100,000 or more
aggregated approximately $17 million and $14 million, respectively. The
following table indicates, as of the dates indicated, the dollar amount of
$100,000 or more by the time remaining until maturity (in thousands):
<TABLE>
<CAPTION>
December 31, 1998 December 31, 1997
-------------------------------- -----------------------------
3 Months 3 to 12 1 to 5 3 Months 3 to 12 1 to 5
or less Months Years or less Months Years
-------- ------- ------ -------- ------- ------
<S> <C> <C> <C> <C> <C> <C>
Time certificates $7,753 $5,480 $4,257 $4,251 $7,076 $2,625
</TABLE>
ASSETS
Management of Cornerstone considers many criteria in managing assets,
including creditworthiness, diversification and structural characteristics,
maturity and interest rate sensitivity. The following table sets forth
Cornerstone's interest-earning assets by category at December 31, 1998 and 1997.
<TABLE>
<CAPTION>
(In thousands) December 31, 1998 December 31, 1997
----------------- -----------------
<S> <C> <C>
Interest-bearing deposits with banks $ 11 $ 55
Investment securities held to maturity 9,078 10,780
Investment securities available for sale 9,280 7,476
Federal funds sold 8,425 1,130
Loans:
Real estate 52,351 42,716
Commercial and other 21,542 18,789
-------- -------
Total loans 73,893 61,505
Provision for loan losses 1,400 915
-------- -------
Loans, net 72,493 60,590
-------- -------
Interest-earning assets $100,687 $80,946
-------- =======
</TABLE>
INVESTMENT PORTFOLIO
At December 31, 1998, obligations of the United States Government or
its agencies represented 16.4% of the investment portfolio. The following table
presents the composition of the book value (historical amortized cost basis) of
Cornerstone's investment portfolio at December 31, 1998 and 1997.
<TABLE>
<CAPTION>
(In thousands) December 31, 1998 December 31, 1997
----------------- -----------------
<S> <C> <C>
AVAILABLE FOR SALE:
U. S. Treasuries $ 400 $ 1,448
Obligations of U.S. Government agencies 1,180 1,815
States and political subdivisions -- --
Other securities 7,637 4,213
------- -------
Total available for sale $ 9,217 $ 7,476
------- -------
HELD TO MATURITY:
Obligations of U.S. Government agencies $ 352 $ 3,173
States and political subdivisions -- --
Other investment securities 8,726 7,607
------- -------
Total investment securities held to maturity $ 9,078 $10,780
------- -------
Total investment portfolio $18,295 $18,256
======= =======
</TABLE>
The following table presents the maturity distribution of the book
value and estimated market value of Cornerstone's investment portfolio at
December 1998 and 1997. The weighted average yields on these instruments are
presented based on final maturity.
<PAGE> 9
<TABLE>
<CAPTION>
December 31, 1998 December 31, 1997
--------------------------------- -----------------------------------
Weighted Weighted
Book Estimated Average Book Estimated Average
Value Market Value Yield Value Market Value Yield
-------- ------------ -------- ----- -------------- ---------
(In thousands)
<S> <C> <C> <C> <C> <C> <C>
AVAILABLE FOR SALE:
U. S. Treasuries:
Due within 1 year 400 403 6.28% 1,047 1,047 5.62%
Due after 1 year but within 5 years -- -- -- 401 404 6.28%
Total 400 403 6.28% 1,448 1,451 5.80%
Obligations of U.S. Government agencies:
Due within 1 year 1,180 1,201 6.94% 518 520 6.05%
Due after 1 year but within 5 years -- -- -- 1,097 1,107 6.84%
Due after 5 years but within 10 years -- -- -- 200 200 7.50%
Due after 10 years
Total 1,180 1,201 6.94% 1,815 1,827 6.37%
States and political subdivisions:
Due after 10 years
Other investment securities:
Due within 1 year 3,598 3,616 5.88% 213 222 7.72%
Due after 1 year but within 5 years 3,255 3,264 6.20% 689 691 6.62%
Due after 5 years but within 10 years 784 796 6.67% 603 608 6.76%
Due after 10 years -- -- -- 2,708 2,746 6.76%
Total 7,637 7,676 6.10% 4,213 4,267 6.79%
Total available for sale 9,217 9,280 6.22% 7,476 7,545 6.39%
HELD TO MATURITY:
U. S. Government agencies:
Due within 1 year 1,290 1,301 6.09% 1,014 1,013 5.95%
Due after 1 year but within 5 years 126 126 6.89% 2,159 2,161 5.36%
Due after 10 years -- -- -- -- -- --
Total 1,415 1,427 6.16% 3,173 3,174 5.69%
State and political subdivisions:
Due after 5 years but within 10 years
Due after 10 years
Total
Other:
Due within 1 year 1,671 1,687 6.19% 3,881 3,927 6.79%
</TABLE>
<PAGE> 10
<TABLE>
<S> <C> <C> <C> <C> <C> <C>
Due after 1 year but within 5 years 4,809 4,809 6.23% 3,157 3,159 6.82%
Due after 5 years but within 10 years 1,183 1,180 6.48% 145 146 6.89%
Due after 10 years -- -- -- 424 430 6.55%
Total 7,662 7,676 6.26% 7,607 7,662 6.79%
Total held to maturity 9,078 9,103 6.24% 10,780 10,836 6.16%
Total investments 18,295 18,383 6.23% 18,325 18,452 6.42%
</TABLE>
INVESTMENT POLICY
The objective of Cornerstone's investment policy is to invest funds not
otherwise needed to meet the loan demand of Cornerstone's market area and to
meet the five following objectives; Gap Management, Liquidity, Pledging, Return,
and Local Community Support. In doing so, Cornerstone will use the portfolio to
provide structure and liquidity that the Loan Portfolio cannot. The Management
Investment Committee will balance the market and credit risks against the
potential investment return, make investments compatible with the pledge
requirements of Cornerstone's deposits of public funds, maintains compliance
with regulatory investment requirements, and assists the various public entities
with their financing needs. The Management Investment Committee is authorized to
execute security transactions for the investment portfolio based on the
decisions of the Board Asset/Liability Committee. All the investment
transactions occurring since the previous Board Asset Liability Committee
meeting are reviewed by the Board Asset Liability Committee 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
Cornerstone's needed liquidity and longer term securities purchased to generate
stable income for Cornerstone during periods of interest rate fluctuations.
<PAGE> 11
LOAN PORTFOLIO
The following table summarizes certain information concerning
Cornerstone's loan portfolio (in thousands):
<TABLE>
<CAPTION>
December 31, 1998 December 31, 1997
----------------- -----------------
Amount % of Total Loans Amount % of Total Loans
------- ---------------- ------- ----------------
<S> <C> <C> <C> <C>
Real estate loans:
Construction and land development $ 5,456 7.38% $ 8,581 13.95%
Secured by residential properties 22,638 30.64% 13,152 21.38%
Other real estate loans 24,257 32.83% 20,983 34.12%
------- -------
Total real estate loans 52,351 70.85% 42,716 69.45%
Commercial and industrial loans 13,164 17.81% 12,373 20.12%
Consumer loans 8,128 11.00% 6,241 10.15%
All other loans 250 .34% 175 0.28%
------- ------- ------- -------
Total loans $73,893 100.00% $61,505 100.00%
------- ------ ======= ======
</TABLE>
The following tables set forth maturities of the loan portfolio and the
sensitivity to interest rate changes of Cornerstone's loan portfolio (in
thousands).
<TABLE>
<CAPTION>
December 31, 1998
Maturity Range
-----------------
One Year One Through Over
or Less Five Years Five Years Total
-------- ----------- ---------- ------
<S> <C> <C> <C> <C>
Real estate construction loans 5,456 -- -- 5,456
Real estate mortgage loans 22,305 23,085 1,505 46,895
Commercial and industrial 8,320 4,244 600 13,164
loans
All other loans 2,974 4994 410 8,378
------ ------ ----- ------
Total loans 39,055 32,323 2,515 73,893
</TABLE>
<TABLE>
<CAPTION>
December 31, 1997
Maturity Range
-----------------
One Year One Through Over
or Less Five Years Five Years Total
-------- ----------- ---------- --------
<S> <C> <C> <C> <C>
Real estate construction loans $11,453 $17,395 $ 716 $29,564
Real estate mortgage loans 6,237 4,139 2,776 13,152
Commercial and industrial 7,548 3,594 1,231 12,373
loans
All other loans 5,587 397 432 6,416
------- ------- ------ -------
Total loans $30,825 $25,525 $5,155 $61,505
======= ======= ====== =======
</TABLE>
LOAN POLICY
All lending activities of Cornerstone are under the direct supervision
and control of the Directors Loan Committee, which consists of the chairman, the
chief executive officer, the executive vice president of lending and four
outside directors. The loan committee enforces loan authorizations for each
officer, decides on loans exceeding such limits, services all requests for
officer credits to the extent allowable under current laws and regulations,
administers all problem credits, and determines the allocation of funds for each
lending division. Cornerstone's established maximum loan volume to deposits is
85%. The loan portfolio consists primarily of real estate, commercial and
installment loans. Commercial loans consist of either real estate loans or term
loans. Maturity of term loans is normally limited to five to seven years.
Conventional real estate loans may be made up to 90% of the appraised value or
purchase cost of the real estate for no more than a thirty-year term.
Installment loans are based on the earning capacity and vocational stability of
the borrower.
<PAGE> 12
Management of Cornerstone periodically reviews the loan portfolio,
particularly nonaccrual and renegotiated loans. The review may result in a
determination that a loan should be placed on a nonaccrual status for income
recognition. In addition, to the extent that management identifies potential
losses in the loan portfolio, it reduces the book value of such loans, through
charge-offs, to their estimated collectible value. Cornerstone's policy is to
classify as nonaccrual any loan on which payment of principal or interest is 90
days or more past due except where there is adequate collateral to cover
principal and accrued interest and the loan is in the process of collection. No
concessions are granted and late fees are collected. In addition, a loan will be
classified as nonaccrual if, in the opinion of the management, based upon a
review of the borrower's or guarantor's financial condition, collateral value or
other factors, payment is questionable, even though payments are not 90 days or
more past due.
When a loan is classified as nonaccrual, any unpaid interest is
reversed against current income. Interest is included in income thereafter only
to the extent received in cash. The loan remains in a nonaccrual classification
until such time as the loan is brought current, when it may be returned to
accrual classification. When principal or interest on a nonaccrual loan is
brought current, if in management's opinion future payments are questionable,
the loan would remain classified as nonaccrual. After a nonaccrual or
renegotiated loan is charged off, any subsequent payments of either interest or
principal are applied first to any remaining balance outstanding, then to
recoveries and lastly to income.
The large number of consumer installment loans and the relatively small
dollar amount of each makes an individual review impracticable. It is
Cornerstone's policy to charge off any consumer installment loan which is past
due 90 days or more.
In addition, mortgage loans secured by real estate are placed on
nonaccrual status when the mortgagor is in bankruptcy, or foreclosure
proceedings are instituted. Any accrued interest receivable remains in interest
income as an obligation of the borrower.
Cornerstone's underwriting guidelines are applied to three major
categories of loans, commercial and industrial, real estate, which includes
residential, construction and development and certain other real estate loans
and consumer loans. Cornerstone requires its loan officers and loan committee to
consider the borrower's character, the borrower's financial condition as
reflected in current financial statements, the borrower's management capability,
the borrower's industry and the economic environment in which the loan will be
repaid. Before approving a loan, the loan officer or committee must determine
that the borrower is basically honest and creditworthy, determine that the
borrower is a capable manager, understand the specific purpose of the loan,
understand the source and plan of repayment, determine that the purpose, plan
and source of repayment as well as collateral are acceptable, reasonable and
practical given the normal framework within which the borrower operates.
CREDIT RISK MANAGEMENT AND RESERVE FOR LOAN LOSSES
Credit risk and exposure to loss are inherent parts of the banking
business. Management seeks to manage and minimize these risks through its loan
and investment policies and loan review procedures. Management establishes and
continually reviews lending and investment criteria and approval procedures that
it believes reflect the risk sensitive nature of Cornerstone. The loan review
procedures are set to monitor adherence to the established criteria and to
ensure that on a continuing basis such standards are enforced and maintained.
Management's objective in establishing lending and investment standards
is to manage the risk of loss and provide for income generation through pricing
policies. To effectuate this policy, Cornerstone makes commercial real estate
and other loans with one year or less fixed maturity.
The loan portfolio is regularly reviewed and management determines the
amount of loans to be charged-off. In addition, such factors as Cornerstone's
previous loan loss experience, prevailing and anticipated economic conditions,
industry concentrations and the overall quality of the loan portfolio are
considered. While management uses available information to recognize losses on
loans and real estate owned, future additions to the allowance may be necessary
based on changes in economic conditions. In addition, various regulatory
agencies, as an integral part of their examination process, periodically review
<PAGE> 13
the allowances for losses on loans and real estate owned. Such agencies may
require Cornerstone to recognize additions to the allowances based on their
judgments about information available at the time of their examinations. In
addition, any loan or portion thereof which is classified as a "loss" by
regulatory examiners is charged-off.
The reserve for loan losses is increased by provisions charged to
operating expense. The reserve is reduced by charging off loans or portions of
loans at the time they are deemed by management to be uncollectible and
increased when loans previously charged off are recovered. The resulting reserve
for loan losses is viewed by management as a single, unallocated reserve
available for all loans and, in management's opinion, is adequate to provide for
reasonably foreseeable potential loan losses. Rules and formulas relative to the
adequacy of the reserve, although useful as guidelines to management, are not
rigidly applied. The reserve for loan losses was $ 1,400 at year end, or 1.89%
of loans outstanding. The following table presents data related to Cornerstone's
reserve for loan losses for the years ended December 31, 1998 and 1997.
<TABLE>
<CAPTION>
(In thousands) December 31,1998 December 31, 1997
---------------- -----------------
<S> <C> <C>
Beginning balance $ 915 $ 497
Provision for loan losses 715 434
Net charge-offs (230) (16)
------- -----
Ending balance $ 1,400 $ 915
======= =====
</TABLE>
The following table sets forth information regarding loans which are
past due 90 days or more and certain other information as of the dates
indicated:
<TABLE>
<CAPTION>
(In thousands) December 31, 1998 December 31, 1997
----------------- -----------------
<S> <C> <C>
Nonaccrual loans 609 --
Restructured loans --
Loans past due 90 days or more to principal or interest
payments 114 144
Nonperforming loans as a percentage of net loans before
allowance for loan losses 1.0% 0.02%
Allowance for loan losses as a percentage of
nonperforming loans 193.64% 635.42%
</TABLE>
ITEM 2. PROPERTIES
Cornerstone has its principal offices in its main office building at
5319 Highway 153, Chattanooga, Tennessee, which is owned and occupied by
Cornerstone Community Bank. Cornerstone operates branches at 4154 Ringgold Road,
and 610 Georgia Avenue, Chattanooga, Tennessee. It also leases the space in
which it operates two branches in Albertson's Supermarkets. These two branches
each are comprised of approximately 450 square feet in each supermarket and are
leased pursuant to lease agreements entered into in August and November 1992 for
initial five year terms. Each lease provides two five year extensions. The
leases have been renewed for the first renewal period. The Georgia Avenue branch
contains 1800 square feet and is leased pursuant to a lease agreement, which
provides for an initial term of three years with two three-year renewal options.
ITEM 3. LEGAL PROCEEDINGS
There are no material pending legal proceedings to which Cornerstone or
the Bank is a party or of which any of their properties are subject; nor are
there material proceedings known to the Cornerstone to be contemplated by any
governmental authority; nor are there material proceedings known to Cornerstone,
pending or contemplated, in which any director, officer or affiliate or any
principal security holder of Cornerstone, or any associate of any of the
foregoing, is a party or has an interest adverse to Cornerstone or the Bank.
<PAGE> 14
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None
<PAGE> 15
PART II
ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Cornerstone Common Stock is not listed, traded or quoted on any
securities exchange or in the over-the-counter market, and no dealer makes a
market in the Common Stock, although isolated transactions between individuals
occur from time to time. To Cornerstone management's knowledge, the most recent
transaction with respect to Cornerstone Common Stock without warrants was $13.00
per share.
There were approximately 495 holders of record of the Common Stock as
of March 1, 1999.
Cornerstone currently intends to retain its earnings, if any, for use
in the business and does not anticipate paying any cash dividends in the
foreseeable future. The board of directors cannot predict when such dividends,
if any, will ever be made. The payment of dividends, if any, shall at all times
be subject to the payment of Cornerstone's expenses, the maintenance of
reasonable working capital and risk reserves, and minimum capitalization
requirements for state banks. As a condition of its approval to begin
operations, the Bank is restricted by the Department of Financial Institutions
of the State of Tennessee from paying dividends until after February 1999
without the prior written consent of the Commissioner of the Department.
ITEM 6. SELECTED FINANCIAL DATA
See Item 14.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
GENERAL
The following should be read in conjunction with the information and
tables which follow. For a discussion of liquidity and the impact of inflation,
see "Capital Resources/Liquidity" below.
The 1997 statistical disclosures of Cornerstone under Guide 3 represent
historical financial information presented on a pro forma basis as if the merger
of The Bank of East Ridge and Cornerstone Community Bank occurred as of January
1, 1997. Guide 3 financial information presented on the pro forma basis provides
comparable data that is reasonable and meaningful to the combined banking
operations that began on the merger date of October 15, 1997.
SUMMARY
Net income for 1998 was $248,332, a 10.81% increase from Cornerstone's
net income of $224,100 in 1997. Net income per common share for 1998 was 28.6%
lower than in 1997. Pretax income for 1998 increased $31,854 from 1997 pretax
income of $368,434.
The decrease in net income per share from 1997 to 1998 is primarily due
to a 162% increase in the loan loss provision and high interest expense paid on
core deposits and jumbo (over $100m) certificates of deposit.
FINANCIAL CONDITION
Earning Assets. Average earning assets in 1998 increased $19.4 million
or 26.4% over 1997 primarily due to an increase in average loans outstanding.
The loan growth was primarily funded by a significant increase in time deposits.
<PAGE> 16
Loan Portfolio. Cornerstone's average loans for 1998 were $69 million,
an increase of 38% over $50 million in average loans for 1997. Loan growth for
1998 was primarily funded through increased deposit growth. Real estate loans
increased by $10 million or 24% and commercial loans increased by $1 million or
8% over 1997. The increase in ending balances from 1997 to 1998 was consistent
with the increase in average balances.
Investment Portfolio. Cornerstone's investment securities portfolio
increased by 5% or $1.0 million from 1997 to 1998. Cornerstone maintains an
investment strategy of seeking portfolio yields within acceptable risk levels,
as well as providing liquidity. Cornerstone maintains two classifications of
investment securities. "Held to Maturity" and "Available for Sale." The
"Available for Sale" securities are carried at fair market value, whereas the
"Held to Maturity" securities are carried at book value. At year end 1998,
unrealized gains in the "Available for Sale" portfolio amounted to $63,050.
Deposits. Cornerstone's average deposits increased $22.3 million or 31%
from 1997 to 1998. From yearend 1997 to yearend 1998, total deposits increased
$16.2 million or 20%. The largest portion of growth during 1998 was an $11.2
million, or 23% increase in time deposits. This is due to Cornerstone's strategy
of increasing time deposits by offering competitive rates to customers.
Capital Resources. Stockholders' equity increased $1.8 million or 22%
to $10.0 million as of December 31, 1998, compared with $8.2 million at the end
of 1997. This increase was primarily due to warrants being exercised by
shareholders.
BALANCE SHEET MANAGEMENT
Liquidity Management. Liquidity is the ability of a company to convert
assets into cash without significant loss and to raise funds by increasing
liabilities. Liquidity management involves having the ability to meet day-to-day
cash flow requirements of its customers, whether they are depositors wishing to
withdraw funds or borrowers requiring funds to meet their credit needs.
The primary function of asset/liability management is not only to
assure adequate liquidity in order for Cornerstone to meet the needs of its
customer based, but to maintain an appropriate balance between
interest-sensitive assets and interest-sensitive liabilities so that Cornerstone
can profitably deploy its assets. Both assets and liabilities are considered
sources of liquidity funding and both are, therefore, monitored on a daily
basis.
The asset portion of the balance sheet provides liquidity primarily
through loan repayments and maturity of investment securities. Additional
sources of liquidity are the investment in federal funds sold and prepayments
from the mortgage-backed securities from the investment portfolio.
The liability portion of the balance sheet provides liquidity through
various interest-bearing and noninterest-bearing deposit accounts. At year end
December 31, 1998, Cornerstone had approximately $5 million of federal funds
lines available.
RESULTS OF OPERATIONS
YEAR ENDED DECEMBER 31, 1998 COMPARED TO YEAR ENDED DECEMBER 31, 1997
Net Interest Income. Net interest income is the principal component of
a financial institution's income stream and represents the spread between
interest and fee income generated from earning assets and the interest expense
paid on deposits. The following discussion is on a fully taxable equivalent
basis.
Net interest income for 1998 increased $1,397,000 or 75% over 1997. The
increase in the net interest income from 1997 to 1998 is primarily due to the
increase in interest-earning assets.
<PAGE> 17
Interest income increased $3,957,000 or 92% in 1998 from 1997. Interest
income produced by the loan portfolio increased $3,371,000 or 99% in 1998 from
1997. Interest income on investment securities increased $587,000 or 66% from
1997 to 1998. The increase in investment income is due to an increase in the
average investment securities portfolio during 1998.
Total interest expense increased $2,119,000 or 98% in 1998 from 1997.
The interest expense increase from 1997 to 1998 is primarily due to the increase
in average time deposits.
The trend in net income is commonly evaluated in terms of average rates
using the net interest margin and the interest rate spread. The net interest
margin, or the net yield on earning assets, is computed by dividing fully
taxable equivalent net interest income by average-earning assets. This ratio
represents the difference between the average yield on average-earning assets
and the average rate paid for all funds used to support those earning assets.
The net interest margin decreased 52 basis points in 1998 to 4.28%. The net cost
of funds, defined as interest expense divided by average-earning assets,
decreased 9 basis points from 4.09% in 1997 to 4.00% in 1998. The yield on
earning assets decreased 47 basis points to 8.83% in 1998 from 9.30% in 1997.
Allowance for Loan Losses. The allowance for possible loan losses
represents management's assessment of the risks associated with extending credit
and its evaluation of the quality of the loan portfolio. Management analyzes the
loan portfolio to determine the adequacy of the allowance for possible loan
losses and the appropriate provisions required to maintain a level considered
adequate to absorb anticipated loan losses. Management believes that the
$1,400,000 for December 1998 in the allowance for possible loan losses account
was sufficient to absorb known risks in the portfolio. No assurance can be
given, however, that adverse economic circumstances will not result in increased
losses in the loan portfolio and require greater provisions for possible loan
losses in the future.
Nonperforming Assets. Nonperforming assets include nonperforming loans
and foreclosed real estate held for sale. Nonperforming loans include loans
classified as nonaccrual or renegotiated. Cornerstone's policy is to place a
loan on nonaccrual status when it is contractually past due 90 days or more as
to payment of principal or interest. At the time a loan is placed on nonaccrual
status, interest previously accrued but not collected may be reversed and
charged against current earnings. Recognition of any interest after a loan has
been placed on nonaccrual is accounted for on a cash basis. As of December 31,
1998, Cornerstone had $723,000 of nonperforming assets.
Noninterest Income. Noninterest income consists of revenues generated
from a broad range of financial services and activities including fee-based
services and profits and commissions earned through credit life insurance sales
and other activities. In addition, gains or losses realized from the sale of
investment portfolio securities are included in noninterest income. Total
noninterest income increased by $464,000 or 208% from 1997 to 1998. Fee income
from service charges on deposit accounts increased $270,000 or 137% in 1998
accounting for a larger portion of the total noninterest income increase for the
year.
Noninterest Expense. Noninterest expense for 1998 increased by
$1,829,000 or 106% from 1997. Salaries and employee benefits increased by
$741,000 or 80% from 1997 for a total of $1,670,000. This increase was due to
the East Ridge Bank Acquisition in 1997. Occupancy expense increased by $116,000
or 106% in 1998 which is attributed to the additional expense adding the East
Ridge Branch located on Ringgold Road 1997. All other noninterest expense
increased $971,000 or 142% in 1998, primarily the result of Cornerstone's legal
expenses and other professional expense relating to the loan portfolio in 1998.
CAPITAL RESOURCES/LIQUIDITY
Liquidity. Of primary importance to depositors, creditors and
regulators is the ability to have readily available funds sufficient to repay
fully maturing liabilities. Cornerstone's liquidity, represented by cash and
cash due from banks, is a result of its operating, investing and financing
activities. In order to
<PAGE> 18
insure funds are available at all times, Cornerstone devotes resources to
projecting on a monthly basis the amount of funds which will be required and
maintains relationships with a diversified customer base so funds are
accessible. Liquidity requirements can also be met through short-term borrowings
or the disposition of short-term assets which are generally matched to
correspond to the maturity of liabilities.
Although Cornerstone has no formal liquidity policy, in the opinion of
management, its liquidity levels are considered adequate. Cornerstone is not
subject to any specific regulatory liquidity requirements imposed by regulatory
orders. Cornerstone is subject to general FDIC guidelines which do not require a
minimum level of liquidity. Management believes its liquidity ratios meet or
exceed these guidelines. Management does not know of any trends or demands which
are reasonably likely to result in liquidity increasing or decreasing in any
material manner.
The following table sets forth liquidity ratios for the periods
indicated:
<TABLE>
<CAPTION>
December 31, 1998 December 31, 1997
----------------- -----------------
<S> <C> <C>
Average loans to average deposits 74.41% 69.48%
</TABLE>
Impact of Inflation and Changing Prices. The financial statements and
related financial data presented herein have been prepared in accordance with
generally accepted accounting principles which require the measurement of
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. The impact of inflation on operations of Cornerstone is
reflected in increased operating costs. Unlike most industrial companies,
virtually all of the assets and liabilities of Cornerstone are monetary in
nature. As a result, interest rates may have a more significant impact on
Cornerstone's performance than the effects of general levels of inflation.
Interest rates do not necessarily move in the same direction or in the same
magnitude as the price of goods and services.
CAPITAL ADEQUACY
Capital adequacy refers to the level of capital required to sustain
asset growth over time and to absorb losses. The objective of Cornerstone's
management is to maintain a level of capitalization that is sufficient to take
advantage of profitable growth opportunities while meeting regulatory
requirements. This is achieved by improving profitability through effectively
allocating resources to more profitable businesses, improving asset quality,
strengthening service quality, and streamlining costs. The primary measures used
by management to monitor the results of these efforts are the ratios of average
equity to average assets, average tangible equity to average tangible assets,
and average equity to net loans.
The FDIC has adopted capital guidelines governing the activities of
banks. These guidelines require the maintenance of an amount of capital based on
risk-adjusted assets so that categories of assets with 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 shareholders' equity less goodwill and Tier II capital
which is primarily a portion of the allowance for loan losses and certain
qualifying debt instruments. 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 the regulators. The framework
for calculating risk-based capital requires banks to meet the regulatory
minimums of 4% Tier I and 8% total risk-based capital. In 1990 regulators added
a leverage computation to the capital requirements, comparing Tier I capital to
total average assets less goodwill.
<PAGE> 19
<TABLE>
<CAPTION>
(In thousands) December 31, 1998 December 31, 1997
----------------- -----------------
<S> <C> <C>
CAPITAL:
Tier I capital:
Stockholders' equity 10,024 8,215
Less disallowed intangibles 2,878 2,906
------- ------
Total Tier I capital 7,151 5,309
Tier II capital:
Qualifying debt -- --
Qualifying allowance for loan losses 1,381 915
Total Tier II capital 8,532 6,224
Total capital 8,532 6,224
Risk-adjusted assets 79,598 69,832
Quarterly average assets 105,286 82,957
RATIOS:
Tier I capital to risk-adjusted assets 8.98% 7.60%
Tier II capital to risk-adjusted assets 10.72% 8.91%
Leverage -- Tier I capital to quarterly average assets less
disallowed intangibles 6.98% 6.63%
</TABLE>
The Federal Deposit Insurance Corporation Improvement Act of 1991
("FDICIA") established five capital categories for banks. Under the regulations
defining these five capital categories, each bank is classified into one of the
five categories based on its level of risk-based capital as measured by Tier I
capital, total risk-based capital, and Tier I leverage ratios and its
supervisory ratings. The following table lists the five categories of capital
and each of the minimum requirements for the three risk-based capital ratios.
<TABLE>
<CAPTION>
Total Risk-Based Tier I Risk-Based Leverage
Capital Ratio Capital Ratio Ratio
------------- ------------- -----
<S> <C> <C> <C>
Well-capitalized 10% or above 6% or above 5% or above
Adequately capitalized 8% or above 4% or above 4% or above
Undercapitalized 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
</TABLE>
On December 31, 1998, Cornerstone exceeded the regulatory minimums and
qualified as a well-capitalized institution under the regulations.
YEAR 2000 COMPLIANCE
The Year 2000 poses serious challenges to the banking industry. Many
experts believe that even the most prepared organizations may encounter some
implementation problems. The federal banking agencies are concerned that
financial institutions avoid major disruptions to service and operations. All
banks are required to have an action plan to address Year 2000 issues which must
include an indication of management awareness of the problems and the commitment
to solutions; identification of external risks; and operational issues that are
relevant to a bank's Year 2000 planning.
The Federal Financial Institutions Examination Council ("FFIEC") has
issued guidelines and target time frames to accomplish critical actions
concerning Year 2000 compliance:
* By September 30, 1997, all banks should have identified affected
applications and databases. Mission critical applications should be identified
and an action plan set for Year 2000 work.
* By December 31, 1997, code enhancements and revisions, hardware
upgrades, and other associated changes should be largely completed by all banks.
In addition, for mission critical applications, programming changes should be
largely completed and testing should be well underway.
<PAGE> 20
* Between January 1, 1999 and December 31, 1999, banks should be
testing and implementing their Year 2000 conversion programs.
External factors which may adversely affect Cornerstone include
reliance on vendors, such as third-party data processing services and software
and hardware vendors; electronic data-sensitive exchange among other financial
institutions which may not be Year 2000 compliant; corporate customers of
Cornerstone and other debtors.
Cornerstone has been assessing its state of readiness by evaluating its
information technology ("IT") and non-IT systems. IT systems commonly include
data processing, accounting and telephone systems. With respect to its IT
systems, Cornerstone estimates that its Year 2000 identification, assessment and
remediation efforts are substantially complete. During 1999, further testing
will be carried out in order to ensure that all systems are working properly.
Cornerstone has assessed its Year 2000 status in regard to non-IT systems and
has determined that no material risk exists.
Cornerstone has communicated with its significant vendors in order to
determine the extent to which interfaces with such entities are vulnerable to
Year 2000 issues and whether the products and services purchased from such
entities are Year 2000 compliant. Cornerstone has received either verbal or
written assurance from these vendors that they expect to address all their
significant Year 2000 issues on a timely basis. With respect to significant
borrowers and depositors, Cornerstone does not anticipate any material Year 2000
issues.
Cornerstone believes the cost of its Year 2000 identification,
assessment, remediation and testing efforts will not exceed $100,000.
<PAGE> 21
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
<TABLE>
<CAPTION>
Index to Consolidated Financial Statements: Page
----
<S> <C>
CORNERSTONE BANCSHARES, INC.
Report of Independent Certified Public Accountants on the Financial Statements 1
Consolidated balance sheet 2
Consolidated statement of income 3
Consolidated statements of changes in stockholders' equity 4
Consolidated statement of cash flows 5
Notes to consolidated financial statements 6
Report of Independent Certified Public Accountants on
Accompanying Information 25
Consolidating balance sheet 26
Consolidating statement of income 27
</TABLE>
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None
<PAGE> 22
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Following is certain information regarding the directors and executive
officers of the Company.
DIRECTORS AND EXECUTIVE OFFICERS
The following table provides certain information regarding directors as
of March 25, 1999.
<TABLE>
<CAPTION>
PRINCIPAL OCCUPATIONS
NAME AGE POSITIONS FOR PREVIOUS 5 YEARS
- -------------- --- --------- --------------------
<S> <C> <C> <C>
Ramesh V. Amin 52 Director President, American Plastics,
Inc.
Randy Brooks 46 Director President, R. K. Haskew &
Company, Inc.
B. Kenneth Driver 63 Director President and Chief Operating
Officer, Fillauer, Inc.
Karl Fillauer 51 Director Chairman, Fillauer, Inc.
Gregory B. Jones 46 Chief Executive Officer, Banker
President, Director
Carolyn C. Johnson 55 Executive Vice President, Banker
Director
James H. Large 55 Director President, Key James Brick &
Supply Company, Inc.
Lawrence D. Levine. 69 Director President, Financial
Management Corp.
Russell W. Lloyd 58 Director President, MPL Construction
Co., Inc.
Earl A. Marler, Jr. 62 Chairman of the Board, Banker
Director
Doyce G. Payne, M.D. 48 Director Physician
Turner Smith 58 Director Director, Southeast Energy
Services, Inc.
Billy O. Wiggins 56 Director President, Checks, Inc.
Marsha Yessick 51 Director Owner, Yessick's Design Center
</TABLE>
No director of Cornerstone is related to any other director, except
Messrs. Brooks and Fillauer who are brothers-in-law. No director of Cornerstone
is a director or executive officer of another bank holding company, bank,
savings and loan association, or credit union. The following is a brief
description of the business experience of the executive officers of Cornerstone:
EARL A. MARLER, JR., Chairman of the Board, was employed by J.C.
Bradford & Company as an investment broker from 1992 until 1995. From 1978 to
1992, Mr. Marler was executive vice president of Inter Federal Savings Bank,
Chattanooga, Tennessee. His duties consisted primarily of administrative
responsibilities with emphasis on strategic
<PAGE> 23
planning and marketing. From 1954 to 1978, Mr. Marler was employed by First
Tennessee Bank National Association, Chattanooga, Tennessee, where he became
senior vice president primarily responsible for the retail operations. He
received both a B.S. in Business Administration and a Masters of Business
Administration from the University of Tennessee, Chattanooga in 1958 and 1963,
respectively. He completed the Stonier Graduate School of Banking, Rutgers, New
Jersey and received Graduate Certificates in investments and commercial banking
from the American Institute of Banking.
GREGORY B. JONES, Chief Executive Officer and President, was employed
at Pioneer Bancshares as the Chief Financial Officer from 1994 - 1998. From 1978
to 1994 Mr. Jones served as the Comptroller of the Pioneer Bank. His duties
consisted of primarily administrative responsibilities for the holding company
and the 3 subsidiary banks and direct managerial responsibilities for 2
affiliate companies he created; Pioneer Securities and Center Finance. Prior to
Pioneer Mr. Jones worked at Compass Bank in Huntsville in an Accounting Officer
role. He received his B.S. in Business Administration from the University of
Alabama and his MBA from The University of Tennessee at Chattanooga. He is a
graduate of numerous Banking schools and serves as an instructor for the
Tennessee Bankers Association.
FRANK HUGHES, CHIEF FINANCIAL OFFICER, was employed at Pioneer
Bancshares as the Chief Investment Officer from 1994-1998. His duties were
primarily administrative and concentrated in Asset Liability Management,
Portfolio Management, Budgeting and Cash Management. From 1983 to 1991 Mr.
Hughes worked at SunTrust Bank as an Investment Officer. From 1980 to 1983 he
served as a Platoon Commander in the United States Marine Corps. He received his
BBA from the University of Kentucky and MBA from Vanderbilt University. He holds
a Certified Financial Analyst (CFA) designation. Currently serves as a Commander
of an Artillery Battalion in the United States Marine Corps Reserve.
TRANSACTIONS WITH MANAGEMENT
Cornerstone has and expects to have in the future banking and other
business transactions in the ordinary course of its banking business with
directors, officers, and 10% beneficial owners of Cornerstone and their
affiliates, including members of their families or corporations, partnerships,
or other organizations in which such officers or directors have a controlling
interest, on substantially the same terms (including price, or interest rates
and collateral) as those prevailing at the time for comparable transactions with
unrelated parties. Any such banking transactions will not involve more than the
normal risk of collectibility nor present other unfavorable features to
Cornerstone.
THE CORNERSTONE BOARD AND ITS COMMITTEES
Directors are elected annually and each director holds office until his
successor is elected and qualified. Committees of the Board and their members
include Nominating Committee (Messrs. Fillauer, Jones, Levine, Marler and
Payne), Directors' Loan Committee (Messrs. Amin, Brooks, Jones, Large, Marler,
Lloyd) Asset/Liability Committee (Messrs. Driver, Fillauer, Jones, Marler, Payne
and Wiggins) and Audit Committee (Messrs. Levine, Lloyd, Payne, Smith, and Ms.
Yessick).
No director of Cornerstone is a director or executive officer of
another bank holding company, bank, savings and loan association, or credit
union.
During the last fiscal year, the Board of Directors of Cornerstone held
four meetings. The Directors of Cornerstone also serve as directors of the Bank.
The Board of Directors of the Bank held twelve (12) meetings in 1998.
<PAGE> 24
ITEM 11. EXECUTIVE COMPENSATION.
EXECUTIVE COMPENSATION
No executive officer of Cornerstone received cash compensation in
excess of $100,000 for the years ending December 31, 1998 and 1997. The Summary
Compensation Table provides information for the years indicated about the Chief
Executive Officer ("CEO")
Summary Compensation Table
<TABLE>
<CAPTION>
Annual
Compensation
------------
(a) (b) (c) (d)
Name and Principal Position Year Salary ($) Bonus ($)
--------------------------- ---- ---------- ---------
<S> <C> <C> <C>
Earl A. Marler, Jr., CEO 1998 $74,000 $ 0
1997 $67,500 $3,375
1996 $65,000(1) $ 0
</TABLE>
(1) Annualized.
COMPENSATION OF DIRECTORS
All Directors of the Company receive $450 for attendance at each
regular Board Meeting and non-employee Directors receive $75 for each committee
meeting.
<PAGE> 25
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
OWNERSHIP OF CORNERSTONE COMMON STOCK
As of March 25, 1999, Cornerstone's records indicated the following
number of shares were beneficially owned by, (i) each person who is a director
or a named executive officer of Cornerstone and (ii) all directors and executive
officers as a group.
<TABLE>
<CAPTION>
Amount and Nature
Name of of Beneficial Ownership Percent
Beneficial Owner (Number of Shares)(2) of Class(1)
---------------- ----------------------- -----------
<S> <C> <C> <C>
(i) Ramesh V. Amin 33,187 4.52%
Randy Brooks 19,656 3.00%
B. Kenneth Driver 15,186 2.85%
Karl Fillauer 23,187 2.83%
Carolyn C. Johnson 23,237 3.40%
Gregory B. Jones 5,000 0.50%
James H. Large 27,430 3.41%
Lawrence D. Levine 8,000 1.98%
Russell W. Lloyd 23,187 2.84%
Earl A. Marler, Jr. 32,065 4.54%
Doyce G. Payne, M.D. 32,939 3.45%
Turner Smith 10,000 2.26%
Billy O. Wiggins 38,041 3.52%
Marsha Yessick 8,000 1.48%
(ii) Directors and executive officers as a group
(14 persons) 299,115 29.63%
</TABLE>
(1) Based on 1,009,561 shares outstanding as of March 25, 1999.
(2) Excludes shares subject to options exercisable within 60 days after the
Record Date held by the following persons: Amin (10,000); Brooks
(10,000); Driver (10,000); Fillauer (10,000); Johnson (10,000); Large
(10,000); Levine (10,000); Lloyd (10,000); Marler (10,000); Payne
(10,000); Smith (10,000); Wiggins (10,000); and Yessick (10,000); and
Directors and executive officers as a group (130,000). Such shares are
deemed to be outstanding for the purpose of computing the percentage of
outstanding shares owned by such person, but are not deemed to be
outstanding for the purpose of computing the percentage owned by any
other person.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Cornerstone expects to have in the future banking and other business
transactions in the ordinary course of its banking business with directors,
officers, and 10% beneficial owners of Cornerstone and their affiliates,
including members of their families, or corporations, partnerships, or other
organizations in which such officers or directors have a
<PAGE> 26
controlling interest, on substantially the same terms (including price, or
interest rates and collateral) as those prevailing at the time for comparable
transactions with unrelated parties. Any such banking transactions will not
involve more than the normal risk of collectibility nor present other
unfavorable features to Cornerstone or the Bank.
ITEM 14. EXHIBITS, FINANCIAL STATEMENTS AND REPORTS ON FORM 8-K
(1) Exhibits
<TABLE>
<CAPTION>
Exhibit Number Description
-------------- -----------
<S> <C>
3.1 Articles of Incorporation of Cornerstone Bancshares, Inc., as amended*
3.2 Bylaws of Cornerstone Bancshares, Inc.*
27 Financial Data Schedule (For SEC use only).
</TABLE>
* Incorporated by reference to exhibits filed with the Registrant's
Registration Statement on Form S-4, Registration No. 333-26699.
(2) Financial Statements
See Item 8 above.
(3) Reports on Form 8-K
No reports on Form 8-K were filed during the quarter ended December 31,
1998.
<PAGE> 27
[LOGO]HAZLETT, LEWIS
& BIETER, PLLC
CERTIFIED PUBLIC ACCOUNTANTS
AND BUSINESS ADVISORS
Report of Independent Certified Public Accountants
on the Financial Statements
To the Stockholders and
Board of Directors
Cornerstone Bancshares, Inc.
Chattanooga, Tennessee
We have audited the accompanying consolidated balance sheets of
Cornerstone Bancshares, Inc. and subsidiary as of December 31, 1998 and 1997,
and the related consolidated statements of income, changes in stockholders'
equity, and cash flows for the years then ended. These financial statements are
the responsibility of the Company's management. Our responsibility is to
express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the consolidated financial statements referred to
above present fairly, in all material respects, the financial position of
Cornerstone Bancshares, Inc. and subsidiary as of December 31, 1998 and 1997,
and the results of their operations and their cash flows for the years then
ended in conformity with generally accepted accounting principles.
/s/ Hazlett, Lewis & Bieter, PLLC
Chattanooga, Tennessee
January 15, 1999
-1-
Tivoli Center, Suite 300 - 701 Broad Street - Chattanooga, Tennessee 37402-1894
- Telephone (423) 756-6133
FAX (423) 756-2727 - E-mail: hlb(@)hlbcpa.com - Web.http://www.hlbcpa.com
<PAGE> 28
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
December 31, 1998 and 1997
<TABLE>
<CAPTION>
1998 1997
------------- ------------
<S> <C> <C>
ASSETS
Cash and due from banks $ 4,268,967 $ 6,173,892
Federal funds sold 8,425,000 1,130,000
Securities available for sale 9,280,116 7,544,579
Securities held to maturity 9,077,465 10,779,662
Loans receivable, net of allowance for loan losses 72,492,549 60,411,312
Bank premises and equipment 1,967,329 1,944,219
Accrued interest receivable 638,441 584,446
Excess cost over fair value of net assets acquired 2,834,124 2,862,580
Other assets 1,522,143 1,093,520
------------- ------------
Total assets $ 110,506,134 $ 92,524,210
============= ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits:
Noninterest-bearing demand deposits $ 14,151,526 $ 9,416,616
Interest-bearing demand deposits 12,998,223 12,865,529
Savings deposits and money market accounts 10,283,103 9,879,431
Time deposits of $100,000 or more 17,489,618 13,951,562
Time deposits under $100,000 43,089,138 35,736,667
------------- ------------
Total deposits 98,011,608 81,849,805
Accrued interest payable 270,634 325,551
Other liabilities 470,861 421,972
Notes payable 1,250,000 855,000
------------- ------------
Total liabilities 100,003,103 83,452,328
------------- ------------
Redeemable common stock 478,744 856,797
------------- ------------
Stockholders' equity:
Preferred stock - no par value; 2,000,000 shares
authorized; no shares issued -- --
Common stock - $1.00 par value; 2,000,000 shares
authorized; 1,009,461 and 874,954 shares issued 1,009,461 874,954
and outstanding in 1998 and 1997, respectively
Additional paid-in capital 9,017,430 7,587,441
Retained earnings (deficit) (41,695) (290,027)
Accumulated other comprehensive income 39,091 42,717
------------- ------------
Total stockholders' equity 10,024,287 8,215,085
------------- ------------
Total liabilities and stockholders' equity $ 110,506,134 $ 92,524,210
============= ============
</TABLE>
The Notes to Consolidated Financial Statements are an integral part of these
statements.
-2-
<PAGE> 29
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF INCOME
Years Ended December 31, 1998 and 1997
<TABLE>
<CAPTION>
1998 1997
----------- -----------
<S> <C> <C>
INTEREST INCOME
Loans $ 6,739,054 $ 3,408,638
Securities:
U.S. Treasury 218,590 24,247
U.S. Government agencies 474,718 232,746
Other 603,305 493,831
Income on federal funds sold and deposits in bank 176,299 135,476
----------- -----------
Total interest income 8,211,966 4,294,938
----------- -----------
INTEREST EXPENSE
Interest on time deposits of $100,000 or more 988,663 589,085
Interest on other deposits 3,152,473 1,552,016
Interest on federal funds purchased 8,518 318
Other 81,736 12,038
----------- -----------
Total interest expense 4,231,390 2,153,457
----------- -----------
Net interest income before provision for loan losses 3,980,576 2,141,481
Provision for loan losses 715,343 273,277
----------- -----------
Net interest income after provision for loan losses 3,265,233 1,868,204
----------- -----------
NONINTEREST INCOME
Service charges 467,718 197,414
Other noninterest income 108,304 24,957
Net gains from sale of loans 110,218 --
----------- -----------
Total noninterest income 686,240 222,371
----------- -----------
NONINTEREST EXPENSES
Salaries and employee benefits 1,669,883 928,270
Net occupancy and equipment expense 224,717 108,614
Other operating expenses 1,656,585 685,257
----------- -----------
Total noninterest expenses 3,551,185 1,722,141
----------- -----------
Income before income tax expense 400,288 368,434
Income tax expense 151,956 144,334
----------- -----------
Net income $ 248,332 $ 224,100
=========== ===========
EARNINGS PER SHARE:
Primary $ .25 $ .35
=========== ===========
Fully diluted $ .24 $ .33
=========== ===========
</TABLE>
The Notes to Consolidated Financial Statements are an integral part of these
statements
-3-
<PAGE> 30
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
Years Ended December 31, 1998 and 1997
<TABLE>
<CAPTION>
Total
Comprehensive Stockholders' Common
Income Equity Stock
------------- ------------ -----------
<S> <C> <C> <C>
BALANCE, December 31, 1996 $ 3,047,276 $ 1,100,200
Bank combination 4,232,940 (356,934)
Issuance of common stock 1,580,260 131,688
Redeemable common stock (856,797) --
Comprehensive income:
Net income $ 224,100 224,100 --
Other comprehensive income, net of tax:
Unrealized holding gains (losses) on securities available
for sale, net of reclassification adjustment (12,694) (12,694) --
--------- ------------ -----------
Total comprehensive income $ 211,406
=========
BALANCE, December 31, 1997 8,215,085 874,954
Redemption of common stock (350,107) (27,897)
Issuance of common stock 1,964,187 162,404
Redeemable common stock (49,584) --
Comprehensive income:
Net income $ 248,332 248,332 --
Other comprehensive income, net of tax:
Unrealized holding gains (losses) on securities available
for sale, net of reclassification adjustment (3,626) (3,626) --
--------- ------------ -----------
Total comprehensive income $ 244,706
=========
BALANCE, December 31, 1998 $ 10,024,287 $ 1,009,461
============ ===========
<CAPTION>
Accumulated
Additional Retained Other
Paid-in Earnings Comprehensive
Capital (Deficit) Income
----------- ----------- -------------
<S> <C> <C> <C>
BALANCE, December 31, 1996 $ 34,500 $ 1,903,145 $ 9,431
Bank combination 6,961,166 (2,417,272) 45,980
Issuance of common stock 1,448,572 -- --
Redeemable common stock (856,797) -- --
Comprehensive income:
Net income -- 224,100 --
Other comprehensive income, net of tax:
Unrealized holding gains (losses) on securities available
for sale, net of reclassification adjustment -- -- (12,694)
----------- ----------- ---------
Total comprehensive income
BALANCE, December 31, 1997 7,587,441 (290,027) 42,717
Redemption of common stock (322,210) -- --
Issuance of common stock 1,801,783 -- --
Redeemable common stock (49,584) -- --
Comprehensive income:
Net income -- 248,332 --
Other comprehensive income, net of tax:
Unrealized holding gains (losses) on securities available
for sale, net of reclassification adjustment -- -- (3,626)
----------- ----------- ---------
Total comprehensive income
BALANCE, December 31, 1998 $ 9,017,430 $ (41,695) $ 39,091
=========== =========== =========
</TABLE>
The Notes to Consolidated Financial Statements are an integral part of these
statements.
-4-
<PAGE> 31
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31, 1998 and 1997
<TABLE>
<CAPTION>
1998 1997
------------ ------------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES
Net income $ 248,332 $ 224,100
Adjustments to reconcile net income to net cash
provided by (used in) operating activities:
Depreciation and amortization 421,406 108,251
Provision for loan losses 715,343 273,277
Gains on sales of loans (110,218) --
Deferred income taxes (248,610) (38,314)
Proceeds from sales of loans held for sale 6,969,087 --
Originations of loans held for sale (6,858,869) --
Changes in other operating assets and liabilities:
Accrued interest receivable (53,995) (162,195)
Accrued interest payable (54,917) 125,432
Other assets and liabilities (144,068) (371,283)
------------ ------------
Net cash provided by operating activities 883,491 159,268
------------ ------------
CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from security transactions:
Securities available for sale 6,318,245 2,667,213
Securities held to maturity 8,736,045 4,175,386
Purchase of securities available for sale (8,139,733) (6,347,646)
Purchase of securities held to maturity (7,101,585) --
Net increase in loans (12,796,580) (20,136,327)
Purchase of bank premises and equipment (223,054) (332,638)
Payments related to bank combination (457,637) (4,714,631)
Cash and cash equivalents acquired in bank combination -- 5,050,906
------------ ------------
Net cash used in investing activities (13,664,299) (19,637,737)
------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES
Net increase in deposits 16,161,803 19,889,783
Proceeds from borrowings on debt 395,000 500,000
Redemption of common stock (350,107) --
Issuance of common stock 1,964,187 1,580,260
------------ ------------
Net cash provided by financing activities 18,170,883 21,970,043
------------ ------------
NET INCREASE IN CASH AND CASH EQUIVALENTS 5,390,075 2,491,574
CASH AND CASH EQUIVALENTS, beginning of year 7,303,892 4,812,318
------------ ------------
CASH AND CASH EQUIVALENTS, end of year $ 12,693,967 $ 7,303,892
============ ============
SUPPLEMENTAL DISCLOSURES OF CASH
FLOW INFORMATION
Cash paid during the period for interest $ 4,215,080 $ 2,028,025
Cash paid during the period for taxes 425,171 199,859
============ ============
</TABLE>
The Notes to Consolidated Financial Statements are an integral part of these
statements.
-5-
<PAGE> 32
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1998 and 1997
Note 1. Summary of Significant Accounting Policies
The accounting and reporting policies of Cornerstone Bancshares, Inc.
and subsidiary (Company) conform with generally accepted accounting
principles and practices within the banking industry. The policies
that materially affect financial position and results of operations
are summarized as follows:
Nature of operations:
The Company is a bank-holding company which owns all of the
outstanding common stock of Cornerstone Community Bank (the Bank). The
Bank provides a variety of financial services through 5 locations in
Chattanooga, Tennessee. The Bank's primary deposit products are demand
deposits, savings accounts, and certificates of deposit. Its primary
lending products are commercial loans, real estate loans, and
installment loans.
Principles of consolidation:
The consolidated financial statements include the accounts of the
Company and its subsidiary. All material intercompany accounts and
transactions have been eliminated in consolidation.
Excess cost over fair value of net assets acquired:
The excess cost over fair value of net assets acquired represents the
excess of the cost of the investment over the underlying net assets of
the subsidiary bank at the date of acquisition. Certain amounts have
been allocated to specific tangible assets in the accompanying
financial statements. The excess cost over fair value of net assets
acquired is being amortized over 25 years using the straight-line
method.
Use of estimates:
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the
date of the financial statements and the reported amounts of revenues
and expenses during the reporting period. Actual results could differ
from those estimates.
A material estimate that is particularly susceptible to significant
change relates to the determination of the allowance for losses on
loans. In connection with the determination of the allowance for
losses on loans, management obtains independent appraisals for
significant properties.
-6-
<PAGE> 33
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1998 and 1997
Note 1. Summary of Significant Accounting Policies (continued)
Use of estimates: (continued)
While management uses available information to recognize losses on
loans, future additions to the allowance may be necessary based on
changes in local economic conditions. In addition, regulatory
agencies, as an integral part of their examination process,
periodically review the Bank's allowance for losses on loans. Such
agencies may require the Bank to recognize additions to the allowance
based on their judgments about information available to them at the
time of their examination. Because of these factors, it is reasonably
possible that the allowance for losses on loans may change materially
in the near term.
Cash and cash equivalents: For purposes of reporting cash flows, cash
and cash equivalents include cash on hand, amounts due from banks, and
federal funds sold. Securities held to maturity:
Bonds, notes, and debentures for which the Bank has the positive
intent and ability to hold to maturity are reported at cost, adjusted
for premiums and discounts that are recognized in interest income
using the interest method over the period to maturity.
Securities available for sale:
Securities available for sale consist of bonds, notes, debentures and
certain equity securities not classified as securities held to
maturity. Unrealized holding gains and losses, net of tax, on
securities available for sale are reported as a net amount in a
separate component of stockholders' equity until realized. Gains and
losses on the sale of securities available for sale are determined
using the specific-identification method. Premiums and discounts are
recognized in interest income over the period to maturity.
Loans:
Loans are stated at unpaid principal balances less the allowance for
loan losses.
Loans are placed on nonaccrual when a loan is specifically determined
to be impaired or when, in the opinion of management, there is an
indication that the borrower may be unable to meet payments as they
become due. Any unpaid interest previously accrued on those loans is
reversed from income. Interest income generally is not recognized on
specific impaired loans unless the likelihood of further loss is
remote. Interest payments received on such loans are applied as a
reduction of the loan principal balance. Interest income on other
nonaccrual loans is recognized only to the extent of interest payments
received.
-7-
<PAGE> 34
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1998 and 1997
Note 1. Summary of Significant Accounting Policies (continued)
Loans: (continued)
The allowance for loan losses is maintained at a level which, in
management's judgment, is adequate to absorb credit losses inherent in
the loan portfolio. The amount of the allowance is based on
management's evaluation of the collectibility of the loan portfolio,
including the nature of the portfolio, credit concentrations, trends
in historical loss experience, specific impaired loans, and economic
conditions. Allowances for impaired loans are generally determined
based on collateral values or the present value of estimated cash
flows. The allowance is increased by a provision for loan losses,
which is charged to expense, and reduced by charge-offs, net of
recoveries.
Bank premises and equipment:
Bank premises and equipment are stated at cost, less accumulated
depreciation. Depreciation is computed using the straight-line
depreciation method and accelerated depreciation methods for both
financial statement purposes and income tax purposes. Bank premises
are depreciated over 30 years; and furniture, fixtures and equipment
are depreciated over 5 to 12 years.
Additions and major renewals and betterments are capitalized and
depreciated over their estimated useful lives. Repairs, maintenance,
and minor renewals are charged to operating expense as incurred. When
property is replaced or otherwise disposed of, the cost of such assets
and the related accumulated depreciation are removed from the accounts.
The gain or loss, if any, is recorded in the statement of income.
Deferred income taxes:
Deferred tax assets and liabilities are reflected at currently enacted
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.
Reclassifications:
Certain amounts in the 1997 financial statements have been
reclassified to conform with the 1998 presentation.
Note 2. Securities
Securities have been classified in the balance sheet according to
management's intent as either securities held to maturity or
securities available for sale.
-8-
<PAGE> 35
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1998 and 1997
Note 2. Securities (continued)
The amortized cost and approximate market value of securities at
December 31, 1998 and 1997, is as follows:
<TABLE>
<CAPTION>
1998
----------------------------------------------------------
Gross Gross
Amortized Unrealized Unrealized Market
Cost Gains Losses Value
---------- ---------- ----------- ----------
<S> <C> <C> <C> <C>
Securities available for sale:
U.S. Government
securities $ 400,000 $ 2,644 $ -- $ 402,644
Securities of U.S.
Government agencies
and corporations 2,550,000 8,032 -- 2,558,032
Mortgage-backed
securities 6,267,066 61,376 (9,002) 6,319,440
---------- ------- ----------- ----------
$9,217,066 $72,052 $ (9,002) $9,280,116
========== ======= =========== ==========
Securities held to maturity:
U.S. Government
securities $ 352,082 $ 3,613 $ -- $ 355,695
Mortgage-backed
securities 8,725,383 47,002 (25,394) 8,746,991
---------- ------- ----------- ----------
$9,077,465 $50,615 $ (25,394) $9,102,686
========== ======= =========== ==========
</TABLE>
<TABLE>
<CAPTION>
1997
----------------------------------------------------------
Gross Gross
Amortized Unrealized Unrealized Market
Cost Gains Losses Value
---------- ---------- ----------- ----------
<S> <C> <C> <C> <C>
Securities available for sale:
U.S. Government
securities $1,447,896 $ 3,745 $ (250) $1,451,391
Securities of U.S.
Government agencies
and corporations 1,815,419 11,840 (31) 1,827,228
Mortgage-backed
securities 4,212,366 53,924 (330) 4,265,960
---------- ------- ----- ----------
$7,475,681 $69,509 $(611) $7,544,579
========== ======== ===== ==========
</TABLE>
-9-
<PAGE> 36
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1998 and 1997
Note 2. Securities (continued)
<TABLE>
<CAPTION>
1997
------------------------------------------------------------
Gross Gross
Amortized Unrealized Unrealized Market
Cost Gains Losses Value
----------- ---------- ----------- -----------
<S> <C> <C> <C> <C>
Securities held to maturity:
U.S. Government
securities $ 3,173,685 $ 4,337 $ (3,719) $ 3,174,303
Mortgage-backed
securities 7,605,977 64,843 (9,511) 7,661,309
----------- ------- --------- -----------
$10,779,662 $69,180 $(13,230) $10,835,612
=========== ======= ======== ===========
</TABLE>
The amortized cost and estimated market value of securities at
December 31, 1998, 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.
<TABLE>
<CAPTION>
Securities Available for Sale Securities Held to Maturity
-------------------------- --------------------------
Amortized Fair Amortized Fair
Cost Value Cost Value
---------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
Due in one year or less $ 474,732 $ 479,123 $ 76,307 $ 76,201
Due from one year to
five years 2,883,700 2,896,431 2,346,492 2,377,466
Due from five years to
ten years 733,346 741,469 682,834 688,886
Due after ten years 5,125,288 5,163,093 5,971,832 5,960,133
---------- ---------- ---------- ----------
$9,217,066 $9,280,116 $9,077,465 $9,102,686
========== ========== ========== ==========
</TABLE>
Proceeds from the sale of securities were $2,572,054 in 1997 which
were sold at book value. There were no sales in 1998.
Securities with a book value of approximately $5,116,000 and
$5,697,000 at December 31, 1998 and 1997, respectively, were pledged
to secure various deposits.
-10-
<PAGE> 37
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1998 and 1997
Note 3. Loans and Allowance for Loan Losses
A summary of transactions in the allowance for loan losses for the
years ended December 31, 1998 and 1997, is as follows: 1998 1997
<TABLE>
<CAPTION>
1998 1997
----------- ---------
<S> <C> <C>
Balance, beginning of year $ 915,005 $ 201,422
Provision charged to operating expense 715,343 273,277
Bank combination -- 456,960
Loans charged off, net (230,348) (16,654)
----------- ---------
Balance, end of year $ 1,400,000 $ 915,005
=========== =========
</TABLE>
At December 31, 1998 and 1997, the Bank's loans consist of the
following (in thousands):
<TABLE>
<CAPTION>
1998 1997
-------- --------
<S> <C> <C>
Real estate loans $ 52,351 $ 42,716
Commercial and industrial loans 13,164 12,194
Loans to individuals for household,
family, and other consumer expenditures 8,127 6,241
Other 250 175
-------- --------
Total loans 73,892 61,326
Less - Allowance for loan losses (1,400) (915)
-------- --------
Net loans $ 72,492 $ 60,411
======== ========
</TABLE>
The Bank's only significant concentration of credit at December 31,
1998, occurred in real estate loans which totaled approximately
$52,351,000. While real estate loans accounted for 70 percent of total
loans, these loans were primarily residential development and
construction loans, residential mortgage loans, commercial loans
secured by commercial properties, and consumer loans. Substantially
all real estate loans are secured by properties located in Tennessee.
In the normal course of business, the Bank makes loans to directors
and executive officers of the Bank on substantially the same terms,
including interest rates and collateral, as those prevailing at the
time for comparable transactions with other borrowers. Loans to
directors, executive officers and principal shareholders were
approximately $2,987,000 at December 31, 1998.
At December 31, 1998 and 1997, loans that were specifically classified
as impaired were insignificant in relation to the Bank's loan
portfolio.
-11-
<PAGE> 38
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1998 and 1997
Note 4. Bank Premises and Equipment
A summary of bank premises and equipment at December 31, 1998 and
1997, is as follows:
<TABLE>
<CAPTION>
1998 1997
----------- -----------
<S> <C> <C>
Land $ 463,278 $ 463,278
Buildings and improvements 1,091,255 1,017,986
Furniture, fixtures and equipment 1,419,645 1,282,946
----------- -----------
2,974,178 2,764,210
Accumulated depreciation (1,006,849) (819,991)
----------- -----------
$ 1,967,329 $ 1,944,219
=========== ===========
</TABLE>
The charge to operating expense for depreciation was $199,944 in 1998
and $108,251 in 1997.
Certain bank facilities and equipment are leased under various
operating leases. Rental expense was $89,657 in 1998 and $28,324 in
1997.
Future minimum rental commitments under noncancelable leases are as
follows:
<TABLE>
<S> <C>
1999 $ 70,241
2000 61,681
2001 61,425
2002 44,721
--------
Total $238,068
========
</TABLE>
Note 5. Time Deposits
At December 31, 1998, the scheduled maturities of time deposits are as
follows:
<TABLE>
<S> <C>
1999 $42,962,759
2000 9,586,956
2001 6,565,136
2002 647,539
Thereafter 816,366
-----------
Total $60,578,756
===========
</TABLE>
-12-
<PAGE> 39
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1998 and 1997
Note 6. Income Taxes
Income tax expense in the statement of income for the years ended
December 31, 1998 and 1997, consists of the following:
<TABLE>
<CAPTION>
1998 1997
--------- ---------
<S> <C> <C>
Current tax expense $ 400,566 $ 182,648
Deferred income taxes related to:
Provision for loan losses (199,449) (24,700)
Net operating loss carryforward (11,121) (8,000)
Other (38,040) (5,614)
--------- ---------
Income tax expense $ 151,956 $ 144,334
========= =========
</TABLE>
The income tax benefit is different from the expected tax benefit
computed by multiplying income before income tax benefit by the
statutory federal income tax rates. The reasons for this difference
are as follows:
<TABLE>
<CAPTION>
1998 1997
--------- ---------
<S> <C> <C>
Expected tax at statutory rates $ 136,097 $ 125,268
Increase (decrease) resulting from tax effect of:
State income taxes, net of federal tax benefit 16,013 14,737
Other nondeductible expenses (154) 4,329
--------- ---------
Income tax expense $ 151,956 $ 144,334
========= =========
</TABLE>
The Bank had a net operating loss carryforward for tax purposes of
approximately $29,000 at December 31, 1997, which was carried forward
and used to offset taxable income in 1998.
As of December 31, 1998, deferred tax assets recognized for deductible
temporary differences totaled approximately $620,000 and deferred tax
liabilities for taxable temporary differences totaled approximately
$131,000.
Note 7. Notes Payable
Notes payable represent borrowings under a $1,000,000 revolving line
of credit and a promissory note dated September 30, 1998, with First
Tennessee Bank. Borrowings are collateralized by all of the
outstanding stock of the Bank. Interest is payable annually based on
First Tennessee Bank's base commercial rate, which was 7.75% at
December 31, 1998. The line of credit agreement expires and the
promissory note matures on January 30, 1999. The Company intends to
renew the revolving line of credit at maturity and increase its
borrowing amount by $250,000 in order to payoff the promissory note.
-13-
<PAGE> 40
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1998 and 1997
Note 8. Employee Benefit Plan
The Bank has a 401(k) employee benefit plan covering substantially all
employees who have completed at least one year of service and met
minimum age requirements. The amount of employer contribution is
computed annually under a defined formula based primarily on the
employees' salary. The maximum employer required contribution to the
plan is 3 percent of the employees' annual salary. Any additional
contribution to the plan is determined at the discretion of the Board
of Directors. Total contributions to the plan were $10,850 in 1998 and
$7,491 in 1997.
Note 9. Financial Instruments With Off-Balance-Sheet Risk
The Bank is a party to financial instruments with off-balance-sheet
risk in the normal course of business to meet the financing needs of
its customers. These financial instruments include various commitments
to extend credit and standby letters of credit. These instruments
expose the Bank to varying degrees of credit and interest rate risk in
excess of the amount recognized in the accompanying balance sheet. To
manage this risk, the Bank uses the same management policies and
procedures for financial instruments with off-balance-sheet risk as it
does for financial instruments whose risk is reflected on the balance
sheet.
The credit risk of all financial instruments varies based on many
factors, including the value of collateral held and other security
arrangements. To mitigate credit risk, the Bank generally determines
the need for specific covenant, guarantee, and collateral requirements
on a case-by-case basis, depending on the customer's creditworthiness.
The amount and type of collateral held to reduce credit risk vary, but
may include real estate, machinery, equipment, inventory, and accounts
receivable as well as cash on deposit, stocks, bonds, and other
marketable securities that are generally held in the Bank's
possession. This collateral is valued and inspected to ensure both its
existence and adequacy. The Bank requests additional collateral when
appropriate.
At December 31, 1998, commitments under standby letters of credit and
undisbursed loan commitments aggregated $5,167,000. The Bank's credit
exposure for these financial instruments is represented by their
contractual amounts. The Bank does not anticipate any material losses
as a result of the commitments under standby letters of credit and
undisbursed loan commitments.
-14-
<PAGE> 41
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1998 and 1997
Note 10. Fair Value of Financial Instruments
Fair value estimates are made at a specific point in time, based on
relevant market information about the financial instrument. These
estimates do not reflect any premium or discount that could result
from offering for sale at one time the Company's entire holdings of a
particular financial instrument. Because no market exists for a
significant portion of the Company's financial instruments, fair value
estimates are based on judgments regarding future expected loss
experience, current economic conditions, risk characteristics of
various financial instruments, and other factors. These estimates are
subjective in nature; involve uncertainties and matters of judgment;
and, therefore, cannot be determined with precision. Changes in
assumptions could significantly affect the estimates.
Fair value estimates are based on existing financial instruments
without attempting to estimate the value of anticipated future
business and the value of assets and liabilities that are not
considered financial instruments. The following methods and
assumptions were used to estimate the fair value of each class of
financial instruments:
Cash and cash equivalents:
For cash and cash equivalents, the carrying amount is a reasonable
estimate of fair value.
Securities:
The fair value of securities is estimated based on bid prices
published in financial newspapers or bid quotations received from
securities dealers.
Loans:
The fair value of loans is calculated by discounting scheduled cash
flows through the estimated maturity using estimated market discount
rates, adjusted for credit risk and servicing costs. The estimate of
maturity is based on historical experience with repayments for each
loan classification, modified, as required, by an estimate of the
effect of current economic and lending conditions.
Deposits:
The fair value of deposits with no stated maturity, such as demand
deposits, money market, and savings accounts, is equal to the amount
payable on demand. The fair value of time deposits is based on the
discounted value of contractual cash flows. The discount rate is
estimated using the rates currently offered for deposits of similar
remaining maturities.
-15-
<PAGE> 42
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1998 and 1997
Note 10. Fair Value of Financial Instruments (continued)
Notes payable:
The carrying amount of notes payable approximates their fair value.
The carrying amount and estimated fair value of the Company's
financial instruments at December 31, 1998, are as follows (in
thousands):
<TABLE>
<CAPTION>
Carrying Estimated
Amount Fair Value
-------- ----------
<S> <C> <C>
Assets:
Cash and due from banks $ 4,269 $ 4,269
Federal funds sold 8,425 8,425
Securities 18,357 18,383
Net loans 72,492 72,480
Liabilities:
Noninterest-bearing demand deposits 14,152 14,152
Interest-bearing demand deposits 12,998 12,998
Savings deposits and money market accounts 10,283 10,283
Time deposits 60,579 60,606
Notes payable 1,250 1,250
</TABLE>
Note 11. Contingencies
The Bank is involved in certain claims arising from normal business
activities. Management believes that those claims are without merit or
that the ultimate liability, if any, resulting from them will not
materially affect the Bank's financial position.
The Company is engaged in a comprehensive project to ready the Bank's
computer software and hardware systems for year 2000 compliance. Based
on current estimates, spending to upgrade or replace the Company's
software of hardware systems related to year 2000 compliance is not
expected to be a material amount through 1999. Although it is not
possible to quantify the effects year 2000 compliance issues will have
on customers or operations, the Company does not anticipate related
material adverse effects on its financial position, liquidity or
results of operations.
Note 12. Liquidity and Capital Resources
The Company's primary source of funds with which to pay principal and
interest on its indebtedness is the receipt of dividends from its
subsidiary bank. Banking regulators limit the amount of dividends that
the Bank may pay without prior approval of the Bank's regulatory
agency. As discussed in Note 14, the Bank cannot pay dividends until
March 1999 and then must receive specific regulatory approval for any
dividend payments.
-16-
<PAGE> 43
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1998 and 1997
Note 13. Stock Options and Warrants
The Company has a stock option plan under which members of the Board
of Directors have been granted options to purchase a total of 150,000
shares of the Bank's common stock. The option price was $10.00 per
share which was the estimated fair value of the stock at the June 30,
1996, grant date. The options expire ten years from the date of grant
and were fully vested at the grant date. No options have been
exercised since the original grant date. At December 31, 1998, the
remaining contractual life of outstanding options was 7.5 years.
The Company also has a stock option plan under which officers and
employees can be granted options to purchase shares of the Company's
common stock. There have been no shares allocated under this plan.
A stock warrant was issued with each of the 590,130 original shares of
the Company's common stock which entitles each stockholder to purchase
an additional share of the Company's common stock at a specified
price. At December 31, 1998 and 1997, warrants for the purchase of
323,935 and 458,442 shares, respectively, were outstanding. The
exercise price is $12.00 per share until February 1999 and $15.00 per
share thereafter. If not exercised, such warrants will expire five
years after issuance. In connection with the acquisition of the Bank
of East Ridge 134,507 and 131,688 warrants were exercised in 1998 and
1997, respectively.
Note 14. Regulatory Matters
The Bank is subject to various regulatory capital requirements
administered by the Tennessee Department of Financial Institutions and
the federal banking agencies. Failure to meet minimum capital
requirements can initiate certain mandatory--and possibly additional
discretionary--actions by regulators that, if undertaken, could have a
direct material effect on the Bank's financial statements. Under
capital adequacy guidelines and the regulatory framework for prompt
corrective action, the Bank must meet specific capital guidelines that
involve quantitative measures of the Bank's assets, liabilities, and
certain off-balance-sheet items as calculated under regulatory
accounting practices. The Bank's capital amounts and classification
are also subject to qualitative judgments by the regulators about
components, risk weightings, and other factors.
Quantitative measures established by regulation to ensure capital
adequacy require the Bank to maintain minimum amounts and ratios (set
forth in the table below) of total and Tier I capital (as defined in
the regulations) to risk-weighted assets (as defined), and of Tier I
capital (as defined) to average assets (as defined). Management
believes, as of December 31, 1998, that the Bank meets all capital
adequacy requirements to which it is subject.
-17-
<PAGE> 44
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1998 and 1997
Note 14. Regulatory Matters (continued)
As of December 31, 1998, the most recent notification from the Federal
Deposit Insurance Corporation categorized the Bank as well capitalized
under the regulatory framework for prompt corrective action. There are
no conditions or events since that notification that management
believes have changed the institution's prompt corrective action
category for bank capital.
The Bank's actual capital amounts and ratios are also presented in the
table. Dollar amounts are presented in thousands.
<TABLE>
<CAPTION>
For Capital
Actual Adequacy Purposes
------------------- -------------------
Amount Ratio Amount Ratio
------ ----- ------ -----
<S> <C> <C> <C> <C>
As of December 31, 1998:
Total capital
(to risk-weighted assets) $9,808 12.8% $6,136 8.0%
Tier I capital
(to risk-weighted assets) 8,844 11.5% 3,068 4.0%
Tier I capital
(to average assets) 8,844 8.4% 8,407 8.0%
As of December 31, 1997:
Total capital
(to risk-weighted assets) $7,637 11.4% $5,358 8.0%
Tier I capital
(to risk-weighted assets) 6,721 10.0% 2,679 4.0%
Tier I capital
(to average assets) 6,721 8.1% 6,533 8.0%
</TABLE>
As a condition of the bank combination described in Note 16, the Bank
must meet certain financial conditions as follows:
- The Bank cannot pay dividends through February 1999.
- The Bank must maintain a Tier I capital to assets ratio of
no less than 8% through December 31, 1999.
- The Bank must maintain a minimum allowance for loan losses
ratio of 1.25% through February 1999.
The Bank was in compliance with all of these financial conditions at
December 31, 1998.
-18-
<PAGE> 45
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1998 and 1997
Note 14. Regulatory Matters (continued)
The Bank is operating under a Memorandum of Understanding (Memorandum)
dated November 24, 1998, between the Board of Directors, the Tennessee
Department of Financial Institutions, and the Federal Deposit
Insurance Corporation. Among other things, the Memorandum provides the
following:
- The Board of Directors shall develop a written management
plan that addresses the Bank's plans for size, structure,
growth, earnings, services, information systems, personnel,
accounting, financial reporting and operating matters.
- The Bank shall maintain a Tier I capital ratio of equal to
or greater than 8%.
- The Bank shall not pay dividends without the prior approval
of the FDIC.
- The Bank shall report its progress on the actions required
by the Memorandum to the FDIC on specific dates.
At December 31, 1998, the Bank had reported to the FDIC that it was in
compliance with all provisions of the Memorandum.
Note 15. Other Comprehensive Income
Other comprehensive income consists of unrealized holding gains and
losses on securities available for sale. A summary of other
comprehensive income and the related tax effects for the years ended
December 31, 1998 and 1997, is as follows:
<TABLE>
<CAPTION>
Tax
Before-Tax (Expense) Net-of-Tax
Amount Benefit Amount
---------- -------- ----------
<S> <C> <C> <C>
Year ended December 31, 1998:
Unrealized holding gains and losses
arising during the period $ (5,848) $ 2,222 $ (3,626)
Less reclassification adjustment for
gains realized in net income -- -- --
-------- -------- --------
$ (5,848) $ 2,222 $ (3,626)
======== ======== ========
Year ended December 31, 1997:
Unrealized holding gains and losses
arising during the period $(20,474) $ 7,780 $(12,694)
Less reclassification adjustment for
gains realized in net income -- -- --
-------- -------- --------
$(20,474) $ 7,780 $(12,694)
======== ======== ========
</TABLE>
-19-
<PAGE> 46
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1998 and 1997
Note 16. Bank Combination
On October 15, 1997, the Company completed a combination of the Bank
of East Ridge (East Ridge) with Cornerstone Community Bank
(Cornerstone). The surviving bank operates as Cornerstone Community
Bank. All of East Ridge's outstanding common stock owned by the
Company was redeemed in the combination and all of the Company's
outstanding common stock of record on October 15, 1997, was retired
with stockholders of that date receiving cash and/or newly issued
shares of common stock of the Company. The combination resulted in a
change in control of ownership and management of the Company as the
officers and directors of Cornerstone Community Bank replaced all of
the officers and directors of the Company. The Company changed its
name from East Ridge Bancshares, Inc. to Cornerstone Bancshares, Inc.
concurrent with the combination.
The purchase price totaled $6,125,000 comprised of $4,287,368 cash and
153,136 shares of newly issued common stock. The purchase price
exceeded the fair value of net assets acquired by approximately
$2,800,000, which is being amortized on the straight-line basis over
25 years. The combination has been accounted for as a purchase
accounting transaction and, accordingly, the operating results of East
Ridge are included in the accompanying financial statements from the
date of combination.
The following unaudited pro forma consolidated results of operations
for the year ended December 31, 1997, assumes the Cornerstone and East
Ridge combination occurred as of January 1, 1997 (in thousands):
<TABLE>
<S> <C>
Interest income $7,012
Interest expense 3,387
------
Net interest income 3,625
Provision for loan losses 463
------
Net interest income after provision for loan losses 3,162
Non-interest income 579
Non-interest expense 3,375
------
Income before income taxes 366
Income taxes 97
------
Net income $ 269
======
</TABLE>
-20-
<PAGE> 47
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1998 and 1997
Note 17. Earnings Per Share
Primary earnings per share amounts are computed based on the weighted
average number of shares actually outstanding. Fully diluted earnings
per share are computed based on the weighted average number of shares
actually outstanding plus the shares that would be outstanding
assuming exercise of dilutive stock options and stock warrants, all of
which are considered to be common stock equivalents.
<TABLE>
<CAPTION>
1998 1997
--------- -------
<S> <C> <C>
Primary:
Weighted average number of shares
actually outstanding 987,043 649,468
========= =======
Fully diluted:
Computed above for primary earnings per share 987,043 649,468
Stock options 30,000 28,000
Stock warrants -- --
--------- -------
1,017,043 677,468
========= =======
</TABLE>
Note 18. Redeemable Common Stock
At December 31, 1998 and 1997, the Company was obligated to redeem
certain shares of common stock issued in connection with the bank
combination described in Note 16. Such obligation includes the right
of a certain shareholder to sell certain shares of common stock to the
Company over a three-year period at $12.55, $14.00, and $16.00 per
share in years 1998, 1999, and 2000, respectively. The Company has the
option to redeem such shares during the same period at the same
prices. At December 31, 1997, the Company also had a remaining balance
due former East Ridge Bancshares, Inc.'s shareholders totaling
$77,529.
-21-
<PAGE> 48
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1998 and 1997
Note 19. Condensed Parent Company Financial Statements
Condensed financial statements of Cornerstone Bancshares, Inc. are
summarized as follows:
Condensed Balance Sheets
<TABLE>
<CAPTION>
1998 1997
------------ ------------
<S> <C> <C>
ASSETS
Cash $ 2,934 $ 939,493
Securities held to maturity -- 39,338
Loans receivable, net of allowance for loan losses -- 125,523
Excess cost over fair value of net assets acquired 2,834,124 2,862,580
Other assets 51,376 --
Investment in subsidiary 8,883,624 6,764,184
------------ ------------
Total assets $ 11,772,058 $ 10,731,118
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Accrued interest payable $ 19,027 $ --
Other liabilities -- 804,236
Notes payable 1,250,000 855,000
------------ ------------
Total liabilities 1,269,027 1,659,236
------------ ------------
Redeemable common stock 478,744 856,797
------------ ------------
Stockholders' equity:
Preferred stock; no par value; 2,000,000 shares
authorized; no shares issued -- --
Common stock, $1.00 par value; 2,000,000 shares
authorized; 1,009,461 and 874,954 shares issued
and outstanding in 1998 and 1997, respectively 1,009,461 874,954
Additional paid-in capital 9,017,430 7,587,441
Retained earnings (deficit) (41,695) (290,027)
Accumulated other comprehensive income 39,091 42,717
------------ ------------
Total stockholders' equity 10,024,287 8,215,085
------------ ------------
Total liabilities and stockholders' equity $ 11,772,058 $ 10,731,118
============ ============
</TABLE>
-22-
<PAGE> 49
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1998 and 1997
Note 19. Condensed Parent Company Financial Statements (continued)
Condensed Statements of Income and Retained Earnings
<TABLE>
<CAPTION>
1998 1997
--------- -----------
<S> <C> <C>
INCOME
Net loss from sale of assets $(112,155) $ (103,394)
Equity in subsidiary's earnings 547,672 358,410
--------- -----------
Total income 435,517 255,016
--------- -----------
EXPENSES
Interest expense 122,567 12,038
Other operating expenses 111,194 18,878
--------- -----------
Total expenses 233,761 30,916
--------- -----------
Income before income tax benefit 201,756 224,100
Income tax expense (benefit) (46,576) --
--------- -----------
NET INCOME 248,332 224,100
RETAINED EARNINGS (DEFICIT), beginning of year (290,027) 1,903,145
Bank combination -- (2,417,272)
--------- -----------
RETAINED EARNINGS (DEFICIT), end of year $ (41,695) $ (290,027)
========= ===========
</TABLE>
-23-
<PAGE> 50
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1998 and 1997
Note 19. Condensed Parent Company Financial Statements (continued)
Condensed Statements of Cash Flows
<TABLE>
<CAPTION>
1998 1997
----------- -----------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES
Net income $ 248,332 $ 224,100
Adjustments to reconcile net income to net cash
provided by (used in) operating activities:
Amortization 111,170 --
Equity in earnings of subsidiary (547,672) (358,410)
Changes in other operating assets and liabilities:
Increase in accrued interest payable 19,027 --
Increase (decrease) in other assets and liabilities (743,465) 634,666
----------- -----------
Net cash provided by (used in) operating activities (912,608) 500,356
----------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES
Additional capitalization of subsidiary (1,575,394) (2,080,260)
Payments related to bank combination (457,637) (4,714,631)
Cash and cash equivalents acquired in bank combination -- 5,050,906
----------- -----------
Net cash used in investing activities (2,033,031) (1,743,985)
----------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from borrowings on line of credit 145,000 500,000
Proceeds from notes payable 250,000 --
Redemption of common stock (350,107) --
Issuance of common stock 1,964,187 1,580,260
----------- -----------
Net cash provided by financing activities 2,009,080 2,080,260
----------- -----------
NET INCREASE IN CASH AND CASH EQUIVALENTS (936,559) 836,631
CASH AND CASH EQUIVALENTS, beginning of year 939,493 102,862
----------- -----------
CASH AND CASH EQUIVALENTS, end of year $ 2,934 $ 939,493
=========== ===========
SUPPLEMENTAL DISCLOSURES OF CASH
FLOW INFORMATION
Cash paid during the period for interest $ 103,540 $ 15,353
Cash paid during the period for taxes 425,171 199,859
=========== ===========
</TABLE>
-24-
<PAGE> 51
[LOGO]HAZLETT, LEWIS
& BIETER, PLLC
CERTIFIED PUBLIC ACCOUNTANTS
AND BUSINESS ADVISORS
Report of Independent Certified Public Accountants
on Accompanying Information
To the Stockholders and
Board of Directors
Cornerstone Bancshares, Inc.
Chattanooga, Tennessee
Our report on our audits of the basic financial statements of
Cornerstone Bancshares, Inc. and subsidiary for 1998 and 1997 appears on page
1. Those audits were made for the purpose of forming an opinion on the
consolidated financial statements taken as a whole. The consolidating
information shown on pages 26 and 27 is presented for purposes of additional
analysis of the consolidated financial statements rather than to present the
financial position, results of operations, and cash flows of the individual
companies. The consolidating information has been subjected to the auditing
procedures applied in the audits of the consolidated financial statements and,
in our opinion, is fairly stated in all material respects in relation to the
consolidated financial statements taken as a whole.
/s/Hazlett, Lewis & Bieter, PLLC
Chattanooga, Tennessee
January 15, 1999
-25-
Tivoli Center, Suite 300 - 701 Broad Street - Chattanooga, Tennesee 37402-1894 -
Telephone (423) 756-6133
FAX (423) 756-2727 - E-mail: hlb(@)hlbcpa.com - Web.http://www.hlbcpa.com
<PAGE> 52
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATING BALANCE SHEET
December 31, 1998
<TABLE>
<CAPTION>
Cornerstone
Cornerstone Bancshares,
ASSETS Bank Inc. Eliminations Consolidated
------------ ------------ ------------ -------------
<S> <C> <C> <C> <C>
Cash and due from banks $ 4,268,967 $ 2,934 $ 2,934 $ 4,268,967
Federal funds sold 8,425,000 -- -- 8,425,000
Securities available for sale 9,280,116 -- -- 9,280,116
Securities held to maturity 9,077,465 -- -- 9,077,465
Loans receivable, net of allowance for loan losses 72,492,549 -- -- 72,492,549
Bank premises and equipment 1,967,329 -- -- 1,967,329
Accrued interest receivable 638,441 -- -- 638,441
Excess cost over fair value of net assets acquired -- 2,834,124 -- 2,834,124
Other assets 1,470,767 51,376 -- 1,522,143
Investment in subsidiary -- 8,883,624 8,883,624 --
------------ ------------ ---------- -------------
Total assets $107,620,634 $ 11,772,058 $8,886,558 $ 110,506,134
============ ============ ========== =============
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits:
Noninterest-bearing demand deposits $ 14,154,460 $ -- $ 2,934 $ 14,151,526
Interest-bearing demand deposits 12,998,223 -- -- 12,998,223
Savings deposits and money market accounts 10,283,103 -- -- 10,283,103
Time deposits of $100,000 or more 17,489,618 -- -- 17,489,618
Time deposits under $100,000 43,089,138 -- -- 43,089,138
------------ ------------ ---------- -------------
Total deposits 98,014,542 -- 2,934 98,011,608
Accrued interest payable 251,607 19,027 -- 270,634
Other liabilities 470,861 -- -- 470,861
Notes payable -- 1,250,000 -- 1,250,000
------------ ------------ ---------- -------------
Total liabilities 98,737,010 1,269,027 2,934 100,003,103
------------ ------------ ---------- -------------
Redeemable common stock -- 478,744 -- 478,744
------------ ------------ ---------- -------------
Stockholders' equity:
Preferred stock
Common stock 590,130 1,009,461 590,130 1,009,461
Additional paid-in capital -- 9,017,430 -- 9,017,430
Surplus 7,862,448 -- 7,862,448 --
Retained earnings (deficit) 391,955 (41,695) 391,955 (41,695)
Accumulated other comprehensive income 39,091 39,091 39,091 39,091
------------ ------------ ---------- -------------
Total stockholders' equity 8,883,624 10,024,287 8,883,624 10,024,287
------------ ------------ ---------- -------------
Total liabilities and stockholders' equity $107,620,634 $ 11,772,058 $8,886,558 $ 110,506,134
============ ============ ========== =============
</TABLE>
-26-
<PAGE> 53
CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATING STATEMENT OF INCOME
Year Ended December 31, 1998
<TABLE>
<CAPTION>
Cornerstone Cornerstone
Community Bancshares,
Bank Inc. Eliminations Consolidated
----------- ----------- ------------ ------------
<S> <C> <C> <C> <C>
INTEREST INCOME
Loans $6,779,885 $ -- $ 40,831 $6,739,054
Securities:
U.S. Treasury 218,590 -- -- 218,590
U.S. Government agencies 474,718 -- -- 474,718
Other 603,305 -- -- 603,305
Income on federal funds sold and deposits in bank 176,299 -- -- 176,299
---------- --------- --------- ----------
Total interest income 8,252,797 -- 40,831 8,211,966
---------- --------- --------- ----------
INTEREST EXPENSE
Interest on time deposits of $100,000 or more 988,663 -- -- 988,663
Interest on other deposits 3,152,473 -- -- 3,152,473
Interest on federal funds purchased 8,518 -- -- 8,518
Other -- 122,567 (40,831) 81,736
---------- --------- --------- ----------
Total interest expense 4,149,654 122,567 (40,831) 4,231,390
---------- --------- --------- ----------
Net interest income (expense) before provision for loan losses 4,103,143 (122,567) -- 3,980,576
Provision for loan losses 715,343 -- -- 715,343
---------- --------- --------- ----------
Net interest income (expense) after provision for loan losses 3,387,800 (122,567) -- 3,265,233
---------- --------- --------- ----------
NONINTEREST INCOME
Service charges 467,718 -- -- 467,718
Other noninterest income 108,304 -- -- 108,304
Net gains (losses) from sale of loans 222,373 (112,155) -- 110,218
Equity in subsidiary's earnings -- 547,672 547,672 --
---------- --------- --------- ----------
Total noninterest income 798,395 435,517 547,672 686,240
---------- --------- --------- ----------
NONINTEREST EXPENSES
Salaries and employee benefits 1,669,883 -- -- 1,669,883
Net occupancy and equipment expense 224,717 -- -- 224,717
Other operating expenses 1,545,391 111,194 -- 1,656,585
---------- --------- --------- ----------
Total noninterest expenses 3,439,991 111,194 -- 3,551,185
---------- --------- --------- ----------
Income before income tax benefit 746,204 201,756 547,672 400,288
Income tax expense (benefit) 198,532 (46,576) -- 151,956
---------- --------- --------- ----------
Net income $ 547,672 $ 248,332 $ 547,672 $ 248,332
========== ========= ========= ==========
</TABLE>
-27-
<PAGE> 54
In accordance with Section 13 or 15(d) of the Exchange Act, the
registrant has caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized.
CORNERSTONE BANCSHARES, INC.
By: /s/ Earl A. Marler, Jr.
Chairman of the Board
Date: March 31, 1999
In accordance with the requirements of the Exchange Act, this report
has been signed below by the following persons on behalf of the registrant and
in the capacities and on the dates indicated.
<TABLE>
<CAPTION>
Signature Capacity Date
- --------- -------- ----
<S> <C> <C>
/s/ Earl A. Marler, Jr. Chairman of the Board, and Director March 31, 1999
/s/ Greg Jones President, Chief Executive Officer and Director March 31, 1999
(principal executive officer)
/s/Frank Hughes Chief Financial Officer (principal accounting and March 31, 1999
financial officer)
/s/Ramesh V. Amin Director March 31, 1999
/s/ Randy Brooks Director March 31, 1999
/s/ B. Kenneth Driver Director March 31, 1999
/s/ Karl Fillauer Director March 31, 1999
/s/ James H. Large Director March 31, 1999
/s/ Lawrence D. Levine Director March 31, 1999
/s/ Russell W. Lloyd Director March 31, 1999
/s/ Doyce G. Payne, M.D. Director March 31, 1999
/s/ Turner Smith Director March 31, 1999
/s/ Billy O. Wiggins Director March 31, 1999
/s/ Marsha Yessick Director March 31, 1999
</TABLE>
<TABLE> <S> <C>
<ARTICLE> 9
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
FINANCIAL STATEMENTS OF CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY FOR THE YEAR
ENDED DECEMBER 31, 1998 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH
FINANCIAL STATEMENTS.
</LEGEND>
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> DEC-31-1998
<CASH> 4,268,967
<INT-BEARING-DEPOSITS> 0
<FED-FUNDS-SOLD> 8,425,000
<TRADING-ASSETS> 0
<INVESTMENTS-HELD-FOR-SALE> 0
<INVESTMENTS-CARRYING> 9,077,465
<INVESTMENTS-MARKET> 9,280,116
<LOANS> 73,892,549
<ALLOWANCE> 1,400,000
<TOTAL-ASSETS> 110,506,134
<DEPOSITS> 98,011,608
<SHORT-TERM> 1,250,000
<LIABILITIES-OTHER> 741,495
<LONG-TERM> 0
0
0
<COMMON> 1,009,461
<OTHER-SE> 9,014,826
<TOTAL-LIABILITIES-AND-EQUITY> 110,506,134
<INTEREST-LOAN> 6,739,054
<INTEREST-INVEST> 1,296,613
<INTEREST-OTHER> 176,299
<INTEREST-TOTAL> 8,211,966
<INTEREST-DEPOSIT> 4,141,136
<INTEREST-EXPENSE> 90,254
<INTEREST-INCOME-NET> 3,980,576
<LOAN-LOSSES> 715,343
<SECURITIES-GAINS> 0
<EXPENSE-OTHER> 3,551,185
<INCOME-PRETAX> 400,288
<INCOME-PRE-EXTRAORDINARY> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 248,332
<EPS-PRIMARY> 0.25
<EPS-DILUTED> 0.24
<YIELD-ACTUAL> 4.25
<LOANS-NON> 609,000
<LOANS-PAST> 114,000
<LOANS-TROUBLED> 0
<LOANS-PROBLEM> 0
<ALLOWANCE-OPEN> 915,005
<CHARGE-OFFS> 230,348
<RECOVERIES> 0
<ALLOWANCE-CLOSE> 1,400,000
<ALLOWANCE-DOMESTIC> 0
<ALLOWANCE-FOREIGN> 0
<ALLOWANCE-UNALLOCATED> 14,000,000
</TABLE>
