Mergers and Acquisitions

ECB Bancorp, Inc. Merger Agreement

On September 25, 2012, the Company and ECB Bancorp, Inc. ("ECB") entered into an Agreement and Plan of Merger (the “ECB Merger Agreement”). Pursuant to the ECB Merger Agreement, ECB will merge with and into the Company so that the Company is the surviving bank holding corporation in the merger (the “Merger”). Immediately following the Merger, The East Carolina Bank, a North Carolina banking corporation and a wholly-owned subsidiary of ECB, will be merged with and into Crescent State Bank, a North Carolina banking corporation and a wholly-owned subsidiary of the Company. At the effective time of the Merger, each share of ECB's outstanding common stock, par value $3.50 per share, will be converted into the right to receive 3.55 shares of the Company's common stock, par value $0.001 per share. The completion of the merger is subject to all required regulatory and stockholder approvals.

ECB is a bank holding company, headquartered in Engelhard, North Carolina, whose wholly-owned subsidiary, The East Carolina Bank, is a state-chartered, community bank. The Bank has 25 branch offices in eastern North Carolina stretching from the Virginia to South Carolina state lines east of Interstate 95.

VantageSouth Bank Merger Agreement

On July 27, 2012, the Company filed an application with the Bank’s regulators to merge VantageSouth Bank, which is 100% owned by Piedmont Community Bank Holdings, Inc. (“Piedmont”), into CSB. Additional information relating to Piedmont’s ownership interest in the Company is found in the “Piedmont Investment” section of this Note B. On August 10, 2012, an Agreement and Plan of Merger (“Merger Agreement”) was entered into by the Company, CSB, and VantageSouth Bank to merge VantageSouth Bank into CSB in a share exchange based on the Company’s volume weighted average stock price. Pursuant to terms of the Merger Agreement, outstanding VantageSouth Bank shares will be converted into the Company’s shares equal to the exchange ratio. The exchange ratio will be 4.8204 if the Company’s volume weighted average stock price is at or above $5.25. If the Company’s volume weighted average stock price is at or below $4.75, the exchange ratio will be 5.3278, and if the Company’s volume weighted average stock price is below $5.25 but above $4.75, the exchange ratio will be equal to 25.307 divided by a number equal to the Company’s volume weighted average stock price.

VantageSouth Bank is headquartered in Burlington, North Carolina, and operates five branch offices located in Burlington (2), Fayetteville, and Salisbury (2), North Carolina. As of September 30, 2012, VantageSouth Bank had approximately $260,700 in total assets and 1,382,961 outstanding common shares. The Company’s board of directors established an independent special committee which evaluated, negotiated, and made a favorable recommendation to the board regarding the proposed merger. The North Carolina Banking Commission granted its formal approval of the Merger on September 26, 2012, and the FDIC granted its final approval of the Merger on October 30, 2012. The completion of the merger is subject to stockholder approval.

Piedmont Investment

On November 18, 2011, the Company completed the issuance and sale to Piedmont of 18,750,000 shares of common stock for $75,000 in cash (the “Piedmont Investment”) pursuant to an Investment Agreement (the “Piedmont Investment Agreement”). As part of its investment, Piedmont also made a tender offer to the Company’s stockholders commencing on November 8, 2011 to purchase up to 67% (6,442,105 shares) of our outstanding common stock at a price of $4.75 per share (“Tender Offer”). Pursuant to the Tender Offer, Piedmont purchased 6,128,423 shares of the Company’s common stock for $29,100. As a result of the Piedmont Investment and the Tender Offer, Piedmont owns approximately 88% of the Company’s outstanding common stock.

Staff Accounting Bulletin (“SAB”) Topic No. 5.J, Push Down Basis of Accounting Required in Certain Limited Circumstances, indicates that the acquiror’s application of purchase accounting is required to be pushed down to the acquiree (“push-down accounting”) in purchase transactions that result in an entity becoming substantially wholly owned. In determining whether a company has become substantially wholly owned, SEC staff guidance indicates that push-down accounting would be required if 95% or more of the company has been acquired, permitted if 80% to 95% has been acquired, and prohibited if less than 80% of the company is acquired. The Company determined push-down accounting to be appropriate due to Piedmont’s acquisition of 88% of the Company’s outstanding common stock in the Piedmont Investment and the Tender Offer.

Due to the application of push-down accounting, balances and activity in the Company’s consolidated financial statements prior to the Piedmont Investment have been labeled with “Predecessor Company” while balances and activity subsequent to the Piedmont Investment have been labeled with “Successor Company.”

The following table summarizes the Piedmont Investment and the Successor Company’s opening balance sheet:



	Preliminary Balances at Nov. 18, 2011		Measurement Period Adjustments			Adjusted Balances at Nov. 18, 2011
Fair value of assets acquired:

Cash and cash equivalents	$	226,126	$	—		$	226,126
Investment securities available for sale	89,343		—			89,343
Mortgage loans held for sale	4,588		—			4,588
Loans	561,911		(1,485		)	560,426
Federal Home Loan Bank stock	8,669		—			8,669
Premises and equipment	10,325		—			10,325
Deferred tax asset, net	30,268		1,782			32,050
Bank owned life insurance	19,169		—			19,169
Foreclosed assets	10,584		(405		)	10,179
Goodwill	20,015		3,095			23,110
Other intangible assets	2,260		—			2,260
Other assets	10,094		(1,182		)	8,912
Total assets acquired	993,352		1,805			995,157

Fair value of liabilities assumed:

Deposits	678,289		—			678,289
Borrowings	164,801		—			164,801
Other liabilities	7,111		1,805			8,916
Total liabilities assumed	850,201		1,805			852,006

Net assets	$	143,151	$	—		$	143,151

Non-controlling interests at fair value:

Preferred stock	24,409		—			24,409
Common stock warrants	1,326		—			1,326
Common stock	42,416		—			42,416

Total non-controlling interests	68,151		—			68,151

Purchase price	$	75,000	$	—		$	75,000

The above estimated fair values of assets acquired and liabilities assumed are based on the information that was available to make estimates of fair value during the measurement period through September 30, 2012. The Company is currently within the one-year measurement period with respect to the acquisition date, and thus, material adjustments to these purchase accounting fair value adjustments are possible. In the first nine months of 2012, goodwill increased by $3,095 as a result of adjustments to refine the Company’s acquisition date estimate of market rent on two branch leases, adjustments to refine the valuation of certain other real estate owned, adjustments to the acquisition date fair value of the split-dollar liability on bank owned life insurance, and adjustments to refine acquisition date cash flow estimates and the related valuation of certain loans.

A summary and description of the assets, liabilities and non-controlling interests fair valued in conjunction with applying the acquisition method of accounting is as follows:

Cash and Cash Equivalents. Cash and cash equivalents, which include proceeds from the Piedmont Investment, held at acquisition date approximated fair value on that date and did not require a fair value adjustment.

Securities Available for Sale. Available for sale securities are reported at fair value at acquisition date. To account for the Piedmont Investment, the difference between the fair value and par value became the new premium or discount for each security in the investment portfolio. The fair value of investment securities is primarily based on values obtained from third party pricing models, which are based on recent trading activity for the same or similar securities. Two equity securities were valued at their respective stock market prices.

Loans. All loans in the loan portfolio were adjusted to estimated fair value at the Piedmont Investment date. Upon analyzing estimated credit losses, the Company forecasted expected cash flows over the remaining life of each loan and discounted those expected cash flows to present value at current market interest rates for similar loans considering loan collateral type and credit quality. Based on this valuation, the Company recorded a loan fair value discount of approximately $44,900. In addition, the Company eliminated net deferred loan fees immediately prior to the acquisition of approximately $663.

Federal Home Loan Bank Stock. The Company’s investment in FHLB stock is carried at cost. Given the option to redeem this stock at par through the FHLB, the Company determined that cost approximated fair value at acquisition date and made no related adjustment.

Premises and Equipment. Premises and equipment were adjusted to estimated fair value at acquisition date based on recent appraisals for bank-owned land and buildings. The total fair value adjustment reduced the book value of these assets by approximately $540. At acquisition, accumulated depreciation was eliminated and estimated fair value became the cost basis of these assets.

Deferred Tax Asset. The net deferred tax asset is primarily related to the recognition of differences between certain tax and book bases of assets and liabilities related to purchase accounting at the Piedmont Investment, including fair value adjustments discussed elsewhere in this section, along with federal and state net operating losses that the Company determined to be realizable as of the acquisition date. A valuation allowance is recorded for deferred tax assets, including net operating losses, if the Company determines that it is more likely than not that some portion or all of the deferred tax assets will not be realized. Based on its analysis, the Company determined that no valuation allowance was necessary at acquisition date. See Note K of Item 8 in the Company’s 2011 Form 10-K for further discussion of the Company’s valuation allowance analysis.

Bank Owned Life Insurance. Bank owned life insurance investments are recorded at their cash surrender value, or the amount that can be realized upon surrender. Therefore, no fair value adjustments were made to this amount at acquisition date.

Foreclosed Assets. Foreclosed assets were adjusted to estimated fair value, which includes consideration of recent appraisals and the Company’s disposition strategy, at acquisition date.

Goodwill. Goodwill represents the excess of purchase price over the fair value of acquired net assets. This acquisition was nontaxable and, as a result, there is no tax basis in the goodwill. Accordingly, none of the goodwill associated with the acquisition is deductible for tax purposes.

Other Intangible Assets. The only separately identifiable intangible asset we recorded at acquisition date was related to the value of the Bank’s core customer deposit relationships, or core deposit intangible. This amount represents the present value of the difference between a market participant’s cost of obtaining alternative funds and the current cost to maintain the acquired core deposit base. The present value is calculated over the estimated life of the acquired core deposit base and will be amortized on an accelerated method over a ten-year period. Deposit accounts evaluated for the core deposit intangible were demand deposit accounts, money market accounts and savings accounts. Time deposits were not included in our evaluation of the core deposit intangible.

Deposits. Time deposits were not included in the core deposit intangible evaluation. Instead, a separate valuation of time deposits was conducted due to the contractual time frame associated with these liabilities. Time deposits evaluated for purchase accounting consisted of certificates of deposit (“CD’s”), brokered deposits and CD’s through the Certificate of Deposit Account Registry Services (“CDARS”). The fair value of these deposits was determined by first stratifying the deposit pool by maturity and calculating the contractual interest rates for each maturity period. Then contractual cash flows were projected by period and discounted to present value using current market interest rates for similar duration CD’s.

Outstanding balances of CDs totaled $196,500 at acquisition date, and the estimated fair value premium totaled $4,400. The outstanding balance of brokered deposits was $115,000, and the estimated fair value premium totaled $1,600. The outstanding balance of CDARS was $15,500, and the estimated fair value premium totaled approximately $47. The Company will amortize these premiums into income as a reduction of interest expense on a level-yield basis over the weighted average time deposit terms.

Borrowings. Included in borrowings are FHLB advances as well as a subordinated term loan issued by the Bank and junior subordinated debentures issued in the form of trust preferred securities. Fair values for FHLB advances were determined by developing cash flow estimates for each advance based on scheduled principal and interest payments, contractual interest rates and prepayment penalties. Once the cash flows were determined, the current FHLB advance rate for similar maturity terms was used to discount the cash flows to the present value. The outstanding balance of FHLB advances at the acquisition date was$142,000, and the estimated fair value premium totaled $10,600. Acquired FHLB advances were repaid after the acquisition date prior to December 31, 2011.

Fair values for the trust preferred securities and subordinated term loan were estimated by developing cash flow estimates for each of these debt instruments based on scheduled principal and interest payments. Once the cash flows were determined, a market rate for comparable debt instruments was used to discount the cash flows to their present values. Outstanding trust preferred securities and subordinated debt at the acquisition date were $8,000 and $7,500, respectively, and the estimated fair value discount on each totaled $2,800, and $731, respectively. The Company will accrete these discounts as an increase to interest expense on a level-yield basis over the contractual term of each debt instrument.

Non-controlling Interests. Non-controlling interests, that portion of the Company not owned by Piedmont, include preferred stock and common stock warrants issued pursuant to the U.S. Treasury’s Troubled Asset Relief Program capital purchase program (“TARP CPP”) as well as common stock owned at the acquisition date by legacy stockholders. Non-controlling interests are not disclosed on the Company’s consolidated balance sheet since they represent non-controlling interests of Piedmont, not the Company. However, valuation of these non-controlling ownership interests impacts the Company’s stockholders’ equity through the push down of purchase accounting adjustments. Preferred stock issued under the TARP CPP was valued based on forecasting expected cash flows with an assumed repayment date and discounting these cash flows based on current market yields for similar preferred stock. The discount between the estimated fair value at acquisition date and the $24,900 liquidation value will be accreted to retained earnings over the remaining period to anticipated repayment of these securities. The common stock warrant, also issued to the U.S. Treasury, was valued using a Black-Scholes option pricing model. See Note I – Cumulative Perpetual Preferred Stock for more details.

The fair value of non-controlling common stock was estimated using the closing stock market price on the acquisition date, which was $4.39 per share, and applying this stock price to the number of outstanding non-controlling common shares at that date.

There were no indemnification assets in this transaction, nor was there any contingent consideration to be recognized. Professional and other costs related to the Piedmont Investment were expensed as incurred.