Connecticut

06-1524044

(State or other jurisdiction

of incorporation or organization)

(I.R.S. Employer

Identification No.)

550 Summer St., Stamford, Connecticut

06901

(Address of principal office)

(Zip Code)

Common Stock, par value $0.01 per share

American Stock Exchange

(Title of Each Class)

(Name of each exchange on which registered)

Page

Independent Auditors’ Report

F–1

Consolidated Financial Statements:

Consolidated Statements of Condition as of December 31, 2002 and 2001

F–2

Consolidated Statements of Income for the Years Ended December 31, 2002 and 2001

F–3

Consolidated Statements of Stockholders’ Equity for the Years Ended December 31, 2002 and 2001

F–4

Consolidated Statements of Cash Flows for the Years Ended December 31, 2002 and 2001

F–5

Notes to Consolidated Financial Statements

F–6 to F–27

2002

2001

Assets

$

11,304

$

8,700

22,900

15,599

34,204

24,299

11,392

9,779

26,758

35,349

38,150

45,128

7,244

755

121,475

104,784

1,081

1,075

521

466

2,962

2,915

781

710

5,113

1,037

523

348

$

212,054

$

181,517

Liabilities and Stockholders’ Equity

$

46,610

$

33,673

32,805

35,493

34,106

29,824

69,500

55,483

183,021

154,473

5,723

8,041

126

164

2,529

—  

1,317

898

192,716

163,576

13

12

13,954

11,816

6,205

6,848

(749

)

(880

)

(183

)

—  

98

145

19,338

17,941

$

212,054

$

181,517

2002

2001

$

9,423

$

9,039

1,921

1,727

224

936

11,568

11,702

3,010

3,689

80

144

3,090

3,833

8,478

7,869

363

91

8,115

7,778

507

498

595

—  

153

8

805

439

2,060

945

4,009

3,273

768

640

390

409

564

603

304

289

204

113

1,001

926

7,240

6,253

2,935

2,470

1,115

970

$

1,820

$

1,500

$

1.53

$

1.27

1.48

1.24

Common Stock

Additional
Paid-in
Capital

Retained
Earnings

Number
of Shares
Outstanding

Amount

1,065,744

$

11

$

11,657

$

5,818

—  

—  

—  

1,500

—  

—  

—  

—  

—  

—  

—  

(470

)

9,529

1

137

—  

1,447

—  

22

—  

1,076,720

12

11,816

6,848

—  

—  

—  

1,820

—  

—  

—  

—  

—  

—  

—  

(530

)

109,123

1

1,932

(1,933

)

11,450

—  

52

—  

3,025

—  

27

—  

6,687

—  

112

—  

899

—  

15

—  

1,207,904

$

13

$

13,954

$

6,205

Treasury
Stock

Restricted
Stock

Accumulated
Other
Comprehensive
Income (Loss)

Total
Stockholders’
Equity

$

(880

)

$

—  

$

(22

)

$

16,584

—  

—  

—  

1,500

—  

—  

167

167

1,667

—  

—  

—  

(470

)

—  

—  

—  

138

—  

—  

—  

22

(880

)

—  

145

17,941

—  

—  

—  

1,820

—  

—  

(47

)

(47

)

1,773

—  

—  

—  

(530

)

—  

—  

—  

—  

131

(183

)

—  

—  

—  

—  

—  

27

—  

—  

—  

112

—  

—  

—  

15

$

(749

)

$

(183

)

$

98

$

19,338

2002

2001

$

1,820

$

1,500

576

345

363

91

(22,578

)

(1,586

)

16,684

831

(38

)

10

(6

)

49

(175

)

(169

)

(38

)

21

419

16

(153

)

(8

)

270

(7

)

(2,856

)

1,093

3,497

12,013

8,422

10,171

(2,683

)

(3,039

)

—  

(30,957

)

(17,917

)

(5,628

)

(3,923

)

(99

)

(55

)

(47

)

(434

)

(561

)

(13,093

)

(18,147

)

28,548

30,521

(2,318

)

(521

)

(515

)

(455

)

139

138

25,854

29,683

9,905

12,629

24,299

11,670

$

34,204

$

24,299

$

3,128

$

3,812

1,203

934

2,529

—  

81

—  

(1)

Summary of Significant Accounting Policies

Cornerstone Bancorp, Inc. (the “Bancorp”) is a bank holding company formed by Cornerstone Bank (the “Bank”) for the purpose of owning all of the Bank’s outstanding common stock.  On March 1, 1999, each share of the Bank’s common stock was exchanged on a one-for-one basis for the Bancorp’s common stock.  The Bank is a state-chartered commercial bank that provides a variety of loan and deposit services to individuals and businesses primarily in Southwestern Fairfield County, Connecticut.  The Bank is subject to regulations of the Federal Deposit Insurance Corporation (the “FDIC”) and the State of Connecticut Department of Banking, and undergoes periodic examinations by those regulatory agencies.  The Bancorp is subject to regulation and supervision by the Federal Reserve Board (the “FRB”).  The Bank’s deposit accounts are insured up to applicable limits by the Bank Insurance Fund of the FDIC.

Basis of Financial Statement Presentation

The consolidated financial statements include the accounts of the Bancorp, the Bank and Cornerstone Business Credit, Inc. (a wholly-owned subsidiary of the Bank which commenced small business lending operations in 2001) (collectively, the “Company”). Management has prepared these consolidated financial statements in conformity with accounting principles generally accepted in the United States of America.  All significant intercompany balances and transactions have been eliminated in consolidation.

In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses.  Actual results could differ significantly from those estimates, as a result of changing conditions and future events.  An estimate that is particularly critical and susceptible to near-term change is the allowance for loan losses, which is discussed below.

For purposes of the consolidated statements of cash flows, cash equivalents represent federal funds which are generally sold on an overnight basis.

Prior year amounts are reclassified, whenever necessary, to conform to the current year presentation. Earnings per share, dividends per share, and other share and per share data for all periods has been adjusted for the effect of the 10% stock dividend distributed in June 2002.

Securities

Securities are classified as either available for sale (representing securities that may be sold in the ordinary course of business) or as held to maturity (representing debt securities for which the Company has the ability and positive intent to hold until maturity).  Management determines the classification of securities at the time of purchase.  Securities held to maturity are reported at amortized cost.  Securities available for sale are reported at fair value, with unrealized gains and losses reported on a net-of-tax basis in stockholders’ equity as accumulated other comprehensive income or loss.  Securities are not acquired for trading purposes.

Purchases (sales) of securities are recorded on the trade date, and the resulting payables (receivables) are reported in the consolidated statements of condition. Gains and losses realized on sales of securities are determined using the specific identification method.  Premiums and discounts on debt securities are amortized to interest income over the term of the security.  Unrealized losses on securities are charged to earnings if management determines that the decline in fair value of a security is other than temporary.

As a member of the Federal Home Loan Bank (“FHLB”) of Boston, the Bank is required to hold a certain amount of FHLB stock.  This stock is a non-marketable equity security and, accordingly, is reported at cost.

Loans

Loans are reported at unpaid principal balances less the allowance for loan losses, except for loans held for sale which are reported at the lower of cost or estimated market value in the aggregate.  Gains and losses on sales of loans are recorded at settlement using the specific identification method.  Interest income is accrued based on contractual rates applied to principal amounts outstanding.  Loan origination and commitment fees, and certain direct origination costs, are deferred and amortized to interest income over the life of the related loan.

Loans past due 90 days or more as to principal or interest are placed on non-accrual status except for certain loans which, in management’s judgment, are adequately secured and probable of collection.  When a loan is placed on non-accrual status, previously accrued interest that has not been collected is reversed from current interest income.  Thereafter, the application of principal or interest payments received on non-accrual loans is dependent on the expectation of ultimate repayment of the loan.  If ultimate repayment is reasonably assured, payments are applied to principal and interest in accordance with the contractual terms.  If ultimate repayment is not reasonably assured or management judges it to be prudent, any payments received are applied to principal until ultimate repayment is reasonably assured.  Loans are returned to accrual status when they demonstrate a sufficient period of payment performance and are expected to be fully collectible as to principal and interest.

Allowance for Loan Losses

The allowance for loan losses represents management’s estimate of probable credit losses inherent in the existing loan portfolio.  The allowance is adjusted by periodic provisions for loan losses, and by charge-offs and recoveries.  When amounts on specific loans are judged by management to be uncollectible, those amounts are charged-off to reduce the allowance for loan losses.  Subsequent recoveries, if any, are restored to the allowance when realized.

Management’s determination of the allowance for loan losses is based on the results of continuing reviews of individual loans and borrower relationships, particularly the larger relationships included in the commercial and commercial real estate loan portfolios.  These reviews consider factors such as the borrower’s financial condition, historical and expected ability to make loan payments, and underlying collateral values.  Management’s determination of the allowance for loan losses also considers the level of past due and non-performing loans, the Company’s historical loan loss experience, changes in loan portfolio mix, geographic and borrower concentrations, and current economic conditions.  While management uses the best available information to determine the allowance for loan losses, future adjustments to the allowance may be necessary based on changes in economic and real estate market conditions, particularly in the Company’s market area of Southwestern Fairfield County, Connecticut.  In addition, regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for loan losses.  Such agencies may require the Company to recognize adjustments to the allowance based on their judgments of information available to them at the time of their examination.

Statement of Financial Accounting Standards (“SFAS”) No. 114, Accounting by Creditors for Impairment of a Loan, requires recognition of an impairment loss on a loan within its scope when it is probable that the lender will be unable to collect principal and/or interest payments in accordance with the terms of the loan agreement.  SFAS No. 114 does not apply to large groups of smaller-balance homogeneous loans (such as residential mortgage and consumer loans) that are collectively evaluated for impairment in accordance with SFAS No. 5, Accounting for Contingencies.  Measurement of impairment under SFAS No. 114 may be based on the present value of expected future cash flows discounted at the loan’s effective interest rate or, as a practical expedient, based on the loan’s observable market price or the collateral’s fair value if the loan is collateral dependent.  If the measure of an impaired loan is less than its recorded amount, an impairment allowance is established as part of the allowance for loan losses.

Premises and Equipment

Premises and equipment are reported at cost, less accumulated depreciation and amortization.  Owned assets are depreciated using the straight-line method over the estimated useful lives of the assets (three to twenty years for equipment and thirty-five years for buildings).  Leasehold improvements are amortized over the shorter of their estimated service lives or the term of the lease.

Bank-Owned Life Insurance

Bank-owned life insurance is reported at the cash surrender value of the underlying policies.  Increases in the cash surrender value are recorded in non-interest income. Certain of these policies were purchased in consideration of the Company’s obligations under the salary continuation agreements described in note 14.

Income Taxes

Deferred tax assets and liabilities are recognized for the estimated future tax effects attributable to “temporary differences” between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases.  Deferred tax assets and liabilities are measured using enacted

tax rates expected to apply to future taxable income.  The effect on deferred tax assets and liabilities of an enacted change in tax rates is recognized in income tax expense in the period that includes the enactment date of the change.

A deferred tax liability is recognized for all temporary differences that will result in future taxable income.  A deferred tax asset is recognized for all temporary differences that will result in future tax deductions, subject to reduction of the asset by a valuation allowance in certain circumstances.  This valuation allowance is recognized if, based on an analysis of available evidence, management determines that it is more likely than not that a portion or all of the deferred tax asset will not be realized.  The valuation allowance is subject to ongoing adjustments based on changes in circumstances that affect management’s judgment about the realizability of the deferred tax asset.  Adjustments to increase or decrease the valuation allowance are charged or credited, respectively, to income tax expense.

Earnings Per Common Share

Basic earnings per share (“EPS”) excludes dilution and is computed by dividing income available to common shareholders (net income less dividends on preferred stock, if any) by the weighted average number of common shares outstanding during the period.  Diluted EPS is computed in a similar manner, except that the weighted average number of common shares is increased (using the treasury stock method) by additional common shares that would have been outstanding if all potentially dilutive securities (such as stock options and unvested restricted stock awards) were exercised or vested during the period.

Stock-Based Compensation

The Company accounts for stock-based compensation in accordance with Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations.  Accordingly, compensation expense is not recognized for fixed stock options if the exercise price of the option equals the fair value of the underlying stock at the grant date.  The fair value of restricted stock awards, measured at the grant date, is recognized as unearned compensation (a component of stockholders’ equity) and amortized to compensation expense over the vesting period.

SFAS No. 123, Accounting for Stock-Based Compensation, encourages the use of a fair-value-based method of accounting for employee stock compensation plans, but permits the continued use of the intrinsic-value-based method of accounting prescribed by APB Opinion No. 25.  Under SFAS No. 123, the grant-date fair value of options is recognized as compensation expense over the vesting period (if any). The Company has elected to continue to apply APB Opinion No. 25 and disclose the

pro forma information required by SFAS No. 123.  Had stock-based compensation expense been recognized in accordance with SFAS No. 123, the Company’s net income and earnings per common share would have been adjusted to the following pro forma amounts for the years ended December 31:

2002

2001

(In thousands,
except per share data)

$

1,820

$

1,500

23

—  

(43

)

(21

)

$

1,800

$

1,479

$

1.53

$

1.27

1.51

1.25

$

1.48

$

1.24

1.46

1.22

On a per share basis, the weighted average estimated fair values of options granted during 2002 and 2001 were $2.68 and $2.09, respectively.  These fair values were estimated using the Black Scholes option-pricing model and the following weighted average assumptions:  dividend yield of 2.6% in 2002 and 2.8% in 2001; expected volatility rates of 46% in 2002 and 14% in 2001; expected option life of eight years in 2002 and six years in 2001; and risk-free interest rates of 3.6% in 2002 and 4.3% in 2001.

Borrowings Under Securities Repurchase Agreements

The Company enters into transactions with certain of its commercial customers in which it sells U.S. Government Agency securities under an agreement to repurchase the identical securities from the customer at a later date.  These transactions are accounted for as secured borrowings since the Company maintains effective control over the underlying securities which are pledged as collateral.  The transaction proceeds are recorded as borrowings in the consolidated statements of condition, and the collateral securities continue to be carried as assets of the Company.

Segment Information

Public companies are required to report certain financial information about significant revenue-producing segments of the business for which such information is available and utilized by the chief operating decision maker.  As a community-oriented financial institution, substantially all of the

Company’s operations involve the delivery of loan and deposit services to customers.  Management makes operating decisions and assesses performance based on an ongoing review of these community banking operations, which constitute the Company’s only operating segment for financial reporting purposes.

(2)

Cash Reserve Requirements

The Bank is required to maintain average reserve balances under the Federal Reserve Act and Regulation D issued thereunder.  These reserves were $2,885,000 and $2,368,000 at December 31, 2002 and 2001, respectively, and are included in cash and due from banks in the consolidated statements of condition.

(3)

Securities

The amortized cost, gross unrealized gains and losses, and fair values of securities are summarized below. Mortgage-backed securities consist of pass-through securities guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae.

Amortized
Cost

Gross
Unrealized
Gains

Gross
Unrealized
Losses

Fair
Value

(In thousands)

$

9,082

$

160

$

—  

$

9,242

2,152