Annual Report

 

 

U.S. Securities and Exchange Commission

Washington, D.C. 20549

Form 10-K

þ		Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the fiscal year ended December 31, 2005

o		Transition Report Under Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from                      to                     

Commission file number 000-33227

Southern Community Financial Corporation

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code (336) 768-8500

Securities Registered Pursuant to Section 12(b) of the Exchange Act:
None
Securities Registered Pursuant to Section 12(g) of the Exchange Act:
Common Stock, No Par Value

7.95% Cumulative Trust Preferred Securities
7.95% Junior Subordinated Debentures
Guarantee with respect to 7.95% Cumulative Trust Preferred Securities

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes. o No þ

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

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes þ No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definitions of “accelerated and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o		Accelerated filer þ		Non -accelerated filer o

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

State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter. $152.4 million.

As of February 28, 2006, (the most recent practicable date), the registrant had outstanding 17,583,405 shares of Common Stock, no par value.

 

 

Form 10-K Table of Contents

Index		PAGE
PART I
Item 1. Business			3
Item 1A. Risk Factors			12
Item 1B. Unresolved Staff Comments (None)			18
Item 2. Properties			18
Item 3. Legal			20
Item 4. Submission of Matters to a Vote of Security Holders			20
PART II
Item 5. Market for Common Stock and Related Stockholder Matters and Issuer Purchases of Equity Securities			20
Item 6. Selected Financial Data			21
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations			23
Item 7A. Quantitative and Qualitative Disclosures About Market Risk			54
Item 8. Financial Statements			54
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure			96
Item9A. Controls and Procedures			96
Item9B. Other Information			99
PART III
Item 10. Directors and Executive Officers of the Registrant			99
Item 11. Executive Compensation			99
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters			99
Item 13. Certain Relationships and Related Transactions			100
Item 14. Principal Accountant Fees and Services			100
PART IV
Item 15. Exhibits, Financial Statement Schedules			101

PART I

The Piedmont Triad is the largest Metropolitan Statistical Area located entirely in North Carolina. The MSA is also one of the top 50 in the country in both total population and number of households. Winston-Salem is the largest city in Forsyth County and the fifth largest city in North Carolina. Greensboro is the largest city in Guilford County and the third largest city in North Carolina, while High Point is the second largest city in Guilford County and the eighth largest city in North Carolina. In 2005, Forsyth County had an estimated population of almost 326 thousand and Guilford County has an estimated population of almost 436 thousand.

The Piedmont Triad is the economic hub of northwest North Carolina. In 2005, the median family income in the Piedmont Triad was over $56 thousand dollars. The Piedmont Triad has a very balanced and diversified economy and a work force that exceeded 780 thousand in May 2004. Approximately 99% of the work force is employed in nonagricultural wage and salary positions. The major employment sectors in 2004 were services (36%), manufacturing (15%), trade (14%), government (14%), finance, communications and utilities (10%), and construction (4%). From January 2004 to December 2005, the unemployment rate in the Piedmont Triad decreased from 5.2% to 4.8%.

The Bank serves our market area through nineteen full service banking offices. Our television and radio advertising has extended into this market area for several years, providing the Bank name recognition in the Piedmont Triad area. The Bank’s customers may access various banking services through approximately one hundred ATMs owned or leased by the Bank, through debit cards, and through the Bank’s automated telephone and Internet electronic banking products. These products allow the Bank’s customers to apply for loans, access account information and conduct various transactions from their telephones and computers.

Business Strategy

We established our bank with the objective of becoming a vital, long-term player in our markets with a reputation for quality customer service provided by a financially sound organization. Our business strategy is to operate as an institution that is well-capitalized, strong in asset quality, profitable, independent, customer-oriented and connected to our community.

A commitment to customer service is at the foundation of our approach. Our commitment is to put our customers first and we believe it differentiates us from our competitors. Making good quality, profitable loans, which result in a long-standing relationship with our borrowers, will continue to be a cornerstone of our strategy. We intend to leverage the core relationships we build by providing a variety of services to our customers. With that focus, we target:

	•		Small and medium sized businesses, and the owners and managers of these entities;
	•		Professional and middle managers of locally based companies;
	•		Residential real estate developers; and
	•		Individual consumers.

We intend to grow our franchise through new and existing relationships developed by our associates, and by expanding primarily to contiguous areas through de novo entry and acquisitions which make strategic and economic sense.

We have also diversified our revenue in order to generate non-interest income. These efforts include our mortgage loan department, our small business investment company manager (which generates management fees) and our wealth management department, Southern Community Advisors, which offers investment advisory, brokerage, trust and insurance services. For the year ended December 31, 2005 our non-interest income represented 17.4% of our total revenue. We believe that the profitability of these added businesses and services, not just the revenue generated, is critical to our success.

Key aspects of our strategy and mission include:

	•		To provide community-oriented banking services by delivering a broad range of financial services to our customers through responsive service and communication;
	•		To form a partnership with our customers whereby our decision making and product offerings are geared toward their best long-term interests;
	•		To be recognized in our Community as a long-term player with employees, stockholders and board members committed to that effort; and

•

To be progressive in our adoption of new technology so that we can provide our customers access to products and services that meet their needs for convenience and efficiency.

Our belief is that our way of doing business will build a profitable corporation and shareholder value. We want to consistently reward our shareholders for their investment and trust in us.

Subsidiaries

The Bank operates one subsidiary that provides financial services in addition to those offered directly by the Bank. The Company has a subsidiary to issue trust preferred securities. Each subsidiary is described below.

VCS Management, LLC was formed in March 2000 as the managing general partner of Salem Capital Partners, L.P., a small business investment company licensed by the Small Business Administration. Southern Community Bank and Trust has invested $1.7 million in the partnership, which has a total of $9.2 million of invested capital from various private investors including the Bank. The partnership can also borrow funds on a non-recourse basis from the Small Business Administration to increase its capital available for investment. The partnership makes investments generally in the form of subordinated debt and earns revenue through interest received on its investments and potentially through gains realized from warrants that it receives in conjunction with its debt investments. The Bank shares in any earnings of the partnership through its investment in the partnership. VCS Management, LLC earns fees for managing the investment activities of the partnership. For the year ended December 31, 2005, VCS Management, LLC earned $424 thousand of fee income, representing 0.9% of total consolidated revenue.

In November 2003, Southern Community Capital Trust II (“Trust II”), a newly formed subsidiary of the Company, issued 3,450,000 Trust Preferred Securities (“Trust II Securities”), generating gross total proceeds of $34.5 million. The Trust II Securities pay distributions at an annual rate of 7.95% and mature on December 31, 2033. The Trust II Securities began paying quarterly distributions on December 31, 2003. The Company has fully and unconditionally guaranteed the obligations of Trust II. The Trust II Securities are redeemable in whole or in part at any time after December 31, 2008. The proceeds from the Trust II Securities were utilized to purchase convertible junior subordinated debentures from us under the same terms and conditions as the Trust II Securities. We have the right to defer payment of interest on the debentures at any time and from time to time for a period not exceeding five years, provided that no deferral period extend beyond the stated maturities of the debentures. Such deferral of interest payments by the company will result in a deferral of distribution payments on the related Trust II Securities. Should we defer the payment of interest on the debentures, the Company will be precluded from the payment of cash dividends to shareholders. The principal uses of the net proceeds from the sale of the debentures were to provide cash for the acquisition of The Community Bank, to increase our regulatory capital, and to support the growth and operations of our subsidiary bank. The amount of proceeds we count as Tier 1 capital cannot comprise more than 25% of our core capital elements. Amounts in excess of that 25% limitation count as Tier 2 supplementary capital on our books. At present the entire proceeds from the Trust II Securities qualify as Tier 1 capital of the company for regulatory capital purposes.

Competition

The activities in which the Bank, as our operating subsidiary, engages are highly competitive. Commercial banking in North Carolina is extremely competitive due to state laws which permit state-wide branching. Consequently, many commercial banks have branches located in several communities. One of the largest regional commercial banks in North Carolina, a new community bank and one savings institution also have their headquarters in Winston-Salem. As of June 2005, we operated branches in Forsyth, Guilford, Iredell, Rockingham, Stokes, Surry and Yadkin Counties, North Carolina. On that date, there were 357 branches operated by thirty-five commercial banks, and six savings institutions in these seven counties with approximately $24.3 billion in deposits. Deposits of the Bank in June 2005 were $940.6 million. Many of these competing banks have capital resources and legal lending limits substantially in excess of those available to us and the Bank. Therefore, in our market area, the Bank has significant competition for deposits and loans from other depository institutions.

Other financial institutions such as credit unions, consumer finance companies, insurance companies, brokerage companies, small loan companies and other financial institutions with varying degrees of regulatory restrictions compete vigorously for a share of the financial services market. Credit unions have been permitted to expand their membership criteria and expand their loan services to include such traditional bank services as commercial lending.

These entities pose an ever-increasing challenge to our efforts to serve the markets traditionally served by banks. We expect competition to continue to be significant.

Employees

All employees of Southern Community Financial Corporation, during 2005, were compensated by the Bank. At December 31, 2005, the Bank employed 299 full-time equivalent persons (including our executive officers). None of the employees are represented by any unions or similar groups, and we have not experienced any type of strike or labor dispute. We consider our relationship with our employees to be good and extremely important to our long-term success. The Board and management continually seek ways to enhance their benefits and well being.

SUPERVISION AND REGULATION

Southern Community Financial Corporation is registered as a financial holding company with the Federal Reserve. The Bank is a North Carolina chartered banking corporation and a member bank of the Federal Reserve System. Banking is a complex, highly regulated industry. The primary goals of bank regulations are to maintain a safe and sound banking system and to facilitate the conduct of sound monetary policy. In furtherance of these goals, Congress has created several largely autonomous regulatory agencies and enacted numerous laws that govern banks, bank holding companies and the banking industry. The descriptions of and references to the statutes and regulations below are brief summaries and do not purport to be complete. The descriptions are qualified in their entirety by reference to the specific statutes and regulations discussed.

Southern Community Financial Corporation

Southern Community Financial Corporation is a bank holding company that has elected to be treated as a financial holding company. As a bank holding company under the Bank Holding Company Act of 1956, as amended, we are registered with and subject to regulation by the Federal Reserve. We are required to file annual and other reports with, and furnish information to, the Federal Reserve. The Federal Reserve conducts periodic examinations of us and may examine any of our subsidiaries, including the Bank.

The Bank Holding Company Act provides that a bank holding company must obtain the prior approval of the Federal Reserve for the acquisition of more than five percent of the voting stock or substantially all the assets of any bank or bank holding company. In addition, the Bank Holding Company Act restricts the extension of credit to any bank holding company by its subsidiary bank. The Bank Holding Company Act also provides that, with certain exceptions, a bank holding company may not engage in any activities other than those of banking or managing or controlling banks and other authorized subsidiaries or own or control more than five percent of the voting shares of any company that is not a bank. The Federal Reserve has deemed limited activities to be closely related to banking and therefore permissible for a bank holding company.

Subject to various limitations, federal banking law generally permits a bank holding company to elect to become a “financial holding company.” A financial holding company may affiliate with securities firms and insurance companies and engage in other activities that are “financial in nature.” Among the activities that are deemed “financial in nature” are, in addition to traditional lending activities, securities underwriting, dealing in or making a market in securities, sponsoring mutual funds and investment companies, insurance underwriting and agency activities, certain merchant banking activities as well as activities that the Federal Reserve considers to be closely related to banking.

A bank holding company may become a financial holding company if each of its subsidiary banks is “well capitalized” under the Federal Deposit Insurance Corporation Improvement Act prompt corrective action provisions, is well managed and has at least a satisfactory rating under the Community Reinvestment Act. In addition, the bank holding company must file a declaration with the Federal Reserve that the bank holding company wishes to become a financial holding company. A bank holding company that falls out of compliance with these requirements may be required to cease engaging in some of its activities. Southern Community Financial Corporation elected, and was authorized by the Federal Reserve, to be a financial holding company.

The Federal Reserve serves as the primary “umbrella” regulator of financial holding companies, with supervisory authority over each parent company and limited authority over its subsidiaries. Expanded financial activities of financial holding companies are generally regulated according to the type of such financial activity: banking

activities by banking regulators, securities activities by securities regulators, and insurance activities by insurance regulators. Federal law imposes certain restrictions and disclosure requirements regarding private information collected by financial institutions.

Enforcement Authority . We will be required to obtain the approval of the Federal Reserve prior to engaging in or, with certain exceptions, acquiring control of more than 5% of the voting shares of a company engaged in, any new activity. Prior to granting such approval, the Federal Reserve must weigh the expected benefits of any such new activity to the public (such as greater convenience, increased competition, or gains in efficiency) against the risk of possible adverse effects of such activity (such as undue concentration of resources, decreased or unfair competition, conflicts of interest, or unsound banking practices). The Federal Reserve has cease-and-desist powers over bank holding companies and their nonbanking subsidiaries where their actions would constitute a serious threat to the safety, soundness or stability of a subsidiary bank. The Federal Reserve also has authority to regulate debt obligations (other than commercial paper) issued by bank holding companies. This authority includes the power to impose interest ceilings and reserve requirements on such debt obligations. A bank holding company and its subsidiaries are also prohibited from engaging in certain tie-in arrangements in connection with any extension of credit, lease or sale of property or furnishing of services.

Interstate Acquisitions . Federal banking law generally provides that a bank holding company may acquire or establish banks in any state of the United States, subject to certain aging and deposit concentration limits. In addition, North Carolina banking laws permit a bank holding company that owns stock of a bank located outside North Carolina to acquire a bank or bank holding company located in North Carolina. In any event, federal banking law will not permit a bank holding company to own or control banks in North Carolina if the acquisition would exceed 20% of the total deposits of all federally-insured deposits in North Carolina.

Capital Adequacy . The Federal Reserve has promulgated capital adequacy regulations for all bank holding companies with assets in excess of $150 million. The Federal Reserve’s capital adequacy regulations are based upon a risk based capital determination, whereby a bank holding company’s capital adequacy is determined in light of the risk, both on- and off-balance sheet, contained in the company’s assets. Different categories of assets are assigned risk weightings and are counted at a percentage of their book value.

The regulations divide capital between Tier 1 capital (core capital) and Tier 2 capital. For a bank holding company, Tier 1 capital consists primarily of common stock, related surplus, noncumulative perpetual preferred stock, minority interests in consolidated subsidiaries and a limited amount of qualifying cumulative preferred securities. Goodwill and certain other intangibles are excluded from Tier 1 capital. Tier 2 capital consists of an amount equal to the allowance for loan and lease losses up to a maximum of 1.25% of risk weighted assets, limited other types of preferred stock not included in Tier 1 capital, hybrid capital instruments and term subordinated debt. Investments in and loans to unconsolidated banking and finance subsidiaries that constitute capital of those subsidiaries are excluded from capital. The sum of Tier 1 and Tier 2 capital constitutes qualifying total capital. The Tier 1 component must comprise at least 50% of qualifying total capital.

Every bank holding company has to achieve and maintain a minimum Tier 1 capital ratio of at least 4.0% and a minimum total capital ratio of at least 8.0%. In addition, banks and bank holding companies are required to maintain a minimum leverage ratio of Tier 1 capital to average total consolidated assets (leverage capital ratio) of at least 3.0% for the most highly-rated, financially sound banks and bank holding companies and a minimum leverage ratio of at least 4.0% for all other banks. The Federal Deposit Insurance Corporation and the Federal Reserve define Tier 1 capital for banks in the same manner for both the leverage ratio and the risk-based capital ratio. However, the Federal Reserve defines Tier 1 capital for bank holding companies in a slightly different manner. As of December 31, 2005, our Tier 1 leverage capital ratio and total capital were 9.66% and 13.30%, respectively.

The guidelines also provide that banking organizations experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory level, without significant reliance on intangible assets. The guidelines also indicate that the Federal Reserve will continue to consider a “Tangible Tier 1 Leverage Ratio” in evaluating proposals for expansion or new activities. The Tangible Tier 1 Leverage Ratio is the ratio of Tier 1 capital, less intangibles not deducted from Tier 1 capital, to quarterly average total assets. As of December 31, 2005, the Federal Reserve had not advised us of any specific minimum Tangible Tier 1 Leverage Ratio applicable to us.

The Company’s trust preferred securities, which are accounted for as debt under generally accepted accounting principles, presently qualify as Tier 1 regulatory capital and are reported in Federal Reserve regulatory reports as

minority interest in our consolidated subsidiaries. The junior subordinated debentures do not qualify as Tier 1 regulatory capital. The Board of Governors of the Federal Reserve, on March 1, 2005, adopted a final rule allowing the continued limited inclusion of trust preferred securities in the Tier 1 capital. The Board’s final rule limits restricted core capital elements to twenty-five percent of all core capital elements.

Source of Strength for Subsidiaries. Bank holding companies are required to serve as a source of financial strength for their depository institution subsidiaries, and, if their depository institution subsidiaries become undercapitalized, bank holding companies may be required to guarantee the subsidiaries’ compliance with capital restoration plans filed with their bank regulators, subject to certain limits.

Dividends . As a bank holding company that does not, as an entity, currently engage in separate business activities of a material nature, our ability to pay cash dividends depends upon the cash dividends we receive from our subsidiary bank. Our only source of income is dividends paid by the Bank. We must pay all of our operating expenses from funds we receive from the Bank. North Carolina banking law requires that dividends be paid out of retained earnings and prohibits the payment of cash dividends if payment of the dividend would cause the Bank’s surplus to be less than 50% of its paid-in capital. Also, under federal banking law, no cash dividend may be paid if the Bank is undercapitalized or insolvent or if payment of the cash dividend would render the bank undercapitalized or insolvent, and no cash dividend may be paid by the Bank if it is in default of any deposit insurance assessment due to the FDIC. Therefore, shareholders may receive dividends from us only to the extent that funds are available from our subsidiary bank. In addition, the Federal Reserve generally prohibits bank holding companies from paying dividends except out of operating earnings, and the prospective rate of earnings retention appears consistent with the bank holding company’s capital needs, asset quality and overall financial condition. Because we are a bank holding company, the Federal Reserve may impose restrictions on our payment of cash dividends since we are required to maintain adequate regulatory capital of our own and are expected to serve as a source of financial strength and to commit resources to our subsidiary bank.

Change of Control. State and federal banking law restrict the amount of voting stock of the company that a person may acquire without the prior approval of banking regulators. The Bank Holding Company Act requires that a bank holding company obtain the approval of the Federal Reserve before it may merge with a bank holding company, acquire a subsidiary bank, acquire substantially all of the assets of any bank, or before it may acquire ownership or control of any voting shares of any bank or bank holding company if, after such acquisition, it would own or control, directly or indirectly, more than 5% of the voting shares of that bank or bank holding company. The overall effect of such laws is to make it more difficult to acquire us by tender offer or similar means than it might be to acquire control of another type of corporation. Consequently, our shareholders may be less likely to benefit from rapid increases in stock prices that often result from tender offers or similar efforts to acquire control of other types of companies.

The Bank

The Bank is subject to various requirements and restrictions under the laws of the United States and the State of North Carolina. As a North Carolina bank, our subsidiary bank is subject to regulation, supervision and regular examination by the North Carolina Banking Commission. As a member of the Federal Reserve, the Bank is subject to regulation, supervision and regular examination by the Federal Reserve. The North Carolina Banking Commission and the Federal Reserve have the power to enforce compliance with applicable banking statutes and regulations. These requirements and restrictions include requirements to maintain reserves against deposits, restrictions on the nature and amount of loans that may be made and the interest that may be charged thereon and restrictions relating to investments and other activities of the Bank.

Transactions with Affiliates . The Bank may not engage in specified transactions (including, for example, loans) with its affiliates unless the terms and conditions of those transactions are substantially the same or at least as favorable to the Bank as those prevailing at the time for comparable transactions with or involving other nonaffiliated entities. In the absence of comparable transactions, any transaction between the Bank and its affiliates must be on terms and under circumstances, including credit standards, which in good faith would be offered or would apply to nonaffiliated companies. In addition, transactions referred to as “covered transactions” between the Bank and its affiliates may not exceed 10% of the Bank’s capital and surplus per affiliate and an aggregate of 20% of its capital and surplus for covered transactions with all affiliates. Certain transactions with affiliates, such as loans, also must be secured by collateral of specific types and amounts. The Bank also is prohibited from purchasing low quality assets from an affiliate. Every company under common control with the Bank, including us and Southern Community Capital Trust II, is deemed to be an affiliate of the Bank.

Loans to Insiders . Federal law also constrains the types and amounts of loans that the Bank may make to its executive officers, directors and principal shareholders. Among other things, these loans are limited in amount, must be approved by the Bank’s board of directors in advance, and must be on terms and conditions as favorable to the Bank as those available to an unrelated person.

Regulation of Lending Activities . Loans made by the Bank are also subject to numerous federal and state laws and regulations, including the Truth-In-Lending Act, Federal Consumer Credit Protection Act, the Equal Credit Opportunity Act, the Real Estate Settlement Procedures Act and adjustable rate mortgage disclosure requirements. Remedies to the borrower or consumer and penalties to the Bank are provided if the Bank fails to comply with these laws and regulations. The scope and requirements of these laws and regulations have expanded significantly in recent years.

Branch Banking . All banks located in North Carolina are authorized to branch statewide. Accordingly, a bank located anywhere in North Carolina has the ability, subject to regulatory approval, to establish branch facilities near any of our facilities and within our market area. If other banks were to establish branch facilities near our facilities, it is uncertain whether these branch facilities would have a material adverse effect on our business.

Federal law provides for nationwide interstate banking and branching, subject to certain aging and deposit concentration limits that may be imposed under applicable state laws. Applicable North Carolina statutes permit regulatory authorities to approve de novo branching in North Carolina by institutions located in states that would permit North Carolina institutions to branch on a de novo basis into those states. Federal regulations prohibit an out-of-state bank from using interstate branching authority primarily for the purpose of deposit production. These regulations include guidelines to insure that interstate branches operated by an out-of-state bank in a host state are reasonably helping to meet the credit needs of the host state communities served by the out-of-state bank.

Reserve Requirements. Pursuant to regulations of the Federal Reserve, the bank must maintain average daily reserves against its transaction accounts. No reserves are required to be maintained on the first $7.0 million of transaction accounts, but reserves equal to 3.0% must be maintained on the aggregate balances of those accounts between $7.0 million and $47.6 million, and additional reserves must be maintained on aggregate balances in excess of $47.6 million in an amount equal to 10.0% of the excess. These percentages are subject to adjustment by the Federal Reserve. Because required reserves must be maintained in the form of vault cash or in a non-interest-bearing account at a Federal Reserve Bank, the effect of the reserve requirement is to reduce the amount of the institution’s interest-earning assets. As of December 31, 2005, the Bank met its reserve requirements.

Community Reinvestment. Under the Community Reinvestment Act (“CRA”), as implemented by regulations of the federal bank regulatory agencies, an insured bank has a continuing and affirmative obligation, consistent with its safe and sound operation, to help meet the credit needs of its entire Community, including low and moderate income neighborhoods. The CRA does not establish specific lending requirements or programs for banks, nor does it limit a bank’s discretion to develop the types of products and services that it believes are best suited to its particular Community, consistent with the CRA. The CRA requires the federal bank regulatory agencies, in connection with their examination of insured banks, to assess the banks’ records of meeting the credit needs of their communities, using the ratings of “outstanding,” “satisfactory,” “needs to improve,” or “substantial noncompliance,” and to take that record into account in its evaluation of certain applications by those banks. All banks are required to make public disclosure of their CRA performance ratings. The Bank received a “satisfactory” rating in its most recent CRA examination.

Governmental Monetary Policies . The commercial banking business is affected not only by general economic conditions but also by the monetary policies of the Federal Reserve. Changes in the discount rate on member bank borrowings, control of borrowings, open market transactions in United States government securities, the imposition of and changes in reserve requirements against member banks and deposits and assets of foreign bank branches, and the imposition of and changes in reserve requirements against certain borrowings by banks and their affiliates are some of the monetary policies available to the Federal Reserve. Those monetary policies influence to a significant extent the overall growth of all bank loans, investments and deposits and the interest rates charged on loans or paid on time and savings deposits in order to mitigate recessionary and inflationary pressures. These techniques are used in varying combinations to influence overall growth and distribution of bank loans, investments, and deposits, and their use may also affect interest rates charged on loans or paid for deposits.

The monetary policies of the Federal Reserve Board 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. In view of changing conditions in the national economy and money markets, as well as the effect of actions by monetary and fiscal authorities, no prediction can be made as to possible future changes in interest rates, deposit levels, loan demand or the business and earnings of the Bank.

Dividends . All dividends paid by the Bank are paid to us, the sole shareholder of the Bank. The general dividend policy of the Bank is to pay dividends at levels consistent with maintaining liquidity and preserving our applicable capital ratios and servicing obligations. The dividend policy of the Bank is subject to the discretion of the board of directors of the Bank and will depend upon such factors as future earnings, growth, financial condition, cash needs, capital adequacy, compliance with applicable statutory and regulatory requirements and general business conditions.

The ability of the Bank to pay dividends is restricted under applicable law and regulations. Under North Carolina banking law, dividends must be paid out of retained earnings and no cash dividends may be paid if payment of the dividend would cause the bank’s surplus to be less than 50% of its paid-in capital. Also, under federal banking law, no cash dividend may be paid if the Bank is undercapitalized or insolvent or if payment of the cash dividend would render the Bank undercapitalized or insolvent, and no cash dividend may be paid by the Bank if it is in default of any deposit insurance assessment due to the Federal Deposit Insurance Corporation.

The exact amount of future dividends paid to us by the Bank will be a function of the profitability of the Bank in general and applicable tax rates in effect from year to year. The Bank’s ability to pay dividends in the future will directly depend on future profitability, which cannot be accurately estimated or assured. We expect that, for the foreseeable future, dividends will be paid by the Bank to us as needed to pay any separate expenses of Southern Community Financial Corporation and/or to make required payments on our debt obligations, including the debentures which fund the interest payments on the preferred securities issued by our trust subsidiary, and to pay cash dividends to our shareholders.

Capital Adequacy . The capital adequacy regulations which apply to state banks, such as the Bank, are similar to the Federal Reserve requirements promulgated with respect to bank holding companies discussed above.

Changes in Management . Any depository institution that has been chartered less than two years, is not in compliance with the minimum capital requirements of its primary federal banking regulator, or is otherwise in a troubled condition must notify its primary federal banking regulator of the proposed addition of any person to the board of directors or the employment of any person as a senior executive officer of the institution at least 30 days before such addition or employment becomes effective. During this 30-day period, the applicable federal banking regulatory agency may disapprove of the addition of such director or employment of such officer. The Bank is not subject to any such requirements.

Enforcement Authority . The federal banking laws also contain civil and criminal penalties available for use by the appropriate regulatory agency against certain “institution-affiliated parties” primarily including management, employees and agents of a financial institution, as well as independent contractors such as attorneys and accountants and others who participate in the conduct of the financial institution’s affairs and who caused or are likely to cause more than minimum financial loss to or a significant adverse affect on the institution, who knowingly or recklessly violate a law or regulation, breach a fiduciary duty or engage in unsafe or unsound practices. These practices can include the failure of an institution to timely file required reports or the submission of inaccurate reports. These laws authorize the appropriate banking agency to issue cease and desist orders that may, among other things, require affirmative action to correct any harm resulting from a violation or practice, including restitution, reimbursement, indemnification or guarantees against loss. A financial institution may also be ordered to restrict its growth, dispose of certain assets or take other action as determined by the primary federal banking agency to be appropriate.

Prompt Corrective Action . Banks are subject to restrictions on their activities depending on their level of capital. Federal “prompt corrective action” regulations divide banks into five different categories, depending on their level of capital. Under these regulations, a bank is deemed to be “well capitalized” if it has a total risk-based capital ratio of 10% or more, a core capital ratio of six percent or more and a leverage ratio of five percent or more, and if the bank is not subject to an order or capital directive to meet and maintain a certain capital level. Under these regulations, a bank is deemed to be “adequately capitalized” if it has a total risk-based capital ratio of eight percent or more, a core capital ratio of four percent or more and a leverage ratio of four percent or more (unless it receives the highest composite rating at its most recent examination and is not experiencing or anticipating significant growth, in which instance it must maintain a leverage ratio of three percent or more). Under these regulations, a

bank is deemed to be “undercapitalized” if it has a total risk-based capital ratio of less than eight percent, a core capital ratio of less than four percent or a leverage ratio of less than three percent. Under these regulations, a bank is deemed to be “significantly undercapitalized” if it has a risk-based capital ratio of less than six percent, a core capital ratio of less than three percent and a leverage ratio of less than three percent. Under such regulations, a bank is deemed to be “critically undercapitalized” if it has a leverage ratio of less than or equal to two percent. In addition, the applicable federal banking agency has the ability to downgrade a bank’s classification (but not to “critically undercapitalized”) based on other considerations even if the bank meets the capital guidelines.

If a state member bank, such as the Bank, is classified as undercapitalized, the bank is required to submit a capital restoration plan to the Federal Reserve. An undercapitalized bank is prohibited from increasing its assets, engaging in a new line of business, acquiring any interest in any company or insured depository institution, or opening or acquiring a new branch office, except under certain circumstances, including the acceptance by the Federal Reserve of a capital restoration plan for the bank.

If a state member bank were classified as undercapitalized, the Federal Reserve may take certain actions to correct the capital position of the bank. If a state member bank is classified as significantly undercapitalized, the Federal Reserve would be required to take one or more prompt corrective actions. These actions would include, among other things, requiring sales of new securities to bolster capital, changes in management, limits on interest rates paid, prohibitions on transactions with affiliates, termination of certain risky activities and restrictions on compensation paid to executive officers. If a bank is classified as critically undercapitalized, the bank must be placed into conservatorship or receivership within 90 days, unless the Federal Deposit Insurance Corporation determines otherwise.

The capital classification of a bank affects the frequency of examinations of the bank and impacts the ability of the bank to engage in certain activities and affects the deposit insurance premiums paid by the bank. The Federal Reserve is required to conduct a full-scope, on-site examination of every member bank on a periodic basis.

Banks also may be restricted in their ability to accept brokered deposits, depending on their capital classification. “Well capitalized” banks are permitted to accept brokered deposits, but all banks that are not well capitalized are not permitted to accept such deposits. The Federal Reserve may, on a case-by-case basis, permit member banks that are adequately capitalized to accept brokered deposits if the Federal Reserve determines that acceptance of such deposits would not constitute an unsafe or unsound banking practice with respect to the bank.

Deposit Insurance. The Bank’s deposits are insured up to $100,000 per insured account by the Bank Insurance Fund of the Federal Deposit Insurance Corporation. The bank’s deposit insurance assessments may increase depending upon the risk category and subcategory to which the bank is assigned. The Federal Deposit Insurance Corporation assesses insurance premiums on a bank’s deposits at a variable rate depending on the probability that the deposit insurance fund will incur a loss with respect to the bank. The Federal Deposit Insurance Corporation determines the deposit insurance assessment rates on the basis of the bank’s capital classification and supervisory evaluations. Each of these categories has three subcategories, resulting in nine assessment risk classifications. The three subcategories with respect to capital are “well capitalized,” “adequately capitalized” and “less than adequately capitalized” (that would include “undercapitalized,” “significantly undercapitalized” and “critically undercapitalized” banks). The three subcategories with respect to supervisory concerns are “healthy,” “supervisory concern” and “substantial supervisory concern.” A bank is deemed “healthy” if it is financially sound with only a few minor weaknesses. A bank is deemed subject to “supervisory concern” if it has weaknesses that, if not corrected, could result in significant deterioration of the bank and increased risk to the Bank Insurance Fund of the Federal Deposit Insurance Corporation. A bank is deemed subject to “substantial supervisory concern” if it poses a substantial probability of loss to the Bank Insurance Fund. Any increase in insurance assessments could have an adverse effect on the bank’s earnings.

Our management cannot predict what other legislation might be enacted or what other regulations might be adopted or the effects thereof.

Item 1A. Risk Factors

An investment in our common stock involves risks. Shareholders should carefully consider the risks described below in conjunction with the other information in this Form 10-K and information incorporated by reference in this Form 10-K , including our consolidated financial statements and related notes. If any of the following risks or other risks which have not been identified or which we may believe are immaterial or unlikely, actually occur, our business, financial condition and results of operations could be harmed. This could cause the price of our stock to decline, and shareholders could lose part or all of their investment. This Form 10-K contains forward-looking statements that involve risks and uncertainties, including statements about our future plans, objectives, intentions and expectations. Many factors, including those described below, could cause actual results to differ materially from those discussed in our forward-looking statements.

Risks Related to Holding Southern Community Common Stock

Our business strategy includes the continuation of significant growth plans, and our financial condition and results of operations could be negatively affected if we fail to grow or fail to manage our growth effectively.

We intend to continue pursuing a significant growth strategy for our business. Our prospects must be considered in light of the risks, expenses and difficulties frequently encountered by companies in significant growth stages of development. We cannot assure you we will be able to expand our market presence in our existing markets or successfully enter new markets or that any such expansion will not adversely affect our results of operations. Failure to manage our growth effectively could have a material adverse effect on our business, future prospects, financial condition or results of operations, and could adversely affect our ability to successfully implement our business strategy. Also, if our growth occurs more slowly than anticipated or declines, our operating results could be materially adversely affected. Our ability to successfully grow will depend on a variety of factors including the continued availability of desirable business opportunities, the competitive responses from other financial institutions in our market areas and our ability to manage our growth.

We may face risks with respect to future expansion.

As a strategy, we have sought to increase the size of our franchise by aggressively pursuing business development opportunities, and we have grown rapidly since our incorporation. We have purchased another financial institution as a part of that strategy. We may acquire other financial institutions or parts of those entities in the future. Acquisitions and mergers involve a number of risks, including:

	•		the time and costs associated with identifying and evaluating potential acquisitions and merger partners;
	•		the accuracy of estimates and judgments used to evaluate credit, operations, management and market risks with respect to the target entity;
	•		the time and costs of evaluating new markets, hiring experienced local management and opening new offices, and the time lags between these activities and the generation of sufficient assets and deposits to support the costs of the expansion;
	•		our ability to finance an acquisition and possible ownership and economic dilution to our current shareholders;
	•		the diversion of our management’s attention to the negotiation of a transaction, and the integration of the operations and personnel of the combining businesses;
	•		entry into new markets where we lack experience;
	•		the introduction of new products and services into our business;
	•		the incurrence and possible impairment of goodwill associated with an acquisition and possible adverse short-term effects on our results of operations; and
	•		the risk of loss of key employees and customers.

We may incur substantial costs to expand, and we can give no assurance such expansion will result in the levels of profits we seek. There can be no assurance integration efforts for any future mergers or acquisitions will be successful. Also, we may issue equity securities, including common stock, and securities convertible into shares of

our common stock in connection with future acquisitions, which could cause ownership and economic dilution to our current shareholders and to investors purchasing common stock in this offering. There is no assurance that, following any future mergers or acquisition, our integration efforts will be successful or our company, after giving effect to the acquisition, will achieve profits comparable to or better than our historical experience.

If the value of real estate in our core market areas were to decline materially, a significant portion of our loan portfolio could become under-collateralized, which could have a material adverse effect on us.

With most of our loans concentrated in the Piedmont Triad region of North Carolina, a decline in local economic conditions could adversely affect the values of our real estate collateral. Consequently, a decline in local economic conditions may have a greater effect on our earnings and capital than on the earnings and capital of larger financial institutions whose real estate loan portfolios are geographically diverse. In addition to the financial strength and cash flow characteristics of the borrower in each case, the Bank often secure loans with real estate collateral. At December 31, 2005, approximately 75% of the Bank’s loans had real estate as a primary or secondary component of collateral. The real estate collateral in each case provides an alternate source of repayment in the event of default by the borrower and may deteriorate in value during the time the credit is extended. If we are required to liquidate the collateral securing a loan to satisfy the debt during a period of reduced real estate values, our earnings and capital could be adversely affected.

Interest rate volatility could significantly harm our business.

Southern Community’s results of operations are affected by the monetary and fiscal policies of the federal government and the regulatory policies of governmental authorities. A significant component of Southern Community’s earnings is the net interest income of its subsidiary, Southern Community Bank and Trust. Net interest income is the difference between income from interest-earning assets, such as loans, and the expense of interest-bearing liabilities, such as deposits. We may not be able to effectively manage changes in what we charge as interest on our earning assets and the expense we must pay on interest-bearing liabilities, which may significantly reduce our earnings. The Federal Reserve has made significant changes in interest rates during the last few years. Since rates charged on loans often tend to react to market conditions faster than do rates paid on deposit accounts, these rate changes may have a negative impact on our earnings until we can make appropriate adjustments in our deposit rates. In addition, there are costs associated with our risk management techniques, and these costs could be material. Fluctuations in interest rates are not predictable or controllable and, therefore, there can be no assurances of our ability to continue to maintain a consistent positive spread between the interest earned on our earning assets and the interest paid on our interest-bearing liabilities.

Southern Community may have higher loan losses than it has allowed for.

Southern Community’s loan losses could exceed the allowance for loan losses it has set aside. Southern Community’s average loan size continues to increase and reliance on historic allowances for loan losses may not be adequate. Approximately 69% of our loan portfolio is composed of construction, commercial mortgage and commercial loans. Repayment of such loans is generally considered more subject to market risk than residential mortgage loans. Industry experience shows that a portion of loans will become delinquent and a portion of the loans will require partial or entire charge-off. Regardless of the underwriting criteria Southern Community utilizes, losses may be experienced as a result of various factors beyond its control, including, among other things, changes in market conditions affecting the value of its loan collateral and problems affecting the credit of its borrowers.

The building of market share through our de novo branching strategy could cause our expenses to increase faster than our revenues.

We intend to continue to build market share through our de novo branching strategy. We have regulatory approval to open two new branches, which we intend to do during 2006. There are considerable costs involved in opening branches. New branches generally do not generate sufficient revenues to offset their costs until they have been in operation for at least a year or more. Accordingly, our new branches can be expected to negatively impact our earnings for some period of time until the branches reach certain economies of scale. Our expenses could be further increased if we encounter delays in the opening of any of our new branches. Finally, we have no assurance our new branches will be successful even after they have been established.

If Southern Community loses key employees with significant business contacts in its market area, its business may suffer.

Southern Community’s success is dependent on the personal contacts of its officers and employees in its market area. If Southern Community lost key employees temporarily or permanently, its business could be hurt. Southern Community could be particularly hurt if its key employees went to work for competitors. Southern Community’s future success depends on the continued contributions of its existing senior management personnel, particularly on the efforts of F. Scott Bauer and Jeff T. Clark, each of whom has significant local experience and contacts in its market area.

Government regulations may prevent or impair our ability to pay dividends, engage in acquisitions, or operate in other ways.

Current and future legislation and the policies established by federal and state regulatory authorities will affect Southern Community’s operations. Southern Community is subject to supervision and periodic examination by the Federal Reserve Board and the North Carolina Commissioner of Banks. Southern Community’s principal subsidiary, Southern Community Bank and Trust, as a state chartered commercial bank, also receives regulatory scrutiny from the North Carolina Commissioner of Banks and the Federal Reserve Board. Banking regulations, designed primarily for the protection of depositors, may limit our growth and the return to you as an investor in Southern Community, by restricting its activities, such as:

	•		the payment of dividends to shareholders;
	•		possible transactions with or acquisitions by other institutions;
	•		desired investments;
	•		loans and interest rates;
	•		interest rates paid on deposits; and
	•		the possible expansion of branch offices.

Southern Community has elected to be regulated as a financial holding company to expand its opportunities to provide additional services, but it will have to comply with other federal laws and regulations and could face enforcement actions by regulatory agencies. Southern Community cannot predict what changes, if any, will be made to existing federal and state legislation and regulations or the effect that such changes may have on its business. The cost of compliance with regulatory requirements may adversely affect Southern Community’s ability to operate profitably.

Our trading volume has been low compared with larger bank holding companies and the sale of substantial amounts of our common stock in the public market could depress the price of our common stock.

The average daily trading volume of our shares on The Nasdaq National Market for the three months ended February 15, 2006 was approximately 15,300 shares. Lightly traded stock can be more volatile than stock trading in an active public market like that for the larger bank holding companies. We cannot predict the extent to which an active public market for our common stock will develop or be sustained. In recent years, the stock market has experienced a high level of price and volume volatility, and market prices for the stock of many companies have experienced wide price fluctuations that have not necessarily been related to their operating performance. Therefore, our shareholders may not be able to sell their shares at the volumes, prices, or times that they desire. We cannot predict the effect, if any, that future sales of our common stock in the market, or availability of shares of our common stock for sale in the market, will have on the market price of our common stock. We therefore can give no assurance that sales of substantial amounts of our common stock in the market, or the potential for large amounts of sales in the market, would not cause the price of our common stock to decline or impair our ability to raise capital through sales of our common stock.

Southern Community faces strong competition in its market area, which may limit its asset growth and profitability.

The banking business in Southern Community’s primary market area, which is currently concentrated in the Piedmont Triad area and surrounding areas in central North Carolina, is very competitive, and the level of competition facing it may increase further, which may limit its asset growth and profitability. Southern Community experiences competition in both lending and attracting funds from other banks and nonbank financial institutions

located within our market area, some of which are significantly larger, well-established institutions. Nonbank competitors for deposits and deposit-type accounts include savings associations, credit unions, securities firms, money market funds, life insurance companies and the mutual funds industry. For loans, Southern Community encounters competition from other banks, savings associations, finance companies, mortgage bankers and brokers, insurance companies, small loan and credit card companies, credit unions, pension trusts and securities firms. We may face a competitive disadvantage as a result of our smaller size, lack of multi-state geographic diversification and inability to spread our marketing costs across a broader market.

Southern Community’s Articles of Incorporation include anti-takeover provisions that may prevent shareholders from receiving a premium for their shares or effecting a transaction favored by a majority of shareholders.

Southern Community’s Articles of Incorporation include certain anti-takeover provisions, such as being subject to the Shareholder Protection Act and Control Share Acquisition Act under North Carolina law and a provision allowing our Board of Directors to consider the social and economic effects of a proposed merger, which may have the effect of preventing shareholders from receiving a premium for their shares of common stock and discouraging a change of control of Southern Community by allowing minority shareholders to prevent a transaction favored by a majority of the shareholders. The primary purpose of these provisions is to encourage negotiations with our management by persons interested in acquiring control of our corporation. These provisions may also tend to perpetuate present management and make it difficult for shareholders owning less than a majority of the shares to be able to elect even a single director.

Holders of our trust preferred securities have rights that are senior to those of our common shareholders.

We have supported our continued growth through the issuance of trust preferred securities from special purpose trusts and accompanying junior subordinated debentures. At December 31, 2005, we had outstanding trust preferred securities and accompanying junior subordinated debentures totaling $34.5 million. Payments of the principal and interest on the trust preferred securities of this special purpose trust are conditionally guaranteed by us. Further, the accompanying junior subordinated debentures we issued to the special purpose trust are senior to our shares of common stock. As a result, we must make payments on the junior subordinated debentures before any dividends can be paid on our common stock and, in the event of our bankruptcy, dissolution or liquidation, the holders of the junior subordinated debentures must be satisfied before any distributions can be made on our common stock. We have the right to defer distributions on our junior subordinated debentures (and the related trust preferred securities) for up to five years, during which time no dividends may be paid on our common stock.

The common stock of Southern Community Financial Corporation is not FDIC insured.

The common stock of Southern Community is not a savings or deposit account or other obligation of any bank and is not insured by the Federal Deposit Insurance Corporation, the Bank Insurance Fund or any other governmental agency and is subject to investment risk, including the possible loss of principal.

Risks Related to an Investment in the Preferred Securities

If we do not make interest payments under the debentures, the trust will be unable to pay distributions and liquidation amounts. The guarantee would not apply because the guarantee covers payments only if the trust has funds available.

The trust will depend solely on our payments on the debentures to pay amounts due to holders of the preferred securities on the debentures. Without these payments, the trust will not have sufficient funds to pay distributions or the liquidation amount on the preferred securities. In that case, holders of the preferred securities will not be able to rely on the guarantee for payment of these amounts because the guarantee only applies if the trust has sufficient funds to make distributions or to pay the liquidation amount. Instead, holders of the preferred securities or the property trustee will have to institute a direct action against us to enforce the property trustee’s rights under the indenture relating to the debentures.

We must rely on dividends from our bank subsidiary to make interest payments on the debentures to the trust.

Our ability to make payments on the debentures when due will depend primarily on dividends from our bank subsidiary because we are a holding company and substantially all of our assets are held by our bank subsidiary.

The ability of our bank subsidiary to pay dividends is subject to legal restrictions and the Bank’s profitability, financial condition, capital expenditures and other cash flow requirements. We may also borrow additional funds, issue debt instruments, issue and sell shares of preferred stock, or engage in other types of financing activities, in order to increase our capital. Covenants contained in loan or financing agreements or other debt instruments could restrict or condition our payment of cash dividends based on various financial considerations or factors.

Regulatory authorities may limit dividends paid to us and thereby our ability to make interest payments on the debentures to the trust.

We cannot assure holders of the preferred securities that our bank subsidiary will be able to pay dividends in the future due to regulatory restrictions or that our regulators will not attempt to preclude us from making interest payments on the subordinated debentures. North Carolina banking law requires that cash dividends be paid by a bank only out of retained earnings and prohibits the payment of cash dividends if payment of the dividend would cause the bank’s surplus to be less than 50% of its paid-in capital. We may also be precluded from making interest payments on the subordinated debentures by our regulators in order to address any perceived deficiencies in liquidity or regulatory capital levels at the holding company level. Such regulatory action would require us to obtain consent from our regulators prior to paying dividends on our common stock or interest on the subordinated debentures. In the event our regulators withheld their consent to our payment of interest on the subordinated debentures, we would exercise our right to defer interest payments on the subordinated debentures, and the trust would not have funds available to make distributions on the preferred securities during such period.

Our obligation to make interest payments to the trust on the debentures is subordinated to existing liabilities or additional debt we may incur.

Our obligations under the debentures and the guarantee are unsecured and will rank junior in priority of payment to our existing liabilities and any future senior and subordinated indebtedness and will rank equally with our existing convertible trust preferred securities. We had no senior or subordinated indebtedness at December 31, 2005. However, our issuance of the debentures and the preferred securities does not limit our ability or the ability of our subsidiaries to incur additional indebtedness, guarantees or other liabilities. Also, because we are a holding company, the creditors of our bank subsidiary, including depositors, also will have priority over holders of the preferred securities in any distribution of our subsidiaries’ assets in liquidation, reorganization or otherwise. Accordingly, the debentures and the guarantee will be effectively subordinated to all existing and future liabilities of our subsidiaries, and holders of the preferred securities should look only to our assets for payments on the preferred securities and the debentures.

We have the option to defer interest payments on the debentures for substantial periods.

As long as we are not in default under the indenture relating to the debentures, we may, at one or more times, defer interest payments on the debentures for up to 20 consecutive quarters. If we defer interest payments on the debentures, the trust will defer distributions on the preferred securities during any deferral period. If we elect to defer payments on the debentures for our convertible trust preferred securities, we must also defer payments on the debentures for the preferred securities in this offering and vice versa.

If we defer interest payments, holders of the preferred securities will still be required to recognize the deferred interest amounts as income.

During a deferral period, holders of the preferred securities will be required to recognize as income for federal income tax purposes the amount approximately equal to the interest that accrues on your proportionate share of the debentures, held by the trust in the tax year in which that interest accrues, even though holders of the preferred securities will not receive these amounts until a later date if they hold the preferred securities until the deferred interest is paid.

If holders of the preferred securities sell their preferred securities during a deferral period, they will forfeit the deferred interest amount and only have a capital loss.

Holders of the preferred securities will not receive the cash related to any accrued and unpaid interest from the trust if they sell the preferred securities before the end of any deferral period. During a deferral period, accrued but unpaid distributions will increase their tax basis in the preferred securities. If holders of the preferred securities sell the preferred securities during a deferral period, their increased tax basis will decrease the amount of any capital

gain or increase the amount of any capital loss that they may have otherwise realized on the sale. A capital loss, except in certain limited circumstances, cannot be applied to offset ordinary income. As a result, deferral of distributions could result in ordinary income, and a related tax liability for the holder, and a capital loss that may only be used to offset a capital gain.

Deferrals of interest payments may increase the volatility of the market price of the preferred securities.

If we defer interest payments, the market price of the preferred securities would likely be adversely affected. The preferred securities may trade at a price that does not fully reflect the value of accrued but unpaid interest on the debentures. If holders of the preferred securities sell the preferred securities during a deferral period, they may not receive the same return on investment as someone who continues to hold the preferred securities. Because of our right to defer interest payments, the market price of the preferred securities may be more volatile than the market prices of other securities without a deferral feature.

There are no financial covenants in the indenture and the trust agreement.

The indenture governing the debentures and the trust agreement governing the trust do not require us to maintain any financial ratios or specified levels of net worth, revenues, income, cash flow or liquidity. The instruments do not protect holders of the debentures or the preferred securities in the event we experience significant adverse changes in our financial condition or results of operations. In addition, neither the indenture nor the trust agreement limit our ability or the ability of any subsidiary to incur additional indebtedness. Therefore, holders of the preferred securities should not consider the provisions of these governing instruments as a significant factor in evaluating whether we will be able to comply with our obligations under the debentures or the guarantee.

We may redeem some or all of the debentures at any time after December 31, 2008 and reduce the period during which holders of the preferred securities will receive distributions.

We have the option to redeem any or all of the outstanding debentures after December 31, 2008 without the payment of any premium. Upon early redemption, holders of the preferred securities may be required to reinvest their principal at a time when they may not be able to earn a return that is as high as they were earning on the preferred securities.

We may redeem all of the debentures at any time upon the occurrence of certain events.

We may redeem all of the debentures before their stated maturity without payment of premium within 90 days after certain occurrences at any time during the life of the trust. These occurrences include adverse tax, investment company or bank regulatory developments. Upon early redemption, holders of the preferred securities may be required to reinvest their principal at a time when they may not be able to earn a return that is as high as they were earning on the preferred securities.

We can distribute the debentures to holders of the preferred securities, which may have adverse tax consequences for holders of the preferred securities and could also adversely affect the market price of the preferred securities.

The trustees may dissolve the trust before maturity of the debentures and distribute the debentures to holders of the preferred securities under the terms of the trust agreement. Under current interpretations of United States federal income tax laws supporting classification of the trust as a grantor trust for tax purposes, a distribution of the debentures to holders of the preferred securities upon the dissolution of the trust would not be a taxable event. Nevertheless, if the trust is classified for United States income tax purposes as an association taxable as a corporation at the time it is dissolved, the distribution of the debentures would be a taxable event to holders of the preferred securities. In addition, if there is a change in law, a distribution of the debentures upon the dissolution of the trust could be a taxable event to holders of the preferred securities. Also, the debentures that holders of the preferred securities may receive if the trust is liquidated may trade at a discount to the price that was paid to purchase the preferred securities.

Holders of the preferred securities must rely on the property trustee to enforce their rights if there is an event of default under the indenture.

Holders of the preferred securities may not be able to directly enforce their rights against us under the indenture if an event of default occurs. If an event of default occurs under the indenture, holders of the preferred securities must

rely on the enforcement by the property trustee of its rights as holder of the debentures against us. The holders of a majority in liquidation amount of the preferred securities will have the right to direct the property trustee to enforce its rights. If the property trustee does not enforce its rights following an event of default and there is no request by the record holders of the debentures to do so, any record holder may, to the extent permitted by applicable law, take action directly against us to enforce the property trustee’s rights. If an event of default occurs that is attributable to our failure to pay interest or principal on the debentures, or if we default under the guarantee, holders of the preferred securities may proceed directly against us. Holders of the preferred securities will not be able to exercise directly any other remedies available to the holders of the debentures, unless the property trustee fails to do so.

Holders of preferred securities have limited voting rights to replace the property trustee and the Delaware trustee.

Holders of preferred securities only have voting rights that pertain primarily to certain amendments to the trust agreement. In general, only we can replace or remove any of the trustees. The holders of at least a majority in aggregate liquidation amount of the preferred securities may replace the property trustee and the Delaware trustee only if an event of default under the trust agreement occurs and is continuing.

The subordinated debentures and the preferred securities do not represent deposit accounts and are not insured.

The subordinated debentures and the preferred securities do not represent bank deposit accounts and they are not obligations issued or guaranteed by the Federal Deposit Insurance Corporation or by any other governmental agency.

Item 1B. Unresolved Staff Comments

None

Item 2. Properties

As of December 31, 2005 we operated out of nineteen banking offices, four operations/administrative offices, five lending offices and an investment advisory office. All banking offices have ATMs. A summary of our offices is as follows:

(1) Acquired as part of The Community Bank acquisition.

In addition to the above locations, we have four off site ATMs located at 3484 Robinhood Road, and 401 Deacon Boulevard in Winston-Salem, 1466 River Ridge Road in Clemmons and at 4575 Yadkinville Road, Pfafftown, North Carolina, and approximately 100 outsourced ATM cash dispensing machines throughout North Carolina.

All of our properties, including land, buildings and improvements, furniture, equipment and vehicles, had a net book value at December 31, 2005 of $31.3 million. See further information presented in Note 7 to our consolidated financial statements, which are presented under Item 8 in this Form 10-K .

Additional banking offices may be opened at later dates if deemed appropriate by the Board of Directors and if regulatory approval can then be obtained. The company may acquire property in which a director, directly or indirectly, has an interest. In such event, the acquisition of such facilities shall be approved by a majority of the Board of Directors, excluding any individual who may have such an interest in the property.

Item 3. Legal

We are party to legal proceedings arising in the normal conduct of business. Our management believes that this litigation is not material to our financial position or results of our operations or the operations of the Bank.

Item 4. Submission of Matters to a Vote of Security Holders

There were no matters submitted to a vote of our security holders during the fourth quarter of our fiscal year ended December 31, 2005.

Holders of our common stock will be entitled to receive any cash dividends the Board of Directors may declare. The declaration and payment of future dividends to holders of our common stock will be at the discretion of our Board of Directors and will depend upon our earnings and financial condition, regulatory conditions and considerations and such other factors as our Board of Directors may deem relevant. As a holding company, Southern Community Financial Corporation is ultimately dependent upon its bank subsidiary to provide funding for its operating expenses, debt service (including the interest payments on the preferred securities issued by our remaining trust subsidiary), and dividends. Our primary sources of income are dividends paid by the Bank and interest income on loans and deposits with the bank subsidiary. We must pay all of our operating expenses from funds we receive from the Bank. Various banking laws applicable to our bank subsidiary limit the payment of dividends, management fees and other distributions by the Bank to us and may therefore limit our ability to make dividend payments. Under North Carolina banking law, dividends must be paid out of retained earnings and no cash dividends may be paid if payment of the dividend would cause the Bank’s surplus to be less than 50% of its paid-in capital. Under federal banking law, no cash dividend may be paid if the Bank is undercapitalized or insolvent or if payment of the cash dividend would render the Bank undercapitalized or insolvent, or if it is in default of any deposit insurance assessment due to the Federal Deposit Insurance Corporation.

In the future, any declaration and payment of cash dividends will be subject to the Board of Directors’ evaluation of the Company’s operating results, financial condition, future growth plans, general business and economic conditions, and tax and other relevant considerations. There is no assurance that, in the future, the Company will have funds available to pay cash dividends, or, even if funds are available, that it will pay dividends in any particular amount or at any particular times, or that it will pay dividends at all.

Share Repurchases

On March 29, 2005, the Company announced a plan to repurchase up to 300,000 shares of its common stock. On September 23, 2005, the Company announced a plan to repurchase up to 600,000 additional shares of its common stock. The table below sets forth information with respect to shares of common stock repurchased by the Company during the three months ended December 31, 2005.

determinations. In addition, because future events affecting borrowers and collateral cannot be predicted with certainty, there can be no assurance that the existing allowance for loan losses is adequate or that increases will not be necessary should the quality of any loans deteriorate as a result of the factors discussed herein. Any material increase in the allowance for loan losses may adversely affect our financial condition and results of operations. For further discussion, see “Nonperforming Assets” and “Analysis of Allowance for Loan Losses” under “ASSET QUALITY.”

OVERVIEW

Our founders recognized an opportunity to fulfill the financial service needs of individuals and organizations left underserved by consolidation within the financial services industry. To fill a part of this void, we began in 1995 the process by which Southern Community Financial Corporation was created, and began operations on November 18, 1996. From inception, we have strived to serve the financial needs of small to medium-sized businesses, individuals, residential homebuilders and others in and around the Piedmont Triad area of North Carolina. We offer a broad array of banking and other financial products — products similar to those offered by our larger competitors, but with an emphasis on superior customer service. We believe that our emphasis on quality customer service is the single most important factor among many that have fueled our growth to $1.3 billion in total assets in just over nine years of operations.

We began operations in November 1996 with $11 million in capital, a single branch facility and thirteen employees. Through December 31, 2005, Southern Community Financial Corporation has grown to a total of nineteen full-service banking offices with $941 million in customer deposit accounts. In support of this growth, we have generated additional capital through issuing common stock and retaining operating earnings. At December 31, 2005, we have $135 million of total stockholders’ equity. Through our banking subsidiary we offer traditional banking products as well as a full array of financial services. In October of 2001, we formed Southern Community Financial Corporation, a financial holding company, to become the parent company of Southern Community Bank and Trust. On January 12, 2004 the Company acquired The Community Bank, a $240 million asset community bank with 10 banking offices in contiguous markets. We created Southern Community Advisors, our wealth management division, and have developed and acquired mortgage banking operations. While these operations are currently not significant to our results of operations, we intend to pursue growth in these businesses to enhance our non-interest income. In December 2005, the Bank opened a regional banking office in Greensboro, North Carolina, we began construction of a banking office in Mooresville, a rapidly growing community of the Charlotte region, and announced the opening of a banking office in Raleigh. In addition, during 2005 the Bank expanded its ATM network into eight new counties in North Carolina.

Real estate secured loans, including construction loans and loans secured by existing commercial and residential properties, comprise the majority of our loan portfolio, with the balance of our loans consisting of commercial and industrial loans and loans to individuals. Through associations with various mortgage lending companies, we originate residential mortgages, at both fixed and variable rates, earning fees for loans originated and additional income for loans sold to others. It has been our strategy to recruit skilled banking professionals who are well trained and highly knowledgeable about our market area, enabling us to develop and maintain a loan portfolio of sound credit quality.

We recognize that our growth may expose us to increased operational and market risk, primarily with respect to managing overhead, funding costs and credit quality. We have developed critical functions such as Credit Administration, Training, Audit, and Compliance to assist in managing and monitoring these and other risks. We are committed to creating and maintaining a solid and diversified financial services organization with a focus on customer service. It is our firm belief that this foundation will continue building our loyal customer base while attracting new clients and providing opportunities for future growth. As bank consolidations continue to take place in our markets, Southern Community Financial Corporation is positioned to continue to benefit from their effects.

The Company completed the acquisition of The Community Bank in the first quarter of 2004. This transaction provided much of the Company’s growth in 2004. Additionally, in the first quarter of 2004 the Company redeemed all of the $17 million outstanding 7.25% Cumulative Convertible Trust Preferred Securities issued through Southern Community Capital Trust I through the issuance of 2,060,000 shares of common stock and the retirement of $61 thousand of the convertible trust preferred securities.

Financial Condition at December 31, 2005 and 2004

During the year ended December 31, 2005, our total assets increased by $63.2 million, or 5.2%, to $1.3 billion. Of the increase in total assets, $52.3 million represented growth in interest-earning assets. Continued strong loan demand resulted in an increase of $72.7 million, or 9.1%, in total loans receivable. Total deposits grew to $940.6 million at December 31, 2005, an increase of $95.4 million or 11.3% from the year ago period. Premises and equipment increased by $2.9 million net of depreciation, principally as a result of expanding our banking office network into Greensboro and Mooresville, NC.

Our total loan growth of $72.7 million in 2005 was concentrated in construction and commercial and industrial loans, which increased by $54.6 million and $24.5 million, respectively. Portfolios secured by residential real estate increased by $5.7 million during the year. These increases in loans were slightly offset by declines in commercial mortgage and consumer loans of $8.5 million and $3.7 million, respectively. During 2005 we continued our active program of originating residential mortgage loans for sale. At the end of the year mortgage loans held for sale totaled $1.3 million.

Our total liquid assets, defined as cash and due from banks, federal funds sold and other interest-bearing deposits, and investment securities, decreased by $13.6 million during the year, to $317.2 million at December 31, 2005, due primarily to the sale of $11.7 million of government agency securities in the fourth quarter. Liquid assets represented 24.7% of total assets at December 31, 2005 as compared to 27.1% at the beginning of the year. While we have reduced the size of our investment portfolio in response to the current and expected near-term interest rate environment, we believe our liquidity is adequate to fund expected loan demand and current deposit and borrowing maturities.

Customer deposits continue to be our primary funding source. At December 31, 2005, deposits totaled $940.6 million, an increase of $95.4 million or 11.3% from year-end 2004. While our deposits are primarily generated through our growing branch network, we do utilize out-of-market and brokered deposits as a funding source. Brokered and out-of-market deposits totaled $215.7 million and $195.3 million at year-end 2005 and 2004, respectively. Our emphasis on growing our deposit base in 2005 allowed us to reduce our reliance on other borrowings to fund growth, and we were able to decrease our other borrowings by $31.4 million in 2005. We intend to continue our focus on growing our deposit base; however, we will continue to monitor the costs of our various funding alternatives, and our funding mix may change from time to time.

Total borrowings aggregated $201.7 million at December 31, 2005, and included $157.5 million of advances from the Federal Home Loan Bank of Atlanta (FHLB), trust preferred securities with a carrying value of $35.0 million, federal funds purchased of $4.0 million and securities sold under agreements to repurchase of $5.2 million. We will use FHLB advances and other funding sources as necessary to support balance sheet management and growth. However, we believe that as our branch network grows and matures, the volume of core deposits will become an increasingly larger portion of our funding mix, which over time should contribute to a reduction in our overall funding cost.

Our capital position remains strong, with all of our regulatory capital ratios at levels that make us “well capitalized” under federal bank regulatory capital guidelines. At December 31, 2005, our stockholders’ equity totaled $135.4 million, a decrease of $1.5 million from the December 31, 2004 balance. This net change includes $8.2 million of net income and $1.5 million of proceeds from shares purchased through stock option and stock purchase plans, offset by shares repurchased at a cost of $4.3 million, cash dividends paid of $3.7 million, and a $3.2 million decrease in accumulated other comprehensive income due primarily to unrealized losses on available for sale investment securities.

NET INTEREST INCOME

Like most financial institutions, the primary component of our earnings is net interest income. Net interest income is the difference between interest income, principally from loans and investments, and interest expense, principally on customer deposits and borrowings. Changes in net interest income result from changes in volume and changes in interest rates earned and paid. By volume, we mean the average dollar level of interest-earning assets and interest-bearing liabilities. Spread refers to the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities, and margin refers to net interest income divided by average interest-earning assets.

Spread and margin are influenced by the levels and relative mix of interest-earning assets and interest-bearing liabilities, as well as by levels of noninterest-bearing liabilities. During the years ended December 31, 2005, 2004 and 2003, our average interest-earning assets were $1.2 billion, $1.1 billion, and $655.3 million, respectively. During these same years, our net interest margins were 3.21%, 3.31%, and 3.25%, respectively.

During 2005, the Federal Reserve increased the targeted federal funds rate eight times, and the prime rate correspondingly increased 200 basis points during the year to 7.25%. While it is management’s goal to remain relatively interest rate neutral, the institution is slightly asset sensitive and benefits somewhat from a rising rate environment. However, as our investment portfolio yields did not increase as rapidly as our loan yields or costs of funds, we experienced net margin compression during the first three quarters of 2005. As a result of our emphasis on growing deposits and a relatively minor repositioning of our investment portfolio, our margin expanded in the fourth quarter of 2005. Primarily as a result of our growth in interest-earning assets from strong loan demand, our net interest income increased in 2005 by $2.1 million, or 6.1%.

Average Balances and Average Rates Earned and Paid. The following table sets forth, for the years 2003 through 2005, information with regard to average balances of assets and liabilities, as well as the total dollar amounts of interest income from interest-earning assets and interest expense on interest-bearing liabilities, resultant yields or costs, net interest income, net interest spread, net interest margin and ratio of average interest-earning assets to average interest-bearing liabilities. Average loans include nonaccruing loans, the effect of which is to lower the average yield.

RATE/VOLUME ANALYSIS

The following table analyzes the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities. The table distinguishes between (i) changes attributable to volume (changes in volume multiplied by the prior period’s rate), (ii) changes attributable to rate (changes in rate multiplied by the prior period’s volume), and (iii) net change (the sum of the previous columns). The change attributable to both rate and volume (changes in rate multiplied by changes in volume) has been allocated equally to both the changes attributable to volume and the changes attributable to rate.

professional services costs associated with the corporate governance and internal control requirements of the Sarbanes-Oxley Act of 2002. The Company has undertaken initiatives in slowing the growth of non-interest expenses; however, non-interest expenses will be impacted in 2006 by increased occupancy and personnel costs from branch expansion in Greensboro, Raleigh and Mooresville, and a new operations facility to be acquired in the first half of the year.

Net Interest Income. During 2005, our net interest income increased by $2.1 million or 6.1% to $37.1 million. Our growth in interest income was the result of growth in our overall level of average earning assets from strong loan demand. Average total interest-earning assets increased $99.5 million, or 9.4% during 2005. Our average total interest-bearing liabilities increased by $86.6 million, or 9.2%. The rates earned on a significant portion (over 60%) of our loans adjust immediately when index rates such as our prime rate changes. Conversely, a slight majority of our interest-bearing liabilities, including certificates of deposit and certain borrowings, have rates that are fixed until maturity. As a result, interest rate increases generally result in an immediate increase in our interest income on loans. While increases in interest expense on fixed rate certificates of deposit and borrowings are delayed until renewal, our floating rate borrowings are primarily LIBOR-based, and increases in LIBOR rates typically are in advance of the prime rate in a rising rate environment.

The rising interest rate environment in 2005 resulted in yields on our loan portfolio increasing by 90 basis points, similar to the increase in our funding costs of 92 basis points. However, as the investment portfolio is largely fixed income securities, the yield on our investment portfolio increased only 5 basis points for the year. As a result, we experienced a compression of our net interest margin of 10 basis points compared to 2004, to 3.21%.

During the second half of 2005, we launched initiatives focused on increasing our core deposit base with the goal of improving our funding mix. During the fourth quarter of 2005, we sold $11.7 million of lower-yielding investments at a loss of $322 thousand, which we have used to fund loan growth. As a result, in the fourth quarter of 2005 we achieved expansion of our net interest margin of 10 basis points, compared with the third quarter of 2005. We will continue to evaluate ways to improve our net interest margin; however, these efforts may be impacted by changes in interest rates, competition, and other factors, and there can be no assurances that our margins will continue to expand.

Provision for Loan Losses. We recorded a $950 thousand provision for loan loss for the year ended December 31, 2005, representing a decrease of $1.3 million from the $2.2 million provision we made for the year ended December 31, 2004. The level of provisions for 2005 is reflective of the trends in the loan portfolio, including loan growth, levels of non-performing loans and other loan portfolio quality measures, and analyses of impaired loans. In the second half of 2005, the provision was reduced due to the successful resolution of two relationships for which specific reserves had been established, and repayment of or improvement in higher risk-rated credits. Provisions for loan losses are charged to income to bring our allowance for loan losses to a level deemed appropriate by management based on the factors discussed under “Analysis of Allowance for Loan Losses.” The dollar amount of provisions decreased on a year-over-year basis and the level of the allowance to period-ending loans decreased 21 basis points from the prior year-end to 1.36%. In addition to loan growth affecting our provision for loan losses, net loan charge-offs, which declined 15% to $1.2 million for 2005 from $1.4 million for 2004, also impacted the provision expense. On an annualized basis, our percentage of net loan charge-offs to average loans outstanding was .14% for the year ended December 31, 2005, compared with .19% for the year ended December 31, 2004. The reduction in the charge-offs were principally from our consumer finance lending portfolio, which accounted for $233 thousand or 19% of net charge-offs, a decrease of $455 thousand from the prior year. In 2003, management decided the consumer finance business was no longer part of the Company’s strategic direction, and during the fourth quarter of 2003 ceased originating new consumer finance loans. The residual consumer finance loan portfolio is expected to run off over the next twenty-four months. Nonperforming loans totaled $1.4 million or .16% of total loans at December 31, 2005, compared with $2.2 million or .27% of total loans at December 31, 2004. The allowance for loan losses at December 31, 2005 of $11.8 million represents 1.36% of total loans and 837% of nonperforming loans. The allowance for loan losses at December 31, 2004 of $12.5 million was 1.57% of total loans outstanding and 577% of nonperforming loans at that date.

Non-Interest Income. For the year ended December 31, 2005, non-interest income increased $392 thousand, or 5.3%, to $7.8 million from $7.4 million for the prior year. Growth in non-interest income during 2005 resulted principally from continued strength in deposit and other retail banking fees. In addition, during the fourth quarter non-interest income was impacted positively from gains of $660 thousand from the Company’s investment in Salem Capital Partners, the Company’s affiliated Small Business Investment Company, offset somewhat by the $322 thousand loss on sales of

investment securities. Income from investment brokerage fees increased from the prior year by $31 thousand, or 4.4%, to $743 thousand. Fees on the origination of residential mortgage loans sold into the secondary market increased $356 thousand to $1.1 million. In addition, service charges and fees associated with deposit accounts increased $253 thousand to $3.7 million.

We expect a continued positive trend in service charge fee income in the future as we continue to expand our branch network and deposit base. We continue to invest in experienced personnel to support our mortgage and investment areas. While we anticipate some variations in the performance of these business lines due primarily to external market conditions, we believe these investments provide us with an infrastructure that will support us with a solid base of revenue in the future. In addition, as Salem Capital Partners’ portfolio matures, we anticipate some fluctuation in our non-interest income as gains and losses on their investments are recognized.

Non-Interest Expense . We strive to maintain non-interest expenses at levels that we believe are appropriate given the nature of our operations and the investments in personnel and facilities that have been necessary to support our growth. From 1998 forward, we have consistently maintained our ratio of non-interest expenses to average total assets below 3.0%. For 2005 our ratio was 2.5%, up slightly from 2.4% in 2004. Because of our continued strong growth, we have seen increases in every major component of our non-interest expenses. For the year ended December 31, 2005, our non-interest expense grew by $3.8 million, or 13.8%. Salary and employee benefits expense increased $2.3 million, or 16.7%, and reflects the addition of personnel associated with our expansion in Greensboro and Raleigh, addition of personnel to expand and support our lines of business, and normal increases in salaries and employee benefits. Occupancy and equipment expense increased $1.4 million, or 33.0%, reflecting the expenses associated with our continued banking office expansion in 2004 and 2005 and investments in technology to support our banking operations. Other non-interest expenses increased $72 thousand, or 0.8%, reflecting the increased volume of business activity, principally increases in lending and growth in deposit accounts. Also, the Company has incurred a significant increase in personnel and professional service fees relating to corporate governance initiatives and compliance with the internal control and other requirements of the Sarbanes-Oxley Act of 2002 (SOX). In addition, we incurred a number of unusual expenses in the first quarter of 2005 including costs related to the departure of two former members of senior management and expenses associated with the Company’s decision to vest all outstanding unvested options. The Company has undertaken initiatives in slowing the growth of non-interest expenses: however, non-interest expenses will be impacted in 2006 by increased occupancy and personnel costs from branch expansion in Greensboro, Raleigh and Mooresville, and a new operations facility to be acquired in the first half of the year.

Provision for Income Taxes. Our provision for income taxes, as a percentage of income before income taxes, was 35.4% for the year ending December 31, 2005 and 35.9% for the year ended December 31, 2004.

RESULTS OF OPERATIONS
Years Ended December 31, 2004 and 2003

Net Income. Our net income for 2004 was $8.1 million, an increase of $4.4 million from net income of $3.7 million earned in 2003. Net income per share was $.47 basic and $.45 diluted for the year ended December 31, 2004, up from $.41 basic and $.40 diluted for 2003. We continued to experience strong growth, in most part due to the acquisition of The Community Bank, with total assets averaging $1.2 billion during 2004 as compared to $696.5 million in 2003, an increase of 67.7%. Our net interest income after provision for loan losses increased by $13.7 million and our non-interest income grew by $2.4 million to $7.4 million. Non-interest expense increased $9.2 million, or 50.1% as a result of the Community acquisition and related merger and integration expenses. Provision expense for loan losses remained relatively unchanged from the prior year. During the first half of 2004 the Bank endured a historically low interest rate environment which hampered our asset yields. As the Federal Reserve increased the targeted federal funds rate in July of 2004, the prime rate increased for the first time since June of 2000. In the last half of 2004; the prime rate increased 125 basis points to 5.25%. While it is management’s goal to remain relatively interest rate neutral, the institution is slightly asset sensitive and does benefit from rising rate environment. As a result of our growth in interest-earning assets (Community transaction coupled with strong loan demand) combined with lower funding costs and rising interest rates during the later portion of the year, our net interest income increased $13.7 million. Our expense growth included some non-recurring merger related costs as well as personnel and other infrastructure costs associated with bringing core processing and item capture in-house, as well

as other expansion of our business. While these expenses represent investments in building and refining our franchise for the future, their initial effect hampers earnings.

Net Interest Income. During 2004, our net interest income increased by $13.7 million or 64.6% to $35.0 million. Our growth in interest income was the result of growth in our overall level of average earning assets due to the Community transaction as well as strong loan demand. Average total interest-earning assets increased $401.6 million or 61.3%, during 2004 as compared to 2003, while our average yield dropped by 33 basis points from 5.50% to 5.17%. The rates earned on a significant portion of our loans adjust immediately when index rates such as our prime rate changes. Conversely, most of our interest-bearing liabilities, including certificates of deposit and borrowings, have rates fixed until maturity. As a result, interest rate increases generally result in an immediate increase in our interest income on loans. There is a more delayed impact on interest expense because most reductions in interest costs only occur upon renewals of certificates of deposit or borrowings. Our average total interest-bearing liabilities increased by $343.9 million, or 57.5%. With rates sustained at lower levels for the first half of 2004, our average cost of interest-bearing liabilities decreased by 38 basis points from 2.47% to 2.09%, allowing our interest rate spread to increase 5 basis points. For the year ended December 31, 2004, our net interest spread was 3.08% and our net interest margin was 3.31%. For the year ended December 31, 2003, our net interest spread was 3.03% and our net interest margin was 3.25%. In November 2003 the Company, through its non-bank subsidiary Southern Community Capital Trust II, issued 3,450,000 Trust Preferred Securities generating total proceeds of $34.5 million. The Securities pay distributions at an annual rate of 7.95% and mature on December 31, 2033. The principal uses of the net proceeds from the sale of the debentures were to provide cash for the acquisition of The Community Bank, to increase our regulatory capital, and to support the growth and operations of our subsidiary bank. While this transaction has strengthened the Company’s overall financial condition, its fixed rate coupon will initially hamper our margins given the current interest rate environment. The Company has entered into a $20.0 million notional amount receive fixed, pay floating interest rate swap to manage the impact of this transaction on the Company’s margin and consolidated asset/ liability position. On a net basis this swap reduced interest expense by $869 thousand in 2004. We believe that our balance sheet is well positioned to produce consistent growing results in the future as the Company continues to expand our marketplace.

Provision for Loan Losses. We recorded a $2.2 million provision for loan loss for the year ended December 31, 2004, representing a slight decrease of $46 thousand from the $2.3 million provision we made for the year ended December 31, 2003. The level of provisions for 2004 is consistent with that of the loan growth, excluding the Community transaction, and net charge-offs that the Bank experienced in the previous year. Gross loans increased $97.8 million in 2003 and $98.8 in 2004 excluding the $177.6 million of loans contributed through the Community acquisition. Provisions for loan losses are charged to income to bring our allowance for loan losses to a level deemed appropriate by management based on the factors discussed under “Analysis of Allowance for Loan Losses.” While the dollar amount of provisions remained relatively flat on a year-over-year basis, the level of the allowance to period-ending loans increased 17 basis points from the prior year-end to 1.57%. In addition to loan growth affecting our provision for loan losses, net loan charge-offs, which remained relatively stable at $1.4 million for both 2004 and 2003, also impacted the provision expense. On an annualized basis, our percentage of net loan charge-offs to average loans outstanding was .19% for the year ended December 31, 2004 as compared with .29% for the year ended December 31, 2003. Our consumer finance lending portfolio accounted for $687 thousand or 49.3% of net charge-offs during 2004, a decrease of $87 thousand from the prior year. Management decided the consumer finance business was no longer part of the Company’s strategic direction, and during the fourth quarter of 2003 ceased originating new consumer finance loans. However, it is expected that the residual consumer finance loan portfolio will payoff in a twelve to twenty-four month time frame and the Company’s level of charge-offs as a percentage of loan outstandings will decline. Nonperforming loans totaled $2.2 million or .27% of total loans at December 31, 2004, as compared with $769 thousand or .15% of total loans at December 31, 2003. The allowance for loan losses at December 31, 2004 of $12.5 million represents 1.57% of total loans and 577% of nonperforming loans. The allowance for loan losses at December 31, 2003 of $7.3 million equaled 1.40% of total loans outstanding at that date.

Non-Interest Income. For the year ended December 31, 2004, non-interest income increased $2.4 million, or 48.6%, to $7.4 million from $5.0 million for the prior year despite declines in investment brokerage and mortgage origination fees. This favorable increase resulted primarily from an increase of $2.1 million, or 142.8% to $3.5 million, in service charges and fees on deposit accounts due to the addition of Community coupled with deposit growth and the benefit of a full year of the overdraft protection service implemented during 2003. Non-interest income also benefited from a one-time gain

received on The Community Bank’s investment in Sidus Financial, LLC (Sidus). Sidus was a mortgage banking company that served Community bank and mortgage broker customers. On October 4, 2004, Sidus was sold for a combination of cash, stock and future consideration if certain performance targets are met. As a result of this transaction, the Company realized a pre-tax gain of $293 thousand. In addition, during the fourth quarter the Company posted a pre-tax gain of $107 thousand on our investment in Salem Capital Partners, L.P. Income from investment brokerage fees decreased from the prior year by $235 thousand, or 24.8%, to $712 thousand. The strong 2003 results were due to a new investment product that was offered for a limited time. Fees on the origination of residential mortgage loans sold into the secondary market declined $600 thousand to $750 thousand as the level of home mortgage refinancings dramatically slowed from the levels experienced in 2002 and 2003 due to the low interest rate environment in those periods. While market conditions may not provide the opportunities to generate fee income similar to those levels we experienced in 2003, management is committed to growing our non-interest income base through continued support of those areas that generate our fee income.

Non-Interest Expense . We strive to maintain non-interest expenses at levels that we believe are appropriate given the nature of our operations and the investments in personnel and facilities that have been necessary to support our growth. From 1998 forward, we have consistently maintained our ratio of non-interest expenses to average total assets below 3.0%. For 2004 our ratio was 2.36%, down from a ratio of 2.63% in 2003. Because of our continued strong growth we have seen increases in every major component of our non-interest expenses. For the year ended December 31, 2004, our non-interest expense increased $9.2 million, or 50.1%. Salary and employee benefits expense increased $4.1 million, or 43.2%, and reflects the addition of personnel associated with Community transaction, staff additions to bring item processing in-house for the consolidated company, additions of personnel to expand and support our lines of business, and normal increases in salaries and employee benefits. Occupancy and equipment expense increased $1.3 million, or 42.9%, reflecting the expenses associated with our continued expansion and investments in technology to support our banking operations, including in-house processing. Other non-interest expenses increased $3.7 million, or 65.7%, reflecting the increased volume of business activity, principally increases in lending and growth in deposit accounts. Also, the Company has incurred a significant increase in professional service fees in connection with our preparation for compliance with the internal control requirements and other provisions of the Sarbanes-Oxley Act of 2002 (SOX). In addition, we incurred a full year of fees paid to service our consumer finance loan portfolio. During the fourth quarter of 2003, the Bank ceased operation of its consumer finance subsidiary. Simultaneously, the Bank entered into an agreement with the former president of that subsidiary to service these loans on the behalf of the Bank. On October 18, 2004, the Bank and Community were merged into a single bank under the Bank’s name. In conjunction with this merger, the newly consolidated bank has successfully brought core processing in-house. This function was previously an outsourced service for the Bank. As a consequence of converting the Bank’s primary operating system, it was necessary to terminate our contract with our previous item processing provider at a cost of $550 thousand. The Company believes that the synergies we will achieve by taking these steps will have an immediate and lasting positive impact on our customers as well as our non-interest expense.

Provision for Income Taxes. Our provision for income taxes, as a percentage of income before income taxes, was 35.9% for the year ending December 31, 2004 and 35.0% for the year ended December 31, 2003.

LIQUIDITY

Market and public confidence in our financial strength and in the strength of financial institutions in general will largely determine our access to appropriate levels of liquidity. This confidence is significantly dependent on our ability to maintain sound asset quality and appropriate levels of capital resources.

The term “liquidity” refers to our ability to generate adequate amounts of cash to meet our needs for funding loan originations, deposit withdrawals, maturities of borrowings and operating expenses. Management measures our liquidity position by giving consideration to both on- and off-balance sheet sources of, and demands for, funds on a daily and weekly basis.

Sources of liquidity include cash and cash equivalents, net of federal requirements to maintain reserves against deposit liabilities, investment securities eligible for pledging to secure borrowings from correspondent banks pursuant to securities sold under repurchase agreements, investments available for sale, loan repayments, loan sales, deposits, and

borrowings from the Federal Home Loan Bank secured with pledged loans and securities, and from correspondent banks under overnight federal funds credit lines. In addition to interest rate-sensitive deposits, the Company’s primary demand for liquidity is anticipated funding under credit commitments to customers.

We have maintained a relatively high level of liquidity in the form of federal funds sold and investment securities. These aggregated $292.6 million at December 31, 2005, compared to $313.0 million and $231.0 million at December 31, 2004 and 2003, respectively. Supplementing customer deposits as a source of funding, we have available lines of credit from various correspondent banks to purchase federal funds on a short-term basis of approximately $73.0 million. We also have the credit capacity to borrow up to $320.8 million, as of December 31, 2005, from the Federal Home Loan Bank of Atlanta, with $157.5 million outstanding as of that date. At December 31, 2004 we had FHLB borrowings outstanding of $147.8 million. We also had repurchase agreements with a total outstanding balance of $5.2 million at December 31, 2005, all of which were done as accommodations for our deposit customers. We had no repurchase agreement borrowings outstanding with our correspondent banks at year-end 2005. Securities sold under agreements to repurchase generally mature within ninety days from the transaction date and are collateralized by U.S. government agency obligations. We have repurchase lines of credit aggregating $130 million from various institutions. The repurchases must be adequately collateralized.

At December 31, 2005, our outstanding commitments to extend credit consisted of loan commitments of $224.1 million and amounts available under home equity credit lines and letters of credit of $75.0 million, and $12.0 million, respectively. We believe that our combined aggregate liquidity position from all sources is sufficient to meet the funding requirements of loan demand and deposit maturities and withdrawals in the near term.

Throughout our nine-year history, our loan demand has exceeded our growth in core deposits. We have therefore relied heavily on certificates of deposits as a source of funds. While the majority of these funds are from our local market area, the Bank has utilized brokered and out-of-market certificates of deposits to diversify and supplement our deposit base. In 2005, we focused on expanding our non-maturity deposit base, which has resulted in a reduced reliance on time deposits. Certificates of deposits represented 54.7% of our total deposits at December 31, 2005, a decrease from 60.4% at December 31, 2004. Brokered and out-of-market deposits totaled $215.7 million at year-end 2005 and $195.3 million at year-end 2004, which comprised 22.9% and 23.1% of total deposits, respectively. Certificates of deposit of $100,000 or more, inclusive of brokered and out-of-market certificates, represented 32.3% of our total deposits at December 31, 2005 and 33.3% at December 31, 2004. A portion of these deposits are controlled by members of our Board of Directors and Advisory Board members, or otherwise come from customers considered to have long-standing relationships with our management. Based upon the nature of these relationships, management does not believe we are subject to significant liquidity risk related to these deposits. Large certificates of deposits are generally considered rate sensitive. While we will need to pay competitive rates to retain these deposits at their maturities, there are other subjective factors that will determine their continued retention.

     The following table reflects other commitments of the Company outstanding as of December 31, 2005.

OFF-BALANCE SHEET ARRANGEMENTS

Information about the Company’s off-balance sheet risk exposure is presented in Note 18 to the accompanying consolidated financial statements. As part of its ongoing business, the Company does not participate in transactions that generate relationships with unconsolidated entities or financial partnerships, such as entities often referred to as special purpose entities (SPEs), which generally are established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As of December 31, 2005, the Company’s sole SPE activity is with Southern Community Capital Trust II, the subsidiary that issued 3,450,000 Trust Preferred Securities in November 2003. The Trust Preferred Securities are backed by junior subordinated debentures issued by the Company, which are included in long-term debt on the balance sheet.

The Company’s trust preferred securities presently qualify as Tier 1 regulatory capital and are reported in Federal Reserve regulatory reports as a minority interest in our consolidated subsidiaries. The junior subordinated debentures do not qualify as Tier 1 regulatory capital. The Board of Governors of the Federal Reserve, on March 1, 2005, adopted a final rule allowing the continued limited inclusion of trust preferred securities in Tier 1 capital. The Board’s final rule limits restricted core capital elements to twenty-five percent of all core capital elements.

In November of 2003, Southern Community Capital Trust II (“Trust II”), a newly formed subsidiary of the Company, issued 3,450,000 Trust Preferred Securities (“Trust II Securities”), generating total proceeds of $34.5 million. The Trust II Securities pay distributions at an annual rate of 7.95% and mature on December 31, 2033. The Trust II Securities began paying quarterly distributions on December 31, 2003. The Company has fully and unconditionally guaranteed the obligations of Trust II. The Trust II Securities are redeemable in whole or in part at any time after December 31, 2008. The proceeds from the Trust II Securities were utilized to purchase convertible junior subordinated debentures from us under the same terms and conditions as the Trust II Securities. We have the right to defer payment of interest on the debentures at any time and from time to time for a period not exceeding five years, provided that no deferral period extend beyond the stated maturities of the debentures. Such deferral of interest payments by the Company will result in a deferral of distribution payments on the related Trust II Securities. Should we defer the payment of interest on the debentures; the Company will be precluded from the payment of cash dividends to shareholders. The principal uses of the net proceeds from the sale of the debentures were to provide cash for the acquisition of The Community Bank, to increase our regulatory capital, and to support the growth and operations of our subsidiary banks. The amount of proceeds we count as Tier 1 capital cannot comprise more than 25% of our core capital elements. Amounts in excess of the 25% limitation count as Tier 2 supplementary capital for regulatory purposes.

In February of 2002, Southern Community Capital Trust I (“Trust I”) issued 1,725,000 Cumulative Convertible Trust Preferred Securities (“Trust I Securities”), generating total proceeds of $17.3 million. The Trust I Securities were redeemed on March 12, 2004 which resulted in the issuance of 2,060,000 shares of our common stock through the conversions and the retirement of $61 thousand of the convertible trust preferred securities.

During 2005 the Company declared and paid four cash dividends. In the first quarter of 2005 the Company paid a $0.12 per share annual dividend. In the second quarter of 2005, we began paying quarterly dividends of $0.03 per share. In total the Company returned $3.7 million or $0.21 per share to common shareholders in the form of cash dividends during 2005.

The Company’s Board of Directors authorized programs in March and September of 2005 to repurchase up to 300,000 and 600,000 shares of common stock, respectively. During 2005, a total of 460,800 shares of common stock were repurchased and retired at an average price of $9.27 per share.

ASSET/LIABILITY MANAGEMENT

Our results of operations depend substantially on net interest income. Like most financial institutions, our interest income and cost of funds are affected by general economic conditions and by competition in the market place. The purpose of asset/liability management is to provide stable net interest income growth by protecting earnings from undue interest rate risk, which arises from volatile interest rates and changes in the balance sheet mix, and by managing the risk/return relationships between liquidity, interest rate risk, market risk and capital adequacy. We adhere to a Board-approved asset/liability management policy that provides guidelines for controlling, monitoring, and reporting exposure to interest rate risk. Our policy is to manage the Company’s net interest income exposure by measuring the impact of changing interest rate environments and adjusting the mix of assets and liabilities to provide an acceptable return within established risk limits. Net interest income simulation and gap reports in conjunction with other tools are utilized to measure and monitor interest rate risk.

When suitable lending opportunities are not sufficient to utilize available funds, we have generally invested such funds in securities, primarily securities issued by governmental agencies and mortgage-backed securities. The securities portfolio contributes to increased profitability and plays an important part in our overall interest rate risk management. However, management of the securities portfolio alone cannot balance overall interest rate risk. The securities portfolio must be used in combination with other asset/liability techniques to actively manage the balance sheet. The primary objectives in the overall management of the securities portfolio are safety, liquidity, yield, asset/liability management (interest rate risk), and investing in securities that can be pledged for public deposits or for borrowings.

In reviewing the needs of our Bank with regard to proper management of its asset/liability program, we estimate future needs, taking into consideration investment portfolio purchases, calls and maturities in addition to estimated loan and deposit increases (due to increased demand through marketing) and forecasted interest rate changes. We use a number of measures to monitor and manage interest rate risk, including income simulations and gap analyses. An income simulation model is the primary tool used to assess the direction and magnitude of changes in net interest income resulting from changes in interest rates. Key assumptions in the model include prepayment speeds on mortgage-related assets, cash flows and maturities of other investment securities, loan and deposit volumes and pricing. These assumptions are inherently uncertain and, as a result, the model cannot precisely estimate net interest income or precisely predict the impact of higher or lower interest rates on net interest income. Actual results will differ from simulated results due to timing, magnitude and frequency of interest rate changes and changes in market conditions and management strategies, among other factors. Based on the results of the income simulation model, as of November 30, 2005, if interest rates increase by two percentage points, our net interest income over a one-year time frame could increase by approximately 1.5% or $586 thousand. As of November 30, 2005, if interest rates decrease by two percentage points, our net interest income over a one-year time frame could decrease by approximately 8.3% or $3.2 million.

The analysis of interest rate gap (the difference between the amount of interest-earning assets and interest-bearing liabilities re-pricing or maturing during a given period of time) is another standard tool we use to measure exposure to interest rate risk. We believe that because interest rate gap analysis does not address all factors that can affect earnings performance, it should be used in conjunction with other methods of evaluating interest rate risk.

Our balance sheet, based on gap measurements, was asset-sensitive at December 31, 2005 in the three-month horizon and liability-sensitive in the four-month to one-year time frame. An asset-sensitive position means that there are more assets than liabilities subject to repricing in that period as market rates change, and conversely with a liability-sensitive position. As a result, in a falling rate environment, our earnings position could deteriorate initially followed by improvement, with the opposite expectation in a rising rate environment, depending on the correlation of rate changes in these categories.

The following table presents information about the periods in which the interest-sensitive assets and liabilities at December 31, 2005 will either mature or be subject to repricing in accordance with market rates, and the resulting interest-sensitivity gaps. This table shows the sensitivity of the balance sheet at one point in time and is not necessarily indicative of what the sensitivity will be on other dates. Included in interest-bearing liabilities subject to rate changes within 90 days is 100% of the money market, NOW and savings deposits. These types of deposits historically have not repriced coincidentally with or in the same proportion as general market indicators. As simplifying assumptions concerning repricing behavior, all money market, NOW and savings deposits are assumed to reprice immediately and fixed rate loans and mortgage-backed securities are assumed to reprice at their contractual maturity.