Who
We
Are
Southern
Community Financial Corporation (“we” or the “Company”) is the holding company
for Southern Community Bank and Trust (the “Bank”), a community bank with
twenty-one banking offices operating in eight counties throughout North
Carolina. The Bank commenced operations on November 18, 1996 and effective
October 1, 2001 became a wholly-owned subsidiary of the newly formed holding
company. We have banking offices in the Piedmont Triad area, including
Winston-Salem (our headquarters), Greensboro and High Point, and surrounding
areas; Mooresville (the Charlotte area), and Raleigh, and opened a loan
production office in Asheville with a branch planned for 2007.
At
December 31, 2006, we had total assets of $1.4 billion, net loans of $1.0
billion, deposits of $1.0 billion, and shareholders’ equity of $136.2 million.
We had net income of $4.2 million, $7.7 million, and $8.1 million and diluted
earnings per share of $0.24, $0.42, and $0.45 for the years ended December
31,
2006, 2005 and 2004, respectively.
We
have
been, and intend to remain, a community-focused financial institution offering
a
full range of financial services to individuals, businesses and nonprofit
organizations in the communities we serve. Our banking services include
checking
and savings accounts; commercial, installment, mortgage, and personal loans;
trust and investment services; safe deposit boxes and other associated
services
to satisfy the needs of our customers.
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In
our ten years of existence we have accomplished the
following:
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Advanced
into third position in deposit market share in our home base
of Forsyth
County and fifth position in the Piedmont Triad;
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Acquired
The Community Bank, Pilot Mountain, North Carolina, in January
2004,
raising our assets to over $1.0 billion and increasing the
number of
banking offices;
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Began
payment of an annual cash dividend in 2004, which was increased
and made a
quarterly dividend in 2005;
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Began
in-house item processing for the Bank in October 2004;
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Began
offering trust services in 2002 including investment management,
administration and advisory services primarily for individuals,
partnerships and corporations;
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Listed
our common stock on the NASDAQ National Market System on January
2, 2002,
and beginning July 3, 2006, on the NASDAQ Global Select Market;
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Maintained
a strong credit culture. As of December 31, 2006, our non-performing
assets totaled $3.5 million or 0.25% of total assets and our
allowance for
loan losses was $13.0 million or 1.26% of total loans and 495%
of
non-performing loans; and
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Developed
a full service financial institution operating in four of the
fastest
growing markets in North
Carolina.
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The
website for the Bank is
www.smallenoughtocare
.com
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Our
periodic reports on Forms 10-Q and 10-K are available on our website under
“Investor Relations.” The Company is registered as a financial holding company
with the Federal Reserve System. The Bank is organized under the laws of
North
Carolina and the Federal Deposit Insurance Corporation insures its deposits
up
to applicable limits. The address of our principal executive office is
4605
Country Club Road, Winston-Salem, North Carolina 27104 and our telephone
number
is (336) 768-8500. Our common stock and our trust preferred securities
are
traded on the NASDAQ Global Select Market System under the symbols “SCMF” and
“SCMFO”, respectively.
Our
Market Area
We
consider our primary market area to be the Piedmont Triad area of North
Carolina, Raleigh, and Asheville, and to a lesser extent, adjoining
counties. The Piedmont Triad is a 12 county region located in north
central North Carolina and is named for the three largest cities in the
region,
Winston-Salem (where our headquarters is located), Greensboro and High
Point. The region has one-fifth of the state’s population and one-fifth of
its labor force. Its estimated population at the end of 2006 was in excess
of
1.9 million. The region’s population is expected to grow an estimated 15.5%
between 2000 and 2010.
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 2006, Forsyth County
had an
estimated population of almost 326 thousand and Guilford County has an
estimated
population of almost 441 thousand.
The
Piedmont Triad is the economic hub of northwest North Carolina. In 2006,
the
median family income ranged from a low of $45.2 thousand dollars in the
Mt. Airy
micropolitan area to a high of $58.2 thousand dollars in the Winston-Salem
metropolitan area. The Piedmont Triad has a very balanced and diversified
economy and a work force that exceeded 800 thousand in 2005. Approximately
99%
of the work force is employed in nonagricultural wage and salary positions.
The
major employment sectors in 2005 were services (34%), manufacturing (20%),
trade
(16%), government (12%), financial (7%), and construction (5%). From January
2006 to December 2006, the unemployment rate in the Piedmont Triad decreased
from 4.9% to 4.8%.
The
Bank
serves our market area through twenty-one 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 over 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:
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Small and medium sized businesses, and the
owners and
managers of these entities;
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Professional
and middle managers of locally based
companies;
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Residential
real estate developers; and
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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, 2006 our
non-interest income, excluding securities gains and losses, represented
16.1% 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:
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To
provide community-oriented banking services by delivering a
broad range of
financial services to our customers through responsive service
and
communication;
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To
form a partnership with our customers whereby our decision
making and
product offerings are geared toward their best long-term
interests;
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To
be recognized in our community as a long-term player with employees,
stockholders and board members committed to that effort;
and
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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.
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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. (“SCP I”), a small business investment company
licensed by the Small Business Administration. The Bank 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. During 2006, Salem Capital Partners II, L.P. (“SCP II”) was formed
and licensed by the Small Business Administration, with a purpose and operations
similar to SCP I. At December 31, 2006, the Bank has committed to investing
up
to $2 million in SCP II, or approximately 19.7% of the total committed
capital
for SCP II. In connection with the formation of SCP II, a new entity, SCP
Advisor LLC, was formed to manage SCP I and II. The Bank owns 49% of SCP
Advisor
LLC. For the year ended December 31, 2006, the Company earned $792 thousand,
or
1.8% of total revenue, from its SBIC activities, including income from
the
investments in SCP I and II and SBIC management fees.
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 for
regulatory capital purposes. 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 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 2006, we operated branches in
Forsyth,
Guilford, Iredell, Rockingham, Stokes, Surry, Wake and Yadkin Counties,
North
Carolina. On that date, there were 590 branches operated by forty-five
banks and
nine savings institutions in these eight counties with approximately $38.0
billion in deposits. Deposits of the Bank in June 2006 were $985.1 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
During
2006, all employees of Southern Community Financial Corporation were compensated
by the Bank. At December 31, 2006, the Bank employed 326 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 which is not a member 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, 2006, our Tier 1 leverage capital ratio and total capital
were
8.73% and 11.40%, 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, 2006, 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 Federal Reserve 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. During 2006, the Bank elected to withdraw
as a
member of the Federal Reserve System and the Bank is now subject to regulation,
supervision and regular examination by the Federal Deposit Insurance
Corporation. The North Carolina Banking Commission and the FDIC 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 the Company 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. During 2006, no reserves were
required to be maintained on the first $7.8 million of transaction accounts,
but
reserves equal to 3.0% were required to be maintained on the aggregate
balances
of those accounts between $7.8 million and $48.3 million, and additional
reserves were required to be maintained on aggregate balances in excess
of $48.3
million in an amount equal to 10.0% of the excess. These percentages are
subject
to annual adjustment by the Federal Reserve, which has advised that for
2007, no
reserves will be required to be maintained on the first $8.5 million of
transaction accounts, but reserves equal to 3.0% must be maintained on
the
aggregate balances of those accounts between $8.5 million and $45.8 million,
and
additional reserves required on aggregate balances in excess of $45.8 million
in
an amount equal to 10.0% of the excess. 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, 2006,
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 bank, such as the Bank, is classified as undercapitalized, the bank
is
required to submit a capital restoration plan to the FDIC. 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 FDIC of a capital restoration
plan for the bank.
If
a
state bank were classified as undercapitalized, the FDIC may take certain
actions to correct the capital position of the bank. If a state bank is
classified as significantly undercapitalized, the FDIC 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 FDIC 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 FDIC may, on a case-by-case basis,
permit
member banks that are adequately capitalized to accept brokered deposits
if the
FDIC 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 deposit accounts are insured up to the maximum per insured account by
Federal Deposit Insurance Corporation. During 2006, the FDIC approved a
new
risk-based assessment system for deposit insurance. It is expected that
all
banks will pay assessments under this revised system, while under the previous
system, certain banks deemed not to pose a threat to the deposit insurance
system did not pay any assessments. The FDIC determines the Bank’s deposit
insurance assessment rates on the basis of four risk categories. Under
the
revised assessment rate schedule, the Bank's assessment will range from
0.02 to
0.04% at the lowest assessment risk category up to a maximum assessment
of 0.40%
of the Bank's average deposit base, with the exact assessment determined
by the
Bank's assets, its capital and the FDIC's supervisory opinion of its operations.
The insurance assessment rate may change periodically. Increases in the
assessment rate may have an adverse effect on the Bank's operating results.
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:
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the
time and costs associated with identifying and evaluating potential
acquisitions and merger partners;
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the
accuracy of estimates and judgments used to evaluate credit,
operations,
management and market risks with respect to the target
entity;
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the
time and costs of evaluating new markets, hiring experienced
local
management and opening new offices, and the time lags between
these
activities and the generation of sufficient assets and deposits
to support
the costs of the expansion;
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our
ability to finance an acquisition and possible ownership and
economic
dilution to our current
shareholders;
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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;
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entry
into new markets where we lack experience;
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the
introduction of new products and services into our
business;
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the
incurrence and possible impairment of goodwill associated with
an
acquisition and possible adverse short-term effects on our
results of
operations; and
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the
risk of loss of key employees and
customers.
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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 secures loans
with
real estate collateral. At December 31, 2006, approximately 72% 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 70% 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 a new branch in Asheville, North Carolina,
which we intend to do during 2007. 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 FDIC. 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:
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the
payment of dividends to shareholders;
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possible
transactions with or acquisitions by other institutions;
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loans
and interest rates;
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interest
rates paid on deposits; and
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the
possible expansion of branch
offices.
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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 Global Select
Market
for the three months ended January 31, 2007 was approximately 13,500 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, 2006, 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, 2006. 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.