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-two banking offices operating in nine 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.
Our
banking offices are located in the Piedmont Triad area (including Winston-Salem
(our headquarters), Greensboro, High Point and surrounding areas) Mooresville
(the Charlotte area), Raleigh and Asheville.
At
December 31, 2007, the Company had total assets of $1.6 billion, net loans
of
$1.2 billion, deposits of $1.0 billion and shareholders’ equity of $142.3
million. The Company had net income of $7.6 million, $4.2 million and $7.7
million and diluted earnings per share of $0.43, $0.24 and $0.42 for the years
ended December 31, 2007, 2006 and 2005, respectively.
The
Company has been, and intends 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.
In
our
eleven years of existence the Company has:
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Established
a reputation for superior service to our customers and the communities
in
which we operate;
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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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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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Maintained
a strong credit culture. As of December 31, 2007, our nonperforming
assets
totaled $2.8 million or 0.18% of total assets and our allowance for
loan
losses amounted to $14.3 million or 1.20% of total loans and 695%
of
nonperforming loans;
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Acquired
The Community Bank, Pilot Mountain, North Carolina, in January 2004,
raising our assets at that time to over $1.0 billion and increasing
the
number of banking offices;
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The
website for the Bank is
www.smallenoughtocare
.com.
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. The Federal Deposit Insurance Corporation insures the Bank’s 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 one of our trust preferred security
issues are traded on the NASDAQ Global Select Market System under the symbols
“SCMF” and “SCMFO”, respectively.
Our
Market Area
The
Company’s primary market areas are the Piedmont Triad area of North Carolina,
Mooresville (the Charlotte area) Asheville (Western Mountains of North Carolina)
and Raleigh (Research Triangle region in the eastern Piedmont of North
Carolina). The Piedmont Triad is a twelve 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-sixth of the state’s population and one-fifth of
its labor force. The NC State Data Center estimated that the Triad’s population
at the end of 2006 was in excess of 1.6 million.
Winston-Salem
is the largest city in Forsyth County and the fifth largest city in North
Carolina according to the US Census Bureau in 2002. 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, the US Census
Bureau
estimated the population of Forsyth County to exceed 332 thousand and Guilford
County to exceed 451 thousand. The populations of Forsyth County and Guilford
County are projected to grow to 427 thousand and 589 thousand by
2030.
The
Piedmont Triad is the economic hub of northwest North Carolina. In 2006, the
US
Department of Housing and Urban Development estimated that the 2005 median
family income ranged from a low of $45,200 in the Mt. Airy micropolitan area
to
a high of $58,200 in the Winston-Salem metropolitan area. The Piedmont Triad
has
a very balanced and diversified economy and a work force that exceeded 816
thousand in 2006, according to the NC Employment Security Commission.
Approximately 99% of the work force is employed in nonagricultural wage and
salary positions. According to the NC Employment Security Commission, the major
employment sectors in 2006 were services (36%), manufacturing (18%), trade
(11%), government (12%), financial (7%) and construction (6%). During 2007,
the
unemployment rate in the Piedmont Triad varied from month to month but remained
unchanged for the year at 4.7%.
The
Raleigh-Cary metropolitan statistical area is the fastest growing MSA in North
Carolina, with a 2006 population, estimated by the US Census Bureau, of over
786
thousand. The Wake County population is projected to more than double from
the
2000 Census level of 628 thousand to 1.37 million by 2030. The US Census Bureau
also estimated the area’s 2004 median household income to be over $57,800 and
2005 non-farm labor force to be over 355 thousand, which is in excess of 10%
of
the state’s total non-farm labor force. According to the NC Employment Security
Commission, the area’s unemployment rate in 2007 was 3.6%.
The
Charlotte metropolitan statistical area is the second fastest growing MSA in
North Carolina. The Mecklenburg County population is projected to grow from
the
2000 Census level of 695 thousand to 1.3 million by 2030. Mooresville is located
in the Lake Norman area, north of Charlotte.
Asheville
is the largest city in Western North Carolina and, according to the US Census
Bureau, its metropolitan statistical area had a 2005 estimated population of
almost 393 thousand. In 2006, SRC, Inc. estimated the median family income
in
the area to be $40,700. The Western North Carolina region has a balanced and
diversified economy. According to the US Bureau of Labor Statistics, the major
employment sectors in 2007 were education and health services (16.9%),
government (15.1%), retail (13.1%), leisure and hospitality (12.4%),
manufacturing (11.9%), services (9.4%) and construction (6.5%).
The
Bank
serves our market area through twenty-two 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
The
Company’s primary
objective is to become 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 a well capitalized
institution that is 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
employees and by expanding primarily to contiguous areas through branching
and
acquisitions which make strategic and economic sense.
We
have
also diversified our revenue in order to generate non-interest income. These
efforts include expansion of mortgage banking, wealth management and investment
in Small Business Investment Company (SBIC) activities through Salem Capital
Partners. Southern Community Advisors, our wealth management group, offers
investment advisory, brokerage, trust and insurance services. For more
information on the Company’s SBIC activities, see SUBSIDIARIES. For the year
ended December 31, 2007 our non-interest income, excluding securities gains
and
losses, represented 20.6% of our total revenue. We believe that the
profitability of these added businesses and services, not just the revenue
generated, is critical to our long term 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
In
addition to those financial services offered by the Bank, the Company has a
subsidiary, Southern Community Capital Trust II (“Trust II”), to issue trust
preferred securities. The Bank has an interest in an unconsolidated subsidiary
(VCS Management LLC) to house its investment in its SBIC activities. Each
subsidiary is described below.
In
November 2003, Southern Community Capital Trust II publicly issued 3,450,000
shares of 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 junior
subordinated debentures from the Bank 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 extends 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
qualifying for 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.
VCS
Management, LLC was formed in March 2000 as the managing general partner of
what
is now known as Salem Capital Partners, L.P. (“SCP I”), a small business
investment company (SBIC) 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, 2007, the Bank has committed to
investing up to $2 million in SCP II. In January 2008, SCP II has commitments
for $33 million from various private investors, including the $2 million from
the Bank. 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, 2007, the Company earned $2.1 million, or 3.8%
of total revenue, from its SBIC activities, including income from the
investments in SCP I and II and SBIC management fees.
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
statewide 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.
Currently,
we operate branches in Buncombe, Forsyth, Guilford, Iredell, Rockingham, Stokes,
Surry, Wake and Yadkin Counties, North Carolina. In June 2007, there were 695
branches operated by forty-seven banks and thirteen savings institutions in
these nine counties with approximately $44.9 billion in deposits. On that date,
deposits of the Bank were $1.0 billion for a 2.25% market share. The top three
deposit market share leaders in this market area account for 63% of deposits.
Many of these competing banks have capital resources and legal lending limits
substantially in excess of those available to 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
2007, all employees of Southern Community Financial Corporation were compensated
by the Bank. At December 31, 2007, the Bank employed 337 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
employee
benefits and the well being of employees.
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 may conduct periodic examinations of the Holding Company and may examine
any of its 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, 2007, the Company’s leverage capital ratio, Tier 1 risk-based
capital ratio and total risk-based capital ratio were 8.96%, 10.28 and 11.44%,
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, 2007, 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 from Trust II, 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 Company’s trust
preferred securities from Trust III also qualify as Tier I regulatory capital
although they are part of a pooled transaction and are not a subsidiary of
the
holding company. The junior subordinated debentures related to Trust III 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 primary
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.
The Federal Reserve may impose restrictions on the Company’s 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
.
The
Bank is also 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 2007, no reserves were
required to be maintained on the first $8.5 million of transaction accounts,
but
reserves equal to 3.0% were required on the aggregate balances of those accounts
between $8.5 million and $45.8 million, and additional reserves were required
on
aggregate balances in excess of $45.8 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 2008, no reserves will be required to be
maintained on the first $9.3 million of transaction accounts, but reserves
equal
to 3.0% will be required on the aggregate balances of those accounts between
$9.3 million and $43.9 million, and additional reserves are required on
aggregate balances in excess of $43.9 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, 2007, 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
Bank’s 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 the Company, 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 the Company 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 the Company as needed to pay any separate expenses of Southern Community
Financial Corporation and/or to make required payments on the Company’s debt
obligations, including the debentures which fund the interest payments on the
preferred securities issued by the Company’s “Trust II” subsidiary and to pay
cash dividends to the Company’s 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
ten percent 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 deposits are insured up to $100,000 per insured non-IRA account and up to
$250,000 per IRA account by the Deposit Insurance Fund of the Federal Deposit
Insurance Corporation. The Bank is required to pay deposit insurance assessments
set by the FDIC. The FDIC determines the Bank’s deposit insurance assessment
rates on the basis of four risk categories. The Bank's assessment is determined
by a formula that ranges from 0.02% to 0.04% at the lowest assessment 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 and was significantly increased for all depository institutions
during 2007. Increases in the assessment rate may have an adverse effect on
the
Bank's operating results. The FDIC has the authority to terminate deposit
insurance.
Our
management cannot predict what other legislation might be enacted or what other
regulations might be adopted or the effects thereof.
An
investment in our common stock
involves risk. 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
continuing significant growth plans. 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, 2007,
approximately 63% 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
loss
experience and other assumptions related to management’s assessment of the
adequacy of the Company’s allowances for loan losses may not be warranted.
Approximately 86% of our loan portfolio is composed of construction, commercial
mortgage and commercial loans. Repayment of such loans is generally considered
subject to greater credit 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
are
currently operating in a temporary facility in Asheville and will begin
construction of a permanent building in early 2008 and plan to occupy the
facility by year end 2008. We also are operating in a temporary facility in
Raleigh and plan to begin construction in late 2008 and open the new office
in
2009. 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 February 29, 2008 was approximately 12,793 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, 2007, we had outstanding trust preferred securities and
accompanying junior subordinated debentures totaling $44.5 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. 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 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 event
s.
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.