| SOUTHERN COMMUNITY FINANCIAL CORP Item 1A Risk Factors 12 Item 1A Risk Factors An investment in our common stock involves risks |
| Shareholders should carefully consider the risks described below in conjunction with the other information in this Form 10-K and information incorporated by reference in this Form 10-K, including our consolidated financial statements and related notes |
| If any of the following risks or other risks which have not been identified or which we may believe are immaterial or unlikely, actually occur, our business, financial condition and results of operations could be harmed |
| This could cause the price of our stock to decline, and shareholders could lose part or all of their investment |
| This Form 10-K contains forward-looking statements that involve risks and uncertainties, including statements about our future plans, objectives, intentions and expectations |
| Many factors, including those described below, could cause actual results to differ materially from those discussed in our forward-looking statements |
| Risks Related to Holding Southern Community Common Stock Our business strategy includes the continuation of significant growth plans, and our financial condition and results of operations could be negatively affected if we fail to grow or fail to manage our growth effectively |
| We intend to continue pursuing a significant growth strategy for our business |
| Our prospects must be considered in light of the risks, expenses and difficulties frequently encountered by companies in significant growth stages of development |
| We cannot assure you we will be able to expand our market presence in our existing markets or successfully enter new markets or that any such expansion will not adversely affect our results of operations |
| Failure to manage our growth effectively could have a material adverse effect on our business, future prospects, financial condition or results of operations, and could adversely affect our ability to successfully implement our business strategy |
| Also, if our growth occurs more slowly than anticipated or declines, our operating results could be materially adversely affected |
| Our ability to successfully grow will depend on a variety of factors including the continued availability of desirable business opportunities, the competitive responses from other financial institutions in our market areas and our ability to manage our growth |
| We may face risks with respect to future expansion |
| As a strategy, we have sought to increase the size of our franchise by aggressively pursuing business development opportunities, and we have grown rapidly since our incorporation |
| We have purchased another financial institution as a part of that strategy |
| We may acquire other financial institutions or parts of those entities in the future |
| Acquisitions and mergers involve a number of risks, including: • the time and costs associated with identifying and evaluating potential acquisitions and merger partners; • the accuracy of estimates and judgments used to evaluate credit, operations, management and market risks with respect to the target entity; • the time and costs of evaluating new markets, hiring experienced local management and opening new offices, and the time lags between these activities and the generation of sufficient assets and deposits to support the costs of the expansion; • our ability to finance an acquisition and possible ownership and economic dilution to our current shareholders; • the diversion of our management’s attention to the negotiation of a transaction, and the integration of the operations and personnel of the combining businesses; • entry into new markets where we lack experience; • the introduction of new products and services into our business; • the incurrence and possible impairment of goodwill associated with an acquisition and possible adverse short-term effects on our results of operations; and • the risk of loss of key employees and customers |
| We may incur substantial costs to expand, and we can give no assurance such expansion will result in the levels of profits we seek |
| There can be no assurance integration efforts for any future mergers or acquisitions will be successful |
| Also, we may issue equity securities, including common stock, and securities convertible into shares of Page 12 _________________________________________________________________ our common stock in connection with future acquisitions, which could cause ownership and economic dilution to our current shareholders and to investors purchasing common stock in this offering |
| There is no assurance that, following any future mergers or acquisition, our integration efforts will be successful or our company, after giving effect to the acquisition, will achieve profits comparable to or better than our historical experience |
| If the value of real estate in our core market areas were to decline materially, a significant portion of our loan portfolio could become under-collateralized, which could have a material adverse effect on us |
| With most of our loans concentrated in the Piedmont Triad region of North Carolina, a decline in local economic conditions could adversely affect the values of our real estate collateral |
| Consequently, a decline in local economic conditions may have a greater effect on our earnings and capital than on the earnings and capital of larger financial institutions whose real estate loan portfolios are geographically diverse |
| In addition to the financial strength and cash flow characteristics of the borrower in each case, the Bank often secure loans with real estate collateral |
| At December 31, 2005, approximately 75prca 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 69prca of our loan portfolio is composed of construction, commercial mortgage and commercial loans |
| Repayment of such loans is generally considered more subject to market risk than residential mortgage loans |
| Industry experience shows that a portion of loans will become delinquent and a portion of the loans will require partial or entire charge-off |
| Regardless of the underwriting criteria Southern Community utilizes, losses may be experienced as a result of various factors beyond its control, including, among other things, changes in market conditions affecting the value of its loan collateral and problems affecting the credit of its borrowers |
| The building of market share through our de novo branching strategy could cause our expenses to increase faster than our revenues |
| We intend to continue to build market share through our de novo branching strategy |
| We have regulatory approval to open two new branches, which we intend to do during 2006 |
| There are considerable costs involved in opening branches |
| New branches generally do not generate sufficient revenues to offset their costs until they have been in operation for at least a year or more |
| Accordingly, our new branches can be expected to negatively impact our earnings for some period of time until the branches reach certain economies of scale |
| Our expenses could be further increased if we encounter delays in the opening of any of our new branches |
| Finally, we have no assurance our new branches will be successful even after they have been established |
| Page 13 _________________________________________________________________ If Southern Community loses key employees with significant business contacts in its market area, its business may suffer |
| Southern Community’s success is dependent on the personal contacts of its officers and employees in its market area |
| If Southern Community lost key employees temporarily or permanently, its business could be hurt |
| Southern Community could be particularly hurt if its key employees went to work for competitors |
| Southern Community’s future success depends on the continued contributions of its existing senior management personnel, particularly on the efforts of F Scott Bauer and Jeff T Clark, each of whom has significant local experience and contacts in its market area |
| Government regulations may prevent or impair our ability to pay dividends, engage in acquisitions, or operate in other ways |
| Current and future legislation and the policies established by federal and state regulatory authorities will affect Southern Community’s operations |
| Southern Community is subject to supervision and periodic examination by the Federal Reserve Board and the North Carolina Commissioner of Banks |
| Southern Community’s principal subsidiary, Southern Community Bank and Trust, as a state chartered commercial bank, also receives regulatory scrutiny from the North Carolina Commissioner of Banks and the Federal Reserve Board |
| Banking regulations, designed primarily for the protection of depositors, may limit our growth and the return to you as an investor in Southern Community, by restricting its activities, such as: • the payment of dividends to shareholders; • possible transactions with or acquisitions by other institutions; • desired investments; • loans and interest rates; • interest rates paid on deposits; and • the possible expansion of branch offices |
| Southern Community has elected to be regulated as a financial holding company to expand its opportunities to provide additional services, but it will have to comply with other federal laws and regulations and could face enforcement actions by regulatory agencies |
| Southern Community cannot predict what changes, if any, will be made to existing federal and state legislation and regulations or the effect that such changes may have on its business |
| The cost of compliance with regulatory requirements may adversely affect Southern Community’s ability to operate profitably |
| Our trading volume has been low compared with larger bank holding companies and the sale of substantial amounts of our common stock in the public market could depress the price of our common stock |
| The average daily trading volume of our shares on The Nasdaq National Market for the three months ended February 15, 2006 was approximately 15cmam300 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 Page 14 _________________________________________________________________ located within our market area, some of which are significantly larger, well-established institutions |
| Nonbank competitors for deposits and deposit-type accounts include savings associations, credit unions, securities firms, money market funds, life insurance companies and the mutual funds industry |
| For loans, Southern Community encounters competition from other banks, savings associations, finance companies, mortgage bankers and brokers, insurance companies, small loan and credit card companies, credit unions, pension trusts and securities firms |
| We may face a competitive disadvantage as a result of our smaller size, lack of multi-state geographic diversification and inability to spread our marketing costs across a broader market |
| Southern Community’s Articles of Incorporation include anti-takeover provisions that may prevent shareholders from receiving a premium for their shares or effecting a transaction favored by a majority of shareholders |
| Southern Community’s Articles of Incorporation include certain anti-takeover provisions, such as being subject to the Shareholder Protection Act and Control Share Acquisition Act under North Carolina law and a provision allowing our Board of Directors to consider the social and economic effects of a proposed merger, which may have the effect of preventing shareholders from receiving a premium for their shares of common stock and discouraging a change of control of Southern Community by allowing minority shareholders to prevent a transaction favored by a majority of the shareholders |
| The primary purpose of these provisions is to encourage negotiations with our management by persons interested in acquiring control of our corporation |
| These provisions may also tend to perpetuate present management and make it difficult for shareholders owning less than a majority of the shares to be able to elect even a single director |
| Holders of our trust preferred securities have rights that are senior to those of our common shareholders |
| We have supported our continued growth through the issuance of trust preferred securities from special purpose trusts and accompanying junior subordinated debentures |
| At December 31, 2005, we had outstanding trust preferred securities and accompanying junior subordinated debentures totaling dlra34dtta5 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 |
| Page 15 _________________________________________________________________ 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 50prca of its paid-in capital |
| We may also be precluded from making interest payments on the subordinated debentures by our regulators in order to address any perceived deficiencies in liquidity or regulatory capital levels at the holding company level |
| Such regulatory action would require us to obtain consent from our regulators prior to paying dividends on our common stock or interest on the subordinated debentures |
| In the event our regulators withheld their consent to our payment of interest on the subordinated debentures, we would exercise our right to defer interest payments on the subordinated debentures, and the trust would not have funds available to make distributions on the preferred securities during such period |
| Our obligation to make interest payments to the trust on the debentures is subordinated to existing liabilities or additional debt we may incur |
| Our obligations under the debentures and the guarantee are unsecured and will rank junior in priority of payment to our existing liabilities and any future senior and subordinated indebtedness and will rank equally with our existing convertible trust preferred securities |
| We had no senior or subordinated indebtedness at December 31, 2005 |
| However, our issuance of the debentures and the preferred securities does not limit our ability or the ability of our subsidiaries to incur additional indebtedness, guarantees or other liabilities |
| Also, because we are a holding company, the creditors of our bank subsidiary, including depositors, also will have priority over holders of the preferred securities in any distribution of our subsidiaries’ assets in liquidation, reorganization or otherwise |
| Accordingly, the debentures and the guarantee will be effectively subordinated to all existing and future liabilities of our subsidiaries, and holders of the preferred securities should look only to our assets for payments on the preferred securities and the debentures |
| We have the option to defer interest payments on the debentures for substantial periods |
| As long as we are not in default under the indenture relating to the debentures, we may, at one or more times, defer interest payments on the debentures for up to 20 consecutive quarters |
| If we defer interest payments on the debentures, the trust will defer distributions on the preferred securities during any deferral period |
| If we elect to defer payments on the debentures for our convertible trust preferred securities, we must also defer payments on the debentures for the preferred securities in this offering and vice versa |
| If we defer interest payments, holders of the preferred securities will still be required to recognize the deferred interest amounts as income |
| During a deferral period, holders of the preferred securities will be required to recognize as income for federal income tax purposes the amount approximately equal to the interest that accrues on your proportionate share of the debentures, held by the trust in the tax year in which that interest accrues, even though holders of the preferred securities will not receive these amounts until a later date if they hold the preferred securities until the deferred interest is paid |
| If holders of the preferred securities sell their preferred securities during a deferral period, they will forfeit the deferred interest amount and only have a capital loss |
| Holders of the preferred securities will not receive the cash related to any accrued and unpaid interest from the trust if they sell the preferred securities before the end of any deferral period |
| During a deferral period, accrued but unpaid distributions will increase their tax basis in the preferred securities |
| If holders of the preferred securities sell the preferred securities during a deferral period, their increased tax basis will decrease the amount of any capital Page 16 _________________________________________________________________ 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 |
| 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 Page 17 _________________________________________________________________ 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 |