Item 1. Business
Who We Are
Southern Community Financial Corporation (“we” or the “Company”) is the holding company for Southern Community Bank and Trust (the “Bank”), a community bank with twenty-one banking offices operating in eight counties throughout North Carolina. The Bank commenced operations on November 18, 1996 and effective October 1, 2001 became a wholly-owned subsidiary of the newly formed holding company. We have banking offices in the Piedmont Triad area, including Winston-Salem (our headquarters), Greensboro and High Point, and surrounding areas; Mooresville (the Charlotte area), and Raleigh, and opened a loan production office in Asheville with a branch planned for 2007.
At December 31, 2006, we had total assets of $1.4 billion, net loans of $1.0 billion, deposits of $1.0 billion, and shareholders’ equity of $136.2 million. We had net income of $4.2 million, $7.7 million, and $8.1 million and diluted earnings per share of $0.24, $0.42, and $0.45 for the years ended December 31, 2006, 2005 and 2004, respectively.
We have been, and intend to remain, a community-focused financial institution offering a full range of financial services to individuals, businesses and nonprofit organizations in the communities we serve. Our banking services include checking and savings accounts; commercial, installment, mortgage, and personal loans; trust and investment services; safe deposit boxes and other associated services to satisfy the needs of our customers.
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 and the Federal Deposit Insurance Corporation insures its deposits up to applicable limits. The address of our principal executive office is Country Club Road, Winston-Salem, North Carolina 27104 and our telephone number is (336) 768-8500. Our common stock and our trust preferred securities are traded on the NASDAQ Global Select Market System under the symbols “SCMF” and “SCMFO”, respectively.
Our Market Area
We consider our primary market area to be the Piedmont Triad area of North Carolina, Raleigh, and Asheville, and to a lesser extent, adjoining counties. The Piedmont Triad is a 12 county region located in north central North Carolina and is named for the three largest cities in the region, Winston-Salem (where our headquarters is located), Greensboro and High Point. The region has one-fifth of the state’s population and one-fifth of its labor force. Its estimated population at the end of 2006 was in excess of 1.9 million. The region’s population is expected to grow an estimated 15.5% between 2000 and 2010.
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The Piedmont Triad is the largest Metropolitan Statistical Area located entirely in North Carolina. The MSA is also one of the top 50 in the country in both total population and number of households. Winston-Salem is the largest city in Forsyth County and the fifth largest city in North Carolina. Greensboro is the largest city in Guilford County and the third largest city in North Carolina, while High Point is the second largest city in Guilford County and the eighth largest city in North Carolina. In 2006, Forsyth County had an estimated population of almost 326 thousand and Guilford County has an estimated population of almost 441 thousand.
The Piedmont Triad is the economic hub of northwest North Carolina. In 2006, the median family income ranged from a low of $45.2 thousand dollars in the Mt. Airy micropolitan area to a high of $58.2 thousand dollars in the Winston-Salem metropolitan area. The Piedmont Triad has a very balanced and diversified economy and a work force that exceeded 800 thousand in 2005. Approximately 99% of the work force is employed in nonagricultural wage and salary positions. The major employment sectors in 2005 were services (34%), manufacturing (20%), trade (16%), government (12%), financial (7%), and construction (5%). From January 2006 to December 2006, the unemployment rate in the Piedmont Triad decreased from 4.9% to 4.8%.
The Bank serves our market area through twenty-one full service banking offices. Our television and radio advertising has extended into this market area for several years, providing the Bank name recognition in the Piedmont Triad area. The Bank’s customers may access various banking services through over one hundred ATMs owned or leased by the Bank, through debit cards, and through the Bank’s automated telephone and Internet electronic banking products. These products allow the Bank’s customers to apply for loans, access account information and conduct various transactions from their telephones and computers.
Business Strategy
We established our bank with the objective of becoming a vital, long-term player in our markets with a reputation for quality customer service provided by a financially sound organization. Our business strategy is to operate as an institution that is well-capitalized, strong in asset quality, profitable, independent, customer-oriented and connected to our community.
A commitment to customer service is at the foundation of our approach. Our commitment is to put our customers first and we believe it differentiates us from our competitors. Making good quality, profitable loans, which result in a long-standing relationship with our borrowers, will continue to be a cornerstone of our strategy. We intend to leverage the core relationships we build by providing a variety of services to our customers. With that focus, we target:
· 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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Individual consumers.
We intend to grow our franchise through new and existing relationships developed by our associates, and by expanding primarily to contiguous areas through de novo entry and acquisitions which make strategic and economic sense.
We have also diversified our revenue in order to generate non-interest income. These efforts include our mortgage loan department, our small business investment company manager (which generates management fees) and our wealth management department, Southern Community Advisors, which offers investment advisory, brokerage, trust and insurance services. For the year ended December 31, 2006 our non-interest income, excluding securities gains and losses, represented 16.1% of our total revenue. We believe that the profitability of these added businesses and services, not just the revenue generated, is critical to our success.
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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.
Our belief is that our way of doing business will build a profitable corporation and shareholder value. We want to consistently reward our shareholders for their investment and trust in us.
Subsidiaries
The Bank operates one subsidiary that provides financial services in addition to those offered directly by the Bank. The Company has a subsidiary to issue trust preferred securities. Each subsidiary is described below.
VCS Management, LLC was formed in March 2000 as the managing general partner of Salem Capital Partners, L.P. (“SCP I”), a small business investment company licensed by the Small Business Administration. The Bank has invested $1.7 million in the partnership, which has a total of $9.2 million of invested capital from various private investors including the Bank. The partnership can also borrow funds on a non-recourse basis from the Small Business Administration to increase its capital available for investment. The partnership makes investments generally in the form of subordinated debt and earns revenue through interest received on its investments and potentially through gains realized from warrants that it receives in conjunction with its debt investments. The Bank shares in any earnings of the partnership through its investment in the partnership. During 2006, Salem Capital Partners II, L.P. (“SCP II”) was formed and licensed by the Small Business Administration, with a purpose and operations similar to SCP I. At December 31, 2006, the Bank has committed to investing up to $2 million in SCP II, or approximately 19.7% of the total committed capital for SCP II. In connection with the formation of SCP II, a new entity, SCP Advisor LLC, was formed to manage SCP I and II. The Bank owns 49% of SCP Advisor LLC. For the year ended December 31, 2006, the Company earned $792 thousand, or 1.8% of total revenue, from its SBIC activities, including income from the investments in SCP I and II and SBIC management fees.
In November 2003, Southern Community Capital Trust II (“Trust II”), a newly formed subsidiary of the Company, issued 3,450,000 Trust Preferred Securities (“Trust II Securities”), generating gross total proceeds of $34.5 million. The Trust II Securities pay distributions at an annual rate of 7.95% and mature on December 31, 2033. The Trust II Securities began paying quarterly distributions on December 31, 2003. The Company has fully and unconditionally guaranteed the obligations of Trust II. The Trust II Securities are redeemable in whole or in part at any time after December 31, 2008. The proceeds from the Trust II Securities were utilized to purchase convertible junior subordinated debentures from us under the same terms and conditions as the Trust II Securities. We have the right to defer payment of interest on the debentures at any time and from time to time for a period not exceeding five years, provided that no deferral period extend beyond the stated maturities of the debentures. Such deferral of interest payments by the Company will result in a deferral of distribution payments on the related Trust II Securities. Should we defer the payment of interest on the debentures, the Company will be precluded from the payment of cash dividends to shareholders. The principal uses of the net proceeds from the sale of the debentures were to provide cash for the acquisition of The Community Bank, to increase our regulatory capital, and to support the growth and operations of our subsidiary bank. The amount of proceeds we count as Tier 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.
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Competition
The activities in which the Bank engages are highly competitive. Commercial banking in North Carolina is extremely competitive due to state laws which permit state-wide branching. Consequently, many commercial banks have branches located in several communities. One of the largest regional commercial banks in North Carolina, a new community bank and one savings institution also have their headquarters in Winston-Salem. As of June 2006, we operated branches in Forsyth, Guilford, Iredell, Rockingham, Stokes, Surry, Wake and Yadkin Counties, North Carolina. On that date, there were 590 branches operated by forty-five banks and nine savings institutions in these eight counties with approximately $38.0 billion in deposits. Deposits of the Bank in June 2006 were $985.1 million. Many of these competing banks have capital resources and legal lending limits substantially in excess of those available to us and the Bank. Therefore, in our market area, the Bank has significant competition for deposits and loans from other depository institutions.
Other financial institutions such as credit unions, consumer finance companies, insurance companies, brokerage companies, small loan companies and other financial institutions with varying degrees of regulatory restrictions compete vigorously for a share of the financial services market. Credit unions have been permitted to expand their membership criteria and expand their loan services to include such traditional bank services as commercial lending. These entities pose an ever-increasing challenge to our efforts to serve the markets traditionally served by banks. We expect competition to continue to be significant.
Employees
During 2006, all employees of Southern Community Financial Corporation were compensated by the Bank. At December 31, 2006, the Bank employed 326 full-time equivalent persons (including our executive officers). None of the employees are represented by any unions or similar groups, and we have not experienced any type of strike or labor dispute. We consider our relationship with our employees to be good and extremely important to our long-term success. The Board and management continually seek ways to enhance their benefits and well being.
SUPERVISION AND REGULATION
Southern Community Financial Corporation is registered as a financial holding company with the Federal Reserve. The Bank is a North Carolina chartered banking corporation which is not a member of the Federal Reserve System. Banking is a complex, highly regulated industry. The primary goals of bank regulations are to maintain a safe and sound banking system and to facilitate the conduct of sound monetary policy. In furtherance of these goals, Congress has created several largely autonomous regulatory agencies and enacted numerous laws that govern banks, bank holding companies and the banking industry. The descriptions of and references to the statutes and regulations below are brief summaries and do not purport to be complete. The descriptions are qualified in their entirety by reference to the specific statutes and regulations discussed.
Southern Community Financial Corporation
Southern Community Financial Corporation is a bank holding company that has elected to be treated as a financial holding company. As a bank holding company under the Bank Holding Company Act of 1956, as amended, we are registered with and subject to regulation by the Federal Reserve. We are required to file annual and other reports with, and furnish information to, the Federal Reserve. The Federal Reserve conducts periodic examinations of us and may examine any of our subsidiaries, including the Bank.
The Bank Holding Company Act provides that a bank holding company must obtain the prior approval of the Federal Reserve for the acquisition of more than five percent of the voting stock or substantially all the assets of any bank or bank holding company. In addition, the Bank Holding Company Act restricts the extension of credit to any bank holding company by its subsidiary bank. The Bank Holding Company Act also provides that, with certain exceptions, a bank holding company may not engage in any activities other than those of banking or managing or controlling banks and other authorized subsidiaries or own or control more than five percent of the voting shares of any company that is not a bank. The Federal Reserve has deemed limited activities to be closely related to banking and therefore permissible for a bank holding company.
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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 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 capital constitutes qualifying total capital. The Tier 1 component must comprise at least 50% of qualifying total capital.
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Every bank holding company has to achieve and maintain a minimum Tier 1 capital ratio of at least 4.0% and a minimum total capital ratio of at least 8.0%. In addition, banks and bank holding companies are required to maintain a minimum leverage ratio of Tier 1 capital to average total consolidated assets (leverage capital ratio) of at least 3.0% for the most highly-rated, financially sound banks and bank holding companies and a minimum leverage ratio of at least 4.0% for all other banks. The Federal Deposit Insurance Corporation and the Federal Reserve define Tier 1 capital for banks in the same manner for both the leverage ratio and the risk-based capital ratio. However, the Federal Reserve defines Tier 1 capital for bank holding companies in a slightly different manner. As of December 31, 2006, our Tier 1 leverage capital ratio and total capital were 8.73% and 11.40%, respectively.
The guidelines also provide that banking organizations experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory level, without significant reliance on intangible assets. The guidelines also indicate that the Federal Reserve will continue to consider a “Tangible Tier 1 Leverage Ratio” in evaluating proposals for expansion or new activities. The Tangible Tier 1 Leverage Ratio is the ratio of Tier 1 capital, less intangibles not deducted from Tier 1 capital, to quarterly average total assets. As of December 31, 2006, the Federal Reserve had not advised us of any specific minimum Tangible Tier 1 Leverage Ratio applicable to us.
The Company’s trust preferred securities, which are accounted for as debt under generally accepted accounting principles, presently qualify as Tier 1 regulatory capital and are reported in Federal Reserve regulatory reports as minority interest in our consolidated subsidiaries. The junior subordinated debentures do not qualify as Tier 1 regulatory capital. The Federal Reserve limits restricted core capital elements to twenty-five percent of all core capital elements.
Source of Strength for Subsidiaries. Bank holding companies are required to serve as a source of financial strength for their depository institution subsidiaries, and, if their depository institution subsidiaries become undercapitalized, bank holding companies may be required to guarantee the subsidiaries’ compliance with capital restoration plans filed with their bank regulators, subject to certain limits.
Dividends. As a bank holding company that does not, as an entity, currently engage in separate business activities of a material nature, our ability to pay cash dividends depends upon the cash dividends we receive from our subsidiary bank. Our only source of income is dividends paid by the Bank. We must pay all of our operating expenses from funds we receive from the Bank. North Carolina banking law requires that dividends be paid out of retained earnings and prohibits the payment of cash dividends if payment of the dividend would cause the Bank’s surplus to be less than 50% of its paid-in capital. Also, under federal banking law, no cash dividend may be paid if the Bank is undercapitalized or insolvent or if payment of the cash dividend would render the bank undercapitalized or insolvent, and no cash dividend may be paid by the Bank if it is in default of any deposit insurance assessment due to the FDIC. Therefore, shareholders may receive dividends from us only to the extent that funds are available from our subsidiary bank. In addition, the Federal Reserve generally prohibits bank holding companies from paying dividends except out of operating earnings, and the prospective rate of earnings retention appears consistent with the bank holding company’s capital needs, asset quality and overall financial condition. Because we are a bank holding company, the Federal Reserve may impose restrictions on our payment of cash dividends since we are required to maintain adequate regulatory capital of our own and are expected to serve as a source of financial strength and to commit resources to our subsidiary bank.
Change of Control. State and federal banking law restrict the amount of voting stock of the company that a person may acquire without the prior approval of banking regulators. The Bank Holding Company Act requires that a bank holding company obtain the approval of the Federal Reserve before it may merge with a bank holding company, acquire a subsidiary bank, acquire substantially all of the assets of any bank, or before it may acquire ownership or control of any voting shares of any bank or bank holding company if, after such acquisition, it would own or control, directly or indirectly, more than 5% of the voting shares of that bank or bank holding company. The overall effect of such laws is to make it more difficult to acquire us by tender offer or similar means than it might be to acquire control of another type of corporation. Consequently, our shareholders may be less likely to benefit from rapid increases in stock prices that often result from tender offers or similar efforts to acquire control of other types of companies.
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The Bank
The Bank is subject to various requirements and restrictions under the laws of the United States and the State of North Carolina. As a North Carolina bank, our subsidiary bank is subject to regulation, supervision and regular examination by the North Carolina Banking Commission. During 2006, the Bank elected to withdraw as a member of the Federal Reserve System and the Bank is now subject to regulation, supervision and regular examination by the Federal Deposit Insurance Corporation. The North Carolina Banking Commission and the FDIC have the power to enforce compliance with applicable banking statutes and regulations. These requirements and restrictions include requirements to maintain reserves against deposits, restrictions on the nature and amount of loans that may be made and the interest that may be charged thereon and restrictions relating to investments and other activities of the Bank.
Transactions with Affiliates. The Bank may not engage in specified transactions (including, for example, loans) with its affiliates unless the terms and conditions of those transactions are substantially the same or at least as favorable to the Bank as those prevailing at the time for comparable transactions with or involving other nonaffiliated entities. In the absence of comparable transactions, any transaction between the Bank and its affiliates must be on terms and under circumstances, including credit standards, which in good faith would be offered or would apply to nonaffiliated companies. In addition, transactions referred to as “covered transactions” between the Bank and its affiliates may not exceed 10% of the Bank’s capital and surplus per affiliate and an aggregate of 20% of its capital and surplus for covered transactions with all affiliates. Certain transactions with affiliates, such as loans, also must be secured by collateral of specific types and amounts. The Bank also is prohibited from purchasing low quality assets from an affiliate. Every company under common control with the Bank, including the Company and Southern Community Capital Trust II, is deemed to be an affiliate of the Bank.
Loans to Insiders. Federal law also constrains the types and amounts of loans that the Bank may make to its executive officers, directors and principal shareholders. Among other things, these loans are limited in amount, must be approved by the Bank’s board of directors in advance, and must be on terms and conditions as favorable to the Bank as those available to an unrelated person.
Regulation of Lending Activities. Loans made by the Bank are also subject to numerous federal and state laws and regulations, including the Truth-In-Lending Act, Federal Consumer Credit Protection Act, the Equal Credit Opportunity Act, the Real Estate Settlement Procedures Act and adjustable rate mortgage disclosure requirements. Remedies to the borrower or consumer and penalties to the Bank are provided if the Bank fails to comply with these laws and regulations. The scope and requirements of these laws and regulations have expanded significantly in recent years.
Branch Banking. All banks located in North Carolina are authorized to branch statewide. Accordingly, a bank located anywhere in North Carolina has the ability, subject to regulatory approval, to establish branch facilities near any of our facilities and within our market area. If other banks were to establish branch facilities near our facilities, it is uncertain whether these branch facilities would have a material adverse effect on our business.
Federal law provides for nationwide interstate banking and branching, subject to certain aging and deposit concentration limits that may be imposed under applicable state laws. Applicable North Carolina statutes permit regulatory authorities to approve de novo branching in North Carolina by institutions located in states that would permit North Carolina institutions to branch on a de novo basis into those states. Federal regulations prohibit an out-of-state bank from using interstate branching authority primarily for the purpose of deposit production. These regulations include guidelines to insure that interstate branches operated by an out-of-state bank in a host state are reasonably helping to meet the credit needs of the host state communities served by the out-of-state bank.
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Reserve Requirements. Pursuant to regulations of the Federal Reserve, the bank must maintain average daily reserves against its transaction accounts. During 2006, no reserves were required to be maintained on the first $7.8 million of transaction accounts, but reserves equal to 3.0% were required to be maintained on the aggregate balances of those accounts between $7.8 million and $48.3 million, and additional reserves were required to be maintained on aggregate balances in excess of $48.3 million in an amount equal to 10.0% of the excess. These percentages are subject to annual adjustment by the Federal Reserve, which has advised that for 2007, no reserves will be required to be maintained on the first $8.5 million of transaction accounts, but reserves equal to 3.0% must be maintained on the aggregate balances of those accounts between $8.5 million and $45.8 million, and additional reserves required on aggregate balances in excess of $45.8 million in an amount equal to 10.0% of the excess. Because required reserves must be maintained in the form of vault cash or in a non-interest-bearing account at a Federal Reserve Bank, the effect of the reserve requirement is to reduce the amount of the institution’s interest-earning assets. As of December 31, 2006, the Bank met its reserve requirements.
Community Reinvestment. Under the Community Reinvestment Act (“CRA”), as implemented by regulations of the federal bank regulatory agencies, an insured bank has a continuing and affirmative obligation, consistent with its safe and sound operation, to help meet the credit needs of its entire Community, including low and moderate income neighborhoods. The CRA does not establish specific lending requirements or programs for banks, nor does it limit a bank’s discretion to develop the types of products and services that it believes are best suited to its particular Community, consistent with the CRA. The CRA requires the federal bank regulatory agencies, in connection with their examination of insured banks, to assess the banks’ records of meeting the credit needs of their communities, using the ratings of “outstanding,” “satisfactory,” “needs to improve,” or “substantial noncompliance,” and to take that record into account in its evaluation of certain applications by those banks. All banks are required to make public disclosure of their CRA performance ratings. The Bank received a “satisfactory” rating in its most recent CRA examination.
Governmental Monetary Policies. The commercial banking business is affected not only by general economic conditions but also by the monetary policies of the Federal Reserve. Changes in the discount rate on member bank borrowings, control of borrowings, open market transactions in United States government securities, the imposition of and changes in reserve requirements against member banks and deposits and assets of foreign bank branches, and the imposition of and changes in reserve requirements against certain borrowings by banks and their affiliates are some of the monetary policies available to the Federal Reserve. Those monetary policies influence to a significant extent the overall growth of all bank loans, investments and deposits and the interest rates charged on loans or paid on time and savings deposits in order to mitigate recessionary and inflationary pressures. These techniques are used in varying combinations to influence overall growth and distribution of bank loans, investments, and deposits, and their use may also affect interest rates charged on loans or paid for deposits.
The monetary policies of the Federal Reserve Board have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future. In view of changing conditions in the national economy and money markets, as well as the effect of actions by monetary and fiscal authorities, no prediction can be made as to possible future changes in interest rates, deposit levels, loan demand or the business and earnings of the Bank.
Dividends. All dividends paid by the Bank are paid to us, the sole shareholder of the Bank. The general dividend policy of the Bank is to pay dividends at levels consistent with maintaining liquidity and preserving our applicable capital ratios and servicing obligations. The dividend policy of the Bank is subject to the discretion of the board of directors of the Bank and will depend upon such factors as future earnings, growth, financial condition, cash needs, capital adequacy, compliance with applicable statutory and regulatory requirements and general business conditions.
The ability of the Bank to pay dividends is restricted under applicable law and regulations. Under North Carolina banking law, dividends must be paid out of retained earnings and no cash dividends may be paid if payment of the dividend would cause the bank’s surplus to be less than 50% of its paid-in capital. Also, under federal banking law, no cash dividend may be paid if the Bank is undercapitalized or insolvent or if payment of the cash dividend would render the Bank undercapitalized or insolvent, and no cash dividend may be paid by the Bank if it is in default of any deposit insurance assessment due to the Federal Deposit Insurance Corporation.
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The exact amount of future dividends paid to us by the Bank will be a function of the profitability of the Bank in general and applicable tax rates in effect from year to year. The Bank’s ability to pay dividends in the future will directly depend on future profitability, which cannot be accurately estimated or assured. We expect that, for the foreseeable future, dividends will be paid by the Bank to us as needed to pay any separate expenses of Southern Community Financial Corporation and/or to make required payments on our debt obligations, including the debentures which fund the interest payments on the preferred securities issued by our trust subsidiary, and to pay cash dividends to our shareholders.
Capital Adequacy. The capital adequacy regulations which apply to state banks, such as the Bank, are similar to the Federal Reserve requirements promulgated with respect to bank holding companies discussed above.
Changes in Management. Any depository institution that has been chartered less than two years, is not in compliance with the minimum capital requirements of its primary federal banking regulator, or is otherwise in a troubled condition must notify its primary federal banking regulator of the proposed addition of any person to the board of directors or the employment of any person as a senior executive officer of the institution at least 30 days before such addition or employment becomes effective. During this 30-day period, the applicable federal banking regulatory agency may disapprove of the addition of such director or employment of such officer. The Bank is not subject to any such requirements.
Enforcement Authority. The federal banking laws also contain civil and criminal penalties available for use by the appropriate regulatory agency against certain “institution-affiliated parties” primarily including management, employees and agents of a financial institution, as well as independent contractors such as attorneys and accountants and others who participate in the conduct of the financial institution’s affairs and who caused or are likely to cause more than minimum financial loss to or a significant adverse affect on the institution, who knowingly or recklessly violate a law or regulation, breach a fiduciary duty or engage in unsafe or unsound practices. These practices can include the failure of an institution to timely file required reports or the submission of inaccurate reports. These laws authorize the appropriate banking agency to issue cease and desist orders that may, among other things, require affirmative action to correct any harm resulting from a violation or practice, including restitution, reimbursement, indemnification or guarantees against loss. A financial institution may also be ordered to restrict its growth, dispose of certain assets or take other action as determined by the primary federal banking agency to be appropriate.
Prompt Corrective Action. Banks are subject to restrictions on their activities depending on their level of capital. Federal “prompt corrective action” regulations divide banks into five different categories, depending on their level of capital. Under these regulations, a bank is deemed to be “well capitalized” if it has a total risk-based capital ratio of 10% or more, a core capital ratio of six percent or more and a leverage ratio of five percent or more, and if the bank is not subject to an order or capital directive to meet and maintain a certain capital level. Under these regulations, a bank is deemed to be “adequately capitalized” if it has a total risk-based capital ratio of eight percent or more, a core capital ratio of four percent or more and a leverage ratio of four percent or more (unless it receives the highest composite rating at its most recent examination and is not experiencing or anticipating significant growth, in which instance it must maintain a leverage ratio of three percent or more). Under these regulations, a bank is deemed to be “undercapitalized” if it has a total risk-based capital ratio of less than eight percent, a core capital ratio of less than four percent or a leverage ratio of less than three percent. Under these regulations, a bank is deemed to be “significantly undercapitalized” if it has a risk-based capital ratio of less than six percent, a core capital ratio of less than three percent and a leverage ratio of less than three percent. Under such regulations, a bank is deemed to be “critically undercapitalized” if it has a leverage ratio of less than or equal to two percent. In addition, the applicable federal banking agency has the ability to downgrade a bank’s classification (but not to “critically undercapitalized”) based on other considerations even if the bank meets the capital guidelines.
If a state bank, such as the Bank, is classified as undercapitalized, the bank is required to submit a capital restoration plan to the FDIC. An undercapitalized bank is prohibited from increasing its assets, engaging in a new line of business, acquiring any interest in any company or insured depository institution, or opening or acquiring a new branch office, except under certain circumstances, including the acceptance by the FDIC of a capital restoration plan for the bank.
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If a state bank were classified as undercapitalized, the FDIC may take certain actions to correct the capital position of the bank. If a state bank is classified as significantly undercapitalized, the FDIC would be required to take one or more prompt corrective actions. These actions would include, among other things, requiring sales of new securities to bolster capital, changes in management, limits on interest rates paid, prohibitions on transactions with affiliates, termination of certain risky activities and restrictions on compensation paid to executive officers. If a bank is classified as critically undercapitalized, the bank must be placed into conservatorship or receivership within 90 days, unless the Federal Deposit Insurance Corporation determines otherwise.
The capital classification of a bank affects the frequency of examinations of the bank and impacts the ability of the bank to engage in certain activities and affects the deposit insurance premiums paid by the bank. The FDIC is required to conduct a full-scope, on-site examination of every member bank on a periodic basis.
Banks also may be restricted in their ability to accept brokered deposits, depending on their capital classification. “Well capitalized” banks are permitted to accept brokered deposits, but all banks that are not well capitalized are not permitted to accept such deposits. The FDIC may, on a case-by-case basis, permit member banks that are adequately capitalized to accept brokered deposits if the FDIC determines that acceptance of such deposits would not constitute an unsafe or unsound banking practice with respect to the bank.
Deposit Insurance. The Bank’s deposit accounts are insured up to the maximum per insured account by Federal Deposit Insurance Corporation. During 2006, the FDIC approved a new risk-based assessment system for deposit insurance. It is expected that all banks will pay assessments under this revised system, while under the previous system, certain banks deemed not to pose a threat to the deposit insurance system did not pay any assessments. The FDIC determines the Bank’s deposit insurance assessment rates on the basis of four risk categories. Under the revised assessment rate schedule, the Bank's assessment will range from 0.02 to 0.04% at the lowest assessment risk category up to a maximum assessment of 0.40% of the Bank's average deposit base, with the exact assessment determined by the Bank's assets, its capital and the FDIC's supervisory opinion of its operations. The insurance assessment rate may change periodically. Increases in the assessment rate may have an adverse effect on the Bank's operating results.
Our management cannot predict what other legislation might be enacted or what other regulations might be adopted or the effects thereof.
Item 1A.
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.
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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.
We may incur substantial costs to expand, and we can give no assurance such expansion will result in the levels of profits we seek. There can be no assurance integration efforts for any future mergers or acquisitions will be successful. Also, we may issue equity securities, including common stock, and securities convertible into shares of our common stock in connection with future acquisitions, which could cause ownership and economic dilution to our current shareholders and to investors purchasing common stock in this offering. There is no assurance that, following any future mergers or acquisition, our integration efforts will be successful or our company, after giving effect to the acquisition, will achieve profits comparable to or better than our historical experience.
If the value of real estate in our core market areas were to decline materially, a significant portion of our loan portfolio could become under-collateralized, which could have a material adverse effect on us.
With most of our loans concentrated in the Piedmont Triad region of North Carolina, a decline in local economic conditions could adversely affect the values of our real estate collateral. Consequently, a decline in local economic conditions may have a greater effect on our earnings and capital than on the earnings and capital of larger financial institutions whose real estate loan portfolios are geographically diverse. In addition to the financial strength and cash flow characteristics of the borrower in each case, the Bank often secures loans with real estate collateral. At December 31, 2006, approximately 72% of the Bank’s loans had real estate as a primary or secondary component of collateral. The real estate collateral in each case provides an alternate source of repayment in the event of default by the borrower and may deteriorate in value during the time the credit is extended. If we are required to liquidate the collateral securing a loan to satisfy the debt during a period of reduced real estate values, our earnings and capital could be adversely affected.
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Interest rate volatility could significantly harm our business.
Southern Community’s results of operations are affected by the monetary and fiscal policies of the federal government and the regulatory policies of governmental authorities. A significant component of Southern Community’s earnings is the net interest income of its subsidiary, Southern Community Bank and Trust. Net interest income is the difference between income from interest-earning assets, such as loans, and the expense of interest-bearing liabilities, such as deposits. We may not be able to effectively manage changes in what we charge as interest on our earning assets and the expense we must pay on interest-bearing liabilities, which may significantly reduce our earnings. The Federal Reserve has made significant changes in interest rates during the last few years. Since rates charged on loans often tend to react to market conditions faster than do rates paid on deposit accounts, these rate changes may have a negative impact on our earnings until we can make appropriate adjustments in our deposit rates. In addition, there are costs associated with our risk management techniques, and these costs could be material. Fluctuations in interest rates are not predictable or controllable and, therefore, there can be no assurances of our ability to continue to maintain a consistent positive spread between the interest earned on our earning assets and the interest paid on our interest-bearing liabilities.
Southern Community may have higher loan losses than it has allowed for.
Southern Community’s loan losses could exceed the allowance for loan losses it has set aside. Southern Community’s average loan size continues to increase and reliance on historic allowances for loan losses may not be adequate. Approximately 70% of our loan portfolio is composed of construction, commercial mortgage and commercial loans. Repayment of such loans is generally considered more subject to market risk than residential mortgage loans. Industry experience shows that a portion of loans will become delinquent and a portion of the loans will require partial or entire charge-off. Regardless of the underwriting criteria Southern Community utilizes, losses may be experienced as a result of various factors beyond its control, including, among other things, changes in market conditions affecting the value of its loan collateral and problems affecting the credit of its borrowers.
The building of market share through our de novo branching strategy could cause our expenses to increase faster than our revenues.
We intend to continue to build market share through our de novo branching strategy. We have regulatory approval to open a new branch in Asheville, North Carolina, which we intend to do during 2007. There are considerable costs involved in opening branches. New branches generally do not generate sufficient revenues to offset their costs until they have been in operation for at least a year or more. Accordingly, our new branches can be expected to negatively impact our earnings for some period of time until the branches reach certain economies of scale. Our expenses could be further increased if we encounter delays in the opening of any of our new branches. Finally, we have no assurance our new branches will be successful even after they have been established.
If Southern Community loses key employees with significant business contacts in its market area, its business may suffer.
Southern Community’s success is dependent on the personal contacts of its officers and employees in its market area. If Southern Community lost key employees temporarily or permanently, its business could be hurt. Southern Community could be particularly hurt if its key employees went to work for competitors. Southern Community’s future success depends on the continued contributions of its existing senior management personnel, particularly on the efforts of F. Scott Bauer and Jeff T. Clark, each of whom has significant local experience and contacts in its market area.
Government regulations may prevent or impair our ability to pay dividends, engage in acquisitions, or operate in other ways.
Current and future legislation and the policies established by federal and state regulatory authorities will affect Southern Community’s operations. Southern Community is subject to supervision and periodic examination by the Federal Reserve Board and the North Carolina Commissioner of Banks. Southern Community’s principal subsidiary, Southern Community Bank and Trust, as a state chartered commercial bank, also receives regulatory scrutiny from the North Carolina Commissioner of Banks and the FDIC. Banking regulations, designed primarily for the protection of depositors, may limit our growth and the return to you as an investor in Southern Community, by restricting its activities, such as:
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the payment of dividends to shareholders;
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possible transactions with or acquisitions by other institutions;
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desired investments;
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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.
Southern Community has elected to be regulated as a financial holding company to expand its opportunities to provide additional services, but it will have to comply with other federal laws and regulations and could face enforcement actions by regulatory agencies. Southern Community cannot predict what changes, if any, will be made to existing federal and state legislation and regulations or the effect that such changes may have on its business. The cost of compliance with regulatory requirements may adversely affect Southern Community’s ability to operate profitably.
Our trading volume has been low compared with larger bank holding companies and the sale of substantial amounts of our common stock in the public market could depress the price of our common stock.
The average daily trading volume of our shares on the NASDAQ Global Select Market for the three months ended January 31, 2007 was approximately 13,500 shares. Lightly traded stock can be more volatile than stock trading in an active public market like that for the larger bank holding companies. We cannot predict the extent to which an active public market for our common stock will develop or be sustained. In recent years, the stock market has experienced a high level of price and volume volatility, and market prices for the stock of many companies have experienced wide price fluctuations that have not necessarily been related to their operating performance. Therefore, our shareholders may not be able to sell their shares at the volumes, prices, or times that they desire. We cannot predict the effect, if any, that future sales of our common stock in the market, or availability of shares of our common stock for sale in the market, will have on the market price of our common stock. We therefore can give no assurance that sales of substantial amounts of our common stock in the market, or the potential for large amounts of sales in the market, would not cause the price of our common stock to decline or impair our ability to raise capital through sales of our common stock.
Southern Community faces strong competition in its market area, which may limit its asset growth and profitability.
The banking business in Southern Community’s primary market area, which is currently concentrated in the Piedmont Triad area and surrounding areas in central North Carolina, is very competitive, and the level of competition facing it may increase further, which may limit its asset growth and profitability. Southern Community experiences competition in both lending and attracting funds from other banks and nonbank financial institutions located within our market area, some of which are significantly larger, well-established institutions. Nonbank competitors for deposits and deposit-type accounts include savings associations, credit unions, securities firms, money market funds, life insurance companies and the mutual funds industry. For loans, Southern Community encounters competition from other banks, savings associations, finance companies, mortgage bankers and brokers, insurance companies, small loan and credit card companies, credit unions, pension trusts and securities firms. We may face a competitive disadvantage as a result of our smaller size, lack of multi-state geographic diversification and inability to spread our marketing costs across a broader market.
Southern Community’s Articles of Incorporation include anti-takeover provisions that may prevent shareholders from receiving a premium for their shares or effecting a transaction favored by a majority of shareholders.
Southern Community’s Articles of Incorporation include certain anti-takeover provisions, such as being subject to the Shareholder Protection Act and Control Share Acquisition Act under North Carolina law and a provision allowing our Board of Directors to consider the social and economic effects of a proposed merger, which may have the effect of preventing shareholders from receiving a premium for their shares of common stock and discouraging a change of control of Southern Community by allowing minority shareholders to prevent a transaction favored by a majority of the shareholders. The primary purpose of these provisions is to encourage negotiations with our management by persons interested in acquiring control of our corporation. These provisions may also tend to perpetuate present management and make it difficult for shareholders owning less than a majority of the shares to be able to elect even a single director.
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Holders of our trust preferred securities have rights that are senior to those of our common shareholders.
We have supported our continued growth through the issuance of trust preferred securities from special purpose trusts and accompanying junior subordinated debentures. At December 31, 2006, we had outstanding trust preferred securities and accompanying junior subordinated debentures totaling $34.5 million. Payments of the principal and interest on the trust preferred securities of this special purpose trust are conditionally guaranteed by us. Further, the accompanying junior subordinated debentures we issued to the special purpose trust are senior to our shares of common stock. As a result, we must make payments on the junior subordinated debentures before any dividends can be paid on our common stock and, in the event of our bankruptcy, dissolution or liquidation, the holders of the junior subordinated debentures must be satisfied before any distributions can be made on our common stock. We have the right to defer distributions on our junior subordinated debentures (and the related trust preferred securities) for up to five years, during which time no dividends may be paid on our common stock.
The common stock of Southern Community Financial Corporation is not FDIC insured.
The common stock of Southern Community is not a savings or deposit account or other obligation of any bank and is not insured by the Federal Deposit Insurance Corporation, the Bank Insurance Fund or any other governmental agency and is subject to investment risk, including the possible loss of principal.
Risks Related to an Investment in the Preferred Securities
If we do not make interest payments under the debentures, the trust will be unable to pay distributions and liquidation amounts. The guarantee would not apply because the guarantee covers payments only if the trust has funds available.
The trust will depend solely on our payments on the debentures to pay amounts due to holders of the preferred securities on the debentures. Without these payments, the trust will not have sufficient funds to pay distributions or the liquidation amount on the preferred securities. In that case, holders of the preferred securities will not be able to rely on the guarantee for payment of these amounts because the guarantee only applies if the trust has sufficient funds to make distributions or to pay the liquidation amount. Instead, holders of the preferred securities or the property trustee will have to institute a direct action against us to enforce the property trustee’s rights under the indenture relating to the debentures.
We must rely on dividends from our bank subsidiary to make interest payments on the debentures to the trust.
Our ability to make payments on the debentures when due will depend primarily on dividends from our bank subsidiary because we are a holding company and substantially all of our assets are held by our bank subsidiary. The ability of our bank subsidiary to pay dividends is subject to legal restrictions and the Bank’s profitability, financial condition, capital expenditures and other cash flow requirements. We may also borrow additional funds, issue debt instruments, issue and sell shares of preferred stock, or engage in other types of financing activities, in order to increase our capital. Covenants contained in loan or financing agreements or other debt instruments could restrict or condition our payment of cash dividends based on various financial considerations or factors.
Regulatory authorities may limit dividends paid to us and thereby our ability to make interest payments on the debentures to the trust.
We cannot assure holders of the preferred securities that our bank subsidiary will be able to pay dividends in the future due to regulatory restrictions or that our regulators will not attempt to preclude us from making interest payments on the subordinated debentures. North Carolina banking law requires that cash dividends be paid by a bank only out of retained earnings and prohibits the payment of cash dividends if payment of the dividend would cause the bank’s surplus to be less than 50% of its paid-in capital. We may also be precluded from making interest payments on the subordinated debentures by our regulators in order to address any perceived deficiencies in liquidity or regulatory capital levels at the holding company level. Such regulatory action would require us to obtain consent from our regulators prior to paying dividends on our common stock or interest on the subordinated debentures. In the event our regulators withheld their consent to our payment of interest on the subordinated debentures, we would exercise our right to defer interest payments on the subordinated debentures, and the trust would not have funds available to make distributions on the preferred securities during such period.
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Our obligation to make interest payments to the trust on the debentures is subordinated to existing liabilities or additional debt we may incur.
Our obligations under the debentures and the guarantee are unsecured and will rank junior in priority of payment to our existing liabilities and any future senior and subordinated indebtedness and will rank equally with our existing convertible trust preferred securities. We had no senior or subordinated indebtedness at December 31, 2006. However, our issuance of the debentures and the preferred securities does not limit our ability or the ability of our subsidiaries to incur additional indebtedness, guarantees or other liabilities. Also, because we are a holding company, the creditors of our bank subsidiary, including depositors, also will have priority over holders of the preferred securities in any distribution of our subsidiaries’ assets in liquidation, reorganization or otherwise. Accordingly, the debentures and the guarantee will be effectively subordinated to all existing and future liabilities of our subsidiaries, and holders of the preferred securities should look only to our assets for payments on the preferred securities and the debentures.
We have the option to defer interest payments on the debentures for substantial periods.
As long as we are not in default under the indenture relating to the debentures, we may, at one or more times, defer interest payments on the debentures for up to 20 consecutive quarters. If we defer interest payments on the debentures, the trust will defer distributions on the preferred securities during any deferral period. If we elect to defer payments on the debentures for our convertible trust preferred securities, we must also defer payments on the debentures for the preferred securities in this offering and vice versa.
If we defer interest payments, holders of the preferred securities will still be required to recognize the deferred interest amounts as income.
During a deferral period, holders of the preferred securities will be required to recognize as income for federal income tax purposes the amount approximately equal to the interest that accrues on your proportionate share of the debentures, held by the trust in the tax year in which that interest accrues, even though holders of the preferred securities will not receive these amounts until a later date if they hold the preferred securities until the deferred interest is paid.
If holders of the preferred securities sell their preferred securities during a deferral period, they will forfeit the deferred interest amount and only have a capital loss.
Holders of the preferred securities will not receive the cash related to any accrued and unpaid interest from the trust if they sell the preferred securities before the end of any deferral period. During a deferral period, accrued but unpaid distributions will increase their tax basis in the preferred securities. If holders of the preferred securities sell the preferred securities during a deferral period, their increased tax basis will decrease the amount of any capital gain or increase the amount of any capital loss that they may have otherwise realized on the sale. A capital loss, except in certain limited circumstances, cannot be applied to offset ordinary income. As a result, deferral of distributions could result in ordinary income, and a related tax liability for the holder, and a capital loss that may only be used to offset a capital gain.
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Deferrals of interest payments may increase the volatility of the market price of the preferred securities.
If we defer interest payments, the market price of the preferred securities would likely be adversely affected. The preferred securities may trade at a price that does not fully reflect the value of accrued but unpaid interest on the debentures. If holders of the preferred securities sell the preferred securities during a deferral period, they may not receive the same return on investment as someone who continues to hold the preferred securities. Because of our right to defer interest payments, the market price of the preferred securities may be more volatile than the market prices of other securities without a deferral feature.
There are no financial covenants in the indenture and the trust agreement.
The indenture governing the debentures and the trust agreement governing the trust do not require us to maintain any financial ratios or specified levels of net worth, revenues, income, cash flow or liquidity. The instruments do not protect holders of the debentures or the preferred securities in the event we experience significant adverse changes in our financial condition or results of operations. In addition, neither the indenture nor the trust agreement limit our ability or the ability of any subsidiary to incur additional indebtedness. Therefore, holders of the preferred securities should not consider the provisions of these governing instruments as a significant factor in evaluating whether we will be able to comply with our obligations under the debentures or the guarantee.
We may redeem some or all of the debentures at any time after December 31, 2008 and reduce the period during which holders of the preferred securities will receive distributions.
We have the option to redeem any or all of the outstanding debentures after December 31, 2008 without the payment of any premium. Upon early redemption, holders of the preferred securities may be required to reinvest their principal at a time when they may not be able to earn a return that is as high as they were earning on the preferred securities.
We may redeem all of the debentures at any time upon the occurrence of certain events.
We may redeem all of the debentures before their stated maturity without payment of premium within 90 days after certain occurrences at any time during the life of the trust. These occurrences include adverse tax, investment company or bank regulatory developments. Upon early redemption, holders of the preferred securities may be required to reinvest their principal at a time when they may not be able to earn a return that is as high as they were earning on the preferred securities.
We can distribute the debentures to holders of the preferred securities, which may have adverse tax consequences for holders of the preferred securities and could also adversely affect the market price of the preferred securities.
The trustees may dissolve the trust before maturity of the debentures and distribute the debentures to holders of the preferred securities under the terms of the trust agreement. Under current interpretations of United States federal income tax laws supporting classification of the trust as a grantor trust for tax purposes, a distribution of the debentures to holders of the preferred securities upon the dissolution of the trust would not be a taxable event. Nevertheless, if the trust is classified for United States income tax purposes as an association taxable as a corporation at the time it is dissolved, the distribution of the debentures would be a taxable event to holders of the preferred securities. In addition, if there is a change in law, a distribution of the debentures upon the dissolution of the trust could be a taxable event to holders of the preferred securities. Also, the debentures that holders of the preferred securities may receive if the trust is liquidated may trade at a discount to the price that was paid to purchase the preferred securities.
Holders of the preferred securities must rely on the property trustee to enforce their rights if there is an event of default under the indenture.
Holders of the preferred securities may not be able to directly enforce their rights against us under the indenture if an event of default occurs. If an event of default occurs under the indenture, holders of the preferred securities must rely on the enforcement by the property trustee of its rights as holder of the debentures against us. The holders of a majority in liquidation amount of the preferred securities will have the right to direct the property trustee to enforce its rights. If the property trustee does not enforce its rights following an event of default and there is no request by the record holders of the debentures to do so, any record holder may, to the extent permitted by applicable law, take action directly against us to enforce the property trustee’s rights. If an event of default occurs that is attributable to our failure to pay interest or principal on the debentures, or if we default under the guarantee, holders of the preferred securities may proceed directly against us. Holders of the preferred securities will not be able to exercise directly any other remedies available to the holders of the debentures, unless the property trustee fails to do so.
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Holders of preferred securities have limited voting rights to replace the property trustee and the Delaware trustee.
Holders of preferred securities only have voting rights that pertain primarily to certain amendments to the trust agreement. In general, only we can replace or remove any of the trustees. The holders of at least a majority in aggregate liquidation amount of the preferred securities may replace the property trustee and the Delaware trustee only if an event of default under the trust agreement occurs and is continuing.
The subordinated debentures and the preferred securities do not represent deposit accounts and are not insured.
The subordinated debentures and the preferred securities do not represent bank deposit accounts and they are not obligations issued or guaranteed by the Federal Deposit Insurance Corporation or by any other governmental agency.
Item 1B.
Item 1B. Unresolved Staff Comments
None.
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Item 2.
Item 2. Properties
As of December 31, 2006 we operated out of twenty-one banking offices, six operations/administrative offices, three lending offices and an investment advisory office. All banking offices have ATMs. A summary of our offices is as follows:
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(1) Acquired as part of The Community Bank acquisition.
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In addition to the above locations, we have four off site ATMs located at Robinhood Road, and 401 Deacon Boulevard in Winston-Salem, 1466 River Ridge Road in Clemmons and at 4575 Yadkinville Road, Pfafftown, North Carolina, and approximately 100 outsourced ATM cash dispensing machines throughout North Carolina.
All of our properties, including land, buildings and improvements, furniture, equipment and vehicles, had a net book value at December 31, 2006 of $40.5 million. See further information presented in Note 7 to our consolidated financial statements, which are presented under Item 8 in this Form 10-K.
Additional banking offices may be opened at later dates if deemed appropriate by the Board of Directors and if regulatory approval can then be obtained. The Company may acquire property in which a director, directly or indirectly, has an interest. In such event, the acquisition of such facilities shall be approved by a majority of the Board of Directors, excluding any individual who may have such an interest in the property.
Item 3.
Item 3. Legal
We are party to legal proceedings arising in the normal conduct of business. Our management believes that this litigation is not material to our financial position or results of our operations or the operations of the Bank.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
There were no matters submitted to a vote of our security holders during the fourth quarter of our fiscal year ended December 31, 2006.
PART II
Item 5.
Item 5. Market for Common Stock and Related Stockholder Matters and Issuer Purchases of Equity Securities
Price Range of Common Stock and Dividends
Our common stock and preferred securities are listed on the NASDAQ Global Select Market under the symbols “SCMF” and “SCMFO”, respectively. The following table sets forth the high and low sales prices per share of our common stock and our preferred securities (“SCMFO”), based on published financial sources, and our dividend payments for the last two years.
At February 28, 2007, there were approximately 7,520 holders of record of our common stock.
* Our first annual cash dividend of $0.11 per share of its common stock was paid on March 15, 2004. On March 15, 2005, the Company paid its second annual cash dividend of $0.12 per share of its common stock. We paid quarterly cash dividends of $0.03 per share each on June 1, September 1, December 1, 2005, and March 1, 2006. We paid quarterly cash dividends of $0.035 per share each on June 1, September 1 and December 1, 2006. On February 1, 2007 we announced the declaration of a quarterly cash dividend of $0.035 per share of the common stock, to be paid on March 1, 2007 to shareholders on record as of the close of business on February 15, 2007.
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Holders of our common stock will be entitled to receive any cash dividends the Board of Directors may declare. The declaration and payment of future dividends to holders of our common stock will be at the discretion of our Board of Directors and will depend upon our earnings and financial condition, regulatory conditions and considerations and such other factors as our Board of Directors may deem relevant. As a holding company, Southern Community Financial Corporation is ultimately dependent upon its bank subsidiary to provide funding for its operating expenses, debt service (including the interest payments on the preferred securities issued by our remaining trust subsidiary), and dividends. Our primary sources of income are dividends paid by the Bank and interest income on loans and deposits with the bank subsidiary. We must pay all of our operating expenses from funds we receive from the Bank. Various banking laws applicable to our bank subsidiary limit the payment of dividends, management fees and other distributions by the Bank to us and may therefore limit our ability to make dividend payments. Under North Carolina banking law, dividends must be paid out of retained earnings and no cash dividends may be paid if payment of the dividend would cause the Bank’s surplus to be less than 50% of its paid-in capital. Under federal banking law, no cash dividend may be paid if the Bank is undercapitalized or insolvent or if payment of the cash dividend would render the Bank undercapitalized or insolvent, or if it is in default of any deposit insurance assessment due to the Federal Deposit Insurance Corporation.
In the future, any declaration and payment of cash dividends will be subject to the Board of Directors’ evaluation of our operating results, financial condition, future growth plans, general business and economic conditions, and tax and other relevant considerations. There is no assurance that, in the future, we will have funds available to pay cash dividends, or, even if funds are available, that we will pay dividends in any particular amount or at any particular times, or that we will pay dividends at all.
Share Repurchases
We announced a plan to repurchase up to 300,000 shares of our common stock in March 2005, to repurchase an additional 600,000 shares of our common stock in September 2005 and to repurchase up to an additional 1 million shares of our common stock in July 2006. Through December 31, 2006, we had repurchased 837,926 shares at an average price of $9.48 per share under the three plans, including 96,826 shares at an average price of $10.06 purchased during the fourth quarter of 2006. The table below sets forth information with respect to shares of common stock repurchased by us during the three months ended December 31, 2006.
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Item 6.
Item 6. Selected Financial Data
SELECTED CONSOLIDATED FINANCIAL INFORMATION AND OTHER DATA
The following tables set forth selected consolidated financial information and other data. The results for 2004 include The Community Bank from January 12, 2004. The information set forth below does not purport to be complete and should be read in conjunction with our consolidated financial statements appearing elsewhere in this annual report.
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(1)
Net interest margin is net interest income divided by average interest-earning assets.
(2)
Cash dividends and the dividend payout ratios for 2006 reflect a quarterly dividend paid March 15, 2006 of $0.03 per share, and quarterly dividends of $0.035 per share paid on June 1, September 1, and December 1, 2006. 2005 represents an annual dividend of $0.12 per share paid on March 15, 2005, and quarterly dividends of $0.03 per share paid on June 1, September 1, and December 1, 2005. 2004 represents an annual dividend paid on March 15, 2004.
(3)
Net interest spread is the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities.
(4)
Efficiency ratio is non-interest expense divided by the sum of net interest income and non-interest income.
(5)
Nonperforming assets consist of non-accrual loans, restructured loans, and real estate owned, where applicable.
(6)
Capital ratios are for the Bank.
(7)
Total revenue consists of net interest income and non-interest income.
(8)
All per share data has been restated to reflect the dilutive effect of 5% stock dividends in 2002.
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Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following presents management’s discussion and analysis of our financial condition and results of operations and should be read in conjunction with the financial statements and related notes included elsewhere in this annual report. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ significantly from those anticipated in these forward-looking statements as a result of various factors. The following discussion is intended to assist in understanding the financial condition and results of our operations.
CRITICAL ACCOUNTING POLICY
Our accounting policies are in accordance with accounting principles generally accepted in the United States and with general practice within the banking industry. We make a number of estimates and assumptions relating to reported amounts of assets, liabilities, revenues and expenses in the preparation of the financial statements and disclosures. Material estimates and assumptions that are most susceptible to significant change relate to the determination of the allowance for loan losses. The allowance for loan losses represents management’s estimate of probable losses inherent in the loan portfolio. Management’s judgments include those involved in risk grading the loan portfolio, determining specific allowances for loans considered impaired, and evaluating the impact of current economic conditions on the levels of the allowance. While management believes that the allowance for loan losses is appropriate and adequate to cover probable losses inherent in the portfolio, future adjustments to the allowance may be necessary and results of operations could be adversely affected if circumstances differ substantially from the assumptions used in making the determinations. In addition, because future events affecting borrowers and collateral cannot be predicted with certainty, there can be no assurance that the existing allowance for loan losses is adequate or that increases will not be necessary should the quality of any loans deteriorate as a result of the factors discussed herein. Any material increase in the allowance for loan losses may adversely affect our financial condition and results of operations. For further discussion, see “Nonperforming Assets” and “Analysis of Allowance for Loan Losses” under “ASSET QUALITY.”
OVERVIEW
Our founders recognized an opportunity to fulfill the financial service needs of individuals and organizations left underserved by consolidation within the financial services industry. To fill a part of this void, we began in 1995 the process by which Southern Community Financial Corporation was created, and began operations on November 18, 1996. From inception, we have strived to serve the financial needs of small to medium-sized businesses, individuals, residential homebuilders and others in and around our markets in North Carolina. We offer a broad array of banking and other financial products - products similar to those offered by our larger competitors, but with an emphasis on superior customer service. We believe that our emphasis on quality customer service is the single most important factor among many that have fueled our growth to $1.4 billion in total assets in just over ten years of operations.
We began operations in November 1996 with $11 million in capital, a single branch facility and thirteen employees. Through December 31, 2006, Southern Community Financial Corporation has grown to a total of twenty-one full-service banking offices with $1.0 billion in customer deposit accounts. In support of this growth, we have generated additional capital through issuing common stock and retaining operating earnings. At December 31, 2006, we have $136 million of total stockholders’ equity. Through our banking subsidiary we offer traditional banking products as well as a full array of financial services. In October 2001, we formed Southern Community Financial Corporation, a financial holding company, to become the parent company of Southern Community Bank and Trust. On January 12, 2004 we acquired The Community Bank, a $240 million asset community bank with 10 banking offices in contiguous markets. We created Southern Community Advisors, our wealth management division, and have developed and acquired mortgage banking operations. While these operations are currently not significant to our results of operations, we intend to pursue growth in these businesses to enhance our non-interest income. In 2006, the Bank opened a regional banking office in Mooresville, a rapidly growing community of the Charlotte region, and a regional banking office in Raleigh. In addition, we recently received regulatory approval to open a new branch in Asheville, North Carolina, which we intend to do in 2007.
Real estate secured loans, including construction loans and loans secured by existing commercial and residential properties, comprise the majority of our loan portfolio, with the balance of our loans consisting of commercial and industrial loans and loans to individuals. Through associations with various mortgage lending companies, we originate residential mortgages, at both fixed and variable rates, earning fees for loans originated and additional income for loans sold to others. It has been our strategy to recruit skilled banking professionals who are well trained and highly knowledgeable about our market area, enabling us to develop and maintain a loan portfolio of sound credit quality.
We recognize that our growth may expose us to increased operational and market risk, primarily with respect to managing overhead, funding costs and credit quality. We have developed critical functions such as Credit Administration, Training, Audit, and Compliance to assist in managing and monitoring these and other risks. We are committed to creating and maintaining a solid and diversified financial services organization with a focus on customer service. It is our firm belief that this foundation will continue building our loyal customer base while attracting new clients and providing opportunities for future growth. As bank consolidations continue to take place in our markets, Southern Community Financial Corporation is positioned to continue to benefit from their effects.
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Financial Condition at December 31, 2006 and 2005
During the year ended December 31, 2006, our total assets increased by $148.9 million, or 11.6%, to $1.4 billion. Of the increase in total assets, $127.0 million represented growth in interest-earning assets. Continued strong loan demand resulted in an increase of $164.6 million, or 18.9%, in total loans receivable. Total deposits grew to $1.02 billion at December 31, 2006, an increase of $82.6 million or 8.8% from the year ago period. Premises and equipment increased by $9.2 million net of depreciation, principally as a result of expanding our network with the new regional office in Mooresville, NC and a new state of the art Operations Center.
Our total loan growth of $164.6 million in 2006 was concentrated in commercial mortgage and construction loans, which increased by $73.3 million and $60.0 million, respectively. Commercial and industrial loans increased by $25.8 million and loans secured by residential real estate grew by $18.3 million during the year. These gains were offset slightly by a reduction in consumer loans of $7.8 million. During 2006 we continued our program of originating residential mortgage loans for sale. At the end of the year mortgage loans held for sale totaled $3.6 million.
Our total liquid assets, defined as cash and due from banks, federal funds sold and other interest-bearing deposits, and investment securities, decreased by $31.7 million during the year, to $285.4 million at December 31, 2006, as we restructured our balance sheet during 2006 to dispose of certain lower-yielding investments and reinvest the proceeds in higher-yielding investment securities and in the loan portfolio. Liquid assets represented 19.9% of total assets at December 31, 2006 as compared to 24.6% at the beginning of the year. While we have reduced the size of our investment portfolio in response to the current and expected near-term interest rate environment, we believe our liquidity is adequate to fund expected loan demand and current deposit and borrowing maturities.
Customer deposits continue to be our primary funding source. At December 31, 2006, deposits totaled $1.02 billion, an increase of $82.6 million or 8.8% from year-end 2005. We continue to focus on attracting non-maturity deposits to improve the funding mix and reduce funding costs. Those efforts are reflected in a $78.0 million or 24.8% increase year-over-year in money market, savings and NOW account deposits, which ended the year at $393.2 million. While our deposits are primarily generated through our growing branch network, we do utilize out-of-market and brokered deposits as a funding source. Brokered and out-of-market deposits totaled $162.8 million and $215.7 million at year-end 2006 and 2005, respectively. We intend to continue our focus on growing our deposit base; however, we will continue to monitor the costs of our various funding alternatives, and our funding mix may change from time to time.
Total borrowings aggregated $265.3 million at December 31, 2006, and included $177.7 million of advances from the Federal Home Loan Bank of Atlanta (FHLB), trust preferred securities with a carrying value of $34.9 million, federal funds purchased of $23.2 million and securities sold under agreements to repurchase of $14.5 million. We have entered into long-term financing through term repurchase agreements with various parties, which total $15.0 million at December 31, 2006. We will use FHLB advances and other funding sources as necessary to support balance sheet management and growth. However, we believe that as our branch network grows and matures, the volume of core deposits will become an increasingly larger portion of our funding mix, which over time should contribute to a reduction in our overall funding cost.
Our capital position remains strong, with all of our regulatory capital ratios at levels that make us “well capitalized” under federal bank regulatory capital guidelines. At December 31, 2006, our stockholders’ equity totaled $136.2 million, an increase of $1.3 million from the December 31, 2005 balance. This net change includes $4.2 million of net income, $749 thousand of proceeds from shares purchased through stock option and stock purchase plans, and $2.4 million in other comprehensive income due primarily to realized losses on available for sale investment securities recognized from the balance sheet restructuring that had previously been recorded as unrealized losses, offset somewhat by shares repurchased at a cost of $3.7 million, and cash dividends paid of $2.4 million.
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NET INTEREST INCOME
Like most financial institutions, the primary component of our earnings is net interest income. Net interest income is the difference between interest income, principally from loans and investments, and interest expense, principally on customer deposits and borrowings. Changes in net interest income result from changes in volume and changes in interest rates earned and paid. By volume, we mean the average dollar level of interest-earning assets and interest-bearing liabilities. Spread refers to the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities, and margin refers to net interest income divided by average interest-earning assets. Spread and margin are influenced by the levels and relative mix of interest-earning assets and interest-bearing liabilities, as well as by levels of noninterest-bearing liabilities. During the years ended December 31, 2006, and 2004, our average interest-earning assets were $1.23 billion, $1.16 billion, and $1.06 billion, respectively. During these same years, our net interest margins were 3.30%, 3.20%, and 3.26%, respectively.
During 2006, the Federal Reserve increased the targeted federal funds rate four times, and the prime rate correspondingly increased 100 basis points during the year to 8.25%. While it is management’s goal to remain relatively interest rate neutral, the Bank has been slightly asset sensitive and benefited somewhat from a rising rate environment. Net interest income totaled $40.7 million, an increase of $3.8 million or 10.2% over the $37.0 million for the same period in 2005. Net interest income benefited from strong growth in average earning assets, coupled with increased yields on the loan portfolio due to interest rate increases by the Federal Reserve and the balance sheet restructuring. Due to strong loan demand, our level of average earning assets has increased $75.9 or 6.6% for the year ending December 31, 2006, net of the impact of the reduction in our investment portfolio. Our efforts in repositioning our balance sheet by reducing our level of investment securities to total assets while increasing our focus on deposit growth are reflected in the mix of interest-earning assets and liabilities and the resulting expansion of our net interest margin. Our average yield on interest-earning assets in 2006 increased 105 basis points above that of 2005 to 6.94%. Rising rates have also affected our funding costs, and for 2006, funding costs increased 100 basis points to 4.02% from 3.02% for the comparable period a year ago. Average interest bearing liabilities increased $86.7 or 8.4% to $1.11 billion from $1.03 billion for the period ended December 31, 2006.
Average Balances and Average Rates Earned and Paid. The following table sets forth, for the years 2004 through 2006, information with regard to average balances of assets and liabilities, as well as the total dollar amounts of interest income from interest-earning assets and interest expense on interest-bearing liabilities, resultant yields or costs, net interest income, net interest spread, net interest margin and ratio of average interest-earning assets to average interest-bearing liabilities. Average loans include nonaccruing loans, the effect of which is to lower the average yield.
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(1) Nonaccrual notes are included in the loan amounts.
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RATE/VOLUME ANALYSIS
The following table analyzes the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities. The table distinguishes between (i) changes attributable to volume (changes in volume multiplied by the prior period’s rate), (ii) changes attributable to rate (changes in rate multiplied by the prior period’s volume), and (iii) net change (the sum of the previous columns). The change attributable to both rate and volume (changes in rate multiplied by changes in volume) has been allocated equally to both the changes attributable to volume and the changes attributable to rate.
RESULTS OF OPERATIONS
Years Ended December 31, 2006 and 2005
Net Income. Our net income for 2006 was $4.2 million, a decrease of $3.5 million from net income of $7.7 million earned in 2005. Net income per share was $0.24 basic and diluted for the year ended December 31, 2006, and $0.43 basic and $0.42 diluted for 2005. The decrease is due primarily to the major initiative undertaken the Company to restructure our balance sheet, which resulted in an after tax charge of $2.7 million in the second quarter of 2006. We have continued to experience strong asset growth, driven by solid loan growth of $164.6 million or 18.9%, which was supported primarily by an increase of $82.6 million in our deposit base. During 2006, average earning assets increased $75.9 million or 6.6% to $1.23 billion, and average interest bearing liabilities rose $86.7 million or 8.4%. Our growth in interest earning assets and the expansion of our net interest margin produced an increase in net interest income of $3.8 million, or 10.2% for 2006 compared with 2005. The provision for loan losses increased to $2.5 million from $950 thousand, as 2005 reflected the benefit of the successful resolution of certain impaired credits for which reserves had previously been provided.
Non-interest income fell $3.5 million to $3.7 million. The decrease in non-interest income was due primarily to the $4.2 million pre-tax loss associated with the restructuring of our investment portfolio in the second quarter of 2006. Our service charges on deposit accounts increased $563 thousand or 15.0% as we continued our focus in attracting transaction accounts. Non-interest expenses increased $4.5 million, or 14.3%, primarily due to increased personnel and occupancy and equipment costs as we continue to build our infrastructure to fuel and support our growth. We are undertaking initiatives to slow the growth of non-interest expenses; however, non-interest expenses will be impacted in 2007 by increased occupancy and personnel costs from branch expansion in Asheville and Raleigh, and a full year of costs from our new operations facility opened in July 2006.
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Net Interest Income. During 2006, our net interest income increased by $3.8 million or 10.2% to $40.7 million. Our growth in interest income was the result of growth in our overall level of average earning assets from strong loan demand. Average total interest-earning assets increased $75.9 million, or 6.7% during 2006, as the increase in average loan balances of $120.5 million was offset somewhat by a decrease in our average investment portfolio of $43.6 million. Our average total interest-bearing liabilities increased by $86.7 million, or 8.4%. The rates earned on a significant portion (approximately 58%) of our loans adjust immediately when index rates such as our prime rate changes. Until recently, a slight majority of our interest-bearing liabilities, including certificates of deposit and certain borrowings, had rates that were fixed until maturity. As a result, interest rate increases have generally resulted in an immediate increase in our interest income on loans. While increases in interest expense on fixed rate certificates of deposit and borrowings are delayed until renewal, our floating rate borrowings are primarily LIBOR-based, and changes in LIBOR rates typically are in advance of changes in the prime rate. Our goal is to manage to a neutral position with respect to the impact of future changes in rates.
The rising interest rate environment in the first half of 2006 resulted in yields on our loan portfolio increasing by 100 basis points, similar to the increase in our funding costs of 100 basis points. As a result of our balance sheet restructuring, the yields on the investment portfolio increased 79 basis points to 4.59%. The increase in yields from our balance sheet restructuring, combined with our focus on increasing non-maturity deposits and improving our funding mix, resulted in an increase in our net interest margin for the year of 10 basis points.
We will continue to evaluate ways to improve our net interest margin; however, we expect the impact of the current interest rate environment, and the impact of competition on loan yields and deposit costs, will continue to put pressure on our net interest margin in 2007, and expect some margin compression over the near term.
Provision for Loan Losses. We recorded a $2.5 million provision for loan loss for the year ended December 31, 2006, representing an increase of $1.6 million from the $950 thousand provision we made for the year ended December 31, 2005. The level of provisions for 2006 is reflective of the trends in the loan portfolio, including loan growth, levels of non-performing loans and other loan portfolio quality measures, and analyses of impaired loans. The provision for 2005 benefited from the successful resolution of certain relationships for which specific reserves had previously been established, and repayment of or improvement in higher risk-rated credits. Provisions for loan losses are charged to income to bring our allowance for loan losses to a level deemed appropriate by management based on the factors discussed under “Analysis of Allowance for Loan Losses.” The provision for loan losses in 2006 was .26% of average loans, while 2005, which benefited from the successful resolution of certain credits described above, was .11% of average loans. On an annualized basis, our percentage of net loan charge-offs to average loans outstanding was .13% for the year ended December 31, 2006, compared with .14% for the year ended December 31, 2005. Nonperforming loans totaled $2.6 million or .26% of total loans at December 31, 2006, compared with $1.4 million or .16% of total loans at December 31, 2005. The allowance for loan losses at December 31, 2006 of $13.0 million represents 1.26% of total loans and 495% of nonperforming loans. The allowance for loan losses at December 31, 2005 of $11.8 million was 1.36% of total loans outstanding and 837% of nonperforming loans at that date.
Non-Interest Income. For the year ended December 31, 2006, non-interest income decreased $3.5 million, or 48.5%, to $3.7 million from $7.1 million for the prior year. This decline is primarily due to a $4.2 million pre-tax loss on the sale of investment securities recorded in the second quarter of 2006 related to our balance sheet restructuring. During 2006, service charges and fees on deposit accounts increased $563 thousand, or 15.0%, as we continued our focus on attracting transaction accounts. Fees and income from the origination and sale of residential mortgage loans increased $99 thousand or 9.0% to $1.2 million. Income from investment brokerage and trust fees declined from the prior year by $108 thousand, to $780 thousand. Income from our investments in and management fees from Salem Capital Partners, our Small Business Investment Company affiliate, of $792 thousand were down $419 thousand from 2005. The fourth quarter of 2005 included a gain of $660 thousand from the exit of certain investments made by Salem.
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We expect a continued positive trend in service charge fee income in the future as we expand our branch network and deposit base. We continue to invest in experienced personnel to support our mortgage and investment areas. While we anticipate some variations in the performance of these business lines due primarily to external market conditions, we believe these investments provide us with an infrastructure that will support us with a solid base of revenue in the future. As Salem Capital Partners’ portfolio matures, we anticipate some fluctuation in our non-interest income as gains and losses on their investments are recognized.
Non-Interest Expense. We strive to maintain non-interest expenses at levels that we believe are appropriate given the nature of our operations and the investments in personnel and facilities that have been necessary to support our growth. From 1998 forward, we have consistently maintained our ratio of non-interest expenses to average total assets below 3.0%. For 2006 our ratio was 2.62%, up from 2.44% in 2005. Because of our continued strong growth, we have seen increases in every major component of our non-interest expenses. For the year ended December 31, 2006, our non-interest expense grew by $4.5 million, or 14.3%. Salary and employee benefits expense increased $2.8 million, or 17.4%, and reflects the addition of personnel associated with our expansion in Mooresville, Raleigh, and Asheville, the addition of personnel to expand and support our lines of business, and normal increases in salaries and employee benefits. Occupancy and equipment expense increased $1.0 million, or 18.1%, reflecting the expenses associated with our continued banking office expansion in 2005 and 2006, the opening of our state of the art operations facility, and investments in technology to support our banking operations. Other non-interest expenses increased $650 thousand, or 6.9%, reflecting the increased volume of business activity, principally increases in lending and growth in deposit accounts. The Company is undertaking initiatives in slowing the growth of non-interest expenses; however, non-interest expenses will be impacted in 2007 by increased occupancy and personnel costs from branch expansion in Asheville and Raleigh, and a full year of costs in the new operations facility.
Provision for Income Taxes. Our provision for income taxes, as a percentage of income before income taxes, was 31.0% for the year ending December 31, 2006 and 35.2% for the year ended December 31, 2005, reflective of the impact of tax-exempt interest income as a larger percentage of pre-tax income.
RESULTS OF OPERATIONS
Years Ended December 31, 2005 and 2004
Net Income. Our net income for 2005 was $7.7 million, a decrease of $442 thousand from net income of $8.1 million earned in 2004. Net income per share was $0.43 basic and $0.42 diluted for the year ended December 31, 2005, and $0.47 basic and $0.45 diluted for 2004. We have continued to experience strong asset growth, driven by solid loan growth of $72.7 or 9.1% which was supported by a $96.4 million increase in our deposit base, allowing us to reduce our reliance on wholesale borrowings. During 2005 average earning assets increased $99.5 million or 9.4% to $1.2 billion, outpacing the $87.1 or 9.2% rise in average interest bearing liabilities. The provision for loan losses decreased to $950 thousand from $2.2 million, largely a result of the successful resolution of certain relationships identified as impaired credits in the fourth quarter of 2004. Our net interest income after provision for loan losses increased by $3.8 million; however, our non-interest income fell $815 thousand to $7.1 million. The decrease in non-interest income was due primarily to a $1.2 million decline in net cash settlement and changes in the fair market value of interest rate swaps. In addition, the company realized a $266 thousand loss on the sale of investment securities, a result of balance sheet management activities. These declines were partially offset by growth in service charges on deposit accounts and other fee based service income. Non-interest expenses increased $3.8 million, or 13.8%, primarily due to increased personnel and occupancy and equipment costs as we continue to build our infrastructure to fuel and support our growth. In addition, during 2005 the Company experienced a series of unusual expenses including charges associated with the departure of two former members of senior management, expenses associated with the Company’s decision to vest all outstanding unvested options, and a higher than normal level of personnel and professional services costs associated with the corporate governance and internal control requirements of the Sarbanes-Oxley Act of 2002. The Company has undertaken initiatives in slowing the growth of non-interest expenses; however, non-interest expenses will be impacted in 2006 by increased occupancy and personnel costs from branch expansion in Greensboro, Raleigh and Mooresville, and a new operations facility to be acquired in the first half of the year.
Net Interest Income. During 2005, our net interest income increased by $2.5 million or 7.2% to $37.0 million. Our growth in interest income was the result of growth in our overall level of average earning assets from strong loan demand. Average total interest-earning assets increased $99.5 million, or 9.4% during 2005. Our average total interest-bearing liabilities increased by $87.1 million, or 9.2%. The rates earned on a significant portion (over 60%) of our loans adjust immediately when index rates such as our prime rate change. Conversely, a slight majority of our interest-bearing liabilities, including certificates of deposit and certain borrowings, have rates that are fixed until maturity. As a result, interest rate increases generally result in an immediate increase in our interest income on loans. While increases in interest expense on fixed rate certificates of deposit and borrowings are delayed until renewal, our floating rate borrowings are primarily LIBOR-based, and increases in LIBOR rates typically are in advance of the prime rate in a rising rate environment.
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The rising interest rate environment in 2005 resulted in yields on our loan portfolio increasing by 90 basis points, similar to the increase in our funding costs of 88 basis points. However, as the investment portfolio is largely fixed income securities, the yield on our investment portfolio increased only 5 basis points for the year. As a result, we experienced a compression of our net interest margin of 6 basis points compared to 2004, to 3.20%.
During the second half of 2005, we launched initiatives focused on increasing our core deposit base with the goal of improving our funding mix. During the fourth quarter of 2005, we sold $11.7 million of lower-yielding investments at a loss of $322 thousand, which we have used to fund loan growth. As a result, in the fourth quarter of 2005 we achieved expansion of our net interest margin of 19 basis points, compared with the third quarter of 2005.
Provision for Loan Losses. We recorded a $950 thousand provision for loan loss for the year ended December 31, 2005, representing a decrease of $1.3 million from the $2.2 million provision we made for the year ended December 31, 2004. The level of provisions for 2005 is reflective of the trends in the loan portfolio, including loan growth, levels of non-performing loans and other loan portfolio quality measures, and analyses of impaired loans. In the second half of 2005, the provision was reduced due to the successful resolution of two relationships for which specific reserves had been established, and repayment of or improvement in higher risk-rated credits. Provisions for loan losses are charged to income to bring our allowance for loan losses to a level deemed appropriate by management based on the factors discussed under “Analysis of Allowance for Loan Losses.” The dollar amount of provisions decreased on a year-over-year basis and the level of the allowance to period-ending loans decreased 21 basis points from the prior year-end to 1.36%. In addition to loan growth affecting our provision for loan losses, net loan charge-offs, which declined 15% to $1.2 million for 2005 from $1.4 million for 2004, also impacted the provision expense. On an annualized basis, our percentage of net loan charge-offs to average loans outstanding was .14% for the year ended December 31, 2005, compared with .19% for the year ended December 31, 2004. The reduction in the charge-offs were principally from our consumer finance lending portfolio, which accounted for $233 thousand or 19% of net charge-offs, a decrease of $455 thousand from the prior year. In 2003, management decided the consumer finance business was no longer part of the Company’s strategic direction, and during the fourth quarter of 2003 ceased originating new consumer finance loans. The residual consumer finance loan portfolio is expected to run off over the next twenty-four months. Nonperforming loans totaled $1.4 million or .16% of total loans at December 31, 2005, compared with $2.2 million or .27% of total loans at December 31, 2004. The allowance for loan losses at December 31, 2005 of $11.8 million represents 1.36% of total loans and 837% of nonperforming loans. The allowance for loan losses at December 31, 2004 of $12.5 million was 1.57% of total loans outstanding and 577% of nonperforming loans at that date.
Non-Interest Income. For the year ended December 31, 2005, non-interest income decreased $815 thousand, or 10.3%, to $7.1 million from $7.9 million for the prior year. This decline is due to a $1.2 million decrease in net cash settlement and changes in the fair market value of interest rate swaps, and a $266 thousand realized loss on the sale of investment securities taken in the fourth quarter of 2005. These declines were partially offset by continued strength in deposit and other retail banking fees as well as realized gains from Salem Capital Partners (SCP). During the fourth quarter of 2005 non-interest income was impacted positively by a gain of $660 thousand from the Company’s investment in SCP, the Company’s affiliated Small Business Investment Company. Income from investment brokerage fees increased from the prior year by $31 thousand, or 4.4%, to $743 thousand. Fees on the origination of residential mortgage loans sold into the secondary market increased $356 thousand to $1.1 million. In addition, service charges and fees associated with deposit accounts increased $253 thousand to $3.7 million.
Non-Interest Expense. We strive to maintain non-interest expenses at levels that we believe are appropriate given the nature of our operations and the investments in personnel and facilities that have been necessary to support our growth. From 1998 forward, we have consistently maintained our ratio of non-interest expenses to average total assets below 3.0%. For 2005 our ratio was 2.44%, up slightly from 2.36% in 2004. Because of our continued strong growth, we have seen increases in every major component of our non-interest expenses. For the year ended December 31, 2005, our non-interest expense grew by $3.8 million, or 13.8%. Salary and employee benefits expense increased $2.3 million, or 16.7%, and reflects the addition of personnel associated with our expansion in Greensboro and Raleigh, addition of personnel to expand and support our lines of business, and normal increases in salaries and employee benefits. Occupancy and equipment expense increased $1.4 million, or 33.0%, reflecting the expenses associated with our continued banking office expansion in 2004 and 2005 and investments in technology to support our banking operations. Other non-interest expenses increased $72 thousand, or .8%, reflecting the increased volume of business activity, principally increases in lending and growth in deposit accounts. Also, the Company has incurred a significant increase in personnel and professional service fees relating to corporate governance initiatives and compliance with the internal control and other requirements of the Sarbanes-Oxley Act of 2002 (SOX). In addition, we incurred a number of unusual expenses in the first quarter of 2005 including costs related to the departure of two former members of senior management and expenses associated with the Company’s decision to vest all outstanding unvested options.
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Provision for Income Taxes. Our provision for income taxes, as a percentage of income before income taxes, was 35.2% for the year ending December 31, 2005 and 36.0% for the year ended December 31, 2004.
LIQUIDITY
Market and public confidence in our financial strength and in the strength of financial institutions in general will largely determine our access to appropriate levels of liquidity. This confidence is significantly dependent on our ability to maintain sound asset quality and appropriate levels of capital resources.
The term “liquidity” refers to our ability to generate adequate amounts of cash to meet our needs for funding loan originations, deposit withdrawals, maturities of borrowings and operating expenses. Management measures our liquidity position by giving consideration to both on- and off-balance sheet sources of, and demands for, funds on a daily and weekly basis.
Sources of liquidity include cash and cash equivalents, net of federal requirements to maintain reserves against deposit liabilities, investment securities eligible for pledging to secure borrowings from correspondent banks pursuant to securities sold under repurchase agreements, investments available for sale, loan repayments, loan sales, deposits, and borrowings from the Federal Home Loan Bank secured with pledged loans and securities, and from correspondent banks under overnight federal funds credit lines. In addition to interest rate-sensitive deposits, the Company’s primary demand for liquidity is anticipated funding under credit commitments to customers.
We have maintained a relatively high level of liquidity in the form of federal funds sold and investment securities. These aggregated $256.3 million at December 31, 2006, compared to $292.6 million and $313.0 million at December 31, 2005 and 2004, respectively. The decrease in 2006 resulted from a decision to reduce our investment portfolio as a percentage of our total assets, and utilize those funds to invest in higher yielding securities and to fund loan growth. Supplementing customer deposits as a source of funding, we have available lines of credit from various correspondent banks to purchase federal funds on a short-term basis of approximately $78.0 million. We also have the credit capacity to borrow up to $358.5 million, as of December 31, 2006, from the Federal Home Loan Bank of Atlanta, with $177.7 million outstanding as of that date. At December 31, 2005 we had FHLB borrowings outstanding of $157.5 million. At December 31, 2006, we had funding of $15 million in the form of term repurchase agreements with maturities from three to five years. We also had short-term repurchase agreements with total outstanding balances of $14.6 million and $5.2 million at December 31, 2006 and 2005, respectively, all of which were done as accommodations for our deposit customers. Securities sold under agreements to repurchase generally mature within ninety days from the transaction date and are collateralized by U.S. government agency obligations. We have repurchase lines of credit aggregating $130 million from various institutions. The repurchases must be adequately collateralized.
At December 31, 2006, our outstanding commitments to extend credit consisted of loan commitments of $339.7 million and amounts available under home equity credit lines and letters of credit of $86.9 million, and $11.8 million, respectively. We believe that our combined aggregate liquidity position from all sources is sufficient to meet the funding requirements of loan demand and deposit maturities and withdrawals in the near term.
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Throughout our ten-year history, our loan demand has typically exceeded our growth in core deposits. We have therefore relied heavily on certificates of deposits as a source of funds. While the majority of these funds are from our local market area, the Bank has utilized brokered and out-of-market certificates of deposits to diversify and supplement our deposit base. In 2006, we continued our focus on expanding our non-maturity deposit base, which has resulted in a reduced reliance on time deposits. Certificates of deposits represented 51.0% of our total deposits at December 31, 2006, a decrease from 54.7% at December 31, 2005. Brokered and out-of-market deposits totaled $162.8 million at year-end 2006 and $215.7 million at year-end 2005, which comprised 15.9% and 22.9% of total deposits, respectively. Certificates of deposit of $100,000 or more, inclusive of brokered and out-of-market certificates, represented 30.7% of our total deposits at December 31, 2006 and 32.3% at December 31, 2005. A portion of these deposits are controlled by members of our Board of Directors and Advisory Board members, or otherwise come from customers considered to have long-standing relationships with our management. Based upon the nature of these relationships, management does not believe we are subject to significant liquidity risk related to these deposits. Large certificates of deposits are generally considered rate sensitive. While we will need to pay competitive rates to retain these deposits at their maturities, there are other subjective factors that will determine their continued retention.
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CONTRACTUAL OBLIGATIONS AND COMMITMENTS
In the normal course of business there are various outstanding contractual obligations of the Company that will require future cash outflows. In addition, there are commitments and contingent liabilities, such as commitments to extend credit, which may or may not require future cash outflows. The following table reflects contractual obligations of the Company outstanding as of December 31, 2006.
OFF-BALANCE SHEET ARRANGEMENTS
Information about the Company’s off-balance sheet risk exposure is presented in Note 18 to the accompanying consolidated financial statements. As part of its ongoing business, the Company does not participate in transactions that generate relationships with unconsolidated entities or financial partnerships, such as entities often referred to as special purpose entities (SPEs), which generally are established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As of December 31, 2006, the Company’s sole SPE activity is with Southern Community Capital Trust II, the subsidiary that issued 3,450,000 Trust Preferred Securities in November 2003. The Trust Preferred Securities are backed by junior subordinated debentures issued by the Company, which are included in long-term debt on the balance sheet.
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CAPITAL RESOURCES
Stockholders’ equity at December 31, 2006 was $136.2 million. At that date, our capital to asset ratio was 9.5%, and all of our capital ratios exceeded the minimums established for a well-capitalized bank holding company by regulatory measures. Our Tier 1 risk-based capital ratio at December 31, 2006 was 10.2%.
The Bank and the Company are subject to minimum capital requirements. See “SUPERVISION AND REGULATION.” As the following table indicates, at December 31, 2006, the Company exceeded its regulatory capital requirements.
The Company’s trust preferred securities presently qualify as Tier 1 regulatory capital and are reported in Federal Reserve regulatory reports as a minority interest in our consolidated subsidiaries. The junior subordinated debentures do not qualify as Tier 1 regulatory capital. The Board of Governors of the Federal Reserve, on March 1, 2005, adopted a final rule allowing the continued limited inclusion of trust preferred securities in Tier 1 capital. The Board’s final rule limits restricted core capital elements to twenty-five percent of all core capital elements.
In November of 2003, Southern Community Capital Trust II (“Trust II”), a newly formed subsidiary of the Company, issued 3,450,000 Trust Preferred Securities (“Trust II Securities”), generating total proceeds of $34.5 million. The Trust II Securities pay distributions at an annual rate of 7.95% and mature on December 31, 2033. The Trust II Securities began paying quarterly distributions on December 31, 2003. The Company has fully and unconditionally guaranteed the obligations of Trust II. The Trust II Securities are redeemable in whole or in part at any time after December 31, 2008. The proceeds from the Trust II Securities were utilized to purchase convertible junior subordinated debentures from us under the same terms and conditions as the Trust II Securities. We have the right to defer payment of interest on the debentures at any time and from time to time for a period not exceeding five years, provided that no deferral period extend beyond the stated maturities of the debentures. Such deferral of interest payments by the Company will result in a deferral of distribution payments on the related Trust II Securities. Should we defer the payment of interest on the debentures; the Company will be precluded from the payment of cash dividends to shareholders. The principal uses of the net proceeds from the sale of the debentures were to provide cash for the acquisition of The Community Bank, to increase our regulatory capital, and to support the growth and operations of our subsidiary banks. The amount of proceeds we count as Tier 1 capital cannot comprise more than 25% of our core capital elements. Amounts in excess of the 25% limitation count as Tier 2 supplementary capital for regulatory purposes.
In February 2002, Southern Community Capital Trust I (“Trust I”) issued 1,725,000 Cumulative Convertible Trust Preferred Securities (“Trust I Securities”), generating total proceeds of $17.3 million. The Trust I Securities were redeemed on March 12, 2004 which resulted in the issuance of 2,060,000 shares of our common stock through the conversions and the retirement of $61 thousand of the convertible trust preferred securities.
During 2006 and 2005, the Company declared and paid four cash dividends. In the first quarter of 2005 the Company paid a $0.12 per share annual dividend. In the second quarter of 2005, we began paying quarterly dividends of $0.03 per share. In June 2006, the quarterly dividend was increased to $0.035 per share. In total the Company returned $2.4 million or $0.135 per share, and $3.7 million or $0.21 per share to common shareholders in the form of cash dividends during 2006 and 2005, respectively.
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The Company’s Board of Directors authorized programs in March and September 2005 and July 2006 to repurchase up to 300,000 shares, 600,000 shares and 1 million shares of common stock, respectively. During 2006 and 2005, 377,126 and 460,800 shares of common stock were repurchased and retired at an average price of $9.76 and $9.27 per share, respectively.
ASSET/LIABILITY MANAGEMENT
Our results of operations depend substantially on net interest income. Like most financial institutions, our interest income and cost of funds are affected by general economic conditions and by competition in the market place. The purpose of asset/liability management is to provide stable net interest income growth by protecting earnings from undue interest rate risk, which arises from volatile interest rates and changes in the balance sheet mix, and by managing the risk/return relationships between liquidity, interest rate risk, market risk and capital adequacy. We adhere to a Board-approved asset/liability management policy that provides guidelines for controlling, monitoring, and reporting exposure to interest rate risk. Our policy is to manage the Company’s net interest income exposure by measuring the impact of changing interest rate environments and adjusting the mix of assets and liabilities to provide an acceptable return within established risk limits. Net interest income simulation and gap reports in conjunction with other tools are utilized to measure and monitor interest rate risk.
When suitable lending opportunities are not sufficient to utilize available funds, we have generally invested such funds in securities, primarily securities issued by governmental agencies and mortgage-backed securities. The securities portfolio contributes to increased profitability and plays an important part in our overall interest rate risk management. However, management of the securities portfolio alone cannot balance overall interest rate risk. The securities portfolio must be used in combination with other asset/liability techniques to actively manage the balance sheet. The primary objectives in the overall management of the securities portfolio are safety, liquidity, yield, asset/liability management (interest rate risk), and investing in securities that can be pledged for public deposits or for borrowings.
In reviewing the needs of our Bank with regard to proper management of its asset/liability program, we estimate future needs, taking into consideration investment portfolio purchases, calls and maturities in addition to estimated loan and deposit increases (due to increased demand through marketing) and forecasted interest rate changes. We use a number of measures to monitor and manage interest rate risk, including net interest income simulations and gap analyses. A net interest income simulation model is the primary tool used to assess the direction and magnitude of changes in net interest income resulting from changes in interest rates. Key assumptions in the model include prepayment speeds on mortgage-related assets, cash flows and maturities of other investment securities, loan and deposit volumes and pricing. These assumptions are inherently uncertain and, as a result, the model cannot precisely estimate net interest income or precisely predict the impact of higher or lower interest rates on net interest income. Actual results will differ from simulated results due to timing, magnitude and frequency of interest rate changes and changes in market conditions and management strategies, among other factors. Based on the results of the income simulation model, as of November 30, 2006, if interest rates increase instantaneously by two percentage points, our net interest income over a one-year time frame could decrease by approximately 3.2% or $1.3 million. As of November 30, 2006, if interest rates decrease instantaneously by two percentage points, our net interest income over a one-year time frame could increase by approximately 2.6% or $1.1 million.
The analysis of interest rate gap (the difference between the amount of interest-earning assets and interest-bearing liabilities re-pricing or maturing during a given period of time) is another standard tool we use to measure exposure to interest rate risk. We believe that because interest rate gap analysis does not address all factors that can affect earnings performance, it should be used in conjunction with other methods of evaluating interest rate risk.
Our balance sheet, based on gap measurements, was liability-sensitive at December 31, 2006 in the three-month to one-year horizon and asset-sensitive beyond one year. An asset-sensitive position means that there are more assets than liabilities subject to repricing in that period as market rates change, and conversely with a liability-sensitive position. As a result, in a falling rate environment, our earnings position could improve initially followed by a reduction, with the opposite expectation in a rising rate environment, depending on the correlation of rate changes in these categories.
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The following table presents information about the periods in which the interest-sensitive assets and liabilities at December 31, 2006 will either mature or be subject to repricing in accordance with market rates, and the resulting interest-sensitivity gaps. This table shows the sensitivity of the balance sheet at one point in time and is not necessarily indicative of what the sensitivity will be on other dates. Included in interest-bearing liabilities subject to rate changes within 90 days is 100% of the money market, NOW and savings deposits. These types of deposits historically have not repriced coincidentally with or in the same proportion as general market indicators. As simplifying assumptions concerning repricing behavior, all money market, NOW and savings deposits are assumed to reprice immediately and fixed rate loans and mortgage-backed securities are assumed to reprice at their contractual maturity.
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MARKET RISK
Market risk reflects the risk of economic loss resulting from adverse changes in market price and interest rates. This risk of loss can be reflected in diminished current market values and/or reduced potential net interest income in future periods. Our market risk arises primarily from interest rate risk inherent in our lending and deposit-taking activities. The structure of our loan and deposit portfolios is such that a significant decline in interest rates may adversely impact net market values and net interest income. We do not maintain a trading account nor are we subject to currency exchange risk or commodity price risk. Interest rate risk is monitored as part of the Bank’s asset/liability management function, which is discussed in “Asset/Liability Management” above. The following table presents information about the contractual maturities, average interest rates and estimated fair values of our financial instruments that are considered market risk sensitive at December 31, 2006.
(1)
Yields on tax-exempt investments have been adjusted to a taxable equivalent basis using federal and state tax rates of 34% and 6.9%, respectively, less estimated disallowed interest expense.
(2)
Callable securities and borrowings with favorable market rates at December 31, 2006 are assumed to mature at their call dates for purposes of this table.
(3)
Includes nonaccrual loans but not the allowance for loan losses.
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QUARTERLY FINANCIAL INFORMATION
The following table sets forth, for the periods indicated, certain of our consolidated quarterly financial information. This information is derived from our unaudited financial statements, which include, in the opinion of management, all normal recurring adjustments which management considers necessary for a fair presentation of the results for such periods. This information should be read in conjunction with our consolidated financial statements included elsewhere in this report. The results for any quarter are not necessarily indicative of results for any future period.
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LENDING ACTIVITIES
General. We provide to our customers residential, commercial and construction loans secured by real estate, as well as a full range of short- to medium-term commercial and industrial, Small Business Administration guaranteed and personal loans, both secured and unsecured. We have implemented loan policies and procedures that establish the basic guidelines governing our lending operations. Generally, those guidelines address the types of loans that we seek, our target markets, underwriting and collateral requirements, terms, interest rate and yield considerations and compliance with laws and regulations. All loans or credit lines are subject to approval procedures and amount limitations. These limitations apply to the borrower’s total outstanding indebtedness to us, including the indebtedness of any guarantor. The policies are reviewed and approved at least annually by our Board of Directors. We supplement our supervision of the loan underwriting and approval process with periodic loan audits by internal loan examiners. We have focused our lending activities on the types of loans that we believe will be most in demand by our target customers, as presented in the loan portfolio composition tables below.
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The following table presents at December 31, 2006 the aggregate maturities of loans in the named categories of our loan portfolio which mature during the periods indicated.
The above table is based on contractual scheduled maturities. Early repayment of loans or renewals at maturity are not considered in this table.
Real Estate Loans. Loans secured by real estate represent our greatest concentration of loans, and are divided into three categories: residential mortgage, commercial mortgage, and construction loans. We make real estate loans for purchasing, constructing and refinancing one-to-four family residential, five or more family residential and commercial properties. We also make loans secured by real estate to commercial and individual borrowers who use the loan proceeds for other purposes. Our real estate loans totaled $834.3 million at December 31, 2006, representing 80.7% of our total loans outstanding. Our loan policy requires appraisal prior to funding a real estate loan and also outlines the requirements for appraisals on renewals.
We pursue an aggressive policy of evaluation and monitoring on any real estate loan that becomes troubled, including reappraisal when appropriate. We recognize and reserve for potential exposures as soon as we identify them. However, the pace of absorption of real properties is affected by each property’s individual nature and characteristics, the status of the real estate market at the time, general economic conditions and other factors that could adversely affect our volume of non-performing real estate loans and our ability to dispose of foreclosed properties without loss.
Residential Mortgage Loans. We provide our customers access to long-term conventional real estate loans through the origination of Federal National Mortgage Association-conforming loans. Many of the fixed-rate one-to-four family owner occupied residential mortgage loans that we originate are for sale in the secondary market and have been pre-sold for the account of third parties. Residential mortgage loans held for sale totaled $3.6 million at December 31, 2006. We receive income from residential mortgage loans originated for sale in the secondary market, with such fees and income from sales aggregating $1.2 million for the year ended December 31, 2006 and $1.1 million for the year ended December 31, 2005. We anticipate that we will continue to be an active originator of residential loans for sale to third parties.
Residential loans are generated through our in-house staff as well as the Bank’s existing customer base, referrals from real estate agents and builders, and local marketing efforts. Our lending efforts include the origination of loans secured by first mortgages on one-to-four family residences and on home equity credit lines. Our residential mortgage loans totaled $262.5 million at December 31, 2006, and included $161.0 million in one-to-four family permanent mortgage loans, $86.6 million in outstanding advances under home equity credit lines, and $14.9 million of other loans secured by residential real estate. Substantially all of our residential mortgage loans are secured by properties located within our market area, although we will make loans secured by properties outside our market area to qualifying existing customers. We believe that the amount of risk associated with this group of loans is mitigated in part due to the type of loans involved. Historically, the amount of losses suffered on this type of loan has been significantly less than those loans collateralized by other types of properties.
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Our one-to-four family residential loans generally have maturities ranging from 1 to 30 years. These loans are either fully amortizing with monthly payments sufficient to repay the total amount of the loan or amortizing with a balloon feature, typically due in fifteen years or less. We review information concerning the income, financial condition, employment history and credit history when evaluating the creditworthiness of an applicant for a residential mortgage loan.
Commercial Mortgage Loans. Our commercial mortgage loans totaled $360.0 million at December 31, 2006. These loans are secured principally by commercial buildings for office, retail, manufacturing, storage and warehouse properties. Generally, in underwriting commercial mortgage loans, we require the personal guaranty of borrowers and a demonstrated cash flow capability sufficient to service the debt. Loans secured by commercial real estate may be in greater amount and involve a greater degree of risk than one-to-four family residential mortgage loans, and payments on such loans are often dependent on successful operation or management of the properties and the underlying businesses. We make commercial mortgage loans at both fixed and variable rates for terms generally up to 15 years.
Construction Loans. We originate one-to-four family residential construction loans for the construction of custom homes (where the home buyer is the borrower or the home is presold), and we provide construction financing to builders including acquisition development and “spec” home financing. We have a staff of lending professionals and assistants who service only our construction loan portfolio. We generally receive a pre-arranged permanent financing commitment from an outside banking entity prior to financing the construction of pre-sold homes. We lend to builders who have demonstrated a favorable record of performance and profitable operations and who are building in our market area. We also make commercial real estate construction loans, as noted in the preceding paragraph. We endeavor to limit our construction lending risk through adherence to established underwriting procedures. Also, we generally require documentation of all draw requests and utilize loan officers to inspect the project prior to funding any draw requests from the builder. With few exceptions, the Bank requires personal guarantees and secondary sources of repayment on construction loans. Construction loans aggregated $211.9 million at December 31, 2006.
Commercial Loans. Commercial business lending is a primary focus of our lending activities. At December 31, 2006, our commercial loan portfolio equaled $177.7 million or 17.2% of total loans. Commercial loans include both secured and unsecured loans for working capital, expansion, and other business purposes. Short-term working capital loans generally are secured by accounts receivable, inventory and/or equipment. The Bank also makes term commercial loans secured by equipment and real estate. Lending decisions are based on an evaluation of the financial strength, management and credit history of the borrower, and the quality of the collateral securing the loan. With few exceptions, the Bank requires personal guarantees and secondary sources of repayment.
Commercial loans generally provide greater yields and reprice more frequently than other types of loans, such as real estate loans. More frequent repricing means that yields on our commercial loans adjust with changes in interest rates.
Loans to Individuals. Loans to individuals include automobile loans, boat and recreational vehicle financing and miscellaneous secured and unsecured personal loans. Consumer loans generally can carry significantly greater risks than other loans, even if secured, if the collateral consists of rapidly depreciating assets such as automobiles and equipment. Repossessed collateral securing a defaulted consumer loan may not provide an adequate source of repayment of the loan. We attempt to manage the risks inherent in consumer lending by following established credit guidelines and underwriting practices designed to minimize risk of loss.
Loan Approvals. Our loan policies and procedures establish the basic guidelines governing our lending operations. Generally, the guidelines address the type of loans that we seek, our target markets, underwriting and collateral requirements, terms, interest rate and yield considerations and compliance with laws and regulations. All loans or credit lines are subject to approval procedures and amount limitations. These limitations apply to the borrower’s total outstanding indebtedness to us, including the indebtedness of any guarantor. The policies are reviewed and approved at least annually. We supplement our supervision of the loan underwriting and approval process with periodic internal loan audits.
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Individual lending authorities are established by the Board of Directors as periodically requested by management. All individual lending authorities are reviewed and approved at least annually by the Board of Directors.
The Board Loan Committee consists of the CEO, President, Managing EVP of Commercial Lending, Chief Credit Officer, and five outside Directors as appointed by the Board of Directors. This Committee meets on a monthly basis to review for approval all loan requests with aggregate exposure in excess of $9.0 million. As of December 31, 2006, the legal lending limit for the Bank was approximately $19.1 million. In the early part of 2005, an internal bank loan committee was formed. This committee is comprised of seven members whom review all loan requests with aggregate exposure between $6.0 million and $9.0 million.
ASSET QUALITY
We consider asset quality to be of primary importance. We employ a formal internal loan review process to ensure adherence to the Lending Policy as approved by the Board of Directors. It is the responsibility of each lending officer to assign an appropriate risk grade to every loan originated. Credit Administration, through the loan review process, validates the accuracy of the initial risk grade assessment. In addition, as a given loan’s credit quality improves or deteriorates, it is Credit Administration’s responsibility to change the borrower’s risk grade accordingly. The function of determining the allowance for loan losses is fundamentally driven by the risk grade system. In determining the allowance for loan losses and any resulting provision to be charged against earnings, particular emphasis is placed on the results of the loan review process. We also give consideration to historical loan loss experience, the value and adequacy of collateral, economic conditions in our market area and other factors. For loans determined to be impaired, the allowance is based on discounted cash flows using the loan’s initial effective interest rate or the fair value of the collateral for certain collateral dependent loans. This evaluation is inherently subjective as it requires material estimates, including the amounts and timing of future cash flows expected to be received on impaired loans that may be susceptible to significant change. The allowance for loan losses represents management’s estimate of the appropriate level of reserve to provide for potential losses inherent in the loan portfolio.
Our policy in regard to past due loans normally requires a charge-off to the allowance for loan losses within a reasonable period after collection efforts and a thorough review has been completed. Further collection efforts are then pursued through various means including legal remedies. Loans carried in a non-accrual status and probable losses are considered in the determination of the allowance for loan losses.
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Nonperforming Assets
The table sets forth, for the period indicated, information about our nonaccrual loans, restructured loans, total nonperforming loans (nonaccrual loans plus restructured loans), and total nonperforming assets.
Our financial statements are prepared on the accrual basis of accounting, including the recognition of interest income on loans, unless we place a loan on nonaccrual basis. We account for loans on a nonaccrual basis when we have serious doubts about the collectibility of principal or interest. Generally, our policy is to place a loan on nonaccrual status when the loan becomes past due 90 days. We also place loans on nonaccrual status in cases where we are uncertain whether the borrower can satisfy the contractual terms of the loan agreement. Amounts received on nonaccrual loans generally are applied first to principal and then to interest only after all principal has been collected. Restructured loans are those for which concessions, including the reduction of interest rates below a rate otherwise available to that borrower or the deferral of interest or principal have been granted due to the borrower’s weakened financial condition. We record interest on restructured loans at the restructured rates, as collected, when we anticipate that no loss of original principal will occur. Potential problem loans are loans which are currently performing and are not included in nonaccrual or restructured loans above, but about which we have serious doubts as to the borrower’s ability to comply with present repayment terms. These loans are likely to be included later in nonaccrual, past due or restructured loans, therefore they are considered by our management in assessing the adequacy of our allowance for loan losses.
At December 31, 2006, we had $2.6 million of nonaccrual loans. At that time, the largest nonaccrual balance to any one borrower was $726 thousand, with the average balance for the 22 nonaccrual loans being $120 thousand.
Foreclosed assets consist of real estate acquired through foreclosure, repossessed assets and idled properties. At December 31, 2006 foreclosed assets totaled $895 thousand or .06% of total assets, and consisted of thirteen properties. The largest dollar value of a foreclosed property at December 31, 2006 was $220 thousand. We have reviewed recent appraisals of these properties and believe that the fair values, less estimated costs to sell, equal or exceed their carrying value.
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Analysis of Allowance for Loan Losses
Our allowance for loan losses is established through charges to earnings in the form of a provision for loan losses. We increase our allowance for loan losses by provisions charged to operations and by recoveries of amounts previously charged off, and we reduce our allowance by loans charged off. We evaluate the adequacy of the allowance monthly. In addition, on a monthly basis our Board Loan Committee reviews our loan portfolio and conducts an evaluation of our credit quality. The Board Loan Committee reports directly to Board of Directors. Quarterly the Board of Directors reviews the loan loss provision. In evaluating the adequacy of the allowance, we consider the growth, composition and industry diversification of the portfolio, historical loan loss experience, current delinquency levels, trends in past dues and classified assets, adverse situations that may affect a borrower’s ability to repay, estimated value of any underlying collateral, prevailing economic conditions and other relevant factors deriving from our limited history of operations. In addition, regulatory agencies, as an integral part of their examination process, periodically review our allowance for loan losses and may require us to make adjustments for estimated losses based upon judgments different from those of our management.
We use our risk grading program, as described under “ASSET QUALITY,” to facilitate our evaluation of probable inherent loan losses and the adequacy of the allowance for loan losses. In this program, risk grades are initially assigned by loan officers, reviewed by Credit Administration, and tested by our internal auditors and our internal loan review function. The testing program includes an evaluation of a sample of new loans, large loans, loans that are identified as having potential credit weaknesses, loans past due 90 days or more, and nonaccrual loans. We strive to maintain our loan portfolio in accordance with conservative loan underwriting policies that result in loans specifically tailored to the needs of our market area. Every effort is made to identify and minimize the credit risks associated with such lending strategies. We have no foreign loans and we do not engage in lease financing or highly leveraged transactions.
We follow a loan review program designed to evaluate the credit risk in our loan portfolio. Through this loan review process, we maintain an internally classified watch list that helps management assess the overall quality of the loan portfolio and the adequacy of the allowance for loan losses. In establishing the appropriate classification for specific assets, management considers, among other factors, the estimated value of the underlying collateral, the borrower's ability to repay, the borrower's payment history and the current status. As a result of this process, certain loans are categorized as substandard, doubtful or loss and reserves are allocated based on management's judgment, objective criteria and historical experience.
Loans classified as "substandard" are those loans with clear and defined weaknesses such as unfavorable financial ratios, uncertain repayment sources or poor financial condition that may jeopardize the liquidation of the debt. They are characterized by the distinct possibility that we will sustain some losses or the borrower may default if the deficiencies are not corrected. A reserve of up to 20% is generally allocated to each of these loans. Loans classified as "doubtful" are those loans that have characteristics similar to substandard loans but with an increased risk that collection or liquidation in full is highly questionable and default is likely. A reserve of 50% is generally allocated to loans classified as doubtful. Loans classified as "loss" are considered uncollectible and of such little value that their continuance as bankable assets is not warranted. This classification does not mean that the loan has absolutely no recovery or salvage value but rather it is not practical or desirable to defer writing off this asset even though partial recovery may be achieved in the future. As a practical matter, when loans are identified as loss they are charged off against the allowance for loan losses. In addition to the above classification categories, we also categorize loans based upon risk grade and loan type, assigning an allowance allocation based upon each category.
Growth in loans outstanding has, throughout our history, been the primary reason for increases in our allowance for loan losses and the resultant provisions for loan losses necessary to provide for those increases. This growth has been spread among our major loan categories, with the concentrations of major loan categories being relatively consistent in recent years. For all full fiscal years through 2000, our loan loss experience was similar to that of other new banks, with net loan charge-offs in each year of less than .10% of average loans outstanding. Net charge-offs in 2006 of $1.3 million, or .13% of average loans outstanding was similar to the 2005 amounts of $1.2 million or .14% of average loans outstanding. Our allowance for loan losses at December 31, 2006 was $13.0 million and represented 1.26% of total loans and 495% of non-performing loans. Our allowance for loan losses at December 31, 2005 of $11.8 million represented 1.36% of total loans and 837% of nonperforming loans.
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The allowance for loan losses represents management's estimate of an amount adequate to provide for probable losses inherent in the loan portfolio. We make specific allowances that are allocated to certain individual loans and pools of loans based on risk characteristics, as discussed below. In addition to the portion of the allowance for loan losses allocated to specific segments of the loan portfolio, we develop a component of the allowance based on qualitative and environmental factors that is not applied to specific loan groups. This unallocated portion is intended to reserve for the inherent risk in the portfolio and the intrinsic inaccuracies associated with the estimation of the allowance for loan losses and its allocation to specific loan categories, as well as other qualitative and environmental factors. In December 2006, the federal banking regulators released an Interagency Policy Statement on the Allowance for Loan and Lease Losses, and related Questions and Answers on Accounting for Loan and Lease Losses. We are in the process of evaluating the guidance in the Interagency Policy Statement and Questions and Answers, and may make enhancements to our processes of determining our allowance for loan losses. However, we do not expect any such changes in our processes to result in a material change in the level of the allowance for loan losses. While management believes that it uses the best information available to establish the allowance for loan losses, future adjustments to the allowance may be necessary and results of operations could be adversely affected if circumstances differ substantially from the assumptions used in making the determinations. Furthermore, while we believe we have established the allowance for loan losses in conformity with generally accepted accounting principles, there can be no assurance that regulators, in reviewing our portfolio, will not require adjustments to our allowance for loan losses. In addition, because future events affecting borrowers and collateral cannot be predicted with certainty, there can be no assurance that the existing allowance for loan losses is adequate or that increases will not be necessary should the quality of any loans deteriorate as a result of the factors discussed herein. Any material increase in the allowance for loan losses may adversely affect our financial condition and results of operations.
During the first quarter of 2005, management completed an extensive review of the allowance for loan losses related to the loan portfolio acquired in the first quarter of 2004 in connection with The Community Bank acquisition. This review was completed during the one year allocation period, and as a result, management determined the allowance for loan losses as recorded in the preliminary purchase price allocation should be adjusted downward. A purchase price allocation adjustment of $491 thousand, less deferred income taxes of $189 thousand was recorded as a reduction of the allowance for loan losses and a reduction of goodwill.
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The following table describes the allocation of the allowance for loan losses among various categories of loans and certain other information for the dates indicated. The allocation is made for analytical purposes only and is not necessarily indicative of the categories in which future losses may occur.
(1) Represents total of all outstanding loans in each category as a percentage of total loans outstanding.
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The following table presents for the periods indicated information regarding changes in our allowance for loan losses.
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INVESTMENT ACTIVITIES
Our investment portfolio plays a primary role in management of liquidity and interest rate sensitivity and, therefore, is managed in the context of the overall balance sheet. The securities portfolio generates approximately 14% of our interest income and serves as a necessary source of liquidity.
Management attempts to deploy investable funds into instruments that are expected to increase the overall return of the portfolio given the current assessment of economic and financial conditions, while maintaining acceptable levels of capital, and interest rate and liquidity risk.
The following table summarizes the amortized cost, gross unrealized gains and losses and the resulting market value of securities at the dates indicated.
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The following table presents the carrying values, fair values, intervals of maturities or re-pricings, and weighted average yields of our investment portfolio at December 31, 2006.
(1) Yields on tax-exempt investments have been adjusted to a taxable equivalent basis using federal and state tax rates of 34% and 6.9%, respectively, less estimated disallowed interest expense.
At December 31, 2006, there were no securities of any issuer (other than U.S. government agencies) that exceeded 10% of the Company’s stockholders’ equity.
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Derivative Financial Instruments
A derivative is a financial instrument that derives its cash flows, and therefore its value, by reference to an underlying instrument, index or reference rate. These instruments primarily consist of interest rate swaps, caps, floors, financial forward and futures contracts and options written or purchased. Derivative contracts are written in amounts referred to as notional amounts. Notional amounts only provide the basis for calculating payments between counterparties and do not represent amounts to be exchanged between parties and are not a measure of financial risks. Credit risk arises when amounts receivable from a counterparty exceed amounts payable. We control our risk of loss on derivative contracts by subjecting counterparties to credit reviews and approvals similar to those used in making loans and other extensions of credit.
We have used interest rate swaps and floors in the management of interest rate risk. Interest rate swaps are contractual agreements between two parties to exchange a series of cash flows representing interest payments. A swap allows both parties to alter the re-pricing characteristics of assets or liabilities without affecting the underlying principal positions. Through the use of a swap, assets and liabilities may be transformed from fixed to floating rates, from floating rates to fixed rates, or from one type of floating rate to another. At December 31, 2006, interest rate swap arrangements with total notional amounts of $110.5 million, with terms ranging up to twenty-seven years, were outstanding. In addition, we purchased $25.0 million notional and $50.0 million notional of interest rate floors referenced to floating rates in 2006 and 2005 respectively. These floors help protect the Company from declines in interest rates by allowing us to receive payments from the floor counterparty on these contracts when the referenced rate falls below a rate specified in the agreement. At December 31, 2006, these floor contracts had between sixteen and twenty-eight months remaining on their terms.
Although off-balance sheet derivative financial instruments do not expose the Company to credit risk equal to the notional amount, such agreements generate credit risk to the extent of the fair value gain of a derivative financial instrument if the counterparty fails to perform. Such risk is minimized through the creditworthiness of the counterparties and the consistent monitoring of these agreements. The counterparties to these arrangements were primarily large commercial banks and investment banks. Where appropriate, master netting agreements are arranged or collateral is obtained in the form of rights to securities.
A discussion of derivatives is presented in Note 17 to our consolidated financial statements, which are presented under Item 8 in this Form 10-K.
Sources of Funds
Deposit Activities
We provide a range of deposit services, including non-interest-bearing checking accounts, interest-bearing checking and savings accounts, money market accounts and certificates of deposit. These accounts generally earn interest at rates established by management based on competitive market factors and our desire to increase or decrease certain types or maturities of deposits. We have used brokered deposits and out-of-market deposits as funding sources. As of December 31, 2006, we have $154.1 million of brokered deposits and $8.7 million of out of market deposits. However, we strive to establish customer relations to attract core deposits in non-interest-bearing transactional accounts and thus to reduce our costs of funds.
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The following table sets forth for the periods indicated the average balances outstanding and average interest rates for each of our major categories of deposits.
The following table presents the amounts and maturities of our certificates of deposit with balances of $100,000 or more at December 31, 2006:
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Borrowings
As an additional source of funding, we use advances from the Federal Home Loan Bank of Atlanta and occasionally term repurchase agreements. As set forth in the following table, outstanding FHLB advances at December 31, 2006 totaled $177.7 million, and are collateralized by loans with a carrying amount of $181.7 million, which approximates market value, and investment securities with a carrying value of $34.2 million. Term repurchase agreements were collateralized by investment securities having a carrying value of $16.1 million. Certain of these agreements contain embedded interest rate or call options that may be exercised by us or the FHLB.
In addition to the Federal Home Loan Bank advances, we also had short-term repurchase agreements with outstanding balances of $14.6 million at December 31, 2006, solely as an accommodation to our customers. Securities sold under agreements to repurchase generally mature within ninety days from the transaction date and are collateralized by U.S. government agency obligations. We also have issued junior subordinated debentures in connection with the trust preferred securities as described below, which have a carrying value of $35.1 million at December 31, 2006. We have repurchase lines of credit of $130.0 million from various institutions. The repurchases must be adequately collateralized.
In addition, we may purchase federal funds through unsecured federal funds lines of credit with various banks aggregating $78.0 million. These lines are intended for short-term borrowings and are subject to restrictions limiting the frequency and term of advances. These lines of credit are payable on demand and bear interest based upon the daily federal funds rate. We had $23.2 million of federal funds borrowings outstanding under these lines as of December 31, 2006.
Borrowings that are scheduled to be repaid within one year are classified as short-term borrowings. For 2006 and 2005, average outstanding short-term borrowings were $55.0 million and $9.2 million, respectively.
In November 2003, Southern Community Capital Trust II (“Trust II”), a newly formed subsidiary of the Company, issued 3,450,000 Trust Preferred Securities (“Trust II Securities”), generating total proceeds of $34.5 million. The Trust II Securities pay distributions at an annual rate of 7.95% and mature on December 31, 2033. The Trust II Securities began paying quarterly distributions on December 31, 2003. The Company has fully and unconditionally guaranteed the obligations of Trust II. The Trust II Securities are redeemable in whole or in part at any time after December 31, 2008. The proceeds from the Trust II Securities were utilized to purchase convertible junior subordinated debentures from us under the same terms and conditions as the Trust II Securities. We have the right to defer payment of interest on the debentures at any time and from time to time for a period not exceeding five years, provided that no deferral period extend beyond the stated maturities of the debentures. Such deferral of interest payments by the Company will result in a deferral of distribution payments on the related Trust II Securities. Should we defer the payment of interest on the debentures, the Company will be precluded from the payment of cash dividends to shareholders. The principal uses of the net proceeds from the sale of the debentures were to provide cash for the acquisition of The Community Bank, to increase our regulatory capital, and to support the growth and operations of our subsidiary banks. The amount of proceeds we count as Tier 1 capital cannot comprise more than 25% of our core capital elements. Amounts in excess of that 25% limitation count as Tier 2 supplementary capital on our books.
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In February 2002, Southern Community Capital Trust I (“Trust I”), issued 1,725,000 Cumulative Convertible Trust Preferred Securities (“Trust I Securities”), generating total proceeds of $17.3 million. We redeemed the Trust I Securities on March 12, 2004, which resulted in the issuance of 2,060,000 shares of our common stock through the conversions and the retirement of $61 thousand of the convertible trust preferred securities.
Other Recent Developments
On February 1, 2007 the Company announced the declaration of a quarterly dividend of $0.035 per share of the common stock, to be paid on March 1, 2007 to shareholders on record as of the close of business on February 15, 2007.
RECENT ACCOUNTING PRONOUNCEMENTS
A discussion of recent accounting pronouncements is presented in Note 2 to our consolidated financial statements, which are presented under Item 8 in this Form 10-K.
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
Statements contained in this annual report, which are not historical facts, are forward-looking statements, as that term is defined in the Private Securities Litigation Reform Act of 1995. Amounts herein could vary as a result of market and other factors. Such forward-looking statements are subject to risks and uncertainties which could cause actual results to differ materially from those currently anticipated due to a number of factors, which include, but are not limited to, factors discussed in documents filed by the Company with the Securities and Exchange Commission and the Bank with the Federal Reserve Bank from time to time. Such forward-looking statements may be identified by the use of such words as “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” and “potential.” Examples of forward-looking statements include, but are not limited to, estimates with respect to the financial condition, expected or anticipated revenue, results of operations and business of the Company that are subject to various factors which could cause actual results to differ materially from these estimates. These factors include, but are not limited to, general economic conditions, changes in interest rates, deposit flows, loan demand, real estate values, and competition; changes in accounting principles, policies, or guidelines; changes in legislation or regulation; and other economic, competitive, governmental, regulatory, and technological factors affecting the Company's operations, pricing, products and services.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
See “MARKET RISK” under Item 7.
Item 8.
Item 8. Financial Statements
The information required by this item is filed herewith.
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Report of Independent Registered Public Accounting Firm
To the Stockholders and the Board of Directors
Southern Community Financial Corporation and Subsidiary
Winston-Salem, North Carolina
We have audited the accompanying consolidated balance sheets of Southern Community Financial Corporation and Subsidiary as of December 31, 2006 and 2005, and the related consolidated statements of operations, comprehensive income, changes in stockholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2006. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Southern Community Financial Corporation and Subsidiary at December 31, 2006 and 2005 and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2006 in conformity with accounting principles generally accepted in the United States of America.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Southern Community Financial Corporation’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated March 15, 2007 expressed unqualified opinions on both management’s assessment of the Company’s internal control over financial reporting and the effectiveness of the Company’s internal control over financial reporting.
/s/ Dixon Hughes PLLC
Raleigh, North Carolina
March 15, 2007
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SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
December 31, 2006 and 2005
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SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS
Years Ended December 31, 2006, 2005 and 2004
See accompanying notes.
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SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
Years Ended December 31, 2006, 2005 and 2004
See accompanying notes.
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SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
Years Ended December 31, 2006, 2005 and 2004
See accompanying notes.
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SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31, 2006, 2005 and 2004
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See accompanying notes.
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SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years Ended December 31, 2006, 2005 and 2004
(1) NATURE OF OPERATIONS
Southern Community Bank and Trust (the “Bank”) was incorporated November 14, 1996 and began banking operations on November 18, 1996. The Bank is engaged in general commercial and retail banking principally in the Piedmont area of North Carolina, operating under the banking laws of North Carolina and the rules and regulations of the Federal Deposit Insurance Corporation. In October 2001, Southern Community Financial Corporation (the “Company”) was formed as a financial holding company for Southern Community Bank and Trust, and is subject to the rules and regulations of the Federal Reserve System. The Bank and the Company undergo periodic examinations by those regulatory authorities.
(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The consolidated financial statements include the accounts of Southern Community Financial Corporation and its wholly-owned subsidiary, Southern Community Bank and Trust and its wholly-owned subsidiary, VCS Management, L.L.C., the managing general partner for Salem Capital Partners L.P., a Small Business Investment Company. All material intercompany transactions and balances have been eliminated in consolidation. Southern Community Financial Corporation and its subsidiary are collectively referred to herein as the “Company”.
Use of Estimates
The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for losses on loans.
Cash and Cash Equivalents
For the purpose of presentation in the consolidated statements of cash flows, cash and cash equivalents are defined as those amounts included in the balance sheet caption “Cash and due from banks”, which include cash on hand, amounts due from banks, and repurchase agreements.
Federal regulations require institutions to set aside specified amounts of cash as reserves against transaction and time deposits. As of December 31, 2006, the daily average gross reserve requirement was $7.6 million.
Investment Securities
Available for sale securities are carried at fair value and consist of bonds, mortgage-backed securities, and municipal securities not classified as trading securities or as held to maturity securities. The cost of debt securities available for sale is adjusted for amortization of premiums and accretion of discounts to maturity. Amortization of premiums, accretion of discounts, interest and dividend income are included in investment income. Unrealized holding gains and losses on available for sale securities are reported as a net amount in accumulated other comprehensive income, net of income taxes. Gains and losses on the sale of available for sale securities are determined using the specific-identification method. Bonds and mortgage-backed securities for which the Bank has the positive intent and ability to hold to maturity are reported at cost, adjusted for premiums and discounts that are recognized in interest income using a method that approximates the interest method over the period to maturity. Declines in the fair value of individual held to maturity and available for sale securities below their cost that are other than temporary would result in write-downs of the individual securities to their fair value. Such write-downs would be included in earnings as realized losses. The classification of securities is generally determined at the date of purchase.
Certain equity security investments that do not have readily determinable fair values and for which the Company does not exercise significant influence are carried at cost and classified within other investments. As of December 31, 2006 and 2005, cost-method investments totaled $11.0 million and $12.0 million, respectively. The securities classified within other investments consisted primarily of shares of Federal Home Loan Bank and Bankers Bank stock. Cost-method investments are reviewed for impairment at least annually or sooner if events or changes in circumstances indicate the carrying value may not be recoverable.
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SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years Ended December 31, 2006, 2005 and 2004
(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Loans Held for Sale
The Company originates single family, residential first mortgage loans on a pre-sold basis. Loans held for sale are carried at the lower of cost or fair value in the aggregate as determined by outstanding commitments from investors. Upon closing, these loans, together with their servicing rights, are sold to other financial institutions under prearranged terms. The Company recognizes certain origination and service release fees upon the sale, which are included in non-interest income in the consolidated statement of operations.
Loans
Loans that management has the intent and ability to hold for the foreseeable future or until maturity are reported at their outstanding principal adjusted for any charge-offs, the allowance for loan losses, and any deferred fees or costs on originated loans and unamortized premiums or discounts on purchased loans. Loan origination fees and certain direct origination costs are capitalized and recognized as an adjustment to yield over the life of the related loan. Interest on loans is recorded based on the principal amount outstanding. The accrual of interest on impaired loans is discontinued when, in management’s opinion, the borrower may be unable to meet payments as they become due. When interest accrual is discontinued, all unpaid accrued interest is reversed against interest income. Interest income is subsequently recognized only to the extent cash payments are received. Loans are written down or charged off when management has determined the loan to be uncollectible in part or in total.
Allowance for Loan Losses
The provision for loan losses is based upon management’s estimate of the amount needed to maintain the allowance for loan losses at a level believed adequate to absorb probable losses inherent in the loan portfolio. In making the evaluation of the adequacy of the allowance for loan losses, management gives consideration to current economic conditions, statutory examinations of the loan portfolio by regulatory agencies, delinquency information and management’s internal review of the loan portfolio. Management evaluates smaller balance, homogeneous loans such as consumer and residential mortgage loans for impairment on a collective basis. Larger balance commercial loans are considered impaired when it is probable that all amounts due will not be collected in accordance with the contractual terms of the loan agreement. The measurement of impaired loans is generally based on the present value of expected future cash flows discounted at the historical effective interest rate, or upon the fair value of the collateral if the loan is collateral dependent. If the recorded investment in the loan exceeds the measure of fair value, a valuation allowance is established as a component of the allowance for loan losses. While management uses the best information available to make evaluations, future adjustments to the allowance may be necessary if conditions differ substantially from the assumptions used in making the evaluations. In addition, regulatory examiners may require the Bank to adjust the allowance for loan losses based on their judgments about information available to them at the time of their examination.
Premises and Equipment
Land is carried at cost. Premises and equipment are stated at cost less accumulated depreciation and amortization. Depreciation is calculated on the straight-line method over the estimated useful lives of the assets which are 11-30 years for buildings and 3-7 years for furniture and equipment. Leasehold improvements are amortized over the terms of the respective leases or the estimated useful lives of the improvements, whichever is shorter. Repairs and maintenance costs are charged to operations as incurred and additions and improvements to premises and equipment are capitalized. Upon sale or retirement, the cost and related accumulated depreciation are removed from the accounts and any gains or losses are reflected in current operations. Long-lived depreciable assets are evaluated periodically for impairment when events or changes in circumstances indicate the carrying amount may not be recoverable.
Foreclosed Assets
Assets acquired through, or in lieu of, foreclosure are held for sale and are initially recorded at fair value at the date of foreclosure, establishing a new cost basis. Principal and interest losses existing at the time of acquisition of such assets are charged against the allowance for loan losses and interest income, respectively. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or fair value less estimated cost to sell. Revenue and expenses from operations and changes in the valuation allowance are included in other expenses.
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SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years Ended December 31, 2006, 2005 and 2004
(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Goodwill and Other Intangibles
Goodwill represents the excess of the cost of an acquisition over the fair value of the net assets acquired. Other intangible assets represent purchased intangible assets that can be separately distinguished from goodwill. Goodwill impairment testing is performed annually, or more frequently if events or circumstances indicate possible impairment. No impairment was identified as a result of the testing performed during 2006 or 2005. Intangible assets with finite lives include core deposits and other intangibles. Intangible assets other than goodwill are subject to impairment testing whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. Core deposit intangibles are amortized on the straight-line method over a period not to exceed 10 years. Note 8 contains additional information regarding goodwill and other intangible assets.
Income Taxes
Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the tax bases of assets and liabilities and their carrying amounts for financial reporting purposes. These temporary differences consist primarily of the allowance for loan losses, differences in the financial statement and income tax basis in premises and equipment and differences in financial statement and income tax basis in accrued liabilities. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which the temporary differences are expected to be recovered or settled. Deferred tax assets are reduced by a valuation allowance if it is more likely than not that the tax benefits will not be realized.
Derivative Instruments
The Company utilizes derivative instruments, principally interest rate swaps and option agreements, to mitigate exposure to adverse changes in fair value or cash flows of certain assets and liabilities. Under the guidelines of SFAS No. 133, derivative financial instruments generally are required to be carried at fair value. Derivative instruments designated in a hedge relationship to mitigate exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges under SFAS No. 133. Derivative instruments designated in a hedge relationship to mitigate exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges.
Fair value hedges are accounted for by recording the fair value of the derivative instrument and the fair value related to the risk being hedged of the hedged asset or liability on the balance sheet with corresponding offsets recorded in the income statement. The adjustment to the hedged asset or liability is included in the basis of the hedged item, while the fair value of the derivative is recorded as a freestanding asset or liability. Actual cash receipts or payments and related amounts accrued during the period on derivatives included in a fair value hedge relationship are recorded as adjustments to the income or expense recorded on the hedged asset or liability. Cash flow hedges are accounted for by recording the fair value of the derivative instrument on the balance sheet as either a freestanding asset or liability, with a corresponding offset recorded in accumulated other comprehensive income within stockholders’ equity, net of tax. Amounts are reclassified from accumulated other comprehensive income to the income statement in the period or periods the hedged transaction affects earnings. Under both the fair value and cash flow hedge methods, derivative gains and losses not effective in hedging the change in fair value or expected cash flows of the hedged item are recognized immediately in the income statement.
The Company has utilized interest rate swap and option agreements to convert a portion of its variable-rate loans to a fixed rate (cash flow hedge), and to convert a portion of its fixed-rate debt to a variable rate (fair value hedge). Interest rate swaps are contracts in which a series of interest rate flows are exchanged over a prescribed period. The notional amount on which the interest payments are based is not exchanged.
Gains and losses from early terminations of derivatives are deferred and amortized as yield adjustments over the shorter of the remaining term of the hedged asset or liability or the remaining term of the derivative instrument. Upon disposition or settlement of the asset or liability being hedged, deferral accounting is discontinued and any gains or losses are recognized in income.
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SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years Ended December 31, 2006, 2005 and 2004
2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Derivative Instruments (Continued)
The Company does not enter into derivative financial instruments for speculative or trading purposes. For derivatives that are economic hedges, but are not designated as hedging instruments or otherwise do not qualify for hedge accounting treatment, all changes in fair value are recognized in noninterest income during the period of change. The net cash settlement on these derivatives is included in noninterest income.
Per Share Data
Basic net income per share is computed by dividing net income available to common shareholders by the weighted average number of shares of common stock outstanding during each period. Diluted net income per share reflects the potential dilution that could occur if stock options were exercised or convertible trust preferred securities were converted, resulting in the issuance of common stock that then shared in the net income of the Company. Diluted earnings per share is computed by dividing net income available to common shareholders by the weighted average number of shares of common stock, common stock equivalents and other potentially dilutive securities using the treasury stock method.
Basic and diluted net income per share have been computed based upon net income as presented in the accompanying consolidated statements of operations divided by the weighted average number of common shares outstanding or assumed to be outstanding as summarized below:
For the year ended December 31, 2006, 2005 and 2004, net income for determining diluted earnings per share was the same as net income. For the years ended December 31, 2006, 2005, and 2004 there were 438,203, 495,516, and 227,630, options, respectively, that were antidilutive since the exercise price exceeded the average market price for the year. These antidilutive common stock equivalents have been omitted from the calculation of diluted earnings per share for their respective years.
Stock-Based Compensation
At December 31, 2006, the Company had certain stock-based employee compensation plans, described more fully in Note 12. Effective January 1, 2006, the Company adopted SFAS 123 (revised 2004), "Share-Based Payment," ("SFAS 123R") which was issued by the FASB in December 2004. SFAS 123R revises SFAS 123 "Accounting for Stock Based Compensation," and supersedes APB 25, "Accounting for Stock Issued to Employees," (APB 25) and its related interpretations. SFAS 123R requires recognition of the cost of employee services received in exchange for an award of equity instruments in the financial statements over the period the employee is required to perform the services in exchange for the award (usually the vesting period). SFAS 123R also requires measurement of the cost of employee services received in exchange for an award based on the grant-date fair value of the award. SFAS 123R also amends SFAS 95 "Statement of Cash Flows," to require that excess tax benefits be reported as financing cash inflows, rather than as a reduction of taxes paid, which is included within operating cash flows.
The Company adopted SFAS 123R using the modified prospective application as permitted under SFAS 123R. Accordingly, prior period amounts have not been restated. Under this application, the Company is required to record compensation expense for all awards granted after the date of adoption and for the unvested portion of previously granted awards that remain outstanding at the date of adoption.
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SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years Ended December 31, 2006, 2005 and 2004
(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Stock-Based Compensation (Continued)
Prior to the adoption of SFAS 123R, the Company used the intrinsic value method as prescribed by APB 25 and thus recognized no compensation expense for options granted to employees with exercise prices equal to the fair market value of the Company's common stock on the date of grant.
During the first quarter 2005, the Company vested all unvested stock options. As a result of this decision, 623,725 non-vested options were accelerated from their established vesting over a 5-year period from date of grant to being fully vested. At the date the decision was made to accelerate the vesting, some of the options had exercise prices below market value. In accordance with the provisions of APB No. 25, compensation expense of $70 thousand ($45 thousand net of tax effect) has been recognized in 2005 to reflect the effects of the accelerated vesting. The Company applied certain assumptions in the determination of the expense recognized during the period, which were based on historical employee attrition rates.
The decision to accelerate the vesting of these options, which the Company believes to be in the best interest of our stockholders, was made primarily to reduce non-cash compensation expenses that would have been recorded in future periods following our application of SFAS No. 123(R). Because these options were accelerated, non-cash compensation expense related to these options is expected to be reduced by approximately $1.6 million (pre-tax) between 2006 and 2009, based on estimated value calculations using the Black-Scholes methodology. Presented below are the pro forma disclosures of net income and earnings per share and other disclosures as if the fair value based method of accounting under the provisions of SFAS 123 had been applied.
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SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years Ended December 31, 2006, 2005 and 2004
(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Comprehensive Income
Comprehensive income is defined as the change in equity during a period for non-owner transactions and comprises net income and other comprehensive income. Other comprehensive income includes revenues, expenses, gains, and losses that are excluded from earnings under current accounting standards. Components of other comprehensive income for the Company consist of the unrealized gains and losses, net of taxes, in the Company’s available for sale securities portfolio, unrealized gains and losses, net of taxes, in the Company’s cash flow hedge instruments, and the components of changes in net benefit plan liabilities that are not recognized as benefit costs.
Accumulated other comprehensive income at December 31, 2006 and 2005 consists of the following:
Segment Reporting
SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information, requires management to report selected financial and descriptive information about reportable operating segments. It also establishes standards for related disclosures about products and services, geographic areas, and major customers. Generally, disclosures are required for segments internally identified to evaluate performance and resource allocation. In all material respects, the Company’s operations are entirely within the commercial banking segment, and the consolidated financial statements presented herein reflect the results of that segment. Also, the Company has no foreign operations or customers.
Risk and Uncertainties
In the normal course of its business, the Company encounters two significant types of risk: economic and regulatory. The two primary components of economic risk to the Company are credit risk and market risk. Credit risk is the risk of default on our loan portfolio that results from borrowers’ failure to make contractually required payments. Market risk arises principally from interest rate risk inherent in our lending, investing, deposit, and borrowing activities.
The Company is subject to the regulations of various government agencies. These regulations may change significantly from period to period. The Company also undergoes periodic examinations by the regulatory agencies, which may subject it to further changes with respect to asset valuations, amounts of required loss allowances or operating restrictions resulting from the regulators’ judgments based on information available to them at the time of their examination.
Reclassifications
Certain amounts of prior years have been reclassified to conform to current year presentation. Such reclassifications had no effect on income or equity.
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SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years Ended December 31, 2006, 2005 and 2004
(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Recent Accounting Pronouncements
SFAS 155, “Accounting for Certain Hybrid Financial Instruments - an amendment of SFAS No. 133 and 140” provides entities relief from the requirement to separately determine the fair value of an embedded derivative that would otherwise be bifurcated from the host contract under SFAS 133. This statement allows an irrevocable election on an instrument-by-instrument basis to measure such a hybrid financial instrument at fair value. This statement is effective for all financial instruments acquired or issued after the beginning of the fiscal years beginning after September 15, 2006. The Company has evaluated this statement and does not believe it will have a material effect on the Company’s financial position, results of operations or cash flows.
SFAS 156, “Accounting for Servicing of Financial Assets - an amendment of SFAS No. 140” requires that all separately recognized servicing assets and liabilities be initially measured at fair value and permits (but does not require) subsequent measurement of servicing assets and liabilities at fair value. This statement is effective for fiscal years beginning after September 15, 2006. The Company has evaluated this statement and does not believe the adoption of its provisions will have a material effect on the Company’s financial position, results of operations or cash flows.
SFAS 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans” requires recognition on the balance sheet of a plan’s overfunded or underfunded status with an offset to comprehensive income. This statement also requires, with limited exceptions, that the funded status of the plan be determined as of the employer’s fiscal year end. The balance sheet recognition provisions of SFAS 158 are effective for entities with publicly traded equity securities for years ending after December 15, 2006 and for all other entities for years ending after June 15, 2007. The Company adopted the provisions of SFAS 158 effective for the year ended December 31, 2006, and as a result recorded an additional minimum pension liability of $147 thousand and accumulated other comprehensive results of $(90) thousand, net of tax.
FIN 48 - In July 2006, the FASB issued Financial Interpretation No. 48, “Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109” (“FIN 48”), which is a change in accounting for income taxes. FIN 48 specifies how tax benefits for uncertain tax positions are to be recognized, measured, and derecognized in financial statements; requires certain disclosures of uncertain tax matters; specifies how reserves for uncertain tax positions should be classified on the balance sheet; and provides transition and interim period guidance, among other provisions. FIN 48 is effective for fiscal years beginning after December 15, 2006 and as a result, is effective for the Company in the first quarter of fiscal 2008. The Company is currently evaluating the impact of FIN 48 on its consolidated financial statements.
EITF 06-4 - The Emerging Issues Task Force (EITF) reached a consensus at its September 2006 meeting regarding EITF 06-4, Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements. The scope of EITF 06-4 is limited to the recognition of a liability and related compensation costs for endorsement split-dollar life insurance policies that provide a benefit to an employee that extends to postretirement periods. Therefore, this EITF would not apply to a split-dollar life insurance arrangement that provides a specified benefit to an employee that is limited to the employee’s active service period with an employer. This EITF 06-4 is effective for fiscal years beginning after December 15, 2007, with earlier application permitted. The Company is currently evaluating the impact of EITF 06-4 on its consolidated financial statements.
EITF 06-5 - The EITF reached a consensus at its September 2006 meeting regarding EITF 06-5, Accounting for Purchases of Life Insurance Determining the Amount That Could be Realized in Accordance with FASB Technical Bulletin No. 85-5. The scope of EITF 06-5 is limited to the determination of net cash surrender value of a life insurance contract in accordance with Technical Bulletin 85-4. This EITF outlines when contractual limitations of the policy should be considered when determining the net realizable value of the contract. EITF 06-5 is effective for fiscal years beginning after December 15, 2006, with earlier application permitted. The Company has evaluated this EITF Issue and does not believe the adoption of its provisions will have a material effect on the Company’s financial position, results of operations or cash flows.
From time to time the FASB issues exposure drafts for proposed statements of financial accounting standards. Such exposure drafts are subject to comment from the public, to revisions by the FASB and to final issuance by the FASB as statements of financial accounting standards. Management considers the effect of the proposed statements on the consolidated financial statements of the Company and monitors the status of changes to and proposed effective dates of exposure drafts.
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SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years Ended December 31, 2006, 2005 and 2004
(3) BUSINESS COMBINATIONS
On January 12, 2004, the Company acquired all the stock of The Community Bank of Pilot Mountain, North Carolina through a definitive agreement in a fixed exchange of cash and stock. The Community Bank, founded in 1987, operates Community-banking offices throughout Surry, Rockingham, Stokes, Iredell and Yadkin counties of North Carolina. For each share of stock owned, The Community Bank shareholders received $53.05 in cash, 4.8714 shares of newly issued Southern Community common stock or a combination of both, subject to an overall allocation of approximately 6.4 million shares of common stock and $15.2 million in cash. The acquisition provided the Company with over $177 million in new loans, over $200 million in new deposits and just under $260 million in total new assets. The results of The Community Bank’s operations are reflected in the Company’s consolidated financial statements from the date of acquisition.
In August 2004, the Company acquired certain assets of two residential mortgage offices from J.R. Davidson Inc., dba Davidson Mortgage in Cornelius, North Carolina in exchange for cash. Davidson Mortgage, formed in 1997, was a mortgage banking company with two offices located in Cornelius, North Carolina and Lexington, South Carolina. Davidson’s primary focus was on conventional conforming and jumbo loan products and it closed over $90 million in loans during the year ended December 31, 2003, its last full year of operations under previous management. The results of Davidson Mortgage’s operations are reflected in the Company’s consolidated financial statements from the date of acquisition. The proforma impact of the Davidson Mortgage acquisition was not material.
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SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years Ended December 31, 2006, 2005 and 2004
(4) INVESTMENT SECURITIES
The following is a summary of the securities portfolio by major classification at December 31, 2006 and 2005:
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SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years Ended December 31, 2006, 2005 and 2004
(4) INVESTMENT SECURITIES (Continued)
The following tables show our investments’ gross unrealized losses and fair value, aggregated by investment category and length of time that the individual securities have been in a continuous unrealized loss position, as of December 31, 2006 and December 31, 2005. For available for sale securities, the unrealized losses relate to seventeen U.S. government agency bonds, nineteen mortgage-backed securities, one municipal and two other securities. For held to maturity securities, the unrealized losses relate to seventeen U.S. government agency bonds, six mortgage-backed securities, and fifteen municipal securities. All investment securities with unrealized losses are considered by management to be temporarily impaired given the credit ratings on these investment securities and management’s intent and ability to hold these securities until recovery. Should the Company decide in the future to sell securities in an unrealized loss position, or determine that impairment of any securities is other than temporary, irrespective of a decision to sell, an impairment loss would be recognized in the period such determination is made.
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SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years Ended December 31, 2006, 2005 and 2004
(4) INVESTMENT SECURITIES (Continued)
During 2006, the Company sold approximately $87.8 million of available for sale government agency and mortgage-backed securities at a loss of $4.2 million, and in 2005, the Company sold approximately $11.7 million of available for sale government agency securities, at a loss of $322 thousand, as part of its asset liability management. In addition, insignificant amounts of equity securities were sold in 2006 and 2005. There were no sales of investment securities in 2004.
The amortized cost and fair values of securities available for sale and held to maturity at December 31, 2006 by contractual maturity are shown below. Actual expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligation.
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SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years Ended December 31, 2006, 2005 and 2004
(4) INVESTMENT SECURITIES (Continued)
Securities with carrying values of $41.6 million and $37.4 million and fair values of $40.1 million and $36.6 million at December 31, 2006 and 2005, respectively, were pledged to secure public deposits as required by law. Additionally, at December 31, 2006, securities with carrying values and fair values of $34.2 million and $34.3 million were pledged to secure the Company’s borrowings from the FHLB. Securities with carrying values of $41.7 million and fair values of $41.5 million were pledged for other purposes, primarily to secure repurchase agreements and derivative positions.
Investments in Equity Securities
The aggregate of the Company’s cost method investments included in other available for sale securities totaled $11.0 million and $12.0 million at December 31, 2006 and 2005, respectively. As of year-end 2006 these investments consisted of Federal Home Loan Bank stock of $10.6 million and The Bankers Bank stock of $404 thousand. The Company estimates that the fair value for these investments approximates cost at December 31, 2006. The Company also has investments in corporate equity securities included in other available for sale investments, which are carried at fair value with unrealized gains and losses included in accumulated other comprehensive income. Such securities had an aggregate cost of $6.9 million and an aggregate fair value of $6.5 million as of December 31, 2006.
(5) LOANS
Following is a summary of loans at December 31, 2006 and 2005:
Loans are primarily made in the Piedmont area of North Carolina. Real estate loans can be affected by the condition of the local real estate market. Commercial and installment loans can be affected by the local economic conditions. Included in residential mortgage loans at December 31, 2006 and 2005 are loans held for sale totaling approximately $3.6 million and $1.3 million, respectively.
The following is a summary of nonperforming assets at December 31, 2006 and 2005:
At December 31, 2006, the recorded investment in loans considered impaired in accordance with SFAS No. 114 totaled $3.1 million. The corresponding valuation allowance for impaired loans with a recorded investment of $1.2 million amounted to $389 thousand; no valuation allowance for the other impaired loans was considered necessary. For the year ended December 31, 2006, the average recorded investment in impaired loans was approximately $2.7 million. The amount of interest recognized on impaired loans during the portion of the year that they were considered impaired was approximately $155 thousand.
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SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years Ended December 31, 2006, 2005 and 2004
(5) LOANS (Continued)
At December 31, 2005, the recorded investment in loans considered impaired in accordance with SFAS No. 114 totaled $1.7 million. The corresponding valuation allowance for impaired loans with a recorded investment of $400 thousand amounted to $58 thousand; no valuation allowance for the other impaired loans was considered necessary. For the year ended December 31, 2005, the average recorded investment in impaired loans was approximately $4.4 million. The amount of interest recognized on impaired loans during the portion of the year that they were considered impaired was approximately $80 thousand.
The Company has granted loans to certain directors and executive officers of the Company and their related interests. Such loans are made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other borrowers and, in management’s opinion, do not involve more than the normal risk of collectibility. All loans to directors and executive officers or their interests are submitted to the Board of Directors for approval. A summary of loans to directors and their interests follows (amounts in thousands):
At December 31, 2006, the Company had pre-approved but unused lines of credit totaling $2.2 million to executive officers, directors and their affiliates.
(6) ALLOWANCE FOR LOAN LOSSES
An analysis of the allowance for loan losses follows:
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SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years Ended December 31, 2006, 2005 and 2004
(7) PREMISES AND EQUIPMENT
Following is a summary of premises and equipment at December 31, 2006 and 2005:
Depreciation and amortization amounting to $3.3 million in 2006, $3.0 million in 2005, and $2.4 million in 2004, is included in occupancy and equipment expense.
(8) GOODWILL AND OTHER INTANGIBLES
The following is a summary of goodwill and other intangible assets at December 31, 2006 and 2005. Other intangibles assets are included in other assets in the consolidated balance sheet.
During the first quarter of 2005, management completed an extensive review of the allowance for loan losses related to the loan portfolio acquired in the first quarter of 2004 in connection with The Community Bank acquisition. This review was completed during the one year allocation period, and as a result, management determined the allowance for loan losses as recorded in the preliminary purchase price allocation should be adjusted downward. A purchase price allocation adjustment of $491 thousand, less deferred income taxes of $189 thousand was recorded as a reduction of the allowance for loan losses and a reduction of goodwill. In addition, an adjustment was made to reduce accrued liabilities assumed by $41 thousand.
Amortization expense associated with acquired intangibles amounted to $362 thousand, $362 thousand, and $208 thousand, for 2006, 2005, and 2004, respectively. The following table presents estimated future amortization expense for other intangibles.
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SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years Ended December 31, 2006, 2005 and 2004
(9) DEPOSITS
Time deposits in denominations of $100,000 or more were approximately $314.6 million and $304.3 million at December 31, 2006 and 2005, respectively. At December 31, 2006, the scheduled maturities of certificates of deposit are as follows:
(10) BORROWINGS
The Company has a $.358.5 million credit line availability with the Federal Home Loan Bank for advances. These advances are secured by both loans with a carrying value of $181.7 million and pledged investment securities with a market value of $34.3 million.
At December 31, 2006, the Company's Federal Home Loan Bank advances of $177.7 million mature through 2026. At December 31, 2006 and 2005, the interest rates on these advances ranged from 0.50% to 5.6175% and from 0.50% to 4.59%, respectively. At December 31, 2006 and 2005, the weighted average interest rates on the advances were 3.06% and 3.46%, respectively.
The Company has also entered into long-term financing through term repurchase agreements with various parties. At December 31, 2006, the interest rates on these term repurchase agreements, which are variable rate agreements based upon LIBOR, range from 4.82% to 5.68%.
Certain of the FHLB advances and the term repurchase agreements contain embedded interest rate options. Some of the options are exercisable by the holder and relate to converting a floating rate to a fixed rate. Other options are held by the bank, and relate to reducing the interest rate charged should the reference rate fall below a rate specified in the agreement.
The contractual maturities of the Federal Home Loan Bank advances and term repurchase agreements at December 31, 2006 are as follows:
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SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years Ended December 31, 2006, 2005 and 2004
(10) BORROWINGS (Continued)
In addition to the above advances, the Company also had repurchase agreements with outstanding balances of $14.6 million and $5.2 million at December 31, 2006 and 2005, respectively, which were for customer accommodations. Securities sold under agreements to repurchase generally mature within ninety days from the transaction date and are collateralized by U.S. Government Agency obligations. The Company has repurchase lines of credit of $130.0 million from various institutions, which must be adequately collateralized.
In addition to the above advances, the Company has lines of credit of $78.0 million from various correspondent banks to purchase federal funds on a short-term basis. The Company had $23.2 million outstanding as of December 31, 2006.
Aggregate borrowings at December 31, 2006 amounted to $265.3 million, including $92.7 million that is due within one year and classified as short-term borrowings and $172.6 million due after one year that is classified as long-term debt in the accompanying consolidated balance sheet.
The following table provides a summary of our borrowings.
(11) JUNIOR SUBORDINATED DEBENTURES
In November of 2003, Southern Community Capital Trust II (“Trust II”), wholly owned by the Company, issued 3,450,000 Trust Preferred Securities (“Trust II Securities”), generating total proceeds of $34.5 million. The Trust II Securities pay distributions at an annual rate of 7.95% and mature on December 31, 2033. The Trust II Securities began paying quarterly distributions on December 31, 2003. The Company has fully and unconditionally guaranteed the obligations of Trust II. The Trust II Securities are redeemable in whole or in part at any time after December 31, 2008. The proceeds from the Trust II Securities were utilized to purchase convertible junior subordinated debentures from us under the same terms and conditions as the Trust II Securities. We have the right to defer payment of interest on the debentures at any time and from time to time for a period not exceeding five years, provided that no deferral period extend beyond the stated maturities of the debentures. Such deferral of interest payments by the Company will result in a deferral of distribution payments on the related Trust II Securities. Should we defer the payment of interest on the debentures, the Company will be precluded from the payment of cash dividends to shareholders. The principal uses of the net proceeds from the sale of the debentures were to provide cash for the acquisition of The Community Bank, to increase our regulatory capital, and to support the growth and operations of our subsidiary bank. The amount of proceeds we count as Tier 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.
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SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years Ended December 31, 2006, 2005 and 2004
(11) JUNIOR SUBORDINATED DEBENTURES (Continued)
In February 2002, Southern Community Capital Trust I (“Trust I”), a newly formed subsidiary of the Company, issued 1,725,000 Cumulative Convertible Trust Preferred Securities (“Trust I Securities”), generating total proceeds of $17.3 million. At December 31, 2003, holders of the Trust I Securities had voluntarily converted $175 thousand of the Trust I Securities into 21,187 shares of our common stock at the Conversion Price of $8.26 per share of our common stock. On January 14, 2004, we announced the redemption of all of the Trust I Securities. The Trust I Securities were redeemed on March 12, 2004, which resulted in the issuance of approximately 2,060,000 shares of our common stock through the conversions and the retirement of $61 thousand of the convertible trust preferred securities. Subject to certain limitations, the Trust I Securities qualified as Tier 1 capital of the Company for regulatory capital purposes. The principal use of the net proceeds from the sale of the convertible debentures was to infuse capital into our bank subsidiary, Southern Community Bank and Trust, to fund its operations and continued expansion, and to maintain the Company’s and the Bank’s status as “well capitalized” under regulatory guidelines.
At December 31, 2006 and 2005, the Company had outstanding 3.45 million shares of the trust preferred securities and related junior subordinated debentures, with carrying amounts of $34.9 million and $35.1 million, respectively.
(12) EMPLOYEE AND DIRECTOR BENEFIT PLANS
401(k) Retirement Plan
The Company maintains a qualified profit sharing 401(k) Plan for employees of age 21 years or over with at least three months of service. Under the plan, employees may contribute up to an annual maximum as determined under the Internal Revenue Code. The Bank matches 100% of such contributions not exceeding 6% of the participants’ compensation. In addition, the board of directors can authorize additional discretionary contributions to the plan. The plan provides that employees’ contributions are 100% vested at all times and the Company’s contributions vest at 20% each year of participation in the plan. The expense related to this plan for the years ended December 31, 2006, 2005, and 2004 totaled approximately $761 thousand, $611 thousand, and $611 thousand, respectively.
Employment Agreements
The Company has entered into employment agreements with its chief executive officer and certain other executive officers to ensure a stable and competent management base. The agreements provide for a three-year term, but the agreements may annually be extended for an additional year. The agreements provide for benefits as spelled out in the contracts and cannot be terminated by the Board of Directors, except for cause, without prejudicing the officers’ rights to receive certain vested benefits, including compensation. In the event of a change in control of the Company, as outlined in the agreements, the acquirer will be bound to the terms of the contracts.
Termination Agreements
Prior to 2005, the Company entered into termination agreements with substantially all other employees, which provide for severance pay benefits in the event of a change in control of the Company which results in the termination of such employee or diminished compensation, duties or benefits. As of December 31, 2006, approximately 48% of the Company’s employees were covered under such agreements.
Defined Benefit Pension Plan
The Company also has a non-contributory Defined Benefit Pension Plan covering substantially all employees of an acquired bank, The Community Bank. This plan was assumed as part of the purchase of The Community Bank in January 2004. Benefits under the plan are based on length of service and qualifying compensation during the final years of employment. Contributions to the plan are based upon the projected unit credit actuarial funding method to comply with the funding requirements of the Employee Retirement Income Security Act. The plan was frozen effective May 1, 2004. No contribution was required for the years ended December 31, 2006, 2005 or 2004, and the Company does not expect to contribute to the plan in 2007. The changes in benefit obligations and plan assets, as well as the funded status, actuarial assumptions and components of net periodic pension cost of the plan at December 31 were:
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SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years Ended December 31, 2006, 2005 and 2004
(12) EMPLOYEE AND DIRECTOR BENEFIT PLANS (Continued)
Defined Benefit Pension Plan (Continued)
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SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years Ended December 31, 2006, 2005 and 2004
(12) EMPLOYEE AND DIRECTOR BENEFIT PLANS (Continued)
Defined Benefit Pension Plan (Continued)
The measurement date used for the plan was December 31, 2006. As of that date, the pension plan experienced plan assets in excess of accumulated projected benefit obligations, for which the projected benefit obligation, accumulated benefit obligation and fair value of plan assets were $845 thousand, $845 thousand and $1.2 million respectively.
The overall expected long-term rate of return on assets assumption is based on: (1) the target asset allocation for plan assets, (2) long-term capital markets forecasts for asset classes employed, and (3) active management excess return expectations to the extent asset classes are actively managed.
Plan assets are invested using allocation guidelines as established by the Plan. The primary objective is to provide long-term capital appreciation through investments in equities and fixed income securities. These guidelines ensure risk control by maintaining minimum and maximum exposure in equity and fixed income/cash equivalents portfolios. The minimum equity and fixed income/cash equivalents investment exposure is 35% and 25%, respectively. The maximum equity and fixed income/cash equivalents investment exposure is 75% and 65%, respectively. The current asset allocation is 62% equity securities and 38% fixed income/cash equivalents securities, which meets the criteria established by the Plan.
Allowable investment types include both U.S. and international equity and fixed income funds. The equity component is composed of common stocks, convertible notes and bonds, convertible preferred stocks and ADR’s of non U.S. companies as well as various mutual funds, including government and corporate bonds, large to mid cap value, growth and world/international equity funds and index funds. The fixed income/cash equivalents component is composed of money market funds, commercial paper, certificates of deposit, U.S. government and agency securities, corporate notes and bonds, preferred stock and fixed income securities of foreign governments and corporations.
The plan's weighted-average asset allocations at December 31, 2006, by asset category are as follows.
Estimated future benefits payments are shown below (in thousands):
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SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years Ended December 31, 2006, 2005 and 2004
(12) EMPLOYEE AND DIRECTOR BENEFIT PLANS (Continued)
Supplemental Retirement
The Company during 2001 implemented a non-qualifying deferred compensation plan for certain key executive and senior officers. The Company has purchased life insurance policies on the participating officers in order to provide future funding of benefit payments. Benefits will accrue during employment based upon the performance of the underlying life insurance policies both during employment and after retirement. Such benefits will continue to accrue and be paid throughout each participant’s life assuming satisfactory performance of the funding life insurance policies. The plan also provides for payment of death or disability benefits in the event a participating officer becomes permanently disabled or dies prior to attainment of retirement age. Provisions of $166 thousand, $313 thousand, and $477 thousand in 2006, 2005, and 2004, respectively, were expensed for future benefits to be provided under this plan. The accrued liability related to this plan was approximately $963 thousand and $787 thousand as of December 31, 2006 and 2005, respectively.
During 1994, The Community Bank had established an unfunded Supplemental Executive Retirement Plan, which is a nonqualified plan that provides additional retirement benefits to certain key management personnel. The accrued liability related to this plan was approximately $1.01 million and $856 thousand at December 31, 2006 and 2005, respectively. Total expense for this plan aggregated $88 thousand for each of the years ended December 31, 2006 and 2005, respectively. The adoption of the provisions of SFAS 158 resulted in the recognition during 2006 of an additional minimum pension liability of $147 thousand and accumulated other comprehensive results, net of tax, of $(90) thousand at December 31, 2006.
Employee Stock Purchase Plan
On December 19, 2002, the Board approved the creation of, and on February 20, 2003 the Board adopted, the 2002 Employee Stock Purchase Plan (the “2002 ESPP”). An aggregate of 1,000,000 shares of common stock of the Company has been reserved for issuance by the Company upon exercise of options to be granted from time to time under the 2002 ESPP. The purpose of the 2002 ESPP is to provide employees of the Company with an opportunity to purchase shares of the common stock of the Company in order to encourage employee participation in the ownership and economic success of the Company.
The ESPP provides employees of the Company the right to purchase, annually, shares of the Company’s common stock at 85% of fair market value. For the 2005-2006 plan year and beyond, the purchase price is 95% of fair value. The number of shares that can be purchased in any calendar year by any individual is limited to the lesser of: (1) shares with a fair market value of $25 thousand; or (2) shares with a fair market value of 20% of the individual’s annual compensation. Shares purchased through the 2002 ESPP must be held by the employee for one year, after which time the employee is free to dispose of the stock.
For the years ended December 31, 2006, 2005 and 2004, employees of the Company purchased 16,508, 21,059, and 22,350 shares, respectively, under the ESPP. In 2006, the shares purchased for the ESPP were purchased on the open market.
Stock Option Plans
During 1997 the Company adopted, with stockholder approval, the 1997 Incentive Stock Option Plan and the 1997 Nonstatutory Stock Option Plan. Both plans were amended in 2000 and in 2001, with stockholder approval, to increase the number of shares available for grant. Each of these plans makes available options to purchase 875,253 shares of the Company’s common stock. During 2002 the Company adopted, with stockholder approval in 2003, the 2002 Incentive Stock Option Plan with 350,000 options available and the 2002 Nonstatutory Stock Option Plan with 150,000 options available. During 2006 the Company adopted, with shareholder approval, the 2006 Nonstatutory Stock Option Plan with 150,000 options available. The exercise price of all options granted to date is the fair value of the Company’s common shares on the date of grant.
All options had an initial vesting period of five years. During the first quarter 2005, the Company vested all unvested stock options. As a result of this decision 623,725 non-vested options were accelerated from their established vesting over a five-year period from date of grant to being fully vested. Stock options granted after December 31, 2005 and stock options granted to advisory board members vest over a five-year period. All unexercised options expire ten years after the date of grant.
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SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years Ended December 31, 2006, 2005 and 2004
(12) EMPLOYEE AND DIRECTOR BENEFIT PLANS (Continued)
Stock Option Plans (Continued)
A summary of the Company’s option plans as of and for the years ended December 31, 2006, 2005, and 2004, is as follows:
The weighted average remaining life of options outstanding and options exercisable at December 31, 2006 is 5.1 years and 4.8 years, respectively. The range of exercise prices for options outstanding at December 31, 2006 is $3.44 to $12.15. Information pertaining to options outstanding at December 31, 2006 is as follows:
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SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years Ended December 31, 2006, 2005 and 2004
(12) EMPLOYEE AND DIRECTOR BENEFIT PLANS (Continued)
Stock Option Plans (Continued)
The estimated average per share fair value of options granted, using the Black-Scholes methodology, together with the assumptions used in estimating those fair values, are displayed below:
The total intrinsic value of options exercised during the years ended December 31, 2006, 2005 and 2004 was $890 thousand, $1.30 million, and $2.22 million, respectively. The aggregate intrinsic value of options outstanding and options exercisable at December 31, 2006 was $2.62 million and $2.58 million, respectively. As of December 31, 2006, there was $246 thousand of unrecognized compensation cost related to nonvested share-based compensation arrangements granted under the plans. That cost is expected to be recognized over a weighted average period of 3.8 years.
Cash received from option exercises under all share-based payment arrangements for the years ended December 31, 2006, 2005 and 2004 was $680 thousand, $978 thousand, and $1.44 million, respectively. The tax benefit realized for tax deductions from option exercise of the share-based payment arrangements for the years ended December 31, 2006, 2005 and 2004 were $69 thousand, $323 thousand and $411 thousand, respectively.
The adoption of SFAS 123R and its fair value compensation cost recognition provisions are different from the nonrecognition provisions under SFAS 123 and the intrinsic value method for compensation cost allowed under APB 25. The adoption of the provisions of SFAS 123R for the year ended December 31, resulted in the recognition of $41 thousand of share-based compensation expense related to employee awards that would have resulted in no expense under the provisions of APB 25, and $18 thousand of share-based compensation expense related to advisory board member awards that would have resulted in a similar expense under the provisions of APB 25. The impact of the adoption of the provisions of SFAS 123R on financial position and results of operations was insignificant.
(13) LEASES
The Company leases office space and equipment under non-cancelable operating leases. Future minimum lease payments under these leases for the years ending December 31 are as follows (amounts in thousands):
Total rental expense under operating leases was $551 thousand in 2006, $607 thousand in 2005, and $432 thousand in 2004.
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SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years Ended December 31, 2006, 2005 and 2004
(14) INCOME TAXES
The significant components of the provision for income taxes for the years ended December 31, 2006, 2005 and 2004 are as follows:
The difference between the provision for income taxes and the amounts computed by applying the statutory federal income tax rate of 34% to income before income taxes is summarized below:
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SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years Ended December 31, 2006, 2005 and 2004
(14) INCOME TAXES (Continued)
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of deferred taxes at December 31, 2006 and 2005 are as follows:
The Company has established a valuation allowance for the deferred tax asset attributable to the parent’s net loss carryforward for state income tax purposes. Management determined that it is likely that the operations at the parent level would not generate sufficient taxable income to realize the deferred tax asset. The changes in the valuation allowance for the years ended December 31, 2006, 2005, and 2004 were increases of $2 thousand, $131 thousand, and $227 thousand, respectively.
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SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years Ended December 31, 2006, 2005 and 2004
(15) NON-INTEREST INCOME AND OTHER NON-INTEREST EXPENSE
The major components of non-interest income and non-interest expense for the years ended December 31, 2006, 2005 and 2004 are set forth in the following tables.
(16) REGULATORY MATTERS
The Bank, as a North Carolina banking corporation, may pay cash dividends to the Company only out of undivided profits as determined pursuant to North Carolina banking laws. However, regulatory authorities may limit payment of dividends by any bank when it is determined that such limitation is in the public interest and is necessary to ensure financial soundness of the bank.
The Bank is subject to various regulatory capital requirements administered by federal and state banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory - and possibly additional discretionary - actions by regulators that, if undertaken, could have a direct material effect on the Company’s consolidated financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Bank’s capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
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SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years Ended December 31, 2006, 2005 and 2004
(16) REGULATORY MATTERS (Continued)
Quantitative measures established by regulation to ensure capital adequacy require the bank to maintain minimum amounts and ratios, as prescribed by regulations, of total and Tier I capital to risk-weighted assets and of Tier I capital to average assets. As of December 31, 2006 and 2005, the most recent notification from the FDIC categorized the Bank as well capitalized under the regulatory framework for prompt correction action. To be categorized as well capitalized, the Bank must maintain minimum amounts and ratios, as set forth in the table below. There are no conditions or events since that notification that management believes have changed the Bank’s category. Information regarding the Bank’s capital and capital ratios is set forth below:
The Company is also subject to these capital requirements. Information regarding the Company’s capital and capital ratios is set forth below:
(17) DERIVATIVES
Derivative Financial Instruments
The Company utilizes stand-alone derivative financial instruments, primarily in the form of interest rate swap and option agreements, in its asset/liability management program. These transactions involve both credit and market risk. Direct credit exposure is limited to the net difference between the calculated amounts to be received and paid, if any. Such difference, which represents the fair value of the derivative instruments, is reflected on the Company’s consolidated balance sheets as derivative assets and derivative liabilities.
The Company is exposed to credit-related losses in the event of nonperformance by the counterparties to these agreements. The Company controls the credit risk of its financial contracts through credit approvals, limits and monitoring procedures, and does not expect any counterparties to fail their obligations. The Company deals only with primary dealers.
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SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years Ended December 31, 2006, 2005 and 2004
(17) DERIVATIVES (Continued)
Risk Management Policies - Hedging Instruments
The primary focus of the Company’s asset/liability management program is to monitor the sensitivity of the Company’s net portfolio value and net income under varying interest rate scenarios to take steps to control its risks. On a quarterly basis, the Company simulates the net portfolio value and net income expected to be earned for a period following the date of simulation. The simulation is based on a projection of market interest rates at varying levels and estimates the impact of such market rates on the levels of interest-earning assets and interest-bearing liabilities during the measurement period. Based upon the outcome of the simulation analysis, the Company considers the use of derivatives as a means of reducing the volatility of net portfolio value and projected net income within certain ranges of projected changes in interest rates. The Company evaluates the effectiveness of entering into any derivative instrument agreement by measuring the cost of such an agreement in relation to the reduction in net portfolio value and net income volatility within an assumed range of interest rates. The Company has certain derivative financial instruments that have been designated as hedges under SFAS 133, and has other derivative financial instruments used as economic hedges but have not been currently qualified by the Company for hedge accounting treatment.
The fair value of the Company’s derivative assets and liabilities and their related notional amounts is summarized below.
Certain derivative liabilities were collateralized by securities, which are held by the counterparty or by third-party safekeepers. The fair value of these securities at December 31, 2006 was $3.9 million.
Certain interest rate swap agreements were terminated in 2003 prior to maturity, and the resulting gains were recognized over the original lives of the agreements. Gains recognized with respect to those agreements for the years ended December 31, 2006, 2005, and 2004 were nil, $219 thousand, and $482 thousand, respectively.
As part of our banking activities, the Company originates certain residential loans and commits these loans for sale. The commitments to originate residential loans and the sales commitments are freestanding derivative instruments and are generally funded within 90 days. The fair value of these commitments was not significant at December 31, 2006.
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SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years Ended December 31, 2006, 2005 and 2004
(17) DERIVATIVES (Continued)
Interest Rate Risk Management - Cash Flow Hedging Instruments
To mitigate exposure to variability in expected future cash flows resulting from changes in interest rates, management may enter into interest rate swap and option agreements. At December 31, 2006, the Company had interest rate option agreements that provide for payments to the Company in the event interest rates decrease below levels provided in the agreements. At December 31, 2006, one such agreement was designated as a cash flow hedge, and two of these agreements were not designated as hedges under SFAS 133. The gains and losses from such hedges not designated as cash flow hedges are recognized in non-interest income in the line item net cash settlement and change in fair value of economic hedges. At December 31, 2005, no interest rate option agreements were designated as hedges under SFAS 133.
Interest Rate Risk Management - Fair Value Hedging Instruments
As part of interest rate risk management, the Company from time to time has entered into interest rate swap agreements to convert certain fixed-rate obligations to floating rates. At December 31, 2006 and 2005, the Company had interest rate swap agreements related to fixed-rate obligations that provide for the Company to pay floating and received fixed interest payments, certain of which had been designated as a fair value hedges under SFAS 133, others of which were not designated as fair value hedges. The gains (losses) from such interest rate swaps that were not designated as accounting hedges are recognized in non-interest income in the line item net cash settlement and change in fair value of economic hedges. The interest rate swap related to the fixed-rate Trust Preferred Securities (the Trust II Securities) has been designated as a fair value hedge. Due to certain differences between the terms of the debt and the terms of the swap, the Company has assessed and evaluated hedge effectiveness of the swap under the “long-haul” method since its inception. Effective July 31, 2006, certain of the interest rate swap agreements used to convert brokered CD liabilities to floating rates were designated as fair value hedges. Prior to designation as fair value hedges, the change in the fair value of the interest rate swap agreements were included in noninterest income. Subsequent to the designation as fair value hedges, the changes in the fair value of the interest rate swap and the changes to the fair value of the hedged CD are included in noninterest income. The difference between the changes in the fair values of the interest rate swaps and the related CDs represents hedge ineffectiveness. The amount of hedge ineffectiveness related to the interest rate swap agreements included in income for the year ended December 31, 2006 was $34 thousand. The amount of ineffectiveness in 2005 and 2004 related to the Trust Preferred Securities was insignificant. The Company currently has no fair value hedges for which hedge effectiveness is evaluated using the “short-cut” method.
(18) OFF-BALANCE SHEET RISK, COMMITMENTS AND CONTINGENCIES
The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheets. The contract or notional amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of conditions established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since some of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company, upon extension of credit is based on management’s credit evaluation of the borrower. Collateral obtained varies but may include real estate, stocks, bonds, and certificates of deposit.
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SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years Ended December 31, 2006, 2005 and 2004
(18) OFF-BALANCE SHEET RISK, COMMITMENTS AND CONTINGENCIES (Continued)
A summary of the contract amount of the Company’s exposure to off-balance sheet risk as of December 31, 2006 and 2005 is as follows (amounts in thousands):
The Company is a party to legal proceedings and potential claims arising in the normal conduct of business. Management believes that this litigation is not material to our financial position or results of our operations or the operations of the Bank.
(19) DISCLOSURES ABOUT FAIR VALUES OF FINANCIAL INSTRUMENTS
Financial instruments include cash and due from banks, federal funds sold, investment securities, loans, bank-owned life insurance, deposit accounts and other borrowings, accrued interest and derivatives. Fair value estimates are made at a specific moment in time, based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of a particular financial instrument. Because no active market readily exists for a portion of the Company’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and, therefore, cannot be determined with precision. Changes in assumptions could significantly affect the estimates.
The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:
Cash and due from banks, federal funds sold, and other interest-bearing deposits
The carrying amounts for cash and due from banks, federal funds sold and other interest-bearing deposits approximate fair value because of the short maturities of those instruments.
Investment securities
Fair value for investment securities equals quoted market price if such information is available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities.
Loans
For certain homogeneous categories of loans, such as residential mortgages, fair value is estimated using the quoted market prices for securities backed by similar loans, adjusted for differences in loan characteristics. The fair value of other types of loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities.
Investment in bank-owned life insurance
The carrying value of bank-owned life insurance approximates fair value because this investment is carried at cash surrender value, as determined by the insurer.
Deposits
The fair value of demand deposits is the amount payable on demand at the reporting date. The fair value of time deposits is estimated based on discounting expected cash flows using the rates currently offered for deposits of similar remaining maturities.
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SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
CONSOLIDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years Ended December 31, 2006, 2005 and 2004
(19) DISCLOSURES ABOUT FAIR VALUES OF FINANCIAL INSTRUMENTS (Continued)
Borrowings
The fair values are based on discounting expected cash flows at the current interest rate for debt with the same or similar remaining maturities and collateral requirements.
Accrued interest
The carrying amounts of accrued interest approximate fair value.
Derivative financial instruments
Fair values for interest rate swap and option agreements are based upon the amounts required to settle the contracts. Fair values for commitments to originate loans held for sale are based on fees currently charged to enter into similar agreements, and for fixed-rate commitments also consider the difference between current levels of interest rates and the committed rates.
Financial instruments with off-balance sheet risk
With regard to financial instruments with off-balance sheet risk discussed in Note 18, it is not practicable to estimate the fair value of future financing commitments.
The carrying amounts and estimated fair values of the Company’s financial instruments, none of which are held for trading purposes, are as follows at December 31, 2006 and 2005:
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SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years Ended December 31, 2006, 2005 and 2004
(20) PARENT COMPANY FINANCIAL DATA
Southern Community Financial Corporation's condensed balance sheets as of December 31, 2006 and 2005, and its related condensed statements of operations and cash flows for each of the years in the three-year period ended December 31, 2006 are as follows:
Condensed Balance Sheets
December 31, 2006 and 2005
(Amounts in thousands)
Condensed Statements of Operations
Years Ended December 31, 2006, 2005 and 2004
(Amounts in thousands)
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SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years Ended December 31, 2006, 2005 and 2004
(20) PARENT COMPANY FINANCIAL DATA (Continued)
Condensed Statements of Cash Flows
Years Ended December 31, 2006, 2005 and 2004
(Amounts in thousands)
(21) SUBSEQUENT EVENTS (unaudited)
On February 1, 2007, the Company announced that its Board of Directors, at its regular meeting on January 24, 2007, declared a quarterly cash dividend of $0.035 per share on the Corporation’s common stock, payable March 1, 2007 to shareholders of record on February 15, 2007.
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Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Item 9A.
Item 9A. Controls and Procedures
Southern Community Financial Corporation’s management, with the participation of its Chief Executive Officer and its Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures as of December 31, 2006. Based on that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of December 31, 2006.
Management’s Report On Internal Control Over Financial Reporting
Management of Southern Community Financial Corporation and Subsidiary (the “Company”) is responsible for establishing and maintaining effective internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934. Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles.
Under the supervision and with the participation of management, including the principal executive officer and principal financial officer, the Company conducted an evaluation of the effectiveness of internal control over financial reporting, including controls over the preparation of financial statements in accordance with the instructions to the Consolidated Financial Statements for Bank Holding Companies (Form FR Y-9C), based on the framework in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation under the framework in Internal Control - Integrated Framework, management of the Company has concluded the Company maintained effective internal control over financial reporting as of December 31, 2006.
Internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives because of its inherent limitations. Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial reporting can also be circumvented by collusion or improper management override. Because of such limitations, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Management is also responsible for compliance with laws and regulations relating to safety and soundness which are designated by the FDIC and the appropriate federal banking agency. Management assessed its compliance with these designated laws and regulations relating to safety and soundness and believes that the Company complied, in all significant respects, with such laws and during the year ended December 31, 2006.
Dixon Hughes PLLC, an independent, registered public accounting firm, has audited the Company’s consolidated financial statements as of and for the year ended December 31, 2006 included in this annual report, and has issued an attestation report on management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006, which is included herein.
Changes in Internal Controls over Financial Reporting
The Company assesses the adequacy of its internal control over financial reporting quarterly and enhances its controls in response to internal control assessments and internal and external audit and regulatory recommendations. No such control enhancements during the quarter ended December 31, 2006 have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
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Report Of Independent Registered Public Accounting Firm
To the Board of Directors and Stockholders
Southern Community Financial Corporation
We have audited management's assessment, included in the accompanying Management’s Annual Report on Internal Control Over Financial Reporting, that Southern Community Financial Corporation and subsidiary (the “Company”) maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management's assessment and an opinion on the effectiveness of the Company's internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Because management’s assessment and our audit were conducted to also meet the reporting requirements of Section 112 of the Federal Deposit Insurance Corporation Improvement Act (FDICIA), management’s assessment and our audit of the Company’s internal control over financial reporting included controls over the preparation of financial statements in accordance with the instructions to the Consolidated Financial Statements for Bank Holding Companies (form FR Y-9 C). A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
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In our opinion, management's assessment that Southern Community Financial Corporation and subsidiary maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also in our opinion, Southern Community Financial Corporation and subsidiary maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements of Southern Community Financial Corporation and subsidiary as of and for the year ended December 31, 2006, and our report dated March 15, 2007, expressed an unqualified opinion on those consolidated financial statements.
We do not express an opinion or any other form of assurance on management’s statement referring to compliance with designated laws and regulations related to safety and soundness.
/s/ Dixon Hughes PLLC
Raleigh, North Carolina
March 15, 2007
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Item 9B.
Item 9B. Other Information
None.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant
Incorporated by reference from the Company's definitive proxy statement, to be filed with the Securities and Exchange Commission with respect to the Annual Meeting of Shareholders to be held on May 23, 2007.
Item 11.
Item 11. Executive Compensation
Incorporated by reference from the Company's definitive proxy statement, to be filed with the Securities and Exchange Commission with respect to the Annual Meeting of Shareholders to be held on May 23, 2007.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management
Incorporated by reference from the Company's definitive proxy statement, to be filed with the Securities and Exchange Commission with respect to the Annual Meeting of Shareholders to be held on May 23, 2007.
The following table sets forth equity compensation plan information at December 31, 2006.
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PART III (Continued)
Item 13.
Item 13. Certain Relationships and Related Transactions
Incorporated by reference from the Company's definitive proxy statement, to be filed with the Securities and Exchange Commission with respect to the Annual Meeting of Shareholders to be held on May 23, 2007.
Item 14.
Item 14. Principal Accountant Fees and Services
Incorporated by reference from the Company's definitive proxy statement, to be filed with the Securities and Exchange Commission with respect to the Annual Meeting of Shareholders to be held on May 23, 2007.
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PART IV
Item 15.
Item 15. Exhibits, Financial Statement Schedules
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on behalf of the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
SIGNATURE
TITLE
DATE
/s/ F. Scott Bauer
Chairman of the Board
F. Scott Bauer
and Chief Executive Officer
March 16, 2007
/s/ David W. Hinshaw
Executive Vice President and Chief Financial Officer
David W. Hinshaw
(principal financiaand accounting officer)
March 16, 2007
/s/ Durward A. Smith, Jr.
Vice Chairman of the Board
Durward A. Smith, Jr.
March 16, 2007
/s/ Don Gray Angell
Director
Don Gray Angell
March 16, 2007
/s/ Edward T. Brown
Director
Edward T. Brown
March 16, 2007
/s/ Zack W. Blackmon, Sr.
Director
Zack W. Blackmon, Sr.
March 16, 2007
/s/ James G. Chrysson
Director
James G. Chrysson
March 16, 2007
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SIGNATURE
TITLE
DATE
/s/ James O. Frye
Director
James O. Frye
March 16, 2007
/s/ Matthew G. Gallins
Director
Matthew G. Gallins
March 16, 2007
/s/ Beverly H. Godfrey
Director
Beverly H. Godfrey
March 16, 2007
/s/ Lynn L. Lane
Director
Lynn L. Lane
March 16, 2007
/s/ H. Lee Merritt, Jr.
Director
H. Lee Merritt, Jr.
March 16, 2007
/s/ W. Samuel Smoak
Director
W. Samuel Smoak
March 16, 2007
Director
William G. Ward, Sr., M.D.
March 16, 2007
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