U.S. Securities and Exchange Commission

Form 10-K

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

For the fiscal year ended December 31, 2004

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

For the transition period from ____________ to ____________

Commission file number 000-33227

Southern Community Financial Corporation

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

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

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

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

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

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes þ No o

State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter. $163.9 million.

As of March 29, 2005, (the most recent practicable date), the registrant had outstanding 17,941,028 shares of Common Stock, no par value.

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Documents Incorporated By Reference

Form 10-K Table of Contents

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PART I

Item 1. Business

Who We Are

Southern Community Financial Corporation (“company”) is the holding company for Southern Community Bank and Trust (“bank”) a Community bank with eighteen banking offices throughout the Piedmont Triad region of 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. The Piedmont Triad area is located in the north central region of North Carolina and includes the cities of Winston-Salem (our headquarters), Greensboro and High Point.

At December 31, 2004, we had total assets of $1.2 billion, net loans of $783.6 million, deposits of $845.2 million, and shareholders’ equity of $136.9 million. We had net income of $8.1 million and $3.7 million and diluted earnings per share of $.45 and $.40 for the years ended December 31, 2004 and 2003, respectively. We had net income of $3.2 million and diluted earnings per share of $.35 for the year ended December 31, 2002.

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.

     In our eight years of existence we have accomplished the following:

	•	Registered 22 consecutive quarters of profitability after becoming profitable in our seventh quarter of operation;
	•	Completed the acquisition of The Community Bank, Pilot Mountain, North Carolina, raising our assets to over $1.0 billion and increasing the number of banking offices to eighteen;
	•	Began payment of an annual cash dividend in 2004;
	•	Were added to the Russell 3000 Index on June 25, 2004;
	•	Began in-house item processing for the bank in October 2004;
	•	Began offering trust services in 2002 including investment management, administration and advisory services primarily for individuals, partnerships and corporations;
	•	Listed our common stock on the Nasdaq National Market System on January 2, 2002; and
	•	Maintained a strong credit culture. As of December 31, 2004, our non-performing assets totaled $3.3 million or 0.27% of total assets and our allowance for loan losses was $12.5 million or 1.57% of total loans and 577% of non-performing loans.

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 a member of the Federal Reserve System and the Federal Deposit Insurance Corporation insures its deposits up to applicable limits. The address of our principal executive office is 4605 Country Club Road, Winston-Salem, North Carolina 27104 and our telephone number is (336) 768-8500. Our common stock and our trust preferred securities are traded on the Nasdaq National 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, and to a lesser extent, adjoining counties. The Piedmont Triad is a 12 county region located in the north central Piedmont of 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 in 2003 was in excess of 1.52 million. The region’s population is expected to grow an estimated 15.5% between 2000 and 2010.

The Piedmont Triad is the largest Metropolitan Statistical Area located entirely in North Carolina. The MSA is also one of the top 50 in the country in both total population and number of households. Winston-Salem is the largest city in Forsyth County and the fourth largest city in North Carolina. Forsyth County had an estimated population of

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314,375 in 2003. The Piedmont Triad is the economic hub of northwest North Carolina. In 2003, the median family income in the Piedmont Triad was over $55,000. The Piedmont Triad has a very balanced and diversified economy and a work force in excess of 779,800 in May 2004. Approximately 99% of the work force is employed in nonagricultural wage and salary positions. The major employment sectors in 2002 were services (36%), manufacturing (19%), trade (14%), government (14%), finance, communications and utilities (10%), and construction (4%). From January 2002 to May 2004, the unemployment rate in the Piedmont Triad had decreased from 6.5% to 5.2%.

The bank serves our market area through eighteen 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 twenty two ATMs owned by the bank and ATMs owned by others, through debit cards, and through the bank’s automated telephone and Internet electronic banking products. These products allow the bank’s customers to apply for loans, access account information and conduct various transactions from their telephones and computers.

Business Strategy

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

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

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

We intend to grow our franchise through new and existing relationships developed by our associates, and by expanding 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, 2004 our non-interest income represented 17.5% of our total revenue. We believe that the profitability of these added businesses and services, not just the revenue generated, is critical to our success.

     Key aspects of our strategy and mission include:

	•	To provide Community-oriented banking services by delivering a broad range of financial services to our customers through responsive service and communication;
	•	To form a partnership with our customers whereby our decision making and product offerings are geared toward their best long-term interests;
	•	To be recognized in our Community as a long-term player with employees, stockholders and board members committed to that effort; and
	•	To be progressive in our adoption of new technology so that we can provide our customers access to products and services that meet their needs for convenience and efficiency.

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

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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., and a small business investment company licensed by the Small Business Administration. Southern Community Bank and Trust has committed $1.7 million for investment in the partnership, which has a total of $9.2 million of committed capital from various private investors including the bank. The partnership can also borrow funds on a non-recourse basis from the Small Business Administration to increase its capital available for investment. The partnership makes investments generally in the form of subordinated debt and earns revenue through interest received on its investments and potentially through gains realized from warrants that it receives in conjunction with its debt investments. The bank shares in any earnings of the partnership through its investment in the partnership. VCS Management earns management fees for managing the investment activities of the partnership. For the year ended December 31, 2004, VCS Management earned $552,000 of fee income, representing 1.3% of total consolidated revenue.

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 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 use of the net proceeds from the sale of the debentures was to provide cash for the acquisition of The Community Bank, to increase our regulatory capital, and to support the growth and operations of our subsidiary bank. The amount of proceeds we count as Tier 1 capital cannot comprise more than 25% of our core capital elements. Amounts in excess of that 25% limitation count as Tier 2 supplementary capital on our books. Subject to certain limitations, a significant amount of the proceeds from the Trust II Securities qualify as Tier 1 capital of the company for regulatory capital purposes.

Competition

The activities in which the bank, as our operating subsidiary, engages are highly competitive. Commercial banking in North Carolina is extremely competitive due to state laws, which permit state-wide branching. Consequently, many commercial banks have branches located in several communities. One of the largest regional commercial banks in North Carolina, and one savings institution have their headquarters in Winston-Salem. As of June 2004, we operated branches in Forsyth, Guilford, Iredell, Rockingham, Stokes, Surry and Yadkin Counties, North Carolina. On that date, there were 351 branches operated by twenty-eight commercial banks, one trust company and five savings institutions in these seven counties with approximately $20.9 billion in deposits. Deposits of the banks in June 2004 were $795.8 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.

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Employees

Southern Community Financial Corporation has no employees of its own and all employees during 2004 were compensated by the bank. At December 31, 2004, the bank employed 271 full-time equivalent persons (including our executive officers). None of the employees are represented by any unions or similar groups, and we have not experienced any type of strike or labor dispute. We consider our relationship with our employees to be good and extremely important to our long-term success. The Board and management continually seek ways to enhance their benefits and well being.

SUPERVISION AND REGULATION

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

Southern Community Financial Corporation

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

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

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

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

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

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regulators. Federal law imposes certain restrictions and disclosure requirements regarding private information collected by financial institutions.

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

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

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

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

Every bank holding company has to achieve and maintain a minimum Tier 1 capital ratio of at least 4.0% and a minimum total capital ratio of at least 8.0%. In addition, banks and bank holding companies are required to maintain a minimum leverage ratio of Tier 1 capital to average total consolidated assets (leverage capital ratio) of at least 3.0% for the most highly-rated, financially sound banks and bank holding companies and a minimum leverage ratio of at least 4.0% for all other banks. The Federal Deposit Insurance Corporation and the Federal Reserve define Tier 1 capital for banks in the same manner for both the leverage ratio and the risk-based capital ratio. However, the Federal Reserve defines Tier 1 capital for bank holding companies in a slightly different manner. As of December 31, 2004, our Tier 1 leverage capital ratio and total capital were 9.68% and 13.82%, 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, 2004, the Federal Reserve had not advised us of any specific minimum Tangible Tier 1 Leverage Ratio applicable to us.

Effective in March 2004, the company was required to apply FASB Interpretation No. (FIN) 46, Consolidation of Variable Interest Entities. This interpretation addresses the consolidation by business enterprises of variable interest entities as defined in the interpretation. Adoption of FIN 46 required us to deconsolidate the company’s remaining

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trust preferred subsidiary, Southern Community Capital Trust II. Upon deconsolidation, the junior subordinated debentures issued by the company to Trust II were included in long-term debt (instead of the trust preferred securities) and the company’s equity interest in Trust II was included in other investments. The deconsolidation of Trust II has not materially impacted net income.

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 the Tier 1 capital. The Board’s final rule limits restricted core capital elements to twenty-five percent of all core capital elements.

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

Dividends. On January 14, 2004, the company announced the declaration of its first annual cash dividend of $0.11 per share of its common stock, which was paid on March 15, 2004, to shareholders of record on February 20, 2004. On January 20, 2005, the company announced the declaration of its second annual cash dividend of $0.12 per share of its common stock, which was paid on March 15, 2005, to shareholders of record on February 22, 2005. 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.

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

The Bank

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

Transactions with Affiliates. Until October 2004 when it was merged with and into the bank, we operated The Community Bank as a separate subsidiary and affiliate of the bank. 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

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

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

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

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

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

Reserve Requirements. Pursuant to regulations of the Federal Reserve, the bank must maintain average daily reserves against its transaction accounts. No reserves are required to be maintained on the first $6.6 million of transaction accounts, but reserves equal to 3.0% must be maintained on the aggregate balances of those accounts between $6.6 million and $45.4 million, and reserves equal to 10.0% plus $1.2 million must be maintained on aggregate balances in excess of $45.4 million. These percentages are subject to adjustment by the Federal Reserve which has announced that, effective January 2005, no reserves will be required to be maintained on the first $7.0 million of transaction accounts, but reserves equal to 3.0% must be maintained on the aggregate balances of those accounts between $7.0 million and $47.6 million, and additional reserves must be maintained on aggregate balances in excess of $47.6 million in an amount equal to 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, 2004, 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.

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

The monetary policies of the Federal Reserve Board have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future. In view of changing conditions in the national economy and money markets, as well as the effect of actions by monetary and fiscal authorities, no prediction can be made as to possible future changes in interest rates, deposit levels, loan demand or the business and earnings of the bank.

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

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

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

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

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

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

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indemnification or guarantees against loss. A financial institution may also be ordered to restrict its growth, dispose of certain assets or take other action as determined by the primary federal banking agency to be appropriate.

Prompt Corrective Action. Banks are subject to restrictions on their activities depending on their level of capital. Federal “prompt corrective action” regulations divide banks into five different categories, depending on their level of capital. Under these regulations, a bank is deemed to be “well capitalized” if it has a total risk-based capital ratio of 10% or more, a core capital ratio of six percent or more and a leverage ratio of five percent or more, and if the bank is not subject to an order or capital directive to meet and maintain a certain capital level. Under these regulations, a bank is deemed to be “adequately capitalized” if it has a total risk-based capital ratio of eight percent or more, a core capital ratio of four percent or more and a leverage ratio of four percent or more (unless it receives the highest composite rating at its most recent examination and is not experiencing or anticipating significant growth, in which instance it must maintain a leverage ratio of three percent or more). Under these regulations, a bank is deemed to be “undercapitalized” if it has a total risk-based capital ratio of less than eight percent, a core capital ratio of less than four percent or a leverage ratio of less than three percent. Under these regulations, a bank is deemed to be “significantly undercapitalized” if it has a risk-based capital ratio of less than six percent, a core capital ratio of less than three percent and a leverage ratio of less than three percent. Under such regulations, a bank is deemed to be “critically undercapitalized” if it has a leverage ratio of less than or equal to two percent. In addition, the applicable federal banking agency has the ability to downgrade a bank’s classification (but not to “critically undercapitalized”) based on other considerations even if the bank meets the capital guidelines.

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

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

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

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

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

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substantial probability of loss to the Bank Insurance Fund. Any increase in insurance assessments could have an adverse effect on the bank’s earnings.

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

Item 2. Properties

As of December 31, 2004 we operated out of eighteen banking offices, four operations/administrative offices, five lending offices and an investment advisory office. All banking offices have ATMs. A summary of our offices is as follows:

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In addition to the above locations, we have four off site ATMs located at 3484 Robinhood Road, and Ernie Shore Field 401 Deacon Boulevard in Winston-Salem, 1466 River Ridge Road in Clemmons and at 4575 Yadkinville Road, Pfafftown, North Carolina.

All of our properties, including land, buildings and improvements, furniture, equipment and vehicles, had a net book value at December 31, 2004 of $28.3 million. [See further information presented in Note 7 to our consolidated financial statements, which are presented under Item 8 in this Form 10-K.]

Additional banking offices may be opened at later dates if deemed appropriate by the Board of Directors and if regulatory approval can then be obtained. The Board of Directors 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.

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Item 3. Legal

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

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

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

PART II

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 is listed on the Nasdaq National Market System under the symbol “SCMF”. 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, for the last two years. The preferred securities did not begin trading until the fourth quarter of 2003.

At March 15, 2005, there were approximately 7,400 holders of record of our common stock.

On January 14, 2004, the company announced the payment of an annual cash dividend of $0.11 per share to all common stock shareholders of record on February 20, 2004. On January 20, 2005, the company announced the declaration of its second annual cash dividend of $0.12 per share of its common stock, which was paid on March 15, 2005, to shareholders of record on February 22, 2005. Holders of our common stock will be entitled to receive any cash dividends the Board of Directors may declare. The declaration and payment of future dividends to holders of our common stock will be at the discretion of our Board of Directors and will depend upon our earnings and financial condition, regulatory conditions and considerations and such other factors as our Board of Directors may deem relevant. As a holding company, Southern Community Financial Corporation is ultimately dependent upon its bank subsidiary to provide funding for its operating expenses, debt service (including the interest payments on the preferred securities issued by our remaining trust subsidiary), and dividends. Our primary sources of income are dividends paid by the bank and interest income on loans and deposits with the bank subsidiary. We must pay all of our operating expenses from funds we receive from the bank. Various banking laws applicable to our bank subsidiary limit the payment of dividends, management fees and other distributions by the bank to us and may therefore limit our ability to make dividend payments. Under North Carolina banking law, dividends must be paid out of retained earnings and no cash dividends may be paid if payment of the dividend would cause the bank’s surplus to be less than 50% of its paid-in capital. Under federal banking law, no cash dividend may be paid if the bank is undercapitalized or insolvent or if payment of the cash dividend would render the bank undercapitalized or insolvent, or if it is in default of any deposit insurance assessment due to the Federal Deposit Insurance Corporation.

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

Item 6. Selected Financial Data

SELECTED CONSOLIDATED FINANCIAL INFORMATION AND OTHER DATA

Effective October 1, 2001, the Southern Community Bank and Trust became a wholly owned subsidiary of Southern Community Financial Corporation. Southern Community Financial Corporation has no material assets other than those of the bank and its investment in Southern Community Capital Trust II. Therefore, the financial statements of the bank prior to October 1, 2001 are the historical consolidated financial statements of Southern Community Financial Corporation. The results for 2004 included 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 the company’s consolidated financial statements appearing elsewhere in this annual report.

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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. All share data have been adjusted to give retroactive effect to stock splits and stock dividends. The following discussion is intended to assist in understanding the financial condition and results of operations of the company.

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CRITICAL ACCOUNTING POLICY

The company’s most significant critical accounting policy is the determination of its allowance for loan losses. A critical accounting policy is one that is both very important to the portrayal of the company’s financial condition and results of operations, and requires management’s most difficult, subjective or complex judgments. What makes these judgments difficult, subjective and/or complex is the need to make estimates about the effects of matters that are inherently uncertain. 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, finally beginning 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 Winston-Salem and the Piedmont Triad area of North Carolina. We offer a broad array of banking and other financial products – products similar to those offered by our larger competitors, but with an emphasis on superior customer service. We believe that our emphasis on quality customer service is the single most important factor among many that have fueled our growth to $1.2 billion in total assets in just over eight years of operations.

We began operations in November 1996 with $11 million in capital, a single branch facility and thirteen employees. Through December 31, 2004, Southern Community Financial Corporation has grown to a total of eighteen full-service banking offices with $845 million in customer deposit accounts. In support of this growth, we have generated $24 million of additional capital through sales of common stock in 1998, 2000 and 2001. Through our banking subsidiary we offer traditional banking products as well as a full array of financial services. More recently we have created a Trust Department that began operating in the first quarter of 2002. In October of 2001, we formed Southern Community Financial Corporation, a financial holding company, to become the parent company of Southern Community Bank and Trust. On January 12, 2004 the company acquired The Community Bank. In the later part of June 2004, The Community Bank subsidiary converted its primary operating system. In October 2004, Southern Community Bank and Trust also converted to this same operating system and the two bank subsidiaries were merged into one charter retaining the Southern Community Bank and Trust name and began in-house core processing for the consolidated bank. In addition, at the end of August 2004, the bank acquired two residential mortgage offices from Davidson Mortgage (Davidson), one office in Cornelius, North Carolina and the other in Lexington, South Carolina.

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

We recognize that our growth may expose us to increased operational and market risk, primarily with respect to managing overhead, funding costs and credit quality. We have developed critical functions such as Training, Audit, Compliance and Credit Administration to assist in managing and monitoring these and other risks. We are committed to creating 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 marketplace, Southern Community Financial Corporation is positioned to continue to benefit from their effects.

Please note that the company completed the acquisition of The Community Bank in the first quarter of 2004. This transaction provided much of the company’s year-over-year growth. At December 31, 2003 Community’s balance sheet had total assets of $258.9 million. Significant balance sheet categories included $69.0 million of investment securities, $176.6 million of loans, $202.9 million of deposits and $27.5 million of capital. Additionally, in the first quarter of 2004 the company announced the redemption of all of its 7.25% Cumulative Convertible Trust Preferred Securities issued through Southern Community Capital Trust I. The Securities were redeemed on March 12, 2004 which resulted in the issuance of 2,060,000 shares of common stock through conversions and the retirement of $61,000 of the convertible trust preferred securities. On January 14, 2004, the company announced the declaration

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of its first annual cash dividend of $0.11 per share of its common stock which was paid on March 15, 2004, to shareholders of record on February 20, 2004. On January 20, 2005, the company announced the declaration of its second annual cash dividend of $0.12 per share of its common stock which was paid on March 15, 2005, to shareholders of record on February 22, 2005.

Financial Condition at December 31, 2004 and 2003

During the year ended December 31, 2004, our total assets increased by $423.9 million, or 53.1%, to $1.2 billion. Of this increase in total assets, $353.2 million represented growth in interest-earning assets. Continued strong loan demand resulted in an increase of $271.1 million, or 52.9%, in net loans receivable. Investment securities, available for sale and held to maturity, increased by $69.3 million and $12.9 million, respectively. Growth in the investment portfolio is primarily due to the addition of The Community Bank in the first quarter of 2004. While Community’s loan portfolio accounted for the $179.6 million increase in net loan growth during the first quarter of 2004, strong loan demand during the balance of the year resulted in $91.5 million of additional loan growth for the company. Federal funds sold, with an average annual return of 1.39%, is the lowest yielding among interest-earning assets. Premises and equipment increased by $11.0 million net of depreciation, principally as a result of the Community acquisition. Other assets increased by $14.9 million during the year, and in addition $50.1 million of goodwill was created as a result of purchase accounting associated with the Community and Davidson transactions.

Loan growth in 2004 was concentrated in commercial and real estate lending. Our total loan growth of $271.1 million in 2004 was spread among portfolios secured by residential and commercial mortgages, which increased by $128.4 million and $68.1 million, respectively. Commercial and industrial lending and construction loan outstandings increased by $40.3 million and $30.4 million, respectively during the year. Consumer lending increased $9.2 million from 2003 levels as Community’s addition more than offset the attrition in the residual Southeastern Acceptance loan portfolio. During 2004 we continued our active program of originations of residential mortgage loans for sale in the secondary market. 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 investment securities, increased by $76.8 million during the year, to $330.7 million at December 31, 2004 versus $253.9 million at the beginning of the year. Liquid assets represented 27.1% of total assets at December 31, 2004 as compared to 31.8% at the beginning of the year. We have been able to further leverage our capital and generate significant funds for investment both through deposit growth and through borrowings. However, our funding growth has been used primarily to fund strong loan demand.

Customer deposits continue to be our primary funding source. While our deposits are primarily generated through our growing branch network, we do utilize some out-of-market and brokered deposits as a funding source. Brokered and out-of-market deposits totaled $195.3 million and $159.2 million at year-end 2004 and 2003, respectively. At December 31, 2004, deposits totaled $845.2 million, an increase of $270.0 million or 46.9% from year-end 2003. We have also utilized borrowings to fund growth in 2004. Total borrowings, including $34.5 million in trust preferred securities issued during 2003, aggregated $233.1 million at December 31, 2004. Borrowings also included $147.8 million of advances from the Federal Home Loan Bank of Atlanta (FHLB), Federal funds purchased of $19.0 million and securities sold under agreements to repurchase of $30.6 million. We will use FHLB advances and other funding sources as necessary to support balance sheet management and growth. However, we believe that as our branch network grows and matures, the volume of core deposits will become an increasingly larger portion of our funding mix, which 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, 2004, our stockholders’ equity totaled $136.9 million, an increase of $86.0 million from the December 31, 2003 balance. This net increase includes $62.7 million of shares issued in association with the Community transaction, $17.0 million associated with the conversion of trust preferred securities, $8.1 million of net income earned during the year, $1.6 million of stock options exercised during the year, and a decrease in accumulated other comprehensive income of $1.0 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, 2004, 2003 and 2002, our average interest-earning assets were $1.1 billion, $655.3 million, and $523.3 million, respectively. During these same years, our net interest margins were 3.31%, 3.25% and 3.34%, respectively.

Average Balances and Average Rates Earned and Paid. The following table sets forth, for the years 2002 through 2004, 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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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, 2004 and 2003

Net Income. Our net income for 2004 was $8.1 million, an increase of $4.4 million from net income of $3.7 million earned in 2003. Net income per share was $.47 basic and $.45 diluted for the year ended December 31, 2004, up from $.41 basic and $.40 diluted for 2003. We have continued to experience strong growth, in most part due to the acquisition of Community, with total assets averaging $1.2 billion during the current year as compared to $696.5 million in 2003, an increase of 67.7%. In absolute terms, our net interest income after provision for loan losses increased by $13.7 million and our non-interest income grew by $2.4 million to $7.4 million. However this growth did not keep pace with the $9.2 million increase in non-interest expenses. Provision expense for loans remained relatively unchanged from the prior year. During the first half of 2004 the bank endured a historically low interest rate environment which hampered our asset yields. As the Federal Reserve increased the targeted federal funds rate in July of 2004, the Prime rate increased for the first time since June of 2000. In the last half of 2004; the Prime rate increased 125 basis points to 5.25%. While it is management’s goal to remain relatively interest rate neutral, the institution is slightly asset sensitive and does benefit from rising rate environment. As a result of our growth in interest-earning assets (Community transaction coupled with strong loan demand) combined with lower funding costs and rising interest rates during the later portion of the year, our net interest income increased $13.7 million. Our expense growth included some non-recurring merger related costs as well as personnel and other infrastructure costs associated with bringing in core in house processing as well as item capture and other expansion of our business. While these expenses represent investments in building and refining our franchise for the future, their initial effect hampers earnings.

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

Provision for Loan Losses. We recorded a $2.2 million provision for loan loss for the year ended December 31, 2004, representing a slight decrease of $46,000 from the $2.3 million provision we made for the year ended December 31, 2003. The level of provisions for 2004 is consistent with that of the loan growth, excluding the Community transaction, and net charge-offs that the bank experienced in the previous year. Gross loans increased $97.8 million in 2003 and $98.8 in 2004 excluding the $177.6 million of loans contributed through the Community acquisition. Provisions for loan losses are charged to income to bring our allowance for loan losses to a level deemed appropriate by management based on the factors discussed under “Analysis of Allowance for Loan Losses.” While the dollar amount of provisions remained relatively flat on a year-over-year basis, the level of the allowance to period-ending loans increased 17 basis points from the prior year-end to 1.57%. In addition to loan growth affecting our provision for loan losses, net loan charge-offs, which remained relatively stable, totaling $1.4 million for both 2004 and 2003, also impacted the provision expense. On an annualized basis, our percentage of net loan charge-offs to average loans outstanding was .19% for the year ended December 31, 2004 as compared with .29% for the year ended December 31, 2003. Our consumer finance lending portfolio accounted for $687,000 or 49.3% of net charge-offs during 2004, a decrease of $87,000 from the prior year. Management decided the consumer finance business was no longer part of the company’s strategic direction, and during the fourth quarter of 2003 ceased originating new consumer finance loans. It is expected that the residual consumer finance loan portfolio will payoff over a twenty-four month time frame and the company’s level of charge-offs as a percentage of loan outstandings will decline. Nonperforming loans totaled $2.2 million or .27% of total loans at December 31, 2004, as compared with $769,000 or .15% of total loans at December 31, 2003. The allowance for loan losses at December 31, 2004 of $12.5 million represents 1.57% of total loans and 577% of nonperforming loans. The allowance for loan losses at December 31, 2003 of $7.3 million equaled 1.40% of total loans outstanding at that date.

Non-Interest Income. For the year ended December 31, 2004, non-interest income increased $2.4 million, or 48.6%, to $7.4 million from $5.0 million for the prior year despite declines in investment brokerage and mortgage origination fees. This favorable increase resulted primarily from an increase of $2.1 million, or 142.8% to $3.5 million, in service charges and fees on deposit accounts due to the addition of Community coupled with deposit growth and the benefit of a full year of the overdraft protection service implemented during 2003. Non-interest income also benefited from a one-time gain received on The Community Bank’s investment in Sidus Financial, LLC (Sidus). Sidus was a mortgage banking company that served Community bank and mortgage broker customers. On October 4, 2004, Sidus was sold for a combination of cash, stock and future consideration if certain performance targets are met. As a result of this transaction, the Company realized a pre-tax gain of $293,000. In addition, during the fourth quarter the company posted a pre-tax gain of $107,000 on our investment in Salem Capital Partners, L.P. Income from investment brokerage fees decreased from the prior year by $235,000, or 24.8%, to $712,000. The strong 2003 results

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were due to a new investment product that was offered for a limited time. Fees on the origination of residential mortgage loans sold into the secondary market declined $600,000 to $750,000 as the level of home mortgage refinancings dramatically slowed from the levels experienced in 2002 and 2003 due to the low interest rate environment in those periods. While market conditions may not provide the opportunities to generate fee income similar to those levels we experienced in 2003, management is committed to growing our non-interest income base through continued support of those areas that generate our fee income.

Non-Interest Expense. We strive to maintain non-interest expenses at levels that we believe are appropriate given the nature of our operations and the investments in personnel and facilities that have been necessary to support our growth. From 1998 forward, we have consistently maintained our ratio of non-interest expenses to average total assets below 3%. For 2004 our ratio was 2.36%, down from a ratio of 2.63% in 2003. Because of our continued strong growth we have seen increases in every major component of our non-interest expenses. For the year ended December 31, 2004, our non-interest expense increased $9.2 million, or 50.1%. Salary and employee benefits expense increased $4.1 million, or 43.2%, and reflects the addition of personnel associated with Community and Davidson transactions, staff additions to bring item processing in-house for the consolidated company, additions of personnel to expand and support our lines of business, and normal increases in salaries and employee benefits. Occupancy and equipment expense increased $1.3 million, or 42.9%, reflecting the expenses associated with our continued expansion and investments in technology to support our banking operations, including in-house processing. Other non-interest expenses increased $3.7 million, or 65.7%, reflecting the increased volume of business activity, principally increases in lending and growth in deposit accounts. Also, the company has incurred a significant increase in fees paid to outside service providers to assist us in the documentation and testing required for compliance with Section 404 of the 2002 Sarbanes-Oxley Act (SOX). In addition, we incurred a full year of fees paid to service our consumer finance loan portfolio. During the fourth quarter of 2003, the bank ceased operation of its consumer finance subsidiary. Simultaneously, the bank entered into an agreement with the former president of that subsidiary to service these loans on the behalf of the bank. On October 18, 2004, the bank and Community were merged into a single bank under the bank’s name. In conjunction with this merger, the newly consolidated bank has successfully brought core processing in-house. This function was previously an outsourced service for the bank. As a consequence of converting the bank’s primary operating system, it was necessary to terminate our contract with our previous item processing provider at a cost of $550,000. The company believes that the synergies we will achieve by taking these steps will have an immediate and lasting positive impact on our customers as well as our non-interest expense

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

RESULTS OF OPERATIONS
Years Ended December 31, 2003 and 2002

Net Income. Our net income for 2003 was $3.7 million, an increase of $449,000 from net income of $3.2 million earned in 2002. Net income per share was $.41 basic and $.40 diluted for the year ended December 31, 2003, up from $.37 basic and $.35 diluted for 2002. We have continued to experience strong growth, with total assets averaging $696.5 million as compared to $555.4 million in 2002, an increase of 25.4%. In absolute terms, our net interest income after provision for loan losses increased by $3.2 million and our non-interest income grew by $1.1 million to $5.0 million, exceeding the increase of $3.6 million in non-interest expenses. Primarily as a result of strong loan growth during 2003, the provision for loan losses increased $630,000 from 2002 levels to $2.3 million. While the interest rate environment was less volatile in 2003 than in recent prior years, we did experience an additional interest rate cut by the Federal Reserve in June of 2003. While this historically low interest rate environment has hampered our asset yields, our growth in interest-earning assets combined with lower funding costs resulted in an increase of $3.8 million in net interest income. Our expense growth included the completion of a new banking office and corporate headquarters building, entering into a servicing agreement for our consumer finance loan portfolio, as well as personnel and other infrastructure costs associated with expansion of our business. While these expenses represent investments in building and refining our franchise for the future, their initial effect hampers earnings.

Net Interest Income. During 2003, our net interest income increased by $3.8 million or 21.7% to $21.3 million. Our growth in interest income was the result of growth in our overall level of average earning assets. Average total interest-earning assets increased $132.1 million, or 25.2%, during 2003 as compared to 2002, while our average yield dropped by 86 basis points from 6.36% to 5.50%. The rates earned on a significant portion of our loans adjust immediately when index rates such as our prime rate changes. Conversely, most of our interest-bearing liabilities, including certificates of deposit and borrowings, have rates fixed until maturity. As a result, interest rate reductions such as the one imposed in June of 2003 generally result in an immediate drop in our interest income on loans, with a more delayed

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impact on interest expense because reductions in interest costs will only occur upon renewals of certificates of deposit or borrowings. Our average total interest-bearing liabilities increased by $124.1 million, or 26.2%, consistent with our increase in interest-earning assets. With rates sustained at lower levels, our average cost of interest-bearing liabilities decreased by 87 basis points from 3.34% to 2.47%, allowing our interest rate spread to remain relatively unchanged. For the year ended December 31, 2003, our net interest spread was 3.03% and our net interest margin was 3.25%. For the year ended December 31, 2002, our net interest spread was 3.02% and our net interest margin was 3.34%. In November of 2003 the company, through its non-bank subsidiary Southern Community Capital Trust II, issued 3,450,000 Trust Preferred Securities generating total proceeds of $34.5 million. The Securities pay distributions at an annual rate of 7.95% and mature on December 31, 2033. The principal use of the net proceeds from the sale of the debentures was to provide cash for the acquisition of The Community Bank, to increase our regulatory capital, and to support the growth and operations of our subsidiary bank. While this transaction has strengthened the company’s overall financial condition, its fixed rate coupon will initially hamper our margins given the current interest rate environment. The company has entered into a $20.0 million notional amount receive fixed, pay floating interest rate swap to manage the impact of this transaction on the company’s margin and consolidated asset/ liability position.

Provision for Loan Losses. We recorded a $2.3 million provision for loan losses for the year ended December 31, 2003, representing an increase of $630,000 from the $1.7 million provision we made for the year ended December 31, 2002. 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.” We have continued to increase the level of our allowance for loan losses as a result of the continued growth in our loan portfolio. Total loans receivable increased by $97.8 million during 2003 and by $61.7 million during 2002. In addition to loan growth affecting our provision for loan losses, net loan charge-offs, which totaled $1.4 million during 2003, an increase from $713,000 in 2002, also impacted the provision expense. On an annualized basis, our percentage of net loan charge-offs to average loans outstanding was .29% for the year ended December 31, 2003 as compared with .18% for the year ended December 31, 2002. Our consumer finance lending accounted for $774,000 or 57.2% of net charge-offs during 2003, an increase of $368,000 from the prior year. Management decided the consumer finance business was no longer part of the company’s strategic direction, and during the fourth quarter of 2003 we ceased originating new consumer finance loans. It is expected that the residual consumer finance loan portfolio will payoff over a thirty-six month time frame and the company’s level of charge-offs as a percentage of loan outstandings will decline. Nonperforming loans totaled $769,000 or .15% of total loans at December 31, 2003, as compared with $1.8 million or .43% of total loans at December 31, 2002. The allowance for loan losses at December 31, 2003 of $7.3 million represents 1.40% of total loans and 946% of nonperforming loans. The allowance for loan losses at December 31, 2002 of $6.3 million equaled 1.50% of total loans outstanding at that date.

Non-Interest Income. For the year ended December 31, 2003, non-interest income increased $1.1 million or 26.9% to $5.0 million from $3.9 million for the prior year. This favorable increase resulted from factors that include an increase of $321,000, or 28.6% to $1.4 million, in service charges and fees on deposit accounts due to deposit growth and implementation of a new overdraft protection program during 2003. Income from investment brokerage fees increased by $614,000, or 184.4%, to $947,000. This increase was a result of a new investment product that was offered for a limited time. Fees on the origination of residential mortgage loans sold into the secondary market remained strong and increased slightly to $1.4 million. Fees generated from mortgage originations during 2002 and 2003 were strong as a result of the increased level of home mortgage refinancings due to the low interest rate environment. However, baring another decline in interest rates we anticipate a reduction in fee income from this line of business in the near term.

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%. For 2003 our ratio was 2.63%, down slightly from a ratio of 2.66% in 2002. 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, 2003, our non-interest expense increased $3.6 million, or 24.0%. Salary and employee benefits expense increased $1.8 million, or 23.8%, and reflects the addition of personnel associated with branch expansion, additions of personnel to expand and support our lines of business, and normal increases in salaries and employee benefits. Occupancy and equipment expense increased $537,000, or 21.4%, reflecting the expenses associated with our continued branch expansion, new corporate office and investments in technology to support our banking operations. Other non-interest expenses increased $1.2 million, or 25.9%, reflecting the increased volume of business activity, principally increases in lending and growth in deposit accounts. In addition, during the fourth quarter of 2003 the bank ceased operation of its consumer finance subsidiary. Simultaneously, the bank entered into an agreement with the former president of that subsidiary to service these loans on the behalf of the bank. The fees paid to service these loans, combined with

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severance payments to the former employees and costs associated with the transaction, contributed to the increase in non-interest expense.

Provision for Income Taxes. Our provision for income taxes, as a percentage of income before income taxes, was 35.0 % for the year ending December 31, 2003 and 35.3% for the year ended December 31, 2002.

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.

Because of our continued growth and the availability of relatively low cost funding sources, we have maintained a relatively high level of liquidity in the form of federal funds sold and investment securities. These aggregated $313.0 million at December 31, 2004, compared to $231.0 million and $152.8 million at December 31, 2003 and 2002, respectively. Supplementing customer deposits as a source of funding, we have available lines of credit from various correspondent banks to purchase federal funds on a short-term basis of approximately $73.0 million. We also have the credit capacity to borrow up to $304.2 million, as of December 31, 2004, from the Federal Home Loan Bank of Atlanta, with $147.8 million outstanding as of that date. At December 31, 2003 we had FHLB borrowings outstanding of $96.5 million. Funding costs have been low during 2004 with lower deposit costs due to the core deposit base acquired from Community coupled with higher rate certificates of deposit maturing into the lower rate environment and increased use of floating rate funding on both deposits and borrowings. We also had repurchase agreements with a total outstanding balance of $30.6 million at December 31, 2004. Of this balance, $10.6 million were done as accommodations for our deposit customers and $20.0 million were outstanding with our correspondent banks. 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, 2004, our outstanding commitments to extend credit consisted of loan commitments of $139.4 million and amounts available under home equity credit lines, other credit lines and letters of credit of $66.4 million, $8.5 million and $10.1 million, respectively. We believe that our combined aggregate liquidity position from all sources is sufficient to meet the funding requirements of loan demand and deposit maturities and withdrawals in the near term.

Throughout our eight-year history, our loan demand has exceeded our growth in core deposits. We have therefore relied heavily on certificates of deposits as a source of funds. While the majority of these funds are from our local market area, the bank has utilized brokered and out-of-market certificates of deposits to diversify and supplement our deposit base. Certificates of deposits represented 60.4% of our total deposits at December 31, 2004, a slight increase from 59.9% at December 31, 2003. Brokered and out-of-market deposits totaled $195.3 million at year-end 2004 and $159.2 million at year-end 2003, which comprised 23.7% and 27.7% of total deposits, respectively. Certificates of deposit of $100,000 or more, inclusive of brokered and out-of-market certificates, represented 33.3% of our total deposits at December 31, 2004 and 31.7% at December 31, 2003. 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, 2004.

     The following table reflects other commitments of the company outstanding as of December 31, 2004.

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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, 2004, 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.

CAPITAL RESOURCES

Stockholders’ equity at December 31, 2004 was $136.9 million. At that date, our capital to asset ratio was 11.2%, 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, 2004 was 11.79%.

The bank and the company are subject to minimum capital requirements. See “SUPERVISION AND REGULATION.” As the following table indicates, at December 31, 2004, 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 the Tier 1 capital. The Board’s final rule limits restricted core capital elements to twenty-five percent of all core capital elements.

As of December 31, 2004 the company had a single subsidiary for the purpose of issuing trust preferred securities.

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 use of the net proceeds from the sale of the debentures was 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. Prior to the closing of the acquisition of The Community Bank on January 12, 2004, substantially all of the proceeds from the Trust II Securities qualified as Tier 2 supplementary capital. Prior to the redemption of the Trust I Securities, approximately $20 million of the proceeds of the Trust II Securities counted as Tier 1 capital on our books. After the redemption of the Trust I Securities on March 12, 2004, subject to certain limitations, substantially all of the proceeds from the Trust II Securities qualify as Tier 1 capital of the company for regulatory capital purposes.

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In February of 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 $175,000 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. We redeemed the Trust I Securities under a provision that permitted us to redeem the Trust I Securities in whole at any time prior to March 31, 2007 once the trading price of our common stock had been at least 125% of the Conversion Price for a period of twenty consecutive trading days ending within five days of the date that we gave notice of redemption. 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 $61,000 of the convertible trust preferred securities. The Trust I Securities paid distributions at an annual rate of 7.25%. The Trust I Securities began paying quarterly distributions on March 31, 2002. The company had fully and unconditionally guaranteed the obligations of Trust I. The proceeds from the Trust I Securities were utilized to purchase convertible junior subordinated debentures from us under the same terms and conditions as the Trust I 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.

ASSET/LIABILITY MANAGEMENT

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

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

In reviewing the needs of our bank with regard to proper management of its asset/liability program, we estimate future needs, taking into consideration investment portfolio purchases, calls and maturities in addition to estimated loan and deposit increases (due to increased demand through marketing) and forecasted interest rate changes. We use a number of measures to monitor and manage interest rate risk, including income simulations and gap analyses. An income simulation model is the primary tool used to assess the direction and magnitude of changes in net interest income resulting from changes in interest rates. Key assumptions in the model include prepayment speeds on mortgage-related assets, cash flows and maturities of other investment securities, loan and deposit volumes and pricing. These assumptions are inherently uncertain and, as a result, the model cannot precisely estimate net interest income or precisely predict the impact of higher or lower interest rates on net interest income. Actual results will differ from simulated results due to timing, magnitude and frequency of interest rate changes and changes in market conditions and management strategies, among other factors. Based on the results of the income simulation model, as of October 31, 2004, if interest rates increase by two percentage points, our net interest income over a one-year time frame could increase by approximately 3.7% or $1.3 million. As of October 31, 2004, if interest rates decrease by one percentage point (given the present level of the targeted Federal funds rate), our net interest income over a one-year time frame could decrease by approximately 3.1% 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

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interest rate risk. We believe that because interest rate gap analysis does not address all factors that can affect earnings performance, it should be used in conjunction with other methods of evaluating interest rate risk.

Our balance sheet, based on gap measurements, was asset-sensitive at December 31, 2004 in the three-month horizon and liability-sensitive in the one-year period. An asset-sensitive position means that there are more assets than liabilities subject to repricing in that period as market rates change, and conversely with a liability-sensitive position. As a result, in a falling rate environment, our earnings position could deteriorate initially followed by improvement, with the opposite expectation in a rising rate environment, depending on the correlation of rate changes in these categories.

The following table presents information about the periods in which the interest-sensitive assets and liabilities at December 31, 2004 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 and NOW 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 and NOW 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, 2004.