U.S.
Securities and Exchange Commission


Washington,
D.C. 20549





Form
10-K




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





For the
fiscal year ended December 31, 2009





 ̈ 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


(Exact
name of registrant as specified in its charter)





North Carolina
              
              56-2270620(State
      or other jurisdiction of
              
              (I.R.S.
      Employer Identification No.)incorporation
      or organization)





4605
      Country Club RoadWinston-Salem, North
    Carolina
                
                27104(Address
      of principal executive offices)
                
                (Zip
      Code)





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





Securities
Registered Pursuant to Section 12(b) of the Exchange Act:


Title of each class
              
              Exchange on which
  registeredCommon
      Stock, No Par Value
              
              The
      NASDAQ Stock Market, LLC7.95%
      Cumulative Trust Preferred Securities
              
              The
      NASDAQ Stock Market, LLC7.95%
      Junior Subordinated Debentures
              
              The
      NASDAQ Stock Market, LLCGuarantee
      with respect to 7.95% Cumulative Trust Preferred
Securities
              
              The
      NASDAQ Stock Market, LLC





Securities
Registered Pursuant to Section 12(g) of the Exchange Act: None





Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act. Yes.  ̈ No
x





Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 15(d) of the Act. Yes  ̈ No
x





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 x No
 ̈





Indicate
by check mark if disclosure of delinquent filers pursuant 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.  ̈





Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate website, if any, every Interactive Date File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding
12 months (or for such shorter periods that the registrant was required to
submit and post such files).  Yes  ̈ No
 ̈





Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting
company.  See definitions of “accelerated and large accelerated filer”
in Rule 12b-2 of the Exchange Act. (Check one):


Large
accelerated filer  ̈          Accelerated
filer  ̈             Non-accelerated
filer  ̈            Smaller
reporting company x





Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act).  Yes  ̈ No
x





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, $41.8 million.





As of
February 26, 2010, the registrant had outstanding 16,818,375 shares of Common
Stock, no par value.




Documents
Incorporated By Reference





Document
            
            Where IncorporatedProxy
      Statement for the Annual Meeting of Shareholders to be held May 26, 2010
      tobe
      mailed to shareholders within 120 days of December 31,
    2009.
            
            Part
      III









Form 10-K
Table of Contents





Index
                                                                            
                                                                            
                                                                            PAGEPART
      IItem
      1.
                                                                            Business
                                                                            
                                                                            3Item
      1A.
                                                                            Risk
      Factors
                                                                            
                                                                            14Item
      1B.
                                                                            Unresolved
      Staff Comments
                                                                            
                                                                            23Item
      2.
                                                                            Properties
                                                                            
                                                                            24Item
      3.
                                                                            Legal
      Proceedings
                                                                            
                                                                            26Item
      4.
                                                                            Reserved
                                                                            
                                                                            26PART
      IIItem
      5.
                                                                            Market
      for Registrant’s Common Equity, Related Stockholder Matters and Issuer
      Purchases of Equity Securities
                                                                            
                                                                            26Item
      6.
                                                                            Selected
      Financial Data
                                                                            
                                                                            28Item
      7.
                                                                            Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operation
                                                                            
                                                                            30Item
      7A.
                                                                            Quantitative
      and Qualitative Disclosures About Market Risk
                                                                            
                                                                            65Item
      8.
                                                                            Financial
      Statements and Supplementary Data
                                                                            
                                                                            65Item
      9.
                                                                            Changes
      in and Disagreements with Accountants on Accounting and Financial
      Disclosure
                                                                            
                                                                            114Item
      9A.
                                                                            Controls
      and Procedures
                                                                            
                                                                            114Item
      9B.
                                                                            Other
      Information
                                                                            
                                                                            116PART
      IIIItem
      10.
                                                                            Directors,
      Executive Officers and Corporate Governance
                                                                            
                                                                            116Item
      11.
                                                                            Executive
      Compensation
                                                                            
                                                                            116Item
      12.
                                                                            Security
      Ownership of Certain Beneficial Owners and Management and Related Stockholder
      Matters
                                                                            
                                                                            116Item
      13.
                                                                            Certain
      Relationships and Related Transactions, and Director
      Independence
                                                                            
                                                                            116Item
      14.
                                                                            Principal
      Accountant Fees and Services
                                                                            
                                                                            116PART
      IVItem
      15.
                                                                            Exhibits,
      Financial Statement Schedules
                                                                            
                                                                            117




Page
2





PART
I





Item 1. Business





Who We
Are





Southern
Community Financial Corporation (“we,” “our,” “us,” Southern Community” or the
“Company”) is the holding company for Southern Community Bank and Trust (the
“Bank”), a community bank with twenty-two banking offices operating in nine
counties throughout central and western North Carolina.  The Bank
commenced operations on November 18, 1996 and effective October 1, 2001 became a
wholly-owned subsidiary of the Company.  Our banking offices are
located in the Piedmont Triad area (including Winston-Salem (our headquarters),
Greensboro, High Point and surrounding areas), Mooresville (the Charlotte area),
Raleigh and Asheville.





At
December 31, 2009, the Company had total assets of $1.7 billion, net loans of
$1.2 billion, deposits of $1.4 billion and shareholders’ equity of $122.0
million.  The Company had net income (loss) available to common
shareholders of $(65.7) million, $5.7 million and $7.6 million and diluted
earnings per common share of $(3.91), $0.33 and $0.43 for the years ended
December 31, 2009, 2008 and 2007, respectively.





The
Company has been, and intends to remain, a community-focused financial
institution offering a full range of financial services to individuals,
businesses and nonprofit organizations in the communities we
serve.  Our banking services include checking and savings accounts;
commercial, installment, mortgage and personal loans; trust and investment
services; safe deposit boxes and other associated services to satisfy the needs
of our customers.





In our
thirteen years of existence, the Company has:





·
            Established
      a reputation for superior service to our customers and the communities in
      which we operate;


·
            Developed
      a full service financial institution operating in four of the fastest
      growing markets in North Carolina;


·
            Maintained
      third position in deposit market share in our home base of Forsyth County
      and fifth position in the Piedmont
Triad;


·
            Acquired
      The Community Bank, Pilot Mountain, North Carolina, in January 2004,
      raising our assets at that time to over $1.0 billion and increasing the
      number of our banking offices.





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 Company and the Bank are organized under
the laws of North Carolina.  The Federal Deposit Insurance Corporation
insures the Bank’s deposits up to applicable limits.  The address of
our principal executive office is 4605 Country Club Road, Winston-Salem, North
Carolina 27104 and our telephone number is (336) 768-8500.  Our common
stock and one of our trust preferred security issues are traded on the NASDAQ
Global Select Market System under the symbols “SCMF” and “SCMFO”,
respectively.





Our
Market Area





The
Company’s primary market areas are the Piedmont Triad area of North Carolina,
Mooresville (the Charlotte area) Asheville (Western Mountains of North Carolina)
and Raleigh (in the Research Triangle region of the eastern Piedmont of North
Carolina).  The Piedmont Triad is a twelve county region located in
north central North Carolina and is named for the three largest cities in the
region, Winston-Salem (where our headquarters is located), Greensboro and High
Point.  The North Carolina State Data Center estimated that in July 2008,
the region’s estimated population was over 1.6 million, approximately 18% of the
state’s population.





Winston-Salem
is the largest city in Forsyth County and, as of July 2008, the fifth largest
city in North Carolina according to the NC State Data Center.  Greensboro
is the largest city in Guilford County and the third largest city in North
Carolina, while High Point is the second largest city in Guilford County and the
ninth largest city in North Carolina according to the July 2008 estimates of the
NC Data Center.  The NC Data Center estimated the July 2008 population
of Forsyth County to exceed 343 thousand and the population of Guilford County
to exceed 468 thousand.  The populations of Forsyth County and
Guilford County are projected to grow to 463 thousand and 643 thousand,
respectively, by 2029.




Page
3




The
Piedmont Triad is the economic hub of northwest North Carolina.  For
fiscal year 2009, the US Department of Housing and Urban Development estimated
that the median family income ranged from a low of $47,700 in the Surry County
area to a high of $59,700 in the Winston-Salem metropolitan area.  The
Piedmont Triad has a very balanced and diversified economy and a work force that
exceeded 801 thousand in December 2009, according to the NC Employment Security
Commission.  Approximately 99% of the work force is employed in
nonagricultural wage and salary positions.  According to the NC
Employment Security Commission, the major employment sectors in the 2nd quarter
of 2009 were healthcare (14.0%), manufacturing (15.2%), trade (15.6%),
government (13.6%), financial (4.4%) and construction (4.6%).  During
2009, NC Employment Security Commission statistics showed that the unemployment
rate in the Piedmont Triad varied from a low of 10.5% in January to a high of
11.8% in June.





The
Raleigh-Cary metropolitan statistical area is the fastest growing metropolitan
statistical area (MSA) in North Carolina.  The NC Data Center
estimated the July 2008 population of Wake County to exceed 864
thousand.  The Wake County population is projected to more than double
by 2030.  The US Department of Housing and Urban Development estimated
the area’s 2009 median family income to be over $76,900.  According to
the NC Employment Security Commission, the labor force in the Raleigh-Cary MSA
exceeded 556 thousand in December 2009 and the unemployment rate during 2009
varied from a low of 7.9% in January to a high of 9.1% in June and
July.





The
Charlotte MSA is the fourth fastest growing MSA in North
Carolina.  The NC Data Center estimated the July 2008 population of
Mecklenburg County to exceed 877 thousand. The Mecklenburg County population is
projected to grow to over 1.3 million by 2030.  According to the NC
Employment Security Commission, the area’s labor force exceeded 848 thousand in
December 2009 and the unemployment rate during 2009 varied from a low of 10.5%
in January to a high of 12.5% in June.  Mooresville is located in the
Lake Norman area, north of Charlotte.





Asheville
is the largest city in Western North Carolina and the thirteenth largest city in
North Carolina, according to the July 2008 estimates of the NC Data Center, with
an estimated population of over 78 thousand.  In 2009, the US
Department of Housing and Urban Development estimated the median family income
in the area to be $55,700.  The Western North Carolina region has a
balanced and diversified economy.  According to the US Bureau of Labor
Statistics, the major employment sectors in the 2nd quarter
of 2009 were education and health services (27.7%), government (20.0%), retail
(12.9%), leisure and hospitality (12.9%), manufacturing (13.1%), and
construction (5.2%).  According to the NC Employment Security
Commission, the Asheville MSA’s labor force exceeded 204 thousand in December
2009 and the unemployment rate during 2009 varied from a low of 8.4% in
September to a high of 9.6% in February.





The Bank
serves our market areas through twenty-two full service banking
offices.  Our television and radio advertising has extended into our
market areas for several years, providing the Bank name
recognition.  The Bank’s customers may access various banking services
through over one hundred and seventy-five ATMs owned or leased by the Bank,
through debit cards, and through the Bank’s automated telephone and Internet
electronic banking products.  These products allow the Bank’s
customers to apply for loans, access account information and conduct various
transactions from their telephones and computers.





Business
Strategy





The
Company’s overall long term objective is to continue to be a vital,
long-standing community bank in our markets with a reputation for quality
customer service provided by a financially sound organization.  Our
business strategy is to operate as a well capitalized institution that is strong
in asset quality, profitable, independent, customer-oriented and connected to
our community.





Southern
Community Bank, along with others in our industry and our community, has been
adversely impacted by the current and challenging economic
cycle.  During the past two years, we have concentrated our efforts on
managing our problem assets.  Our strategy during this economic
downturn has been to focus on promptly identifying and resolving nonperforming
loans and reducing our inventory of foreclosed real estate.  Many of
our borrowers were significantly affected by a weak economy, and we have been
working closely with them during this economic downturn to achieve acceptable
solutions.




Page
4




Regardless
of the impact of the economic cycle, a commitment to customer service remains
the foundation of our approach.  Our commitment is to put our
customers first and we believe it differentiates us from our
competitors.  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;
  and


·
            Individual
      consumers.





We intend
to grow our franchise through new and existing relationships developed by our
employees and by expanding primarily to neighboring areas through branching and
acquisitions which make strategic and economic sense.





We have
also diversified our revenue in order to generate non-interest
income.  These efforts include expansion of mortgage banking, wealth
management and investment in Small Business Investment Company (SBIC) activities
through Salem Capital Partners.  Southern Community Advisors, our
wealth management group, offers investment advisory, brokerage, trust and
insurance services.  For more information on the Company’s SBIC
activities, see below under the heading “SUBSIDIARIES”.  For the year
ended December 31, 2009, our non-interest income, excluding securities gains and
losses, represented 18.1% of our total revenue.  We believe that the
profitability of these added businesses and services, not just the revenue
generated, is critical to our long term success.





Key
aspects of our strategy and mission include:





·
            To
      maintain solid asset quality and remain well
  capitalized;


·
            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 directors 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 continue to support a profitable
corporation and grow shareholder value.  We want to consistently
reward our shareholders for their investment and trust in us.





Subsidiaries





In
addition to those financial services offered by the Bank, the Company has two
subsidiaries, Southern Community Capital Trust II (“Trust II”) and Southern
Community Capital Trust III (“Trust III”), formed to issue trust preferred
securities.  Each subsidiary is described below.





In
November 2003, Southern Community Capital Trust II publicly issued 3,450,000
shares of Trust Preferred Securities (“Trust II Securities”), generating gross
total proceeds of $34.5 million.  The Trust II Securities pay
distributions at an annual rate of 7.95% and mature on December 31,
2033.  The Trust II Securities began paying quarterly distributions on
December 31, 2003.  The Company has fully and unconditionally
guaranteed the obligations of Trust II.  The Trust II Securities are
redeemable in whole or in part at any time after December 31,
2008.  The proceeds from the Trust II Securities were utilized to
purchase junior subordinated debentures from the Bank under the same terms and
conditions as the Trust II Securities.  We have the right to defer
payment of interest on the debentures at any time and from time to time for a
period not exceeding five years, provided that no deferral period extends beyond
the stated maturities of the debentures.  Such deferral of interest
payments by the Company will result in a deferral of distribution payments on
the related Trust II Securities.  Should we defer the payment of
interest on the debentures, the Company will be precluded from the payment of
cash dividends to shareholders.  The principal uses of the net
proceeds from the sale of the debentures were to provide cash for the
acquisition of The Community Bank, to increase our regulatory capital and to
support the growth and operations of our subsidiary bank.




Page
5




In June
2007, $10.0 million of trust preferred securities were placed through Southern
Community Capital Trust III, a newly formed subsidiary of the Company, as part
of a pooled trust preferred security.  The Trust issuer invested the
total proceeds from the sale of the trust preferred securities (the “Trust III
Securities”) in junior subordinated deferrable interest debentures (the “Junior
Subordinated Debentures”) issued by the Company.  The terms of the
trust preferred securities require payment of cumulative cash distributions
quarterly at an annual rate, reset quarterly, equal to LIBOR plus
1.43%.  During 2008, the Company entered into an interest rate swap
derivative contract with a counterparty that shifted this debt service from a
variable rate to a fixed rate of 4.7% per annum.  The dividends paid
to holders of the Trust III Securities, which are recorded as interest expense,
are deductible for income tax purposes.  The Trust III Securities are
redeemable in 30 years with a five year call provision.  The Company
has fully and unconditionally guaranteed the trust preferred securities through
the combined operation of the debentures and other related
documents.  The Company’s obligation under the guarantee is unsecured
and subordinate to senior and subordinated indebtedness of the
Company.  The principal use of the net proceeds from the sale of the
debentures was to provide additional capital into the Company to fund its
operations and continued expansion, and to maintain the Company’s and the Bank’s
status as “well capitalized” under regulatory guidelines.





The
amount of the proceeds generated from the above offerings of trust preferred
securities was $44.5 million.  The amount of proceeds we count as Tier
1 capital cannot comprise more than 25% of our core capital
elements.  For us, this Tier 1 limit was $41.4 million at December 31,
2009.  The $3.1 million in excess of that 25% limitation counts as
Tier 2 supplementary capital on our books.





The Bank
has interests in two unconsolidated entities (VCS Management LLC and SCP Advisor
LLC) to house its investment in its SBIC activities.  VCS Management,
LLC was formed in March 2000 as the managing general partner of what is now
known as Salem Capital Partners, L.P. (“SCP I”), a small business investment
company (SBIC) licensed by the Small Business Administration.  The
Bank has invested $1.7 million in SCP I, which has a total of $9.2 million of
invested capital from various private investors including the
Bank.  The partnership can also borrow funds on a non-recourse basis
from the Small Business Administration to increase its funds available for
investment.  The partnership makes investments generally in the form
of subordinated debt and earns revenue through interest received on its
investments and potentially through gains realized from warrants that it
receives in conjunction with its debt investments.  The Bank shares in
any earnings of the partnership through its investment in the
partnership.  During 2006, Salem Capital Partners II, L.P., (now Salem
Halifax Capital Partners, LP (“SHCP”), was formed and licensed by the Small
Business Administration, with a purpose and operations similar to SCP
I.  Through December 31, 2009, the Bank has contributed $1.2 million
of its $2.0 million capital commitment to SHCP.  As of January 2010,
SCP II has commitments for $35 million from various private investors, including
the $2 million from the Bank.  In connection with the formation of
SHCP, a new entity, SCP Advisor LLC, was formed as the management company for
both SCP I and SHCP with the Bank having 15% ownership.  VCS
Management, LLC is currently dormant and only receives the Bank’s portion of any
carried interest from SCP I.  For the year ended December 31, 2009,
the Company earned $148 thousand, or 0.2% of total revenue, from its SBIC
activities, including income from the investments in SCP I and SCHP and SBIC
management fees.  The revenue stream from SBIC activities has been
irregular over the past two years due to the impact of economic conditions on
certain portfolio companies compared with substantial gains from the exit of
certain portfolio investments during 2007.





Competition





The
activities in which the Bank engages are highly
competitive.  Commercial banking in North Carolina is extremely
competitive due to early adoption of state laws which permitted statewide
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 also have their headquarters in
Winston-Salem.  Currently, we operate branches in Buncombe, Forsyth,
Guilford, Iredell, Rockingham, Stokes, Surry, Wake and Yadkin Counties, North
Carolina.  In June 2009, there were 735 branches operated by fifty-two
banks and eleven savings institutions in these nine counties with approximately
$53.3 billion in deposits.  On that date, deposits of the Bank were
$1.3 billion for a 2.38% market share.  The top three deposit market
share leaders in this market area account for 60.2% of deposits.  Many
of these competing banks have capital resources and legal lending limits
substantially in excess of those available to the Bank.  Therefore, in
our market area, the Bank has significant competition for deposits and loans
from other depository institutions.




Page
6




Other
financial institutions such as credit unions, consumer finance companies,
insurance companies, brokerage companies, small loan companies and other
financial institutions with varying degrees of regulatory restrictions compete
vigorously for a share of the financial services market.  Credit
unions have been permitted to expand their membership criteria and expand their
loan services to include such traditional bank services as commercial
lending.  These entities pose an ever increasing challenge to our
efforts to serve the markets traditionally served by banks.  We expect
competition to continue to be significant.





Employees





During
2009, all employees of the Company were compensated by the Bank.  At
December 31, 2009, the Bank employed 331 full-time equivalent persons (including
our executive officers).  None of the employees are represented by any
unions or similar groups, and we have not experienced any type of strike or
labor dispute.  We consider our relationship with our employees to be
good and extremely important to our long-term success.  The Board and
management continually seek ways to enhance employee benefits and the well being
of employees.





SUPERVISION
AND REGULATION





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





Southern
Community Financial Corporation





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





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





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




Page
7




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





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





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





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





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





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





Every
bank holding company has to achieve and maintain a minimum Tier 1 capital ratio
of at least 4.0% and a minimum total capital ratio of at least
8.0%.  In addition, banks and bank holding companies are required to
maintain a minimum leverage ratio of Tier 1 capital to average total
consolidated assets (leverage capital ratio) of at least 3.0% for the most
highly-rated, financially sound banks and bank holding companies and a minimum
leverage ratio of at least 4.0% for all other banks.  The Federal
Deposit Insurance Corporation and the Federal Reserve define Tier 1 capital for
banks in the same manner for both the leverage ratio and the risk-based capital
ratio.  However, the Federal Reserve defines Tier 1 capital for bank
holding companies in a slightly different manner.  As of December 31,
2009, the Company’s leverage capital ratio, Tier 1 risk-based capital ratio and
total risk-based capital ratio were 9.14%, 11.34% and 12.92%,
respectively.




Page
8




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, 2009, the Federal Reserve had not advised us of any specific
minimum Tangible Tier 1 Leverage Ratio applicable to us.





The
Company’s trust preferred securities, which are accounted for as debt under
generally accepted accounting principles, presently qualify as Tier 1 regulatory
capital and are reported in Federal Reserve regulatory reports as minority
interest in our consolidated subsidiaries.  A portion of the Company’s
trust preferred securities from Trust III also qualifies as Tier I regulatory
capital although they are part of a pooled transaction.  The junior
subordinated debentures related to Trust III do not qualify as Tier 1 regulatory
capital.  The Federal Reserve limits restricted core capital elements
to 25% of all core capital elements.  As of December 31, 2009, $41.4
million of the total $44.5 million in trust preferred securities counted as Tier
1 capital, and the remaining $3.1 million as Tier 2 supplementary
capital.





Under the
United States Treasury’s Capital Purchase Program (CPP), the Company issued
$42.75 million in Cumulative Perpetual Preferred Stock, Series A, on December 5,
2008.  In addition, the Company provided warrants to the Treasury to
purchase 1,623,418 shares of the Company’s common stock at an exercise price of
$3.95 per share.  These warrants are immediately exercisable and
expire ten years from the date of issuance.  The preferred stock is
non-voting, other than having class voting rights on certain matters, and pays
cumulative dividends quarterly at a rate of 5% per annum for the first five
years and 9% per annum thereafter.  The preferred shares are
redeemable at the option of the Company under certain circumstances during the
first three years and thereafter without restriction.





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





Dividends.  As a
bank holding company that does not, as an entity, currently engage in separate
business activities of a material nature, our ability to pay cash dividends
depends upon the cash dividends we receive from our subsidiary
bank.  Our primary source of income is dividends paid by the
Bank.  We must pay all of our operating expenses from funds we receive
from the Bank.  North Carolina banking law requires that dividends be
paid out of retained earnings and prohibits the payment of cash dividends if
payment of the dividend would cause the Bank’s surplus to be less than 50% of
its paid-in capital.  Also, under federal banking law, no cash
dividend may be paid if the Bank is undercapitalized or insolvent or if payment
of the cash dividend would render the Bank undercapitalized or insolvent and no
cash dividend may be paid by the Bank if it is in default of any deposit
insurance assessment due to the FDIC.  Therefore, shareholders may
receive dividends from us only to the extent that funds are available at the
holding company or from our subsidiary bank.  In addition, the Federal
Reserve generally prohibits bank holding companies from paying dividends except
out of operating earnings, and the prospective rate of earnings retention
appears consistent with the bank holding company’s capital needs, asset quality
and overall financial condition.  The Federal Reserve may impose
restrictions on the Company’s payment of cash dividends since we are required to
maintain adequate regulatory capital of our own and are expected to serve as a
source of financial strength and to commit resources to our subsidiary
bank.  As a condition of the issuance of Cumulative Perpetual
Preferred Stock to the United States Treasury under the CPP, the Company must
obtain the consent of the United States Treasury Department to increase the cash
dividend on its common stock from the September 30, 2008 quarterly level of
$0.04 per common share.  On March 24, 2009, Southern Community
Financial Corporation announced that its Board of Directors voted to suspend
payment of a quarterly dividend to common shareholders.  The Board
will continue to evaluate the payment of a quarterly cash dividend on a periodic
basis.




Page
9




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.





TreasuryRegulations.  In
June 2009, theUnited States Treasury
Department adopted new rules to implement the requirements of the American
Recovery and Reinvestment Act of 2009 which added a number of obligations
to institutions that hold investments under the CPP, such as the Company, that
are in addition to those agreed to by the Company at the time of the Treasury
investment.  Among other things, these rules: require that the
Compensation Committee of the Board meet at least every six months and undertake various
reviews of the risks presented to the Company by its compensation practices;
increase the number of employees subject to clawback of incentive compensation
in the event of inaccurate financial statements by the Company; prohibit the
Company from paying any severance compensation to certain executives even where
the Company has a contractual obligation to make those payments; limits the
amount of incentive compensation payments to certain executives and only permits
those payments in the form of restricted stock; requires the Company to permit a
non-binding shareholder vote on the Company’s executive compensation;requires the Company toadopt an excessive or
luxury expenditures policy; prohibits the Company from paying any tax gross-ups
on compensation for certain executives; and requires the Company to identify a
number of its most highly compensated employees.





The
Bank





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





Transactions with
Affiliates.  The Bank may not engage in specified transactions
(including, for example, loans) with its affiliates unless the terms and
conditions of those transactions are substantially the same or at least as
favorable to the Bank as those prevailing at the time for comparable
transactions with or involving other nonaffiliated entities.  In the
absence of comparable transactions, any transaction between the Bank and its
affiliates must be on terms and under circumstances, including credit standards,
which in good faith would be offered or would apply to nonaffiliated
companies.  In addition, transactions referred to as “covered
transactions” between the Bank and its affiliates may not exceed 10% of the
Bank’s capital and surplus per affiliate and an aggregate of 20% of its capital
and surplus for covered transactions with all affiliates.  Certain
transactions with affiliates, such as loans, also must be secured by collateral
of specific types and amounts.  The Bank also is prohibited from
purchasing low quality assets from an affiliate.  Every company under
common control with the Bank, including the Company and Southern Community
Capital Trust II and Trust III, 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.




Page
10




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 ensure that interstate branches operated by an out-of-state bank in a host
state are reasonably helping to meet the credit needs of the host state
communities served by the out-of-state bank.





Reserve Requirements.Pursuant to regulations
of the Federal Reserve, the bank must maintain average daily reserves against
its transaction accounts.  During 2009, no reserves were required to
be maintained on the first $10.3 million of transaction accounts, but reserves
equal to 3.0% were required on the aggregate balances of those accounts between
$10.3 million and $44.4 million, and additional reserves were required on
aggregate balances in excess of $44.4 million in an amount equal to 10.0% of the
excess.  These percentages are subject to annual adjustment by the
Federal Reserve, which has advised that for 2010, no reserves will be required
to be maintained on the first $10.7 million of transaction accounts, but
reserves equal to 3.0% will be required on the aggregate balances of those
accounts between $10.7 million and $55.2 million, and additional reserves are
required on aggregate balances in excess of $55.2 million in an amount equal to
10.0% of the excess.  Because required reserves must be maintained in
the form of vault cash or in an account at a Federal Reserve Bank, the effect of
the reserve requirement is to reduce the amount of the institution’s
interest-earning assets and interest income.  As of December 31, 2009,
the Bank met its reserve requirements.





Community Reinvestment.Under
the Community Reinvestment Act (“CRA”), as implemented by regulations of the
federal bank regulatory agencies, an insured bank has a continuing and
affirmative obligation, consistent with its safe and sound operation, to help
meet the credit needs of its entire community, including low and moderate income
neighborhoods.  The CRA does not establish specific lending
requirements or programs for banks, nor does it limit a bank’s discretion to
develop the types of products and services that it believes are best suited to
its particular community, consistent with the CRA.  The CRA requires
the federal bank regulatory agencies, in connection with their examination of
insured banks, to assess the Bank’s records of meeting the credit needs of their
communities, using the ratings of “outstanding,” “satisfactory,” “needs to
improve,” or “substantial noncompliance,” and to take that record into account
in its evaluation of certain applications by those banks.  All banks
are required to make public disclosure of their CRA performance
ratings.  The Bank received a “satisfactory” rating in its most recent
CRA examination.





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





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




Page
11




Dividends.All dividends
paid by the Bank are paid to the Company, the sole shareholder of the
Bank.  The general dividend policy of the Bank is to pay dividends at
levels consistent with maintaining liquidity and preserving our applicable
capital ratios and servicing obligations.  The dividend policy of the
Bank is subject to the discretion of the Board of Directors of the Bank and will
depend upon such factors as future earnings, growth, financial condition, cash
needs, capital adequacy, compliance with applicable statutory and regulatory
requirements and general business conditions.  In connection with the
Board’s March 24, 2009 decision to suspend the Company’s quarterly cash
dividends to common shareholders, the Board suspended the Bank’s quarterly cash
dividends to the Company.  In lieu of Bank dividends, the Company
utilized some of its cash resources obtained from its issuance of preferred
stock through the Treasury’s CPP to fund its expenses and debt
obligations.





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





The exact
amount of future dividends paid to the Company by the Bank will be a function of
the profitability of the Bank in general and applicable tax rates in effect from
year to year.  The Bank’s ability to pay dividends in the future will
directly depend on future profitability, which cannot be accurately estimated or
assured.  We expect that, once sufficient Bank profitability is
restored, dividends will be paid by the Bank to the Company as needed to pay any
separate expenses of the Company and/or to make required payments on the
Company’s debt obligations, including the debentures which fund the interest
payments on the Company’s trust preferred securities and to pay cash dividends
to the Company’s shareholders.





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





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





Enforcement
Authority.  The federal banking laws also contain civil and
criminal penalties available for use by the appropriate regulatory agency
against certain “institution-affiliated parties” primarily including management,
employees and agents of a financial institution, as well as independent
contractors such as attorneys and accountants and others who participate in the
conduct of the financial institution’s affairs and who caused or are likely to
cause more than minimum financial loss to or a significant adverse affect on the
institution, who knowingly or recklessly violate a law or regulation, breach a
fiduciary duty or engage in unsafe or unsound practices.  These
practices can include the failure of an institution to timely file required
reports or the submission of inaccurate reports.  These laws authorize
the appropriate banking agency to issue cease and desist orders that may, among
other things, require affirmative action to correct any harm resulting from a
violation or practice, including restitution, reimbursement, indemnification or
guarantees against loss.  A financial institution may also be ordered
to restrict its growth, dispose of certain assets or take other action as
determined by the primary federal banking agency to be
appropriate.  The Bank is not subject to any such enforcement
actions.




Page
12




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





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





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





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





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





Deposit
Insurance.  Prior to October 2008, the Bank’s deposits were
generally insured up to $100,000 per insured non-IRA non-transaction account and
up to $250,000 per IRA account by the Deposit Insurance Fund of the Federal
Deposit Insurance Corporation.  The Emergency Economic Stabilization
Act signed October 3, 2008 temporarily raised the basic limit of FDIC deposit
insurance from $100,000 to $250,000.  In September 2009, the FDIC
extended this temporary increase in the standard maximum deposit insurance
amount to $250,000 until December 31, 2013.  The Company is required
to pay deposit insurance assessments set by the FDIC.  The FDIC
determines the Bank’s deposit insurance assessment rates on the basis of four
risk categories.  Prior to 2009,the Bank's
assessment was determined by a formula that ranged from 0.05% to 0.07% at the
lowest assessment category up to a maximum assessment of 0.43% of the Bank's
average deposit base, with the exact assessment determined by the Bank's assets,
its capital and the FDIC's supervisory opinion of its operations.  On
October 7, 2008, the FDIC announced a proposed restoration plan that increased
the deposit insurance premiums for banks, while making adjustments to the
formula that determines a bank’s deposit insurance premiums.  As
amended in FDIC’s DIF restoration plan approved on February 27, 2009, effective
April 1, 2009, the FDIC increased risk-based assessment rates uniformly by seven
basis points (annualized) with banks in the best risk category paying initial
base rates of 0.12% to 0.14% (annualized).  In an effort to encourage
banks to limit the FDIC’s exposure, the insurance assessment rate formula will
also:





·
            Increase
      a bank’s assessment by up to 0.225% based on its risk profile if the bank
      has high levels of secured liabilities (if greater than 25% of domestic
      deposits), since those claims must be paid before depositors can make
      claims in the event of a failure;
and




Page
13




·
            Increase
      a bank’s assessment by up to 0.10% if brokered deposits make up more than
      10% of the institution’s domestic deposits.  For well managed
      and well capitalized institutions, this would only apply when accompanied
      by rapid asset growth.





On
February 27, 2009, the FDIC also approved as a part of its restoration plan the
imposition of a 20 basis point emergency special assessment on insured
depository institutions as of June 30, 2009.  This assessment resulted
in a nonrecurring charge totaling $789 thousand in the second quarter of 2009
which was paid on September 30, 2009.  This final rule also permitted
the FDIC to impose an emergency special assessment after June 30, 2009, of up to
ten basis points if necessary to maintain public confidence in federal deposit
insurance.  Instead of a second special assessment, banks were
required to prepay projected insurance premiums for three years through the year
ending December 31, 2012.  On December 30, 2009, the Bank paid $7.9
million to the FDIC in this prepayment.





On
October 14, 2008, the FDIC announced the creation of the Temporary Liquidity
Guarantee Program (TLPG) to strengthen confidence and encourage liquidity in the
banking system.  The TLGP has two primary components that are
available to financial institutions on a voluntary basis.  The first
component, the Debt Guarantee Program, was a guarantee of newly issued senior
unsecured debt issued on or before June 30, 2009 and would provide protection
until the earlier of the maturity date or June 30, 2012.  Issuers
electing to participate in this program would pay an annual cost of guarantee
tiered from 50 basis points for terms of 180 days or less to 100 basis points
for terms over one year.  The second component, the Transaction
Account Guarantee Program, provides unlimited deposit insurance above the
existing deposit insurance limit for certain non-interest bearing transaction
accounts initially through December 31, 2009.  If an insured
depository institution did not opt-out of the Transaction Account Guarantee
Program, it would be assessed on a quarterly basis an annualized 10 basis point
assessment on balances in noninterest-bearing transaction accounts that exceed
the $250,000 deposit insurance limit.  To orderly phase out these
programs, the FDIC concluded the Debt Guarantee Program on October 31, 2009 and
extended its Transaction Account Guarantee Program until June 30,
2010.  The Company elected to participate in the TLGP’s enhanced
deposit insurance program and the guarantee of unsecured debt; however we have
only utilized the enhanced deposit insurance program.





Item
1A. Risk Factors





An
investment in our common stock involves risk.  Shareholders should
carefully consider the risks described below in conjunction with the other
information in this Form 10-K and information incorporated by reference in this
Form 10-K, including our consolidated financial statements and related
notes.  If any of the following risks or other risks which have not
been identified or which we may believe are immaterial or unlikely, actually
occur, our business, financial condition and results of operations could be
harmed.  This could cause the price of our stock to decline and
shareholders could lose part or all of their investment.  This Form
10-K contains forward-looking statements that involve risks and uncertainties,
including statements about our future plans, objectives, intentions and
expectations.  Many factors, including those described below, could
cause actual results to differ materially from those discussed in our
forward-looking statements.





Risks
Related to Holding Southern Community Common Stock





Continued
slow economic growth in our market area could adversely affect our financial
condition and results of operations.





Economic
growth and migration into our market areas in North Carolina has slowed
significantly and our real estate markets have been subject to a significant
decline in value.  In prior years, these markets experienced
substantial growth in population, new business formation, and residential real
estate sales activity.  A significant amount of our growth was based
upon our loans to residential builders.  Current economic conditions
have resulted in a decrease in residential real estate sales activity in our
markets, which has limited our lending opportunities and negatively affected our
loan portfolio and earnings.  We do not anticipate that the housing
market will improve significantly in the near-term, and accordingly, this could
lead to additional valuation adjustments on our loan portfolio.  A
prolonged period of slow economic growth could have a further material adverse
effect on our business, results of operations and financial
condition.




Page
14




Our
business strategy focuses on organic growth within our target markets and, if we
fail to manage our growth effectively, it would negatively affect our financial
condition and results of operations.




We intend
to continue pursuing a prudent, disciplined growth strategy for our
business.  Over this past year, economic conditions have limited the
amount of loan demand in our markets as well as nationally.  While the
size of our loan portfolio has declined during 2009, our focus has been on
profitability, especially loan and deposit pricing.  Our prospects
must be considered in light of the risks, expenses and difficulties frequently
encountered by companies in mature stages of development.  In order to
execute our growth strategy successfully, we must among other
things:





·
            Identify
      and expand into suitable markets and lines of
  business;


·
            Build
      our customer base;


·
            Maintain
      credit quality;


·
            Attract
      sufficient deposits to fund our anticipated loan
  growth;


·
            Attract
      and retain qualified bank management in each of our targeted
      markets;


·
            Identify
      and pursue suitable opportunities for opening new banking locations;
      and


·
            Maintain
      adequate regulatory capital.





Our
ability to successfully grow will depend on a variety of factors including the
continued availability of desirable business opportunities, the competitive
responses from other financial institutions in our market areas and our ability
to manage our growth.  Failure to manage our growth effectively could
have a material adverse effect on our business, future prospects, financial
condition or results of operations, and could adversely affect our ability to
successfully implement our business strategy





Failure
to effectively manage our credit risk may adversely affect our financial
condition or results of operation.





There are
risks inherent in making any loan, including risks with respect to the period of
time over which the loan may be repaid, risks resulting from changes in economic
and industry conditions, risks inherent in dealing with individual borrowers and
risks resulting from uncertainties as to the future value of
collateral.  The risk on non-payment of loans is inherent in
commercial banking.  We cannot assure you that our credit approval
procedures and loan monitoring procedures will adequately reduce these lending
risks.  We cannot assure you that our credit administration personnel,
policies and procedures will adequately adapt to changes in economic or any
other conditions affecting our customers or the quality of our loan
portfolio.  Declines in the net worth of our borrowers or the value of
their loan collateral could have a material adverse effect on our results of
operations and financial condition.





Further
declines in the value of commercial and residential real estate may adversely
affect our financial condition or results of operation.





Our real
estate lending activities, and the exposure to fluctuations in commercial and
residential real estate values, are significant.  At December 31,
2009, approximately 72% of the Bank’s loans had real estate as a primary or
secondary component of collateral.  The market value of real estate
can fluctuate significantly in a relatively short period of time as a result of
market conditions in the geographic area in which the real estate is
located.  We have been adversely impacted by the decline in real
estate values in our market during 2009.  These declines in local
economic conditions may have a greater effect on our earnings and capital than
on the earnings and capital of larger financial institutions whose real estate
loan portfolios are more geographically diverse.  If the value of the
real estate serving as collateral for our loan portfolio continues to decline
materially, a significant part of our loan portfolio could become
under-collateralized and we may not be able to realize the amount of security
that we anticipated at the time of originating the loan.  The
inability of purchasers of real estate, including residential real estate, to
obtain financing may weaken the financial condition of our borrowers dependent
on the sale or refinancing of the property.  If we restructure loans
to improve the prospects of collectability, such actions may require loans to be
treated as troubled debt restructurings, or non-performing loans which could
adversely affect the adequacy of our allowance for loan losses and our
capital.  If we are required to liquidate the collateral securing a
loan to satisfy the debt during a period of reduced real estate values, our
earnings and capital could be adversely affected.  Declines in the
value of commercial and residential real estate in our markets could have a
material adverse effect on our results of operations and financial
condition.




Page
15




Our
construction loans are subject to additional lending risks that could adversely
affect earnings.





As of
December 31, 2009, approximately 21.9% of our total loan portfolio was comprised
of construction, acquisition and development loans.  In the event of a
continuing general economic slowdown, these loans may have additional risk due
to the borrower’s inability to repay on a timely basis.  In addition
to the normal repayment risk and potential decreases in real estate values,
construction lending may pose additional risks that affect repayment and the
value and marketability of real estate collateral, such as:





·
            Developers,
      builders or owners may fail to complete or develop
    projects;


·
            Developers,
      builders, or owners may experience a decline in liquidity and secondary
      sources of repayment;


·
            Municipalities
      may place moratoriums on building, utility connections or required
      certifications;


·
            Developers
      may fail to sell the improved real
estate;


·
            There
      may be construction delays and cost
overruns;


·
            Loans
      with rising variable rates may experience increases in the borrower’s
      payments on the loan at a time when the borrower’s income is under
      stress;


·
            Collateral
      may prove insufficient;


·
            Permanent
      financing may not be obtained in a timely manner;
  or


·
            Economic
      conditions may negatively impact demand for our borrower’s
      product.





Any of
these conditions could negatively affect collectability, our net income and our
financial condition.





Our
financial condition or results of operation may be adversely affected if we
experience higher loan losses that we have provided for in our loan loss
allowance.




Our
reliance on historic loan loss experience and other assumptions related to our
assessment of the adequacy of our allowance for loan losses may not be warranted
under the current economic situation.  Approximately 75% of our loan
portfolio is composed of construction, commercial mortgage and commercial
loans.  Repayment of such loans is generally considered subject to
greater credit risk than residential mortgage loans.  Historic loan
losses may not be a sufficient guide given the current economic
environment.  Losses may be experienced as a result of various factors
beyond our control, including, among other things, overall economic conditions,
changes in market conditions affecting the value of our loan collateral and
problems affecting the credit of our borrowers.  If our loan losses
are more than what we have provided for in our loan loss assumptions, those
losses could negatively affect our earnings.





Our
financial condition or results of operation may be adversely affected if our
controls and procedures fail or are circumvented.





Management
regularly reviews and updates our internal controls, disclosure controls and
procedures, and corporate governance policies and procedures.  Any
system of controls, however well designed and operated, is based in part on
certain assumptions and can provide only reasonable, not absolute, assurances
that the objectives of the system are met.  Any failure to
circumvention of our controls and procedures or failure to comply with
regulations related to controls and procedures could have a material adverse
effect on our business, results of operations or financial
condition.





Our
de novo branching strategy could cause our expenses to increase faster than our
revenues.





We moved
from temporary facilities into new permanent buildings, for Asheville during the
second quarter 2009 and for Raleigh during the third quarter
2009.  There are considerable costs involved in opening
branches.  New branches generally do not generate sufficient revenues
to offset their costs until they generate certain levels of loans and
deposits.  Accordingly, our new branches can be expected to negatively
impact our earnings for some period of time until the branches reach certain
economies of scale.  Finally, we have no assurance our new branches
will be successful even after they have been established.




Page
16




If
Southern Community loses key employees with significant business contacts in its
market area, its business may suffer.





Southern
Community’s success is dependent on the personal contacts of its officers and
employees in its market area.  If Southern Community lost key
employees temporarily or permanently, its business could be
hurt.  Southern Community could be particularly hurt if its key
employees went to work for competitors.  Southern Community’s future
success depends on the continued contributions of its existing senior management
personnel, particularly on the efforts of F. Scott Bauer and Jeff T. Clark, each
of whom has significant local experience and contacts in its market
area.  While we have entered into employment agreements with certain
key employees, we cannot assure you that we will be successful in retaining
those or other key employees.





We
may be unable to pay future cash dividends or other obligations of the Company,
which may have a material adverse effect on our stock price.





Our Board
of Directors discontinued cash dividends on our common stock during 2009 in
order to conserve our capital.  Our ability to pay cash dividends is
limited by regulatory restrictions and the need to maintain sufficient
capital.  Since the parent company has no operations, we are dependent
upon our bank subsidiary as the operating company as a source of funds to pay
cash dividends.  North Carolina banking law requires a bank to pay
cash dividends 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.  Until our subsidiary bank has earnings, it may
not be prudent for the Bank to pay dividends to us, and we could be unable to
pay cash dividends on our common stock or meet debt or other contractual
obligations.  If we are unable to pay the cash dividends on the
preferred stock held by the US Treasury, we are subject to the contractual
imposition of conditions by the US Treasury, including the election of new board
members by the US Treasury.  The inability to pay cash dividends or
the imposition of conditions by the US Treasury for failure to pay preferred
stock dividends could have a material adverse effect on our stock
price.





Our
trading volume has been low compared with larger bank holding companies which
may cause the market price of our stock to be more volatile.




The
average daily trading volume of our shares on the NASDAQ Global Select Market
for the three months ended February 26, 2010 was approximately 16,497
shares.  Lightly traded stock can be more volatile than stock trading
in an active public market like that for larger bank holding
companies.  A public trading market having the desired characteristics
of depth, liquidity and orderliness depends on the presence in the marketplace
of a significant number of willing buyers and sellers of our common stock at any
given time.  This presence depends on the individual decisions of
investors and general economic and market conditions over which we have no
control.  We cannot predict the extent to which an active public
market for our common stock will develop or be sustained.  In recent
years, the stock market has experienced a high level of price and volume
volatility and market prices for the stock of many companies have experienced
wide price fluctuations that have not necessarily been related to their
operating performance.  Therefore, our shareholders may not be able to
sell their shares at the volumes, prices, or times that they
desire.  We cannot predict the effect, if any, that future sales of
our common stock in the market, or availability of shares of our common stock
for sale in the market, will have on the market price of our common
stock.  Given the lower trading volume of our common stock,
significant sales of our common stock, or the expectation of these sales, could
cause the price of our common stock to decline or impair our ability to raise
capital through sales of our common stock.




Page
17




Given
the current depressed market value of our common stock, if we were required to
raise additional capital, it could have a dilutive effect on the existing
holders of our common stock and adversely affect the market price of our common
stock.





As of
December 31, 2009, we had 13,212,325 million shares of additional authorized
common stock available for issuance, and 957,250 million of additional
authorized preferred shares available for issuance.  We are not
restricted from issuing additional authorized shares of common stock or
securities that are convertible into or exchangeable for, or that represent the
right to receive, our common stock.  We, as well as our banking
regulators, continue to regularly perform a variety of capital analyses,
including the preparation of stress case scenarios, taking into account our
regulatory capital ratios, financial condition, and other relevant
considerations.  If it becomes appropriate in order to maintain or
increase our capital levels above our already “well capitalized” levels, we may
opportunistically issue in public or private transactions additional shares of
common stock or other securities that are convertible into our exchangeable for,
or that represent the right to receive, our common stock.  There could
also be market perceptions that we need to raise additional capital, and
regardless of the outcome of any stress test or other stress case analysis, such
perceptions could have an adverse effect on the price of our common
stock.  Shareholders of our common stock have no preemptive rights
that entitle holders to purchase their pro rata share of any offering of shares
of any class or series.  Therefore, the issuance of any additional
shares of common stock or securities convertible into or exchangeable for common
stock or that represent the right to receive common stock, or the exercise of
such securities, could be substantially dilutive to existing common
shareholders.  The market price of our common stock could also decline
as a result of sales or in anticipation of such sales.





Our
financial condition or results of operation may be adversely affected if we are
required to pay significantly higher FDIC deposit insurance premiums and
assessments in the future.





Recent
insured depository institution failures, as well as deterioration in banking and
economic conditions, have significantly increased the loss provisions of the
FDIC, resulting in a decline in the designated reserve ratio of the Deposit
Insurance Fund to historical lows.  The FDIC expects a higher rate of
insured depository institution failures in the next few years compared to recent
years.  Therefore, the reserve ratio may continue to
decline.  In addition, the deposit insurance limit on FDIC deposit
insurance coverage generally has increased to $250,000 through December 31,
2013, which may result in even larger losses to the Deposit Insurance
Fund.  These developments have caused an increase to our FDIC
insurance premium assessments, and the FDIC may be required to make additional
increases to the assessment rates or to levy additional special assessments on
us.  Higher insurance premiums and assessments increase our costs and
may limit our ability to pursue certain business opportunities.  We
are unable to predict the impact in future periods, including whether and when
additional special assessments will occur.  Significant additional
FDIC insurance premium assessments could have a material adverse effect on our
results of operations or financial condition.





Failure
to realize our deferred tax asset could have a material adverse effect on our
capital.





We
calculate income taxes in accordance with accounting principles generally
accepted in the United States (“U.S. GAAP”), which require the use of the asset
and liability method.  The largest component of our net deferred tax
asset at December 31, 2009 was related to the activity in our allowance for loan
losses.  During 2009, the book-tax differences between our provision
for loan losses and our net charge-offs generated a $4.2 million increase in our
deferred tax assets.  In accordance with U.S. GAAP, we regularly
assess available positive and negative evidence to determine whether it is more
likely than not that our deferred tax asset balances will be
recovered.  Based upon our analysis of our tax position, including
taxes paid in prior years available through carryback, and projections of loan
loss provision versus our anticipated loan charge-offs for 2010, we established
a $2.0 million valuation allowance to properly state the realizability of this
deferred tax asset.  We anticipate that it is more likely than not we
will have sufficient future earnings to utilize this asset to offset future
income tax liabilities.  Realization of a deferred tax asset requires
us to apply significant judgment and is inherently speculative because it
requires the future occurrence of circumstances that cannot be predicted with
certainty.  We may not achieve sufficient future taxable income as the
basis for the ultimate realization of our net deferred tax asset and therefore
we may have to increase the valuation allowance at some point in the
future.  If an increase in the valuation allowance is necessary, it
would require us to incur a charge to operations that could have a material
adverse effect on our earnings and capital position.





Failure
to maintain adequate capital could have a material adverse effect on our
operations.





Given
current economic conditions, capital resources may not be available at all or on
terms acceptable to the Company if it becomes necessary in order to maintain our
capital levels at or above the “well capitalized” level.  An
undercapitalized bank is subject to various restrictions depending on the extent
of the lack of capital.  A bank may be prohibited from increasing its
assets, engaging in a new line of business, acquiring any interest in any
company or insured depository institution, or opening or acquiring a new branch
office, except under certain circumstances, including the acceptance by the FDIC
of a capital restoration plan for the bank.  Certain of these
restrictions, such as a prohibition on renewing brokered certificates of
deposit, become applicable as soon as the bank no longer qualifies as “well
capitalized.”  Therefore, failure to maintain adequate capital could
have a material adverse effect on our operations.




Page
18




We
face strong competition in our market areas, which may limit our asset growth
and profitability.





The
banking business in our primary market areas, in North Carolina, is very
competitive.  We experience competition in both lending and attracting
funds from other banks and nonbank financial institutions located within our
market areas.  Some of our banking competitors are significantly
larger, well-established institutions.  Nonbank competitors for
deposits and deposit-type accounts include savings associations, credit unions,
securities firms, money market funds, life insurance companies and the mutual
funds.  For loans, we encounter competition from other banks, savings
associations, finance companies, mortgage bankers and brokers, insurance
companies, small loan and credit card companies, credit unions, pension trusts
and securities firms.  We face a competitive disadvantage as a result
of our smaller size, lack of multi-state geographic diversification and
inability to spread our marketing costs across a broader market.  This
competition may limit our asset growth and profitability.





In
addition to regulatory restrictions on the payment of dividends, government
regulations may prevent or impair our ability to engage in acquisitions or
operate in other ways.





We are
subject to supervision and periodic examination by the Federal Reserve Board and
the North Carolina Commissioner of Banks.  Our principal bank
subsidiary, Southern Community Bank and Trust, as a state chartered commercial
bank, also receives regulatory scrutiny from the North Carolina Commissioner of
Banks and the FDIC.  Banking regulations, designed primarily for the
protection of depositors, may limit our growth and the return to you as an
investor, by restricting our activities, such as:





·
            The
      payment of dividends to
shareholders;


·
            The
      amounts of capital we must retain;


·
            Possible
      transactions with or acquisitions by other
  institutions;


·
            Desired
      investments;


·
            Loans
      we can make;


·
            Interest
      rates we can pay on deposits; and


·
            The
      possible expansion of branch
offices.





We cannot
predict what changes, if any, will be made to existing federal and state
legislation and regulations or the effect that such changes may have on our
business.  The cost of compliance with regulatory requirements may
adversely affect our ability to operate profitably.





We
may face risks with respect to future expansion.





In the
past, we have sought to increase the size of our franchise by pursuing business
development opportunities and we have grown rapidly since our
incorporation.  We have purchased another financial institution as a
part of that strategy.  We may acquire other financial institutions or
parts of those entities in the future.  Acquisitions and mergers
involve a number of risks, including:





·
            The
      time and costs associated with identifying and evaluating potential
      acquisitions and merger partners;


·
            The
      accuracy of estimates and judgments used to evaluate credit, operations,
      management and market risks with respect to the target
    entity;


·
            The
      time and costs of evaluating new markets, hiring experienced local
      management and opening new offices and the time lags between these
      activities and the generation of sufficient assets and deposits to support
      the costs of the expansion;


·
            Our
      ability to finance an acquisition and possible ownership and economic
      dilution to our current
shareholders;


·
            The
      diversion of our management’s attention to the negotiation of the
      transaction and the integration of the operations and personnel of the
      combining businesses;


·
            Entry
      into new markets where we lack
experience;




Page
19




·
            The
      introduction of new products and services into our
    business;


·
            The
      incurrence and possible impairment of goodwill associated with an
      acquisition and possible adverse short-term effects on our results of
      operations; and


·
            The
      risk of loss of key employees and
customers.





We may
incur substantial costs to expand, and we can give no assurance such expansion
will result in the levels of profits we seek.  There can be no
assurance integration efforts for any future mergers or acquisitions will be
successful.  Also, we may issue equity securities, including common
stock and securities convertible into shares of our common stock in connection
with future acquisitions, which could cause ownership and economic dilution to
our current shareholders and to investors purchasing common stock in this
offering.  There is no assurance that, following any future mergers or
acquisition, our integration efforts will be successful or our company, after
giving effect to the acquisition, will achieve profits comparable to or better
than our historical experience.





Our
Articles of Incorporation include anti-takeover provisions that may prevent
shareholders from receiving a premium for their shares or effecting a
transaction favored by a majority of shareholders.





Our
Articles of Incorporation include certain anti-takeover provisions, such as
being subject to the Shareholder Protection Act and Control Share Acquisition
Act under North Carolina law and a provision allowing our Board of Directors to
consider the social and economic effects of a proposed merger, which may
discourage a change of control of the Company by allowing minority shareholders
to prevent a transaction favored by a majority of the
shareholders.  The primary purpose of these provisions is to encourage
negotiations with our management by persons interested in acquiring control of
our Company.  These provisions may also tend to perpetuate present
management and make it difficult for shareholders owning less than a majority of
the shares to be able to elect even a single director.  These
provisions may have the effect of preventing shareholders from receiving a
premium for their shares of common stock in a change of control
transaction.





Holders
of our trust preferred securities have rights that are senior to those of our
common shareholders.





We have
supported our continued growth through the issuance of trust preferred
securities from special purpose trusts and accompanying junior subordinated
debentures.  At December 31, 2009, we had outstanding trust preferred
securities and accompanying junior subordinated debentures totaling $44.5
million.  Payments of the principal and interest on the trust
preferred securities of this special purpose trust are conditionally guaranteed
by us.  Further, the accompanying junior subordinated debentures we
issued to the special purpose trust are senior to our shares of common
stock.  As a result, we must make payments on the junior subordinated
debentures before any dividends can be paid on our common stock and, in the
event of our bankruptcy, dissolution or liquidation, the holders of the junior
subordinated debentures must be satisfied before any distributions can be made
on our common stock.  We have the right to defer distributions on our
junior subordinated debentures (and the related trust preferred securities) for
up to five years, during which time no dividends may be paid on our common
stock.





Our
common stock is not FDIC insured.





Our
common stock is not a savings or deposit account or other obligation of any bank
and is not insured by the Federal Deposit Insurance Corporation, the Deposit
Insurance Fund or any other governmental agency and is subject to investment
risk, including the possible loss of principal.





Risks Related to an
Investment in the Trust II Securities





If
we do not make interest payments under the debentures, the trust will be unable
to pay distributions and liquidation amounts. The guarantee would not apply
because the guarantee covers payments only if the trust has funds
available.





Trust II
will depend solely on our payments on the debentures to pay amounts due to
holders of the Trust II Securities on the debentures.  Without these
payments, the trust will not have sufficient funds to pay distributions or the
liquidation amount on the Trust II Securities.  In that case, holders
of the Trust II Securities will not be able to rely on the guarantee for payment
of these amounts because the guarantee only applies if the trust has sufficient
funds to make distributions or to pay the liquidation
amount.  Instead, holders of the Trust II Securities or the property
trustee will have to institute a direct action against us to enforce the
property trustee’s rights under the indenture relating to the
debentures.




Page
20




We
must rely on dividends from our bank subsidiary to make interest payments on the
debentures to the trust.





Our
ability to make payments on the debentures when due will depend primarily long
term on dividends received from our bank subsidiary because we are a holding
company and substantially all of our assets are held by our bank
subsidiary.  In addition, the holding company has utilized some of the
proceeds from the Treasury’s preferred stock investment to make interest
payments under the debentures during periods when the bank subsidiary has been
restricted from paying dividends to the holding company due to reduced
profitability.  The ability of our bank subsidiary to pay dividends is
subject to legal restrictions and the Bank’s profitability, financial condition,
capital expenditures and other cash flow requirements.  We may also
borrow additional funds, issue debt instruments, issue and sell shares of
preferred stock, or engage in other types of financing activities, in order to
increase our capital.  Covenants contained in loan or financing
agreements or other debt instruments could restrict or condition our payment of
cash dividends based on various financial considerations or
factors.





Regulatory
authorities may limit dividends paid to us and thereby our ability to make
interest payments on the debentures to the trust.





We cannot
assure holders of the Trust II Securities that our bank subsidiary will be able
to pay dividends in the future due to regulatory restrictions or that our
regulators will not attempt to preclude us from making interest payments on the
subordinated debentures.  North Carolina banking law requires that
cash dividends be paid by a bank only out of retained earnings and prohibits the
payment of cash dividends if payment of the dividend would cause the bank’s
surplus to be less than 50% of its paid-in capital.  Until our
subsidiary bank has earnings, it may not be prudent for the Bank to pay
dividends to us, which would otherwise be available for interest payments on the
debentures.  We may also be precluded from making interest payments on
the subordinated debentures by our regulators in order to address any perceived
deficiencies in liquidity or regulatory capital levels at the holding company
level.  Such regulatory action would require us to obtain consent from
our regulators prior to paying dividends on our common stock or interest on the
subordinated debentures.  In the event our regulators withheld their
consent to our payment of interest on the subordinated debentures, we would
exercise our right to defer interest payments on the subordinated debentures,
and the trust would not have funds available to make distributions on the Trust
II Securities during such period.





Our
obligation to make interest payments to the trust on the debentures is
subordinated to existing liabilities or additional debt we may
incur.





Our
obligations under the debentures and the guarantee are unsecured and will rank
junior in priority of payment to our existing liabilities and any future senior
and subordinated indebtedness.  However, our issuance of the
debentures and the Trust II Securities does not limit our ability or the ability
of our subsidiaries to incur additional indebtedness, guarantees or other
liabilities.  Also, because we are a holding company, the creditors of
our bank subsidiary, including depositors, also will have priority over holders
of the Trust II Securities in any distribution of our subsidiaries’ assets in
liquidation, reorganization or otherwise.  Accordingly, the debentures
and the guarantee will be effectively subordinated to all existing and future
liabilities of our subsidiaries, and holders of the Trust II Securities should
look only to our assets for payments on the Trust II Securities and the
debentures.





We
have the option to defer interest payments on the debentures for substantial
periods.





As long
as we are not in default under the indenture relating to the debentures, we may,
at one or more times, defer interest payments on the debentures for up to 20
consecutive quarters.  If we defer interest payments on the
debentures, the trust will defer distributions on the Trust II Securities during
any deferral period.





If
we defer interest payments, holders of the Trust II Securities will still be
required to recognize the deferred interest amounts as income.





During a
deferral period, holders of the Trust II Securities will be required to
recognize as income for federal income tax purposes the amount approximately
equal to the interest that accrues on their proportionate share of the
debentures, held by the trust in the tax year in which that interest accrues,
even though holders of the Trust II Securities will not receive these amounts
until a later date if they hold the Trust II Securities until the deferred
interest is paid.




Page
21




If
holders of the Trust II Securities sell their securities during a deferral
period, they will forfeit the deferred interest amount and only have a capital
loss.





Holders
of the Trust II Securities will not receive the cash related to any accrued and
unpaid interest from the trust if they sell the Trust II Securities before the
end of any deferral period.  During a deferral period, accrued but
unpaid distributions will increase their tax basis in the Trust II
Securities.  If holders of the Trust II Securities sell the securities
during a deferral period, their increased tax basis will decrease the amount of
any capital gain or increase the amount of any capital loss that they may have
otherwise realized on the sale.  A capital loss, except in certain
limited circumstances, cannot be applied to offset ordinary
income.  As a result, deferral of distributions could result in
ordinary income and a related tax liability for the holder, and a capital loss
that may only be used to offset a capital gain.





Deferrals
of interest payments may increase the volatility of the market price of the
Trust II Securities.





If we
defer interest payments, the market price of the Trust II Securities would
likely be adversely affected.  The Trust II Securities may trade at a
price that does not fully reflect the value of accrued but unpaid interest on
the debentures.  If holders of the Trust II Securities sell the
securities during a deferral period, they may not receive the same return on
investment as someone who continues to hold the Trust II
Securities.  Because of our right to defer interest payments, the
market price of the Trust II Securities may be more volatile than the market
prices of other securities without a deferral feature.





There
are no financial covenants in the indenture and the trust agreement





The
indenture governing the debentures and the trust agreement governing the trust
do not require us to maintain any financial ratios or specified levels of net
worth, revenues, income, cash flow or liquidity.  The instruments do
not protect holders of the debentures or the Trust II Securities in the event we
experience significant adverse changes in our financial condition or results of
operations.  In addition, neither the indenture nor the trust
agreement limits our ability or the ability of any subsidiary to incur
additional indebtedness.  Therefore, holders of the Trust II
Securities should not consider the provisions of these governing instruments as
a significant factor in evaluating whether we will be able to comply with our
obligations under the debentures or the guarantee.





We
may not redeem the Trust II Securities without the consent of the US Treasury
until the earlier of December 6, 2011 or until we redeem the preferred stock we
sold to the Treasury or the Treasury transfers ownership of the preferred
stock.





The
Company has issued Cumulative Perpetual Preferred Stock, Series A, to the US
Treasury.  As a condition of this sale to the US Treasury, the Company
agreed that it may not repurchase or redeem any of its trust preferred
securities, including the Trust II Securities, without the consent of the US
Treasury, prior to the earlier of (i) December 6, 2011 or (ii) the date upon
which we either redeem the Series A preferred shares or the Treasury transfers
ownership of the Series A preferred shares to a third
party.  Therefore, holders of the Trust II Securities should have no
expectation that we will redeem the Trust II Securities during this
period.





We
may redeem some or all of the debentures and reduce the period during which
holders of the Trust II Securities will receive distributions.





We have
the option to redeem any or all of the outstanding debentures without the
payment of any premium upon satisfaction of the conditions to our sale of
preferred stock to the US Treasury.  Upon early redemption, holders of
the Trust II Securities may be required to reinvest their principal at a time
when they may not be able to earn a return that is as high as they were earning
on the Trust II Securities.




Page
22




We
may redeem all of the debentures after December 6, 2011 upon the occurrence of
certain events.





We may
redeem all of the debentures before their stated maturity without payment of
premium within 90 days after certain occurrences.  These occurrences
include adverse tax, investment company or bank regulatory
developments.  Upon early redemption (in compliance with the
conditions of our sale of preferred stock to the US Treasury), holders of the
Trust II Securities may be required to reinvest their principal at a time when
they may not be able to earn a return that is as high as they were earning on
the Trust II Securities.





We
can distribute the debentures to holders of the Trust II Securities, which may
have adverse tax consequences for holders of the Trust II Securities and could
also adversely affect the market price of the Trust II Securities.





The
trustees may dissolve the trust before maturity of the debentures and distribute
the debentures to holders of the Trust II Securities under the terms of the
trust agreement.  Under current interpretations of United States
federal income tax laws supporting classification of the trust as a grantor
trust for tax purposes, a distribution of the debentures to holders of the Trust
II Securities upon the dissolution of the trust would not be a taxable
event.  Nevertheless, if the trust is classified for United States
income tax purposes as an association taxable as a corporation at the time it is
dissolved, the distribution of the debentures would be a taxable event to
holders of the Trust II Securities.  In addition, if there is a change
in law, a distribution of the debentures upon the dissolution of the trust could
be a taxable event to holders of the Trust II Securities.  Also, the
debentures that holders of the Trust II Securities may receive if the trust is
liquidated may trade at a discount to the price that was paid to purchase the
Trust II Securities.





Holders
of the Trust II Securities must rely on the property trustee to enforce their
rights if there is an event of default under the indenture.





Holders
of the Trust II Securities may not be able to directly enforce their rights
against us under the indenture if an event of default occurs.  If an
event of default occurs under the indenture, holders of the Trust II Securities
must rely on the enforcement by the property trustee of its rights as holder of
the debentures against us.  The holders of a majority in liquidation
amount of the Trust II Securities will have the right to direct the property
trustee to enforce its rights.  If the property trustee does not
enforce its rights following an event of default and there is no request by the
record holders of the debentures to do so, any record holder may, to the extent
permitted by applicable law, take action directly against us to enforce the
property trustee’s rights.  If an event of default occurs that is
attributable to our failure to pay interest or principal on the debentures, or
if we default under the guarantee, holders of the Trust II Securities may
proceed directly against us.  Holders of the Trust II Securities will
not be able to exercise directly any other remedies available to the holders of
the debentures, unless the property trustee fails to do so.





Holders
of Trust II Securities have limited voting rights to replace the property
trustee and the Delaware trustee.





Holders
of Trust II Securities only have voting rights that pertain primarily to certain
amendments to the trust agreement.  In general, only we can replace or
remove any of the trustees.  The holders of at least a majority in
aggregate liquidation amount of the Trust II Securities may replace the property
trustee and the Delaware trustee only if an event of default under the trust
agreement occurs and is continuing.





The
subordinated debentures and the Trust II Securities do not represent deposit
accounts and are not insured.





The
subordinated debentures and the Trust II Securities do not represent bank
deposit accounts and they are not obligations issued or guaranteed by the
Federal Deposit Insurance Corporation or by any other governmental agency and
are subject to investment risk, including the possible loss of
principal.





Item
1B. Unresolved Staff Comments





None.




Page
23




Item
2. Properties





As of
December 31, 2009, we operated out of twenty-two banking offices, six
operations/administrative offices, and one lending office.  All
banking offices have ATMs.  A summary of our offices is as
follows:





Approximate
                                                        Square
                                                        Footage
                                                      
                                                      Year
                                                        Established
                                                        orAcquired
                                                      
                                                      Owned or
                                                        LeasedBanking
      Offices:Asheville,
      North Carolina1751
      Hendersonville Road (1)
                                                      
                                                      
                                                      9,821
                                                      
                                                      2009
                                                      
                                                      OwnedClemmons,
      North Carolina6290
      Towncenter Drive
                                                      
                                                      
                                                      3,800
                                                      
                                                      2004
                                                      
                                                      OwnedDobson,
      North Carolina201
      West Kapp Street
                                                      
                                                      
                                                      2,800
                                                      
                                                      1995
                                                      
                                                      OwnedGreensboro,
      North Carolina1505
      Highwoods Blvd.
                                                      
                                                      
                                                      9,800
                                                      
                                                      2005
                                                      
                                                      OwnedHigh
      Point, North Carolina2541
      Eastchester Drive
                                                      
                                                      
                                                      3,000
                                                      
                                                      2003
                                                      
                                                      OwnedJonesville,
      North Carolina503
      Winston Road
                                                      
                                                      
                                                      2,500
                                                      
                                                      1995
                                                      
                                                      OwnedKernersville,
      North Carolina1207
      South Main Street
                                                      
                                                      
                                                      8,300
                                                      
                                                      2002
                                                      
                                                      OwnedKing,
      North Carolina105
      Post Office Street
                                                      
                                                      
                                                      4,000
                                                      
                                                      2004
                                                      
                                                      OwnedMadison,
      North Carolina619
      Ayersville Road
                                                      
                                                      
                                                      2,000
                                                      
                                                      1990
                                                      
                                                      OwnedMooresville,
      North Carolina210
      Knob Hill Road
                                                      
                                                      
                                                      8,800
                                                      
                                                      2006
                                                      
                                                      OwnedMount
      Airy, North Carolina255
      East Independence Blvd.
                                                      
                                                      
                                                      10,345
                                                      
                                                      1999
                                                      
                                                      Owned2010
      Community Drive
                                                      
                                                      
                                                      3,500
                                                      
                                                      1988
                                                      
                                                      OwnedPilot
      Mountain, North Carolina616
      South Key Street
                                                      
                                                      
                                                      8,300
                                                      
                                                      1987
                                                      
                                                      OwnedRaleigh,
      North Carolina3100
      Edwards Mill Road (2)
                                                      
                                                      
                                                      10,740
                                                      
                                                      2009
                                                      
                                                      OwnedSandy
      Ridge, North Carolina4928
      Highway 704 West
                                                      
                                                      
                                                      1,250
                                                      
                                                      1989
                                                      
                                                      OwnedUnion
      Grove, North Carolina1439
      W. Memorial Highway
                                                      
                                                      
                                                      2,300
                                                      
                                                      1990
                                                      
                                                      Owned




Page
24







Approximate
                                
                                YearSquare
                                
                                Established
                                
                                Owned
      orFootage
                                
                                or Acquired
                                
                                LeasedBanking Offices:Walnut
      Cove, North Carolina1072
      North Main Street
                                
                                
                                1,700
                                
                                1999
                                
                                LeasedWinston
      Salem, North Carolina4701
      Country Club Road
                                
                                
                                4,300
                                
                                1996
                                
                                Leased225
      Hanes Mill Road
                                
                                
                                2,800
                                
                                2001
                                
                                Owned3151
      Peters Creek Parkway
                                
                                
                                2,500
                                
                                1998
                                
                                Leased500
      South Stratford Road
                                
                                
                                5,980
                                
                                2008
                                
                                OwnedYadkinville,
      North Carolina532
      East Main Street
                                
                                
                                7,800
                                
                                1998
                                
                                OwnedOperations and Administrative
      Offices:Winston
      Salem, North Carolina465
      Shepherd Street
                                
                                
                                47,114
                                
                                2006
                                
                                Owned100
      Cambridge Plaza (3)
                                
                                
                                7,028
                                
                                2006
                                
                                Owned104
      Cambridge Plaza (3)
                                
                                
                                7,028
                                
                                2006
                                
                                Owned108
      Cambridge Plaza (3)
                                
                                
                                7,028
                                
                                2006
                                
                                Owned112
      Cambridge Plaza (3)
                                
                                
                                7,988
                                
                                2006
                                
                                Owned4605
      Country Club Road - Corporate
                                
                                
                                27,000
                                
                                2003
                                
                                OwnedLending Offices:Winston
      Salem, North Carolina4625
      Country Club Road
                                
                                
                                3,200
                                
                                1998
                                
                                Owned




(1)
Relocated banking office from 80 Peachtree Road, Asheville to 1751
Hendersonville Road, Asheville in May 2009.


(2)
Relocated banking office from 2626 Glenwood Avenue to 3100 Edwards Mill Road,
Raleigh in September 2009.


(3)
Approximately 75% of these properties are leased to tenants.





In
addition to the above locations, the Bank has three off site ATMs (located at
3484 Robinhood Road and 214 West Fourth Street both in Winston-Salem, and 1466
River Ridge Road in Clemmons, North Carolina) and approximately 150 outsourced
ATM cash dispensing machines throughout North Carolina.





All of
our properties, including land, buildings and improvements, furniture, equipment
and vehicles, had a net book value at December 31, 2009 of $42.6
million.  See further information presented in Note 6 to our
consolidated financial statements, which are presented under Item 8 in this Form
10-K.





Additional
banking offices may be opened at later dates if deemed appropriate by the Board
of Directors and if regulatory approval can then be obtained.  The
Company may acquire property in which a director, directly or indirectly, has an
interest.  In such event, the acquisition of such facilities shall be
approved by a majority of the Board of Directors, excluding any individual who
may have such an interest in the property.




Page
25




Item
3.  Legal Proceedings





The
Company is a party to legal proceedings arising in the normal conduct of
business.  Our management believes that this litigation is not
material to the Company’s financial position or results of its operations or the
operations of the Bank.





Item
4.  Reserved





PART
II





Item
5.  Market for Registrant’s Common Equity, Related Stockholder Matters
and Issuer Purchases of Equity Securities





Price
Range of Common Stock and Dividends





Our
common stock and Trust II Securities are listed on the NASDAQ Global Select
Market under the symbols “SCMF” and “SCMFO”, respectively.  The
following table sets forth the high and low sales prices per share of our common
stock and our preferred securities (“SCMFO”), based on published financial
sources, and our dividend payments on the common stock for the last two
years.





Price
                                    
                                    
                                    Declared
                                      Cash
                                      Dividend per
                                      Common
                                      ShareSCMF
                                    
                                    
                                    SCMFOYear
                                    
                                    Quarterly Period
                                    
                                    High
                                    
                                    
                                    Low
                                    
                                    
                                    High
                                    
                                    
                                    Low2008
                                    
                                    First
      Quarter
                                    
                                    $
                                    7.89
                                    
                                    
                                    $
                                    6.26
                                    
                                    
                                    $
                                    9.94
                                    
                                    
                                    $
                                    8.00
                                    
                                    
                                    $
                                    0.040Second
      Quarter
                                    
                                    
                                    7.73
                                    
                                    
                                    
                                    5.52
                                    
                                    
                                    
                                    9.73
                                    
                                    
                                    
                                    7.50
                                    
                                    
                                    
                                    0.040Third
      Quarter
                                    
                                    
                                    6.30
                                    
                                    
                                    
                                    3.86
                                    
                                    
                                    
                                    9.15
                                    
                                    
                                    
                                    6.01
                                    
                                    
                                    
                                    0.040Fourth
      Quarter
                                    
                                    
                                    4.97
                                    
                                    
                                    
                                    2.11
                                    
                                    
                                    
                                    8.74
                                    
                                    
                                    
                                    5.75
                                    
                                    
                                    
                                    0.0402009
                                    
                                    First
      Quarter
                                    
                                    $
                                    4.94
                                    
                                    
                                    $
                                    2.46
                                    
                                    
                                    $
                                    8.96
                                    
                                    
                                    $
                                    6.01
                                    
                                    
                                    $
                                    0.040Second
      Quarter
                                    
                                    
                                    3.99
                                    
                                    
                                    
                                    2.53
                                    
                                    
                                    
                                    7.20
                                    
                                    
                                    
                                    5.51
                                    
                                    
                                    
                                    -Third
      Quarter
                                    
                                    
                                    3.73
                                    
                                    
                                    
                                    2.40
                                    
                                    
                                    
                                    8.00
                                    
                                    
                                    
                                    5.36
                                    
                                    
                                    
                                    -Fourth
      Quarter
                                    
                                    
                                    3.20
                                    
                                    
                                    
                                    1.89
                                    
                                    
                                    
                                    7.43
                                    
                                    
                                    
                                    6.02
                                    
                                    
                                    
                                    -2010
                                    
                                    First
      Quarter
                                    
                                    $
                                    2.85
                                    
                                    
                                    $
                                    2.09
                                    
                                    
                                    $
                                    8.00
                                    
                                    
                                    $
                                    6.18
                                    
                                    
                                    $
                                    -(through
      February 26, 2010)





At
February 26, 2010, there were approximately 7,106 holders of record of our
common stock.





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.  The Company must pay all of its operating expenses from
funds received 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 the Company and may therefore limit the Company’s
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.  As a condition of the issuance of Cumulative
Perpetual Preferred Stock to the United States Treasury under its Capital
Purchase Program, the Company must obtain the consent of the United States
Treasury Department to increase the cash dividend on its common stock from the
September 30, 2008 quarterly level of $0.04 per common share.




Page
26




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





Share
Repurchases





The
Company announced a plan to repurchase up to 300,000 shares of its common stock
in March 2005, to repurchase an additional 600,000 shares in September 2005 and
to repurchase up to an additional 1 million shares in July
2006.  Through December 31, 2008, the Company has repurchased
1,858,073 shares at an average price of $6.99 per share under the three
plans.  No shares were repurchased during 2009.





As a
condition of the issuance of its Cumulative Perpetual Preferred Stock to the
United States Treasury under its CPP, the Company must obtain the consent of the
United States Treasury Department to repurchase any of its common
stock.





Period
                            
                            TotalNumberofShares
                              Purchased
                            
                            
                            AveragePricePaidper Share
                            
                            
                            Total Number of
                              Shares PurchasedasPart ofPublicly
                              Announced
                              Programs
                            
                            
                            MaximumNumber ofSharesThat May YetBePurchased Under
                              the ProgramsOctober
      1, 2009 to December 31, 2009
                            
                            None
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            41,927Total
      for quarter
                            
                            
                            -
                            
                            
                            $
                            -
                            
                            
                            
                            -




Page
27




Item
6. Selected Financial Data





SELECTED
CONSOLIDATED FINANCIAL INFORMATION AND OTHER DATA





The
following tables set forth selected consolidated financial information and other
data.  The information set forth below does not purport to be complete
and should be read in conjunction with our consolidated financial statements
appearing elsewhere in this annual report.





SELECTED
CONSOLIDATED FINANCIAL INFORMATION AND OTHER DATA





For the Years Ended December 31,2009
                  
                  
                  2008
                  
                  
                  2007
                  
                  
                  2006
                  
                  
                  2005(Dollars in thousands, except share and per share data)Operating
      Data:Interest
      income
                  
                  $
                  89,473
                  
                  
                  $
                  96,742
                  
                  
                  $
                  98,908
                  
                  
                  $
                  85,520
                  
                  
                  $
                  68,097Interest
      expense
                  
                  
                  37,726
                  
                  
                  
                  49,282
                  
                  
                  
                  55,141
                  
                  
                  
                  44,798
                  
                  
                  
                  31,128Net
      interest income
                  
                  
                  51,747
                  
                  
                  
                  47,460
                  
                  
                  
                  43,767
                  
                  
                  
                  40,722
                  
                  
                  
                  36,969Provision
      for loan losses
                  
                  
                  34,000
                  
                  
                  
                  8,165
                  
                  
                  
                  2,775
                  
                  
                  
                  2,510
                  
                  
                  
                  950Net
      interest income after provision for loan losses
                  
                  
                  17,747
                  
                  
                  
                  39,295
                  
                  
                  
                  40,992
                  
                  
                  
                  38,212
                  
                  
                  
                  36,019Non-interest
      income
                  
                  
                  12,906
                  
                  
                  
                  11,341
                  
                  
                  
                  11,329
                  
                  
                  
                  3,678
                  
                  
                  
                  7,134Non-interest
      expense
                  
                  
                  100,498
                  
                  
                  
                  42,148
                  
                  
                  
                  40,898
                  
                  
                  
                  35,802
                  
                  
                  
                  31,319Income
      (loss) before income taxes
                  
                  
                  (69,845
                  )
                  
                  
                  8,488
                  
                  
                  
                  11,423
                  
                  
                  
                  6,088
                  
                  
                  
                  11,834Provision
      for income taxes (benefit)
                  
                  
                  (6,686
                  )
                  
                  
                  2,634
                  
                  
                  
                  3,869
                  
                  
                  
                  1,890
                  
                  
                  
                  4,161Net
      income (loss)
                  
                  
                  (63,159
                  )
                  
                  
                  5,854
                  
                  
                  
                  7,554
                  
                  
                  
                  4,198
                  
                  
                  
                  7,673Effective
      dividends on preferred stock
                  
                  
                  2,508
                  
                  
                  
                  185
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Net
      income (loss) available to common shareholders
                  
                  $
                  (65,667
                  )
                  
                  $
                  5,669
                  
                  
                  $
                  7,554
                  
                  
                  $
                  4,198
                  
                  
                  $
                  7,673Securities
      gains (losses) included in non-interest income
                  
                  $
                  1,236
                  
                  
                  $
                  98
                  
                  
                  $
                  -
                  
                  
                  $
                  (4,156
                  )
                  
                  $
                  (266
                  )Per
      Common Share Data:Net
      income (loss)Basic
                  
                  $
                  (3.91
                  )
                  
                  $
                  0.33
                  
                  
                  $
                  0.43
                  
                  
                  $
                  0.24
                  
                  
                  $
                  0.43Diluted
                  
                  
                  (3.91
                  )
                  
                  
                  0.33
                  
                  
                  
                  0.43
                  
                  
                  
                  0.24
                  
                  
                  
                  0.42Cash
      dividends
                  
                  
                  0.040
                  
                  
                  
                  0.160
                  
                  
                  
                  0.155
                  
                  
                  
                  0.135
                  
                  
                  
                  0.120Book
      value
                  
                  
                  4.77
                  
                  
                  
                  8.77
                  
                  
                  
                  8.18
                  
                  
                  
                  7.83
                  
                  
                  
                  7.66Weighted
      average sharesBasic
                  
                  
                  16,787,938
                  
                  
                  
                  17,363,395
                  
                  
                  
                  17,559,352
                  
                  
                  
                  17,566,315
                  
                  
                  
                  17,825,152Diluted
                  
                  
                  16,787,938
                  
                  
                  
                  17,398,318
                  
                  
                  
                  17,624,399
                  
                  
                  
                  17,757,436
                  
                  
                  
                  18,133,859Balance
      Sheet Data:Total
      assets
                  
                  
                  1,728,608
                  
                  
                  
                  1,803,778
                  
                  
                  
                  1,569,182
                  
                  
                  
                  1,436,465
                  
                  
                  
                  1,287,613Loans
                  
                  
                  1,230,275
                  
                  
                  
                  1,314,811
                  
                  
                  
                  1,188,438
                  
                  
                  
                  1,033,411
                  
                  
                  
                  868,827Allowance
      for loan losses
                  
                  
                  29,638
                  
                  
                  
                  18,851
                  
                  
                  
                  14,258
                  
                  
                  
                  13,040
                  
                  
                  
                  11,785Deposits
                  
                  
                  1,314,070
                  
                  
                  
                  1,233,112
                  
                  
                  
                  1,045,237
                  
                  
                  
                  1,024,582
                  
                  
                  
                  941,949Short-term
      borrowings
                  
                  
                  85,477
                  
                  
                  
                  145,197
                  
                  
                  
                  117,772
                  
                  
                  
                  92,748
                  
                  
                  
                  9,186Long-term
      borrowings
                  
                  
                  199,103
                  
                  
                  
                  228,016
                  
                  
                  
                  254,633
                  
                  
                  
                  172,549
                  
                  
                  
                  192,551Stockholders’
      equity
                  
                  
                  121,997
                  
                  
                  
                  187,710
                  
                  
                  
                  142,339
                  
                  
                  
                  136,225
                  
                  
                  
                  134,885Capital
      Ratios:Total
      risk-based capital
                  
                  
                  12.92
                  %
                  
                  
                  13.80
                  %
                  
                  
                  11.44
                  %
                  
                  
                  11.40
                  %
                  
                  
                  13.21
                  %Tier
      1 risk-based capital
                  
                  
                  11.34
                  %
                  
                  
                  12.46
                  %
                  
                  
                  10.28
                  %
                  
                  
                  10.20
                  %
                  
                  
                  11.94
                  %Leverage
      ratio
                  
                  
                  9.14
                  %
                  
                  
                  10.57
                  %
                  
                  
                  8.96
                  %
                  
                  
                  8.73
                  %
                  
                  
                  9.60
                  %Equity
      to assets ratio
                  
                  
                  7.06
                  %
                  
                  
                  10.41
                  %
                  
                  
                  9.07
                  %
                  
                  
                  9.48
                  %
                  
                  
                  10.48
                  %




Page
28




For the Years Ended December 31,2009
                  
                  
                  2008
                  
                  
                  2007
                  
                  
                  2006
                  
                  
                  2005(Dollars in thousands, except share and per share data)Selected
      Performance Ratios:Return
      on average assets
                  
                  
                  -3.57
                  %
                  
                  
                  0.34
                  %
                  
                  
                  0.50
                  %
                  
                  
                  0.31
                  %
                  
                  
                  0.60
                  %Return
      on average equity
                  
                  NM
                  
                  
                  
                  4.02
                  %
                  
                  
                  5.45
                  %
                  
                  
                  3.11
                  %
                  
                  
                  5.67
                  %Net
      interest spread (1)
                  
                  
                  2.95
                  %
                  
                  
                  2.75
                  %
                  
                  
                  2.81
                  %
                  
                  
                  2.92
                  %
                  
                  
                  2.86
                  %Net
      interest margin (2)
                  
                  
                  3.16
                  %
                  
                  
                  2.99
                  %
                  
                  
                  3.19
                  %
                  
                  
                  3.30
                  %
                  
                  
                  3.20
                  %Non-interest
      income as a percentage of total revenue (3)
                  
                  
                  19.96
                  %
                  
                  
                  19.21
                  %
                  
                  
                  20.57
                  %
                  
                  
                  8.28
                  %
                  
                  
                  16.18
                  %Non-interest
      income as a percentage of average assets
                  
                  
                  0.73
                  %
                  
                  
                  0.65
                  %
                  
                  
                  0.75
                  %
                  
                  
                  0.27
                  %
                  
                  
                  0.56
                  %Non-interest
      expense to average assets  (6)
                  
                  
                  5.69
                  %
                  
                  
                  2.42
                  %
                  
                  
                  2.70
                  %
                  
                  
                  2.62
                  %
                  
                  
                  2.44
                  %Efficiency
      ratio (4) (6)
                  
                  
                  155.44
                  %
                  
                  
                  71.65
                  %
                  
                  
                  74.23
                  %
                  
                  
                  80.64
                  %
                  
                  
                  71.01
                  %Dividend
      payout ratio
                  
                  NM
                  
                  
                  
                  48.48
                  %
                  
                  
                  36.05
                  %
                  
                  
                  35.80
                  %
                  
                  
                  56.49
                  %Asset
      Quality Ratios:Nonperforming
      loans to period-end loans
                  
                  
                  3.07
                  %
                  
                  
                  1.10
                  %
                  
                  
                  0.17
                  %
                  
                  
                  0.26
                  %
                  
                  
                  0.16
                  %Allowance
      for loan losses to period-end loans
                  
                  
                  2.41
                  %
                  
                  
                  1.43
                  %
                  
                  
                  1.20
                  %
                  
                  
                  1.26
                  %
                  
                  
                  1.36
                  %Allowance
      for loan losses to nonperforming loans
                  
                  
                  0.79
                  X
                  
                  
                  1.31
                  X
                  
                  
                  6.95
                  X
                  
                  
                  4.95
                  X
                  
                  
                  8.37
                  XNonperforming
      assets to total assets (5)
                  
                  
                  3.32
                  %
                  
                  
                  1.12
                  %
                  
                  
                  0.18
                  %
                  
                  
                  0.25
                  %
                  
                  
                  0.13
                  %Net
      loan charge-offs to average loans outstanding
                  
                  
                  1.82
                  %
                  
                  
                  0.28
                  %
                  
                  
                  0.14
                  %
                  
                  
                  0.13
                  %
                  
                  
                  0.14
                  %Other
      Data:Number
      of banking offices
                  
                  
                  22
                  
                  
                  
                  22
                  
                  
                  
                  22
                  
                  
                  
                  21
                  
                  
                  
                  19Number
      of full-time equivalent employees
                  
                  
                  331
                  
                  
                  
                  337
                  
                  
                  
                  337
                  
                  
                  
                  326
                  
                  
                  
                  299





(1)
            Net
      interest spread is the difference between the average yield on
      interest-earning assets and the average cost of interest-bearing
      liabilities.


(2)
            Net
      interest margin is net interest income divided by average interest-earning
      assets.


(3)
            Total
      revenue consists of net interest income and non-interest
      income.


(4)
            Efficiency
      ratio is non-interest expense divided by the sum of net interest income
      and non-interest income.


(5)
            Nonperforming
      assets consist of nonaccrual loans, restructured loans and real estate
      owned, where applicable.


(6)
            Excluding
      the $49.5 million goodwill impairment charge in 2009, the ratio of
      non-interest expenses to average assets and the efficiency ratio would be
      2.89% and 78.88%, respectively.


NM – Not
meaningful




Page
29




Item
7.  Management’s Discussion and Analysis of Financial Condition and
Results of Operations





The
following presents management’s discussion and analysis of our financial
condition and results of operations and should be read in conjunction with the
financial statements and related notes included elsewhere in this annual
report.  This discussion contains forward-looking statements that
involve risks and uncertainties.  Our actual results could differ
significantly from those anticipated in these forward-looking statements as a
result of various factors.  The following discussion is intended to
assist in understanding the financial condition and results of our
operations.





CRITICAL
ACCOUNTING POLICIES





The
Company’s accounting policies are in accordance with accounting principles
generally accepted in the United States and with general practices within the
banking industry.  Management makes a number of estimates and
assumptions relating to reported amounts of assets, liabilities, revenues and
expenses in the preparation of the financial statements and
disclosures.  Estimates and assumptions that are most significant to
the Company are related to the determination of the allowance for loan losses,
goodwill and other intangible assets and income taxes.





Allowance
for Loan Losses





The
allowance for loan losses represents management’s estimate of probable losses
inherent in the loan portfolio. Determining the appropriate level of the
allowance is one of the most critical and complex accounting estimates for any
financial institution. Management’s judgments include those involved in risk
grading the loan portfolio, determining specific allowances for loans considered
impaired, and evaluating the impact of current economic conditions on the levels
of the allowance. Loans are considered impaired when it is probable that all
amounts due will not be collected in accordance with the contractual terms of
the loan agreement. While management believes that the allowance for loan losses
is appropriate and adequate to cover probable losses inherent in the portfolio,
future adjustments to the allowance may be necessary and results of operations
could be adversely affected if circumstances differ substantially from the
assumptions used in making the determinations. In addition, because future
events affecting borrowers and collateral cannot be predicted with certainty,
there can be no assurance that the existing allowance for loan losses is
adequate or that increases will not be necessary should the quality of any loans
deteriorate as a result of the factors discussed herein. Any material increase
in the allowance for loan losses may adversely affect our financial condition
and results of operations. For further discussion, see “Nonperforming Assets”
and “Analysis of Allowance for Loan Losses” under “ASSET QUALITY.”





Goodwill
and Other Intangibles





Goodwill
represents the excess of the cost of an acquisition over the fair value of the
net assets acquired.  Prior to March 31, 2009, goodwill impairment
testing was performed annually or more frequently if events or circumstances
indicate possible impairment.  The evaluation of goodwill for
impairment included both the income and market approaches to value the
Company.  The income approach consisted of discounting projected
long-term future cash flows, which were derived from internal forecasts and
economic expectations for the Company.  The significant inputs to the
income approach include the long-term target tangible equity to tangible assets
ratio and the discount rate, which was determined utilizing the Company’s cost
of capital adjusted for a company-specific risk factor.  The
company-specific risk factor was used to address the uncertainty of growth
estimates and earnings projections of management.  Under the market
approach, a value was calculated from an analysis of comparable acquisition
transactions based on earnings, book value, assets and deposit premium multiples
from the sale of similar financial institutions.  Another market
valuation approach utilized the current stock price adjusted by an appropriate
control premium as an indicator of fair market value.  Given the
substantial declines in our common stock price, declining operating results,
asset quality trends, market comparables and the economic outlook for our
industry, the Company’s fair value at March 31, 2009 had decreased significantly
compared with previous assessments.  Our goodwill testing for the
first quarter of 2009 indicated that the Company’s fair value did not support
the goodwill recorded at the time of the acquisition of The Community Bank in
January 2004; therefore, the Company recorded a $49.5 million goodwill
impairment charge to write off the entire amount of goodwill as of March 31,
2009.  This non-cash goodwill impairment charge to earnings was one of
the primary reasons for the Company’s $63.2 million net loss for
2009.




Page
30




Income
Taxes





Accrued
taxes represent the estimated amount payable to or receivable from taxing
jurisdictions, either currently or in the future, and are reported, on a net
basis, as a component of “other assets” in the consolidated balance
sheets.  The calculation of the Company’s income tax expense is
complex and requires the use of many estimates and judgments in its
determination.





Management’s
determination of the realization of the net deferred tax asset is based upon
management’s judgment of various future events and uncertainties, including the
timing and amount of future income and the implementation of various tax plans
to maximize realization of the deferred tax asset.  At December 31,
2009, a $2.0 million valuation allowance was established primarily due to the
relative magnitudes of the provision for loan losses and net charge-offs for the
year and the possibility that all of the deferred tax asset associated with the
loan loss reserve may not be realized.





From time
to time, management bases the estimates of related tax liabilities on its belief
that future events will validate management’s current assumptions regarding the
ultimate outcome of tax-related exposures.  While the Company has
obtained the opinion of advisors that the anticipated tax treatment of these
transactions should prevail and has assessed the relative merits and risks of
the appropriate tax treatment, examination of the Company’s income tax returns,
changes in tax law and regulatory guidance may impact the treatment of these
transactions and resulting provisions for income taxes.





OVERVIEW





Southern
Community’s 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, the
founders began in 1995 the process by which Southern Community Bank and Trust
was created, and began operations on November 18, 1996.  From
inception, Southern Community has strived to serve the financial needs of small
to medium-sized businesses, individuals, residential homebuilders and others in
and around our markets in North Carolina.  We offer a broad array of
banking and other financial products; many of which are similar to those offered
by our larger competitors, but we deliver them 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 $1.7 billion in total assets in just over thirteen years of
operations.





The
Company began operations in November 1996 with $11.0 million in capital, a
single branch facility and thirteen employees.  Through December 31,
2009, Southern Community Financial Corporation has grown to a total of
twenty-two full-service banking offices with $1.4 billion in customer deposit
accounts.  In support of this growth, the Company has generated
additional capital through issuing common and preferred stock and, prior to
2009, retaining operating earnings.  At December 31, 2009, the Company
had $122.0 million in total stockholders’ equity.  Through our banking
subsidiary we offer traditional banking products as well as a full array of
financial services.  In October 2001, Southern Community Financial
Corporation, a financial holding company, became the parent company of Southern
Community Bank and Trust.  On January 12, 2004, we acquired The
Community Bank, a $240.0 million asset community bank with 10 banking offices in
contiguous markets.  The Company created Southern Community Advisors,
our wealth management division, and has developed and acquired mortgage banking
operations.  While these operations are currently not significant to
our results of operations, we intend to pursue growth in these businesses to
enhance our non-interest income.





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.  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.





Management
recognizes that our growth may expose the Company to increased operational and
market risk, primarily with respect to managing overhead, funding costs and
credit quality.  The Company has developed critical functions such as
Credit Administration, Training, Audit and Compliance to assist in managing and
monitoring these and other risks.  We are committed to creating and
maintaining a solid and diversified financial services organization with a focus
on customer service.  It is management’s firm belief that this
foundation will continue building our loyal customer base while attracting new
clients and providing opportunities for future growth.  As bank
consolidations continue to take place in our markets, Southern Community
Financial Corporation is positioned to continue to benefit from their
effects.




Page
31




Financial
Condition at December 31, 2009 and 2008





During
the year ended December 31, 2009, our total assets decreased by $75.2 million,
or 4.2%, to $1.7 billion.  The most significant factor contributing to
this decrease was recognizing a $49.5 million charge for goodwill
impairment.  Excluding this charge, total assets decreased $25.7
million or 1.4% year-over-year.  Total loans decreased at the end of
all four quarters of 2009, resulting in a decrease of $84.5 million for the year
due largely to the economic slowdown and weak loan demand as customers became
more conservative when considering their bank debt.  Total deposits
grew to $1.31 billion at December 31, 2009, an increase of $83.3 million or 6.8%
from the year ago period.  Money market, savings and NOW accounts
increased $105.6 million and demand accounts increased $16.3 million while time
deposits decreased $38.6 million as a result of active liability management with
an emphasis on improving the funding mix and lowering funding
costs.  The increase in local deposits decreased the need for brokered
deposits which ended the year $46.4 million less than the prior
year.  The increase in deposits also allowed the Company to repay
$128.0 million in borrowings including $60 million to pay in full our borrowing
from the Federal Reserve Term Auction Facility program.  Other
year-over-year balance sheet changes include increases of $29.1 million in
federal funds sold, $13.9 million in other real estate owned (OREO) and $8.3
million in prepaid assets including the three year FDIC premium.





Total
loans declined $84.5 million in 2009 due to a slowdown in loan demand and
increased nonperforming loans which were transferred to OREO or charged
off.  The decline in total loans was attributed primarily to
construction loans which decreased $82.3 million as contractors struggled to
sell homes built in prior years with minimal new construction in
2009.  To assist the contractors in selling their inventory of
speculative homes, the Company invested $1.3 million in a buyer incentive
program which was a factor in selling approximately 130 houses.  Other
construction loans whose property required foreclosure resulted in a $13.7
million increase in OREO.  Commercial mortgage loans increased $36.1
million during the year which was offset by a $37.9 million decrease in
commercial and industrial loans.  Residential mortgage loans and other
consumer loans were relatively unchanged during 2009.





During
2009, the Bank continued our program of originating residential mortgage loans
primarily for sale.  At the year-end 2009, mortgage loans held for
sale were $3.0 million compared to $316 thousand at the prior year end as
mortgage origination volumes began to stabilize and improve.





Our total
liquid assets, defined as cash and due from banks, federal funds sold,
interest-bearing deposits and investment securities, increased by $33.1 million
during the year, to $395.0 million at December 31, 2009.  Liquid
assets represented 22.8% of total assets at December 31, 2009 as compared to
20.1% at the beginning of the year.  Cash equivalents and federal
funds sold increased $34.1 million while investment securities decreased $961
thousand.  The investment portfolio remained consistent with the prior
year level as yields on investment securities were generally low.  The
majority of securities that were called, matured, or sold during the year were
reinvested in municipal bonds that had the best available yield and provided
income tax benefits.  As of year-end, we believe our liquidity is
adequate to fund future loan demand and manage deposit and borrowing
outflows.





Customer
deposits have traditionally been our primary funding source supplemented by
wholesale funding.  Deposits totaled $1.31 billion, an increase of
$83.3 million or 6.8% from year-end 2008.  Deposit growth during the
current year shifted from time deposits to non-maturity deposits as customers
focused on liquidity.  Money market rates nearly matched rates on
certificates of deposit with terms of one year or less during this environment
of stable but artificially low interest rates.  The change in market
conditions was reflected in a $121.9 million or 21.2% increase year-over-year in
demand, money market, NOW and savings deposits, which ended the year at $697.4
million.  Money market accounts grew $76.4 million as customers
focused on the best yield and availability of funds.  Time deposits
decreased $38.6 million or 5.9% as customers shifted to money market
accounts.  Brokered deposits totaling $214.8 million and $261.2
million at year-end 2009 and 2008, respectively, decreased as the increase in
local deposits were used to repay maturing brokered
deposits.  Management will continue to focus on growing the local core
deposit base; however, we will continue to monitor the costs of our various
funding alternatives.  Our funding mix may change from time to time as
a result.




Page
32




Total
borrowings aggregated $284.6 million at December 31, 2009, and included $104.5
million of advances from the Federal Home Loan Bank of Atlanta (FHLB), junior
subordinated debentures with a carrying value of $45.9 million, securities sold
under agreements to repurchase of $94.8 million and borrowings from individuals
of $39.4 million.  Term Auction Facility advances from the Federal
Reserve Bank which were $60.0 million at the prior year end were repaid in full
in 2009.  At December 31, 2009, we had funding of $90.0 million in the
form of term repurchase agreements with $10.0 million maturing within one year
and $80.0 million with maturities from one to five years.  Management
will use FHLB advances and other funding sources as necessary to support balance
sheet management and growth.  However, management expects that as our
branch network grows and matures, the volume of core deposits will become an
increasingly larger portion of our funding mix, which over time should
contribute to a reduction in our overall funding cost.





The
Company’s 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, 2009, our stockholders’ equity
totaled $122.0 million, a decrease of $65.7 million from the December 31, 2008
balance.  This net change includes $63.2 million of net loss, $228
thousand of stock-based compensation, $20 thousand in other comprehensive income
due primarily to unrealized holding gains on available for sale investment
securities and cash dividends paid of $2.8 million.





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, 2009, 2008 and 2007,
our average interest-earning assets were $1.64 billion, $1.59 billion and $1.37
billion, respectively.  During these same years, our net interest
margins were 3.16%, 2.99% and 3.19%, respectively.





During
2009, the Federal Reserve maintained the federal funds target rate consistent
with year-end 2008 at a range of zero to 0.25%.  The federal funds
rate is currently at a historical low surpassing the previous low of 1.00% in
June 2003.  There is a 300 basis point spread between the federal
funds rate and the prime rate which remained at 3.25% throughout
2009.  While it is management’s goal to remain relatively interest
rate neutral, the Bank’s interest rate sensitivity has been slightly asset
sensitive in 2009, as the funding mix has remained relatively
stable.  Net interest income totaled $51.7 million, an increase of
$4.3 million or 9.0% over the $47.5 million for the same period in
2008.   Net interest income benefited from decreased cost of
funds while the Bank’s asset yields decreased at a slower pace (0.63% from 6.09%
to 5.46%) than cost of funds (0.83% from 3.34% to 2.51%), leading to an improved
net interest margin from 2.99% to 3.16%.  The total cost of funds
decreased $11.6 million while the interest income from interest earning assets
decreased $7.3 million.  The improvement in cost of funds was
attributed to customers shifting their higher rate certificates of deposit to
lower rate money market accounts or renewing their certificates of deposit at a
lower rate.  Further improvement in the cost of funds was realized as
borrowings totaling $49.7 million from the FHLB were repaid during the year and
brokered deposits decreased $46.4 million.  While total interest
income decreased for the year due to decreased outstanding loan balances and an
increase in nonperforming loans, the continued use of interest rate floors on
the majority of our variable rate loans improved the overall yield on
loans.




Page
33




Average Balances and Average Rates
Earned and Paid.  The following
table sets forth, for the years 2007 through 2009, 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.





NET
INTEREST INCOME





For the Years Ended December 31,2009
                    
                    
                    2008
                    
                    
                    2007Average
                      balance
                    
                    
                    Interest
                      earned/paid
                    
                    
                    Average
                      yield/cost
                    
                    
                    Average
                      balance
                    
                    
                    Interest
                      earned/paid
                    
                    
                    Average
                      yield/cost
                    
                    
                    Average
                      balance
                    
                    
                    Interest
                      earned/paid
                    
                    
                    Average
                      yield/cost(Dollars in thousands)Interest-earning
      assets:Loans
      (1)
                    
                    $
                    1,272,087
                    
                    
                    $
                    74,548
                    
                    
                    
                    5.86
                    %
                    
                    $
                    1,279,041
                    
                    
                    $
                    82,125
                    
                    
                    
                    6.42
                    %
                    
                    $
                    1,114,677
                    
                    
                    $
                    86,673
                    
                    
                    
                    7.78
                    %Investment
      securities available for sale
                    
                    
                    327,487
                    
                    
                    
                    14,035
                    
                    
                    
                    4.29
                    %
                    
                    
                    257,153
                    
                    
                    
                    12,378
                    
                    
                    
                    4.81
                    %
                    
                    
                    179,995
                    
                    
                    
                    8,819
                    
                    
                    
                    4.90
                    %Investment
      securities held to maturity
                    
                    
                    18,751
                    
                    
                    
                    877
                    
                    
                    
                    4.68
                    %
                    
                    
                    48,252
                    
                    
                    
                    2,184
                    
                    
                    
                    4.53
                    %
                    
                    
                    71,510
                    
                    
                    
                    3,208
                    
                    
                    
                    4.49
                    %Federal
      funds sold
                    
                    
                    19,846
                    
                    
                    
                    14
                    
                    
                    
                    .07
                    %
                    
                    
                    4,096
                    
                    
                    
                    55
                    
                    
                    
                    1.34
                    %
                    
                    
                    4,231
                    
                    
                    
                    208
                    
                    
                    
                    4.92
                    %Total
      interest-earning assets
                    
                    
                    1,638,171
                    
                    
                    
                    89,474
                    
                    
                    
                    5.46
                    %
                    
                    
                    1,588,542
                    
                    
                    
                    96,742
                    
                    
                    
                    6.09
                    %
                    
                    
                    1,370,413
                    
                    
                    
                    98,908
                    
                    
                    
                    7.22
                    %Other
      assets
                    
                    
                    128,876
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    150,326
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    143,206Total
      assets
                    
                    $
                    1,767,047
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    $
                    1,738,868
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    $
                    1,513,619Interest-bearing
      liabilities:Deposits:NOW
      and money market
                    
                    $
                    466,667
                    
                    
                    $
                    6,787
                    
                    
                    
                    1.45
                    %
                    
                    $
                    510,357
                    
                    
                    $
                    11,412
                    
                    
                    
                    2.24
                    %
                    
                    $
                    441,716
                    
                    
                    $
                    15,499
                    
                    
                    
                    3.51
                    %Time
      deposits greater than $100,000
                    
                    
                    193,505
                    
                    
                    
                    4,833
                    
                    
                    
                    2.50
                    %
                    
                    
                    137,841
                    
                    
                    
                    6,695
                    
                    
                    
                    4.86
                    %
                    
                    
                    311,125
                    
                    
                    
                    14,135
                    
                    
                    
                    4.54
                    %Other
      time deposits
                    
                    
                    486,721
                    
                    
                    
                    14,798
                    
                    
                    
                    3.04
                    %
                    
                    
                    428,950
                    
                    
                    
                    16,541
                    
                    
                    
                    3.86
                    %
                    
                    
                    169,236
                    
                    
                    
                    8,889
                    
                    
                    
                    5.25
                    %Borrowings
                    
                    
                    354,812
                    
                    
                    
                    11,307
                    
                    
                    
                    3.19
                    %
                    
                    
                    397,391
                    
                    
                    
                    14,634
                    
                    
                    
                    3.68
                    %
                    
                    
                    328,909
                    
                    
                    
                    16,618
                    
                    
                    
                    5.05
                    %Total
      interest-bearing liabilities
                    
                    
                    1,501,705
                    
                    
                    
                    37,725
                    
                    
                    
                    2.51
                    %
                    
                    
                    1,474,539
                    
                    
                    
                    49,282
                    
                    
                    
                    3.34
                    %
                    
                    
                    1,250,986
                    
                    
                    
                    55,141
                    
                    
                    
                    4.41
                    %Demand
      deposits
                    
                    
                    107,461
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    104,978
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    108,874Other
      liabilities
                    
                    
                    10,229
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    13,597
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    15,066Stockholders'
      equity
                    
                    
                    147,652
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    145,754
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    138,693Total
      liabilities and stockholders' equity
                    
                    $
                    1,767,047
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    $
                    1,738,868
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    $
                    1,513,619Net
      interest income and net interest spread
                    
                    
                    
                    
                    
                    $
                    51,749
                    
                    
                    
                    2.95
                    %
                    
                    
                    
                    
                    
                    $
                    47,460
                    
                    
                    
                    2.75
                    %
                    
                    
                    
                    
                    
                    $
                    43,767
                    
                    
                    
                    2.81
                    %Net
      interest margin
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    3.16
                    %
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    2.99
                    %
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    3.19
                    %Ratio
      of average interest-earning assets to average interest-bearing
      liabilities
                    
                    
                    
                    
                    
                    
                    109.09
                    %
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    107.73
                    %
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    109.55
                    %





(1)
Nonaccrual notes are included in the loan amounts.




Page
34




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.





December 31, 2009 vs. 2008
                  
                  
                  December 31, 2008 vs. 2007Increase (Decrease) Due to
                  
                  
                  Increase (Decrease) Due toVolume
                  
                  
                  Rate
                  
                  
                  Total
                  
                  
                  Volume
                  
                  
                  Rate
                  
                  
                  Total(Amounts in thousands)Interest
      income:Loans
                  
                  $
                  (427
                  )
                  
                  $
                  (7,150
                  )
                  
                  $
                  (7,577
                  )
                  
                  $
                  11,667
                  
                  
                  $
                  (16,215
                  )
                  
                  $
                  (4,548
                  )Investment
      securities available for sale
                  
                  
                  3,200
                  
                  
                  
                  (1,543
                  )
                  
                  
                  1,657
                  
                  
                  
                  3,747
                  
                  
                  
                  (188
                  )
                  
                  
                  3,559Investment
      securities held to maturity
                  
                  
                  (1,358
                  )
                  
                  
                  51
                  
                  
                  
                  (1,307
                  )
                  
                  
                  (1,048
                  )
                  
                  
                  24
                  
                  
                  
                  (1,024
                  )Federal
      funds sold
                  
                  
                  111
                  
                  
                  
                  (153
                  )
                  
                  
                  (42
                  )
                  
                  
                  (4
                  )
                  
                  
                  (149
                  )
                  
                  
                  (153
                  )Total
      interest income
                  
                  
                  1,526
                  
                  
                  
                  (8,795
                  )
                  
                  
                  (7,269
                  )
                  
                  
                  14,362
                  
                  
                  
                  (16,528
                  )
                  
                  
                  (2,166
                  )Interest
      expense:Deposits:NOW
      and money market
                  
                  
                  (119
                  )
                  
                  
                  (4,506
                  )
                  
                  
                  (4,625
                  )
                  
                  
                  2,036
                  
                  
                  
                  (6,123
                  )
                  
                  
                  (4,087
                  )Time
      deposits greater than $100,000
                  
                  
                  2,047
                  
                  
                  
                  (3,909
                  )
                  
                  
                  (1,862
                  )
                  
                  
                  (8,145
                  )
                  
                  
                  705
                  
                  
                  
                  (7,440
                  )Other
      time deposits
                  
                  
                  1,992
                  
                  
                  
                  (3,735
                  )
                  
                  
                  (1,743
                  )
                  
                  
                  11,829
                  
                  
                  
                  (4,177
                  )
                  
                  
                  7,652Borrowings
                  
                  
                  (2,900
                  )
                  
                  
                  (426
                  )
                  
                  
                  (3,326
                  )
                  
                  
                  2,895
                  
                  
                  
                  (4,879
                  )
                  
                  
                  (1,984
                  )Total
      interest expense
                  
                  
                  1,020
                  
                  
                  
                  (12,756
                  )
                  
                  
                  (11,556
                  )
                  
                  
                  8,615
                  
                  
                  
                  (14,474
                  )
                  
                  
                  (5,859
                  )Net
      interest income increase (decrease)
                  
                  $
                  506
                  
                  
                  $
                  3,781
                  
                  
                  $
                  4,287
                  
                  
                  $
                  5,747
                  
                  
                  $
                  (2,054
                  )
                  
                  $
                  3,693





RESULTS
OF OPERATIONS


Years
Ended December 31, 2009 and 2008





Net Income (Loss).Our net loss
for 2009 was $63.2 million, a decrease of $69.0 million from net income of $5.8
million earned in 2008.  Net income (loss) available to common
shareholders was ($65.7) million and $5.7 million for 2009 and 2008,
respectively.  Net income (loss) per share available to common
shareholders was $(3.91) basic and diluted for the year ended December 31, 2009
and $0.33 basic and diluted for 2008.  Net interest income for 2009
was $51.7 million, up $4.3 million or 9.0%, compared with 2008, due to
improvement in the net interest margin.  The net interest margin of
3.16% improved 17 basis points from the year ago period.  One
significant factor for the loss for the year was the elevated level of asset
quality costs, including a provision for loan losses of $34.0 million for the
year.  Non-interest income was $12.9 million for the year of 2009,
which represents an increase of $1.6 million or 13.8% from non-interest income
of $11.3 million reported for the year of 2008.  The largest increase
in non-interest income was from gain on sale of investment securities which
increased $1.1 million, while the largest decrease was from losses on derivative
activity which decreased $700 thousand for the year.  Non-interest
expense increased $58.4 million, or 138.4%, compared with the previous
year.  The largest increase in non-interest expense resulted from
recognizing a goodwill impairment charge of $49.5 million which, along with the
increase in the loan loss provision and other loan related costs, generated the
loss for the year.  During 2009, average earning assets increased
$49.6 million or 3.1% to $1.64 billion, and average interest bearing liabilities
rose $27.2 million or 1.8%.  A total favorable rate variance of $3.8
million resulted in the improvement in the interest rate margin while the
favorable volume variance was minimal at $506 thousand.




Page
35




Net Interest Income.During 2009,
our net interest income increased $4.3 million or 9.0% to $51.7
million.  Interest income decreased as a result of weak loan demand,
declining market asset yields and reversal of interest income from loans being
reclassified into a non-accrual status.  Our cost of funds decreased
to a greater extent due to an improved deposit mix with a higher percentage of
deposits being in lower cost transaction accounts and reduced levels of higher
cost borrowings.  Average total interest-earning assets increased
$49.6 million, or 3.1%, during 2009 as the average loan balances decreased $7.0
million, the average investment securities portfolio increased $40.8 million, or
13.4%, and federal funds sold increased $15.8 million or 384.5%.  Our
average total interest-bearing liabilities increased by $27.2 million, or
1.8%.  Approximately 44% of the loan portfolio is composed of fixed
rate loans while 56% have a variable interest rate which generally adjusts
immediately when index rates, such as our prime rate,
changes.  However, during 2009, the Company increased its utilization
of interest rate floors on a majority of its variable rate loans which slowed
the decline in its loan yields in 2009.  In addition to the impact of
declining market interest rates on asset yields, the interest foregone for loans
in a nonaccrual status for 2009 was $1.2 million.  Transaction deposit
accounts including NOW and money market accounts also have variable interest
rates; although changes are determined by management and are not based on a
specific index such as prime.  Our certificates of deposit and certain
borrowings have rates that are fixed until maturity.  While repricing
of fixed rate certificates of deposit and borrowings are delayed until renewal,
our floating rate borrowings are primarily LIBOR-based, and changes in LIBOR
rates more closely match changes in interest rates than changes in the prime
rate.





During
2009, the Federal Reserve maintained the federal funds target rate consistent
with year-end 2008 at a range of zero to 0.25%.  The federal funds
rate is currently at a historical low, surpassing the previous low of 1.00% in
June of 2003.  Although the federal funds rate did not change during
the year, the yield on earning assets decreased 63 basis points while our
funding costs decreased 83 basis points.  Net interest income
increased on improved deposit mix, declining borrowing balances and maintaining
a greater portion of yields on loans with the increased utilization of interest
rate floors or variable rate loans during this period of declining market
interest reference rates such as LIBOR.





We will
continue to evaluate ways to improve our net interest margin.  We
expect competition for loan production during this time of weak loan demand to
keep pressure on loan yields; while competition for deposits and the related
deposit costs will not be as intense as in some prior years.  This
should assist us in improving our net interest margin in 2010.  A
significant portion of the funds received from the TARP program have been used
to reduce borrowings and will be used to fund loans when loan demand
improves.  The cost of these are paid as a dividend and not recorded
as interest expense which increases net interest income and improves the net
interest margin.





Provision for Loan
Losses.  We recorded a $34.0 million provision for loan losses
for the year 2009 representing an increase of $25.8 million from the $8.2
million provision for the full year 2008.  The level of provisions is
reflective of the trends in the loan portfolio, including levels of
nonperforming loans and other loan portfolio quality measures, and analyses of
impaired loans.  Provisions for loan losses are charged to income to
bring our allowance for loan losses to a level deemed appropriate by management
based on the factors discussed under “Analysis of Allowance for Loan
Losses.”  The provision for loan losses was 2.67% and 0.64% of average
loans in 2009 and 2008, respectively.  Our percentage of net loan
charge-offs to average loans outstanding was 1.82% for the year ended December
31, 2009, compared with 0.28% for the year ended December 31,
2008.  Nonperforming loans totaled $37.7 million, or 3.07%, of total
loans at December 31, 2009 compared with $14.4 million, or 1.10%, of total loans
at December 31, 2008.  Nonperforming loans and increased net
charge-offs continue to be predominantly related to residential construction and
development lending although we are now beginning to see increased stress in the
commercial real estate portfolio as the weak economy persists.  The
allowance for loan losses at December 31, 2009 of $29.6 million represents 2.41%
of total loans and 0.79% of nonperforming loans.  The allowance for
loan losses at December 31, 2008 of $18.9 million was 1.43% of total loans
outstanding and 131% of nonperforming loans at that date.




Page
36




Non-Interest Income. For the year
ended December 31, 2009, non-interest income increased $1.6 million, or 13.8%.
Gains on sales of investment securities increased $1.1 million although a
portion of the gains was offset by a loss on the early extinguishment of debt
recognized in noninterest expense.  Mortgage banking income increased
$810 thousand as mortgage origination volume increased from refinance activity
during the second and third quarters of 2009.  Service charges on
deposit accounts increased $387 thousand, or 6.6%, of which $184 thousand was
due to increased fees and growth of new deposit accounts, a $344 thousand
increase in debit card income and a decrease of $141 thousand in NSF
fees.  Income from the investment in SBIC activities increased $88
thousand with income of $148 thousand in 2009 compared to $60 thousand in
2008.  The SBIC recognized write-downs in their investments in small
companies who were not able to survive the current economic weakness during
2009.  Gains on economic hedges for 2009 were $234 thousand, a
decrease of $700 thousand compared to $934 thousand in the prior
year.  The year to date decrease included a second quarter
non-recurring $1.0 million write-off of collateral held by Lehman Brothers as
the counterparty on certain terminated derivative contracts which was offset by
a partial recovery of $408 thousand received during the third
quarter.  In addition, gains on derivative activity were also less in
2009 as $1.4 million in nonrecurring gains were recognized in 2008 from calls of
certain brokered deposits and related derivative contracts.  Income
from investment brokerage and trust fees increased from the prior year by $21
thousand to $1.2 million.





Non-Interest
Expense.  The significant increase in non-interest expense in
2009 was due primarily to recognizing non-recurring and non-controllable
expenses and also a reflection of the continued difficult economic
environment.  The most significant expense during 2009 was the $49.5
million goodwill impairment charge which was related to the goodwill generated
by the merger with The Community Bank in January 2004.  The FDIC
deposit insurance assessment for 2009 totaled $3.1 million, an increase of $2.3
million, or 284.4%, including a special assessment of $789
thousand.  FDIC assessments for 2010 and following years will continue
at increased premium rates to rebuild the Deposit Insurance Fund that has been
stressed during the recent economic downturn.  Non-interest expense
related to troubled loans also increased sharply as OREO writedowns increased
$2.4 million and expenses to maintain foreclosed property increased $603
thousand or 215.6%.  The Company began a buyer incentive program near
the end of 2008 to assist contractors in the sales of speculative houses
financed by the Bank.  Under this program, the Bank paid up to $10
thousand to home buyers that purchased certain bank-financed speculative
houses.  The expense for this program during 2009 was $1.3 million
which was a factor in the sales of approximately 130 homes.  Salary
and employee benefits expense increased $464 thousand, or 2.1%, due to health
insurance, which increased $451 thousand, and an increase in commissions of $932
thousand, which was offset by a decrease in incentive pay of $612
thousand.  Cost reductions were established during 2009 including
salary reductions for executive management, a salary increase freeze for all
employees and reducing the 401(k) employer match from 100% to 50% in late third
quarter.  This reduction in 401(k) benefits amounted to $138 thousand
or 16.9%.  Occupancy and equipment expense increased $224 thousand, or
2.9%, in the normal course of business.  Other non-interest expense
increases during 2009 included $403 thousand in professional expenses, $328
thousand in operating charge-offs and $315 thousand in debit card
expense.  Professional expenses increased due to higher legal and
collection costs.  Operating charge-offs reflect a weaker economic
climate.  The debit card expense increase is reflective of increased
transaction volume, as evidenced with our increase in debit card
income.





Provision for Income
Taxes.  The Company recorded an income tax benefit of $6.7
million for the year ending December 31, 2009 compared to income tax expense of
$2.6 million for 2008.  The tax benefit was primarily the result of
the increased provision for loan losses, loan expenses including write-downs and
other increased expenses.  The effective rate for 2009 was (9.6%)
compared to 31.0% for 2008.  The effective rate is reflective of the
impact of tax exempt interest income and income from bank owned life insurance
for both years while the non-deductible goodwill impairment charge was the most
significant factor for the unusually low rate for 2009.  The effective
rate for 2009 was also affected by a $2.0 million valuation allowance related to
the ability of the Company to realize the deferred tax asset for the allowance
for loan losses.





RESULTS
OF OPERATIONS


Years
Ended December 31, 2008 and 2007





Net Income.Our net
income for 2008 was $5.9 million, a decrease of $1.7 million from net income of
$7.6 million earned in 2007.  Net income available to common
shareholders was $5.7 million for 2008.  Net income per common share
was $0.33 basic and diluted for the year ended December 31, 2008 and $0.43 basic
and diluted for 2007.  The decrease is due primarily to the increase
in the provision for loan losses and the decrease in income from our small
business investment company (SBIC) activities.  We have continued to
experience strong asset growth, driven by solid loan growth of $124.8 million or
10.5% and an increase of $105.5 million or 46.1% in investment securities, which
was supported by an increase of $187.9 million in our deposit base and an
increase of $808 thousand in our borrowings.  During 2008, average
earning assets increased $218.1 million or 15.9% to $1.59 billion, and average
interest bearing liabilities rose $223.6 million or 17.9%.  The impact
of the strong loan growth produced a favorable total volume variance ($5.7
million), partially offset by the impact of margin compression resulting in a
negative total rate variance ($2.0 million), produced a net increase in net
interest income of $3.7 million, or 8.4% for 2008 compared with
2007.  The provision for loan losses increased to $8.2 million from
$2.8 million in 2007 as nonperforming loans and net charge-offs increased
substantially in 2008 compared with 2007.




Page
37




Non-interest
income remained relatively unchanged in total from the prior year at $11.3
million, with a decrease of $49 thousand although the components changed
significantly.  Income from the investment in SBIC activities
decreased $2.0 million from the prior year which was offset by increases in
service charges of $928 thousand, hedging activities of $855 thousand, other
non-interest income of $165 thousand and gains from sales of investment
securities of $98 thousand.  These increases in non-interest income
categories were offset by decreases in income from mortgage banking activities
of $49 thousand and income from wealth management of $3 thousand as well as
income from SBIC activities.  Non-interest expenses increased $1.2
million or 2.9% as the Company’s pace of infrastructure expansion moderated
significantly.





Net Interest Income.During 2008,
our net interest income increased $3.7 million or 8.4% to $47.5
million.  Interest income increased as a result of growth in our
overall level of average earning assets primarily from strong loan demand and
additional purchases of investment securities.  Average total
interest-earning assets increased $218.1 million, or 15.9% during 2008, as the
average loan balances increased $164.3 million and the average investment
securities portfolio and federal funds sold increased $53.8 million or
21.0%.  Our average total interest-bearing liabilities increased by
$223.6 million, or 17.9%.  Approximately 44% of the loan portfolio is
composed of fixed rate loans while 56% have a variable interest rate which
generally adjusts immediately when index rates, such as our prime rate,
changes.  Transaction deposit accounts including NOW and money market
accounts also have variable interest rates; although changes are determined by
management and are not based on a specific index such as prime.  Our
certificates of deposit and certain borrowings have rates that are fixed until
maturity.  While repricing of fixed rate certificates of deposit and
borrowings are delayed until renewal, our floating rate borrowings are primarily
LIBOR-based, and changes in LIBOR rates typically are in advance of changes in
the prime rate.  As a result, interest rate decreases have generally
resulted in an immediate decrease in our interest income on loans.





Interest
rates declined steadily during 2008 as the Federal Reserve decreased the
targeted federal funds rate seven times for a total of 400 basis points to end
the year at a range of 0.00% to 0.25%.  The federal funds rate is
currently at an historical low surpassing the previous low of 1.00% in June of
2003.  The rate reductions in 2008 continued a trend of three
decreases totaling 100 basis points in the last quarter of 2007.  As
the federal funds rate decreased, the prime interest rate changed by the same
amount leaving the prime rate at 3.25% at the end of the year.  The
declining interest rate environment throughout the year resulted in a decrease
of 113 basis points for earning assets (136 basis points decrease in loan yields
and only 6 basis point decrease in the yields of investment securities); while
our funding costs decreased 107 basis points.  Although net interest
income increased on increased earning asset balances compared to the prior year,
the net interest margin decreased 20 basis points due to lags in deposit
repricing, a shift in deposit composition from lower yielding to higher yielding
time deposits and deposit pricing as a result of intense competition for
deposits.





Provision for Loan
Losses.  We recorded a $8.2 million provision for loan losses
for the year ended December 31, 2008, representing an increase of $5.4 million
from the $2.8 million provision we made for the year ended December 31,
2007.  The level of provisions is reflective of the trends in the loan
portfolio, including loan growth, levels of nonperforming loans and other loan
portfolio quality measures, and analyses of impaired
loans.  Provisions for loan losses are charged to income to bring our
allowance for loan losses to a level deemed appropriate by management based on
the factors discussed under “Analysis of Allowance for Loan
Losses.”  The provision for loan losses was 0.64% and 0.25% of average
loans in 2008 and 2007 respectively.  On an annualized basis, our
percentage of net loan charge-offs to average loans outstanding was 0.28% for
the year ended December 31, 2008, compared with 0.14% for the year ended
December 31, 2007.  Nonperforming loans totaled $14.4 million, or
1.10%, of total loans at December 31, 2008, compared with $2.1 million, or
0.17%, of total loans at December 31, 2007.  Nonperforming loans and
increased net charge-offs continue to be predominantly related to residential
construction and development lending.  The allowance for loan losses
at December 31, 2008 of $18.9 million represents 1.43% of total loans and 1.31
times nonperforming loans.  The allowance for loan losses at December
31, 2007 of $14.3 million was 1.20% of total loans outstanding and 6.95 times
nonperforming loans at that date.




Page
38




Non-Interest Income. For the year
ended December 31, 2008, non-interest income decreased $49 thousand, or 0.43%,
to remain relatively unchanged at $11.3 million compared to the prior year;
although the components changed significantly.  Income from the
investment in SBIC activities decreased $2.0 million with income of $60 thousand
in 2008 compared to $2.1 million in 2007.  The SBIC recognized
write-downs in their investments in small companies who were not able to survive
the current economic weakness during 2008.  In 2007, the SBIC recorded
some substantial gains including a $1.2 million gain from the exit of certain
portfolio companies in the first quarter.  Gains on economic hedges
for 2008 were $934 thousand, an increase of $855 thousand compared to $79
thousand in the prior year.  Since 2003, the Company has entered into
various interest rate swaps to hedge the interest rate risk inherent in certain
of its brokered certificates of deposit and believes these swaps have been
effective as economic hedges.  Due to the decline in market interest
rates during the year, all of the brokered certificates of deposit and the
related derivatives were called during the first six months of
2008.  As these derivatives and the related brokered deposits were
called prior to maturity, a gain was recognized in non-interest income which
totaled $1.4 million for the first six months of 2008.  During the
third quarter of 2008, Lehman Brothers, the counterparty for two economic
hedges, became insolvent and unable to comply with the terms of the hedges
thereby causing a termination of these derivative contracts by Lehman’s
technical default.  The Company was “in the money” on these contracts,
creating an asset whose collectability was in doubt and therefore was written
off creating the $440 thousand loss in the third quarter.  Service
charges increased $928 thousand or 18.8% during the year primarily due to an
increase of $746 thousand in NSF charges.  Income from investment
brokerage and trust fees increased from the prior year by $223 thousand to $1.1
million on higher transaction volumes in the first half of 2008.  Fees
and income from the origination and sale of residential mortgage loans decreased
$49 thousand or 3.7% to $1.3 million as purchase application volumes decreased
sharply in the second half of 2008.





Non-Interest
Expense.  We strive to maintain non-interest expenses at levels
that we believe are appropriate given the nature of our operations and the
investments in personnel and facilities that have been necessary to support our
growth.  From 1998 forward, we have consistently maintained our ratio
of non-interest expenses to average total assets below 3.0%.  For
2008, our ratio was 2.42%, down from 2.70% in 2007.  As our franchise
expansion slowed during 2008, the rate of increase in non-interest expense also
decreased.  This is also reflected in the decrease in our efficiency
ratio to 71.65% for 2008 from 74.23% for 2007.  For the year ended
December 31, 2008, our non-interest expense grew by $1.2 million, or
2.9%.  Salary and employee benefits expense increased $820 thousand,
or 3.9%, and were attributable to normal increases in operation for salaries,
commissions and employee benefits.  Occupancy and equipment expense
decreased $249 thousand, or 3.1%, as the depreciation expense for facilities and
equipment moderated and other efficiencies were realized.  Other
non-interest expenses increased $618 thousand, or 5.3%, reflecting the increased
volume of business activity, an increase of $367 thousand in the Bank’s FDIC
deposit insurance assessment and the write-off of $291 thousand of goodwill from
a former investment in a mortgage company.





Provision for Income
Taxes.Our provision
for income taxes, as a percentage of income before income taxes, was 31.0% for
the year ending December 31, 2008 and 33.9% for the year ended December 31,
2007, reflective of the impact of tax-exempt interest income and increased
income from bank owned life insurance as a larger percentage of pre-tax
income.




Page
39




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.





Beginning
in December 2007 and throughout 2008, the United States Department of the
Treasury in coordination with the Federal Reserve and Federal Deposit Insurance
Corporation (FDIC) implemented several initiatives to stimulate the economy and
maintain liquidity in our national financial markets in the face of
unprecedented economic conditions.  The Federal Reserve introduced
three new liquidity facilities, in addition to its primary discount window
borrowing program, the Term Auction Facility (TAF), the Term Securities Lending
Facility (TSLF) and the Primary Dealer Credit Facility (PDCF).  These
initiatives were designed to lengthen the duration of access to liquidity,
broaden the types of eligible collateral, expand the range of counterparties for
some activities and reduce the cost of borrowings from the Fed relative to the
federal funds rate.  PDCF for primary dealers provided daily access to
funding to eligible institutions.  The TAF and TSLF constituted a
second type of facility in which a pre-determined amount of longer-term funding
(for a 28 day period or 84 day period) is available at auction on pre-announced
dates for settlement on a later date.  The interest rate and the
distribution of the awards across bidding institutions are determined by the
results of each auction.  The TAF allows banks to borrow against a
wide range of collateral, including securities that are not widely pledged in
private markets and bank loans.  Since the inception of these
initiatives, the Federal Reserve has committed to keep this new array of
liquidity facilities in place for as long as is necessary to maintain liquidity
and promote stability in our financial markets.  On January 27, 2010,
the Federal Reserve announced the closure of the TSLF and the PDCF on February
1, 2010 in light of improved functioning of financial markets, and the final TAF
borrowings were offered at their final auction on March 8,
2010.    The Company utilized the TAF throughout 2009 but
repaid all borrowings during December 2009.





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. The primary sources of
borrowed funds are from the Federal Home Loan Bank, under the Federal Reserve’s
discount window, and from correspondent banks under overnight federal funds
credit lines and revolving lines of credit.  In addition to managing
deposit and borrowing outflows, the Company’s primary demand for liquidity is
anticipated funding under credit commitments to customers.





We have
maintained a sufficient level of liquidity in the form of federal funds sold and
investment securities.  These liquid assets aggregated $353.8 million
at December 31, 2009, compared to $300.9 million and $231.2 million at December
31, 2008 and 2007, respectively.  The increase in 2009 resulted from
increased federal funds sold as deposits have continued to grow while loan
demand has been weak.  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 $102.0
million.  As of December 31, 2009, the Bank has the credit capacity to
borrow up to $431.2 million, from the Federal Home Loan Bank of Atlanta, with
$104.5 million outstanding as of that date.  The Company utilized the
Federal Reserve’s TAF discussed above, throughout 2009 but had no borrowings
outstanding as of December 31, 2009.  At December 31, 2009, we had
funding of $90.0 million in the form of long term repurchase agreements with
$10.0 million maturing within one year and $80.0 million with maturities from
one to ten years.  We also had short-term repurchase agreements with
total outstanding balances of $4.9 million and $13.2 million at December 31,
2009 and 2008, respectively, all of which were done as accommodations for our
deposit customers.  Securities sold under agreements to repurchase are
collateralized by U.S. government agency obligations.  As of December
31, 2009, the Bank had repurchase lines of credit aggregating $100.0 million
from various institutions.  The repurchases must be adequately
collateralized.




Page
40




Throughout
our thirteen-year history, our loan demand has typically exceeded our growth in
core deposits.  We have therefore relied heavily on certificates of
deposit as a source of funds.  While the majority of these funds are
generally from our local market area, the Bank has utilized brokered and
out-of-market certificates of deposit to diversify and supplement our deposit
base.  In 2009, deposit growth shifted from time deposits to
non-maturity deposits as customers focused on liquidity during the declining
interest rate environment.  Certificates of deposit represented 46.9%
of our total deposits at December 31, 2009, a decrease from 53.2% at December
31, 2008.  Brokered and out-of-market certificates of deposit totaled
$214.8 million at year-end 2009 and $261.2 million at year-end 2008, which
comprised 15.9% and 21.2% of total deposits, respectively.  The
Company relied more on brokered and out-of-market certificates of deposit during
periods of irrational deposit pricing in 2008 as some of the largest banks in
our market area paid premium deposit rates to secure their necessary funding for
liquidity purposes after the national commercial paper markets dried
up.  We will continue to monitor the costs of our various funding
alternatives and our funding mix may change from time to
time.  Certificates of deposit of $100 thousand or more, inclusive of
brokered and out-of-market certificates, represented 13.2% of our total deposits
at December 31, 2009 and 14.5% at December 31, 2008.  A portion of
these deposits 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
deposit 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.





At
December 31, 2009, our outstanding commitments to extend credit consisted of
loan commitments of $284.6 million, including amounts available under home
equity credit lines and letters of credit of $98.1 million and $8.3 million,
respectively. We believe that our combined aggregate liquidity position from all
sources is sufficient to meet the funding requirements of loan demand, deposit
and borrowings maturities and deposit withdrawals in the near term.




Page
41




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, 2009.





Payments Due by PeriodOn Demandor Within
                      
                      
                      
                      
                      
                      
                      
                      
                      AfterContractual Obligations
                      
                      Total
                      
                      
                      1 Year
                      
                      
                      2 - 3 Years
                      
                      
                      4 - 5 Years
                      
                      
                      5 Years(In thousands)Short-term
      borrowings
                      
                      $
                      85,477
                      
                      
                      $
                      85,477
                      
                      
                      $
                      -
                      
                      
                      $
                      -
                      
                      
                      $
                      -Long-term
      borrowings
                      
                      
                      199,103
                      
                      
                      
                      -
                      
                      
                      
                      41,250
                      
                      
                      
                      35,000
                      
                      
                      
                      122,853Operating
      leases
                      
                      
                      4,635
                      
                      
                      
                      1,046
                      
                      
                      
                      1,324
                      
                      
                      
                      637
                      
                      
                      
                      1,628Total
      contractual cash obligations excluding deposits
                      
                      
                      289,215
                      
                      
                      
                      86,523
                      
                      
                      
                      42,574
                      
                      
                      
                      35,637
                      
                      
                      
                      124,481Deposits
                      
                      
                      1,314,070
                      
                      
                      
                      947,446
                      
                      
                      
                      266,405
                      
                      
                      
                      100,219
                      
                      
                      
                      -Total
      contractual cash obligations
                      
                      $
                      1,603,285
                      
                      
                      $
                      1,033,969
                      
                      
                      $
                      308,979
                      
                      
                      $
                      135,856
                      
                      
                      $
                      124,481





The
following table reflects other commitments of the Company outstanding as of
December 31, 2009.





Amount of Commitment Expiration Per PeriodWithin
                  
                  
                  
                  
                  
                  
                  
                  
                  AfterOther Commitments
                  
                  Total
                  
                  
                  1 Year
                  
                  
                  2 - 3 Years
                  
                  
                  4 - 5 Years
                  
                  
                  5 Years(In thousands)Undisbursed
      portion of home equity credit lines collateralized primarily by junior
      liens on 1-4 family properties
                  
                  $
                  98,065
                  
                  
                  $
                  242
                  
                  
                  $
                  2,485
                  
                  
                  $
                  4,868
                  
                  
                  $
                  90,470Other
      commitments and credit lines
                  
                  
                  122,104
                  
                  
                  
                  101,389
                  
                  
                  
                  6,648
                  
                  
                  
                  9,512
                  
                  
                  
                  4,555Undisbursed
      portion of construction loans
                  
                  
                  54,435
                  
                  
                  
                  30,041
                  
                  
                  
                  7,397
                  
                  
                  
                  4,008
                  
                  
                  
                  12,989Mortgage
      loan commitments
                  
                  
                  9,954
                  
                  
                  
                  9,954
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Other
      purchase commitments
                  
                  
                  800
                  
                  
                  
                  400
                  
                  
                  
                  400
                  
                  
                  
                  -
                  
                  
                  
                  -Total
      other commitments
                  
                  $
                  285,358
                  
                  
                  $
                  142,026
                  
                  
                  $
                  16,930
                  
                  
                  $
                  18,388
                  
                  
                  $
                  108,014




Page
42




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,
2009, Southern Community Capital Trust II, the subsidiary that issued 3,450,000
shares of Trust Preferred Securities in November 2003 and Southern Community
Capital Trust III, which issued $10.0 million in Trust Preferred Securities in
June 2007 represented the Company’s only SPE activity.  The Trust
Preferred Securities are backed by junior subordinated debentures issued by the
Company, which are included in long-term borrowings on the balance
sheet.





CAPITAL
RESOURCES





Stockholders’
equity at December 31, 2009 was $122.0 million.  At that date, the
Company’s capital to asset ratio was 7.06% and all of our regulatory capital
ratios exceeded the minimums established for a well capitalized bank holding
company.





The Bank
and the Company are subject to minimum capital requirements.  See
“SUPERVISION AND REGULATION.”  As the following table indicates, at
December 31, 2009, the Company exceeded its regulatory capital
requirements.





At December 31, 2009Actual Ratio
                  
                  
                  Minimum Requirement
                  
                  
                  Well Capitalized
                    RequirementsTotal
      risk-based capital ratio
                  
                  
                  12.92
                  %
                  
                  
                  8.00
                  %
                  
                  
                  10.00
                  %Tier
      1 risk-based capital ratio
                  
                  
                  11.34
                  %
                  
                  
                  4.00
                  %
                  
                  
                  6.00
                  %Leverage
      ratio
                  
                  
                  9.14
                  %
                  
                  
                  4.00
                  %
                  
                  
                  5.00
                  %





Under the
United States Treasury’s Capital Purchase Program (CPP), the Company issued
$42.75 million in Cumulative Perpetual Preferred Stock, Series A, on December 5,
2008.  In addition, the Company provided warrants to the Treasury to
purchase 1,623,418 shares of the Company’s common stock at an exercise price of
$3.95 per share.  These warrants are immediately exercisable and
expire ten years from the date of issuance.  The preferred stock is
non-voting, other than having class voting rights on certain matters, and pays
cumulative dividends quarterly at a rate of 5% per annum for the first five
years and 9% per annum thereafter.  The preferred shares are
redeemable at the option of the Company subject to regulatory
approval.





As a
condition of the CPP, the Company must obtain consent from the United States
Department of the Treasury to repurchase its common stock or to increase its
cash dividend on its common stock from the September 30, 2008 quarterly level of
$0.04 per common share.  The Company agreed to certain restrictions on
executive compensation, including limitations on amounts payable to certain
executives under severance arrangements and change in control provisions of
employment contracts and clawback provisions in compensation plans, as part of
the CPP.During 2009, Congress and
the United States Treasury Department imposed additional restrictions on
executive compensation, including a prohibition on severance arrangements with
certain executive officers, limitations on incentive compensation and various
corporate governance requirements that are applicable to participants in the
CPP.





On March
24, 2009, Southern Community Financial Corporation announced that its Board of
Directors voted to suspend payment of a quarterly cash dividend to common
shareholders.  The Board will continue to evaluate a payment of a
quarterly cash dividend on a periodic basis.  During 2009, the Company
declared and paid one quarterly cash dividend compared to four quarterly cash
dividends paid during 2008.  In the first quarter of 2005, the Company
paid a $0.12 per share annual dividend.  In the second quarter of
2005, we began paying quarterly dividends of $0.03 per share.  In June
2006, the quarterly dividend was increased to $0.035 per share and increased in
June of 2007 to $0.04 per share.  In total, the Company returned $2.7
million or $0.16 per share and $2.7 million or $0.155 per share to common
shareholders in the form of cash dividends during 2008 and 2007,
respectively.




Page
43




The
Company’s dividend policy is subject to the discretion of our Board of Directors
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.  Our
ability to pay dividends in the future will directly depend on future
profitability, which cannot be accurately estimated or assured.  In
light of the current economic environment, the FDIC Chairman has encouraged
banks to consider reducing their dividends to preserve capital.  We
cannot guarantee if or when we will resume paying quarterly cash dividends to
shareholders in the future.





The
Company’s Board of Directors authorized programs in March and September 2005 and
July 2006 to repurchase up to 300,000 shares, 600,000 shares and 1 million
shares of common stock, respectively.  During 2008 and 2007, 733,175
and 286,972 shares of common stock were repurchased and retired at an average
price of $3.68 and $8.21 per share, respectively.  Through December
31, 2008, the Company has repurchased 1,858,073 shares at an average price of
$6.99 per share under the three plans.  No shares were repurchased
during 2009.





The
Company’s trust preferred securities presently qualify as Tier 1 regulatory
capital and are reported in Federal Reserve regulatory reports as a minority
interest in our consolidated subsidiaries.  The junior subordinated
debentures do not qualify as Tier 1 regulatory capital.  The Board of
Governors of the Federal Reserve, on March 1, 2005, adopted a final rule
allowing the continued limited inclusion of trust preferred securities in Tier 1
capital.  The Board’s final rule limits restricted core capital
elements to twenty-five percent of all core capital elements.





In June
2007, $10.0 million of trust preferred securities were placed through Southern
Community Capital Trust III (“Trust III”), as part of a pooled trust preferred
security.  The Trust III issuer invested the total proceeds from the
sale of the trust preferred securities in junior subordinated deferrable
interest debentures (the “Junior Subordinated Debentures”) issued by the
Company.  The terms of the trust preferred securities require payment
of cumulative cash distributions quarterly at an annual rate, reset quarterly,
equal to LIBOR plus 1.43%.  During 2008, the Company entered into an
interest rate swap derivative contract with a counterparty that shifted this
debt service from a variable rate to a fixed rate of 4.7% per
annum.  The dividends paid to holders of the trust preferred
securities, which are recorded as interest expense, are deductible for income
tax purposes.  The trust preferred securities are redeemable in 30
years with a five year call provision.  The Company has fully and
unconditionally guaranteed the trust preferred securities through the combined
operation of the debentures and other related documents.  The
Company’s obligation under the guarantee is unsecured and subordinate to senior
and subordinated indebtedness of the Company.  The principal use of
the net proceeds from the sale of the debentures was to provide additional
capital to the Company to fund its operations and continued expansion, and to
maintain the Company’s and the Bank’s status as “well capitalized” under
regulatory guidelines.





In
November of 2003, Southern Community Capital Trust II (“Trust II”), a newly
formed subsidiary of the Company, issued 3,450,000 shares of 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 junior subordinated debentures from the
Bank under the same terms and conditions as the Trust II
Securities.  We have the right to defer payment of interest on the
debentures at any time and from time to time for a period not exceeding five
years, provided that no deferral period 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.  If we defer the payment of interest on the debentures,
the Company will be precluded from the payment of cash dividends to
shareholders.  The principal uses of the net proceeds from the sale of
the debentures were to provide cash for the acquisition of The Community Bank,
to increase our regulatory capital, and to support the growth and operations of
our subsidiary bank.  The amount of proceeds qualifying for Tier 1
capital cannot comprise more than 25% of our core capital
elements.  Amounts in excess of the 25% limitation count as Tier 2
supplementary capital for regulatory purposes.




Page
44




ASSET/LIABILITY
MANAGEMENT





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





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





In
reviewing the needs of our Bank with regard to proper management of its
asset/liability program, we estimate future needs, taking into consideration
investment portfolio purchases, calls and maturities in addition to estimated
loan and deposit increases (due to increased demand through marketing) and
forecasted interest rate changes.  We use a number of measures to
monitor and manage interest rate risk, including net interest income simulations
and gap analyses.  A net interest income simulation model is the
primary tool used to assess the direction and magnitude of changes in net
interest income resulting from changes in interest rates.  Key
assumptions in the model include prepayment speeds on mortgage-related assets,
cash flows and maturities of other investment securities, loan and deposit
volumes and pricing.  These assumptions are inherently uncertain and,
as a result, the model cannot precisely estimate net interest income or
precisely predict the impact of higher or lower interest rates on net interest
income.  Actual results will differ from simulated results due to
timing, magnitude and frequency of interest rate changes and changes in market
conditions and management strategies, among other factors.  Based on
the results of the income simulation model as of December 31, 2009, if interest
rates increase instantaneously by two percentage points, our net interest income
over a one-year time frame could increase by approximately 12.9%, or $4.7
million.  As of December 31, 2009, if interest rates decrease
instantaneously by two percentage points, our net interest income over a
one-year time frame could decrease by approximately 12.4% or $4.5
million.  Given that interest rates were at historic low levels as of
December 31, 2009, it is very unlikely that rates would decrease by 2% from year
end 2009 levels.





The
analysis of interest rate gap (the difference between the amount of
interest-earning assets and interest-bearing liabilities repricing or maturing
during a given period of time) is another standard tool we use to measure
exposure to interest rate risk.  We believe that because interest rate
gap analysis does not address all factors that can affect earnings performance,
it should be used in conjunction with other methods of evaluating interest rate
risk.




Page
45




Our
balance sheet, based on gap measurements, was liability-sensitive at December
31, 2009 in the less than one-year horizon and asset-sensitive beyond one
year.  An asset-sensitive position means that there are more assets
than liabilities subject to repricing in that period as market rates change, and
conversely with a liability-sensitive position.  As a result, in a
falling rate environment, our earnings position could improve initially followed
by a reduction in net interest income, 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, 2009 will either
mature or be subject to repricing in accordance with market rates, and the
resulting interest-sensitivity gaps.  This table shows the sensitivity
of the balance sheet at one point in time and is not necessarily indicative of
what the sensitivity will be on other dates.  Included in
interest-bearing liabilities subject to rate changes within 90 days is 100% of
the money market, NOW and savings deposits.  These types of deposits
historically have not repriced coincidentally with or in the same proportion as
general market indicators.  As simplifying assumptions concerning
repricing behavior, all money market, NOW and savings deposits are assumed to
reprice immediately and fixed rate loans and mortgage-backed securities are
assumed to reprice at their contractual maturity.





At December 31, 20093 Months or Less
                
                
                Over 3 Months
                  to 12 Months
                
                
                Total Within
                  12 Months
                
                
                Over 12Months
                
                
                Total(Dollars in thousands)Interest-earning
      assetsLoans
                
                $
                236,112
                
                
                $
                274,670
                
                
                $
                510,782
                
                
                $
                719,493
                
                
                $
                1,230,275Investment
      securities available for sale
                
                
                -
                
                
                
                4,024
                
                
                
                4,024
                
                
                
                308,756
                
                
                
                312,780Investment
      securities held to maturity
                
                
                -
                
                
                
                4,755
                
                
                
                4,755
                
                
                
                6,164
                
                
                
                10,919Federal
      funds sold and other interest-bearing deposits
                
                
                31,269
                
                
                
                -
                
                
                
                31,269
                
                
                
                -
                
                
                
                31,269Total
      interest-earning assets
                
                $
                267,381
                
                
                $
                283,449
                
                
                $
                550,830
                
                
                $
                1,034,413
                
                
                $
                1,585,243Interest-bearing
      liabilitiesDeposits:Money
      market, NOW and savings deposits
                
                $
                579,027
                
                
                $
                -
                
                
                $
                579,027
                
                
                $
                -
                
                
                $
                579,027Time
      deposits greater than $100,000
                
                
                16,359
                
                
                
                49,366
                
                
                
                65,725
                
                
                
                112,400
                
                
                
                178,125Other
      time deposits
                
                
                75,589
                
                
                
                108,733
                
                
                
                184,322
                
                
                
                254,224
                
                
                
                438,546Borrowings
                
                
                85,477
                
                
                
                -
                
                
                
                85,477
                
                
                
                199,103
                
                
                
                284,580Total
      interest-bearing liabilities
                
                $
                756,452
                
                
                $
                158,099
                
                
                $
                914,551
                
                
                $
                565,727
                
                
                $
                1,480,278Interest
      sensitivity gap per period
                
                $
                (489,071
                )
                
                $
                125,350
                
                
                $
                (363,721
                )
                
                $
                468,686
                
                
                $
                104,965Cumulative
      gap
                
                $
                (489,071
                )
                
                $
                (363,721
                )
                
                $
                (363,721
                )
                
                $
                104,965
                
                
                $
                104,965Cumulative
      ratio of interest-sensitive assets to interest-sensitive
      liabilities
                
                
                35.35
                %
                
                
                60.23
                %
                
                
                60.23
                %
                
                
                107.09
                %
                
                
                107.09
                %




Page
46




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, 2009.




Expected Maturities of Market Sensitive Instruments Held
                          at December 31, 2009 Occurring in the Indicated Year(Dollars in thousands)
                        
                        
                        Average
                        
                        
                        EstimatedBeyond
                        
                        
                        
                        
                        
                        Interest
                        
                        
                        Fair2010
                        
                        
                        2011
                        
                        
                        2012
                        
                        
                        2013
                        
                        
                        2014
                        
                        
                        Five Years
                        
                        
                        Total
                        
                        
                        Rate
                        
                        
                        ValueFINANCIAL
      ASSETSFederal
      funds sold
                        
                        $
                        31,269
                        
                        
                        $
                        -
                        
                        
                        $
                        -
                        
                        
                        $
                        -
                        
                        
                        $
                        -
                        
                        
                        $
                        -
                        
                        
                        $
                        31,269
                        
                        
                        
                        0.07
                        %
                        
                        $
                        31,269Investment
      securities(1)
      (2)
                        
                        
                        8,779
                        
                        
                        
                        4,771
                        
                        
                        
                        6,757
                        
                        
                        
                        12,235
                        
                        
                        
                        2,332
                        
                        
                        
                        288,825
                        
                        
                        
                        323,699
                        
                        
                        
                        4.42
                        %
                        
                        
                        323,960Loans(3)Fixed
      rate
                        
                        
                        96,138
                        
                        
                        
                        75,896
                        
                        
                        
                        68,626
                        
                        
                        
                        101,659
                        
                        
                        
                        82,376
                        
                        
                        
                        114,408
                        
                        
                        
                        539,103
                        
                        
                        
                        6.26
                        %
                        
                        
                        560,405Variable
      rate
                        
                        
                        341,343
                        
                        
                        
                        83,575
                        
                        
                        
                        60,959
                        
                        
                        
                        28,885
                        
                        
                        
                        36,527
                        
                        
                        
                        139,883
                        
                        
                        
                        691,172
                        
                        
                        
                        5.21
                        %
                        
                        
                        696,160Total
                        
                        $
                        477,529
                        
                        
                        $
                        164,242
                        
                        
                        $
                        136,342
                        
                        
                        $
                        142,779
                        
                        
                        $
                        121,235
                        
                        
                        $
                        543,116
                        
                        
                        $
                        1,585,243
                        
                        
                        
                        5.30
                        %
                        
                        $
                        1,611,794FINANCIAL
      LIABILITIESMoney
      market, NOW and savings deposits
                        
                        $
                        579,027
                        
                        
                        $
                        -
                        
                        
                        $
                        -
                        
                        
                        $
                        -
                        
                        
                        $
                        -
                        
                        
                        $
                        -
                        
                        
                        $
                        579,027
                        
                        
                        
                        1.19
                        %
                        
                        $
                        579,027Time
      deposits
                        
                        
                        250,047
                        
                        
                        
                        173,535
                        
                        
                        
                        92,869
                        
                        
                        
                        17,095
                        
                        
                        
                        83,125
                        
                        
                        
                        -
                        
                        
                        
                        616,671
                        
                        
                        
                        2.66
                        %
                        
                        
                        755,442Short-term
      borrowings
                        
                        
                        85,477
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        85,477
                        
                        
                        
                        3.60
                        %
                        
                        
                        85,827Long-term
      borrowings
                        
                        
                        -
                        
                        
                        
                        16,250
                        
                        
                        
                        25,000
                        
                        
                        
                        10,000
                        
                        
                        
                        25,000
                        
                        
                        
                        122,853
                        
                        
                        
                        199,103
                        
                        
                        
                        3.67
                        %
                        
                        
                        211,581Total
                        
                        $
                        914,551
                        
                        
                        $
                        189,785
                        
                        
                        $
                        117,869
                        
                        
                        $
                        27,095
                        
                        
                        $
                        108,125
                        
                        
                        $
                        122,853
                        
                        
                        $
                        1,480,278
                        
                        
                        
                        2.27
                        %
                        
                        $
                        1,631,877





(1)
            Yields
      on tax-exempt investments have been adjusted to a taxable equivalent basis
      using federal and state tax rates of 34% and 6.9%, respectively, less
      estimated disallowed interest
expense.


(2)
            Callable
      securities and borrowings with favorable market rates at December 31, 2009
      are assumed to mature at their call dates for purposes of this
      table.


(3)
            Includes
      nonaccrual loans but not the allowance for loan
  losses.




Page
47




QUARTERLY
FINANCIAL INFORMATION





The
following table sets forth, for the periods indicated, certain of our
consolidated quarterly financial information.  This information is
derived from our unaudited financial statements, which include, in the opinion
of management, all normal recurring adjustments which management considers
necessary for a fair presentation of the results for such
periods.  This information should be read in conjunction with our
consolidated financial statements included elsewhere in this
report.  The results for any quarter are not necessarily indicative of
results for any future period.





Year Ended December 31, 2009
                  
                  
                  Year Ended December 31, 2008Fourth
                  
                  
                  Third
                  
                  
                  Second
                  
                  
                  First
                  
                  
                  Fourth
                  
                  
                  Third
                  
                  
                  Second
                  
                  
                  FirstQuarter
                  
                  
                  Quarter
                  
                  
                  Quarter
                  
                  
                  Quarter
                  
                  
                  Quarter
                  
                  
                  Quarter
                  
                  
                  Quarter
                  
                  
                  Quarter(In thousands, except per share data and common stock price)Interest
      income
                  
                  $
                  22,092
                  
                  
                  $
                  22,186
                  
                  
                  $
                  22,451
                  
                  
                  $
                  22,744
                  
                  
                  $
                  24,278
                  
                  
                  $
                  24,412
                  
                  
                  $
                  23,727
                  
                  
                  $
                  24,325Interest
      expense
                  
                  
                  8,701
                  
                  
                  
                  8,868
                  
                  
                  
                  9,872
                  
                  
                  
                  10,285
                  
                  
                  
                  11,459
                  
                  
                  
                  12,553
                  
                  
                  
                  11,947
                  
                  
                  
                  13,323Net
      interest income
                  
                  
                  13,391
                  
                  
                  
                  13,318
                  
                  
                  
                  12,579
                  
                  
                  
                  12,459
                  
                  
                  
                  12,819
                  
                  
                  
                  11,859
                  
                  
                  
                  11,780
                  
                  
                  
                  11,002Provision
      for loan losses
                  
                  
                  18,000
                  
                  
                  
                  6,000
                  
                  
                  
                  6,000
                  
                  
                  
                  4,000
                  
                  
                  
                  2,360
                  
                  
                  
                  1,350
                  
                  
                  
                  3,530
                  
                  
                  
                  925Net
      interest income (loss) after provision for loan losses
                  
                  
                  (4,609
                  )
                  
                  
                  7,318
                  
                  
                  
                  6,579
                  
                  
                  
                  8,459
                  
                  
                  
                  10,459
                  
                  
                  
                  10,509
                  
                  
                  
                  8,250
                  
                  
                  
                  10,077Non-interest
      income
                  
                  
                  3,526
                  
                  
                  
                  4,189
                  
                  
                  
                  2,610
                  
                  
                  
                  2,581
                  
                  
                  
                  2,518
                  
                  
                  
                  2,077
                  
                  
                  
                  3,098
                  
                  
                  
                  3,589Non-interest
      expense (1)
                  
                  
                  13,578
                  
                  
                  
                  12,621
                  
                  
                  
                  13,721
                  
                  
                  
                  60,578
                  
                  
                  
                  10,653
                  
                  
                  
                  10,204
                  
                  
                  
                  10,672
                  
                  
                  
                  10,560Income
      (loss) before income taxes
                  
                  
                  (14,661
                  )
                  
                  
                  (1,114
                  )
                  
                  
                  (4,532
                  )
                  
                  
                  (49,538
                  )
                  
                  
                  2,324
                  
                  
                  
                  2,382
                  
                  
                  
                  676
                  
                  
                  
                  3,106Income
      taxes
                  
                  
                  (3,944
                  )
                  
                  
                  (683
                  )
                  
                  
                  (1,845
                  )
                  
                  
                  (214
                  )
                  
                  
                  766
                  
                  
                  
                  754
                  
                  
                  
                  73
                  
                  
                  
                  1,041Net
      income (loss)
                  
                  
                  (10,717
                  )
                  
                  
                  (431
                  )
                  
                  
                  (2,687
                  )
                  
                  
                  (49,324
                  )
                  
                  
                  1,558
                  
                  
                  
                  1,628
                  
                  
                  
                  603
                  
                  
                  
                  2,065Effective
      dividend on preferred stock
                  
                  
                  627
                  
                  
                  
                  621
                  
                  
                  
                  633
                  
                  
                  
                  627
                  
                  
                  
                  185
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Net
      income (loss) available to common shareholders
                  
                  $
                  (11,344
                  )
                  
                  $
                  (1,052
                  )
                  
                  $
                  (3,320
                  )
                  
                  $
                  (49,951
                  )
                  
                  $
                  1,373
                  
                  
                  $
                  1,628
                  
                  
                  $
                  603
                  
                  
                  $
                  2,065Per
      common share data:Net
      income (loss):Basic
                  
                  $
                  (0.68
                  )
                  
                  $
                  (0.06
                  )
                  
                  $
                  (0.20
                  )
                  
                  $
                  (2.98
                  )
                  
                  $
                  0.08
                  
                  
                  $
                  0.09
                  
                  
                  $
                  0.03
                  
                  
                  $
                  0.12Diluted
                  
                  
                  (0.68
                  )
                  
                  
                  (0.06
                  )
                  
                  
                  (0.20
                  )
                  
                  
                  (2.98
                  )
                  
                  
                  0.08
                  
                  
                  
                  0.09
                  
                  
                  
                  0.03
                  
                  
                  
                  0.12Common
      stock price:High
                  
                  $
                  3.20
                  
                  
                  $
                  3.73
                  
                  
                  $
                  3.99
                  
                  
                  $
                  4.94
                  
                  
                  $
                  4.97
                  
                  
                  $
                  6.30
                  
                  
                  $
                  7.73
                  
                  
                  $
                  7.89Low
                  
                  
                  1.89
                  
                  
                  
                  2.40
                  
                  
                  
                  2.53
                  
                  
                  
                  2.46
                  
                  
                  
                  2.11
                  
                  
                  
                  3.86
                  
                  
                  
                  5.52
                  
                  
                  
                  6.26





(1)
            Includes
      $49.5 million in goodwill impairment charge recorded 1st
      quarter.




Page
48




LENDING
ACTIVITIES





General.We provide to our
customers residential, commercial and construction loans secured by real estate,
as well as a full range of short- to medium-term commercial and industrial,
Small Business Administration guaranteed and personal loans, both secured and
unsecured.  We have implemented loan policies and procedures that
establish the basic guidelines governing our lending
operations.  Generally, those guidelines address the types of loans
that we seek, our target markets, underwriting and collateral requirements,
terms, interest rate and yield considerations and compliance with laws and
regulations.  All loans or credit lines are subject to approval
procedures and amount limitations.  These limitations apply to the
borrower’s total outstanding indebtedness to us, including the indebtedness of
any guarantor.  The policies are reviewed and approved at least
annually by our Board of Directors.  We supplement our supervision of
the loan underwriting and approval process with periodic loan audits by internal
loan examiners.  We have focused our lending activities on the types
of loans that we believe will be most in demand by our target customers, as
presented in the loan portfolio composition tables below.





At December 31,2009
                  
                  
                  2008
                  
                  
                  2007Percent
                  
                  
                  
                  
                  
                  Percent
                  
                  
                  
                  
                  
                  PercentAmount
                  
                  
                  of Total
                  
                  
                  Amount
                  
                  
                  of Total
                  
                  
                  Amount
                  
                  
                  of Total(Amounts in thousands)Residential
      mortgage loans
                  
                  $
                  395,586
                  
                  
                  
                  32.2
                  %
                  
                  $
                  393,360
                  
                  
                  
                  29.9
                  %
                  
                  $
                  318,038
                  
                  
                  
                  26.8
                  %Commercial
      mortgage loans
                  
                  
                  455,268
                  
                  
                  
                  37.0
                  %
                  
                  
                  419,212
                  
                  
                  
                  31.9
                  %
                  
                  
                  390,948
                  
                  
                  
                  32.9
                  %Construction
      loans
                  
                  
                  178,239
                  
                  
                  
                  14.5
                  %
                  
                  
                  260,549
                  
                  
                  
                  19.8
                  %
                  
                  
                  259,740
                  
                  
                  
                  21.9
                  %Commercial
      and industrial loans
                  
                  
                  183,319
                  
                  
                  
                  14.9
                  %
                  
                  
                  221,231
                  
                  
                  
                  16.8
                  %
                  
                  
                  197,851
                  
                  
                  
                  16.6
                  %Loans
      to individuals
                  
                  
                  17,863
                  
                  
                  
                  1.4
                  %
                  
                  
                  20,459
                  
                  
                  
                  1.6
                  %
                  
                  
                  21,861
                  
                  
                  
                  1.8
                  %Subtotal
                  
                  
                  1,230,275
                  
                  
                  
                  100.0
                  %
                  
                  
                  1,314,811
                  
                  
                  
                  100.0
                  %
                  
                  
                  1,188,438
                  
                  
                  
                  100.0
                  %Less:  Allowance
      for loan losses
                  
                  
                  (29,638
                  )
                  
                  
                  
                  
                  
                  
                  (18,851
                  )
                  
                  
                  
                  
                  
                  
                  (14,258
                  )Net
      loans
                  
                  $
                  1,200,637
                  
                  
                  
                  
                  
                  
                  $
                  1,295,960
                  
                  
                  
                  
                  
                  
                  $
                  1,174,180





At December 31,2006
                    
                    
                    2005Percent
                    
                    
                    
                    
                    
                    PercentAmount
                    
                    
                    of Total
                    
                    
                    Amount
                    
                    
                    of Total(Amounts in thousands)Residential
      mortgage loans
                    
                    $
                    258,885
                    
                    
                    
                    25.1
                    %
                    
                    $
                    244,177
                    
                    
                    
                    28.0
                    %Commercial
      mortgage loans
                    
                    
                    359,987
                    
                    
                    
                    35.0
                    %
                    
                    
                    286,658
                    
                    
                    
                    33.0
                    %Construction
      loans
                    
                    
                    211,858
                    
                    
                    
                    20.6
                    %
                    
                    
                    156,900
                    
                    
                    
                    18.1
                    %Commercial
      and industrial loans
                    
                    
                    177,706
                    
                    
                    
                    17.3
                    %
                    
                    
                    151,950
                    
                    
                    
                    17.5
                    %Loans
      to individuals
                    
                    
                    21,380
                    
                    
                    
                    2.0
                    %
                    
                    
                    29,142
                    
                    
                    
                    3.4
                    %Subtotal
                    
                    
                    1,029,816
                    
                    
                    
                    100.0
                    %
                    
                    
                    868,827
                    
                    
                    
                    100.0
                    %Less:  Allowance
      for loan losses
                    
                    
                    (13,040
                    )
                    
                    
                    
                    
                    
                    
                    (11,785
                    )Net
      loans
                    
                    $
                    1,016,776
                    
                    
                    
                    
                    
                    
                    $
                    857,042




Page
49


The
following table presents at December 31, 2009 the aggregate maturities of loans
in the named categories of our loan portfolio which mature during the periods
indicated.





At December 31, 2009Due within
                
                
                Due after one year
                
                
                Due afterone year
                
                
                but within five years
                
                
                five years
                
                
                TotalAmount
                
                
                Yield
                
                
                Amount
                
                
                Yield
                
                
                Amount
                
                
                Yield
                
                
                Amount
                
                
                Yield(Amounts
      in thousands)Residential
      mortgage loans
                
                $
                145,752
                
                
                
                4.75
                %
                
                $
                92,584
                
                
                
                6.71
                %
                
                $
                146,909
                
                
                
                5.79
                %
                
                $
                385,245
                
                
                
                5.62
                %Commercial
      mortgage loans
                
                
                98,313
                
                
                
                5.66
                %
                
                
                291,711
                
                
                
                6.53
                %
                
                
                53,168
                
                
                
                6.47
                %
                
                
                443,192
                
                
                
                6.33
                %Construction
      loans
                
                
                117,229
                
                
                
                5.62
                %
                
                
                36,437
                
                
                
                5.93
                %
                
                
                12,785
                
                
                
                5.59
                %
                
                
                166,451
                
                
                
                5.69
                %Commercial
      and industrial loans
                
                
                116,341
                
                
                
                5.33
                %
                
                
                53,151
                
                
                
                6.64
                %
                
                
                10,393
                
                
                
                5.67
                %
                
                
                179,885
                
                
                
                5.74
                %Loans
      to individuals
                
                
                8,120
                
                
                
                9.74
                %
                
                
                8,946
                
                
                
                7.30
                %
                
                
                704
                
                
                
                7.12
                %
                
                
                17,770
                
                
                
                8.41
                %Total
                
                
                485,755
                
                
                
                5.37
                %
                
                
                482,829
                
                
                
                6.55
                %
                
                
                223,959
                
                
                
                5.94
                %
                
                
                1,192,543
                
                
                
                5.95
                %Nonaccrual
      loans
                
                
                25,027
                
                
                
                
                
                
                
                11,999
                
                
                
                
                
                
                
                706
                
                
                
                
                
                
                
                37,732Loans,
      gross
                
                $
                510,782
                
                
                
                
                
                
                $
                494,828
                
                
                
                
                
                
                $
                224,665
                
                
                
                
                
                
                $
                1,230,275





The above
table is based on contractual scheduled maturities.  Early repayments
of loans or renewals at maturity are not considered in this table.





Real Estate Loans.Loans secured
by real estate represent our greatest concentration of loans and are divided
into three categories: residential mortgage, commercial mortgage and
construction loans.  We make real estate loans for purchasing,
constructing and refinancing one-to-four family residential, five or more family
residential and commercial properties.  We also make loans secured by
real estate to commercial and individual borrowers who use the loan proceeds for
other purposes.  Our real estate loans totaled $1.03 billion at
December 31, 2009, representing 83.6% of our total loans
outstanding.  Our loan policy requires an appraisal prior to funding a
real estate loan and also outlines the requirements for appraisals on
renewals.





We pursue
an aggressive policy of evaluation and monitoring on any real estate loan that
becomes troubled, including reappraisal when appropriate.  We
recognize and reserve for potential exposures as soon as we identify
them.  However, the pace of absorption of real properties is affected
by each property’s individual nature and characteristics, the status of the real
estate market at the time, general economic conditions and other factors that
could adversely affect our volume of non-performing real estate loans and our
ability to dispose of foreclosed properties without loss.





Residential Mortgage
Loans.We provide
our customers access to long-term conventional real estate loans through the
origination of Federal National Mortgage Association-conforming
loans.  Many of the fixed-rate one-to-four family owner occupied
residential mortgage loans that we originate are for sale in the secondary
market and have been pre-sold for the account of third parties.  As it
relates to loans sold to third party investors, the Bank has no repurchase
obligation on sold loans as long as the underlying borrowers make their first
mortgage payment when due.  Residential mortgage loans held for sale
totaled $3.0 million at December 31, 2009.





Residential
loans are generated through our in-house staff as well as the Bank’s existing
customer base, referrals from real estate agents and builders and local
marketing efforts.  Our lending efforts include the origination of
loans secured by first mortgages on one–to-four family residences and on home
equity credit lines.  Our residential mortgage loans totaled $395.6
million at December 31, 2009 and included $265.2 million in one-to-four family
permanent mortgage loans, $111.0 million in outstanding advances under home
equity credit lines and $19.4 million of other loans secured by residential real
estate.  Substantially all our residential mortgage loans are secured
by properties located within our market area, although we will make loans
secured by properties outside our market area to qualifying existing
customers.  We believe that the amount of risk associated with this
group of loans is mitigated in part due to the type of loans
involved.  Historically, the amount of losses suffered on this type of
loan has been significantly less than those loans collateralized by other types
of properties.  Declining real estate values have increased risk of
loss in this sector in recent periods.




Page
50





Our
one-to-four family residential loans generally have maturities ranging from 1 to
30 years.  These loans are either fully amortizing with monthly
payments sufficient to repay the total amount of the loan or amortizing with a
balloon feature, typically due in fifteen years or less.  We review
information concerning the income, financial condition, employment history and
credit history when evaluating the creditworthiness of an applicant for a
residential mortgage loan.





Commercial Mortgage
Loans.  Our commercial mortgage loans totaled $455.3 million at
December 31, 2009.  These loans are secured principally by commercial
buildings for office, retail, manufacturing, storage and warehouse
properties.  Generally, in underwriting commercial mortgage loans, we
require the personal guaranty of borrowers and a demonstrated cash flow
capability sufficient to service the debt.  Loans secured by
commercial real estate may be in greater amount and involve a greater degree of
risk than one-to-four family residential mortgage loans, and payments on such
loans are often dependent on successful operation or management of the
properties and the underlying businesses.  We make commercial mortgage
loans at both fixed and variable rates for payment terms with amortizations up
to 20 years.





Construction Loans.We
originate one-to-four family residential construction loans for the construction
of custom homes (where the home buyer is the borrower or the home is presold),
and we provide construction financing to builders including acquisition
development and “spec” home financing.  We have a staff of lending
professionals and assistants who service only our construction loan
portfolio.  We generally receive a pre-arranged permanent financing
commitment from an outside banking entity prior to financing the construction of
pre-sold homes.  We lend to builders who have demonstrated a favorable
record of performance and profitable operations and who are building in our
market area.  We also make commercial real estate construction loans,
as noted in the preceding paragraph.  We endeavor to limit our
construction lending risk through adherence to established underwriting
procedures.  Also, we generally require documentation of all draw
requests and utilize loan officers to inspect the project prior to funding any
draw requests from the builder.  With few exceptions, the Bank
requires personal guarantees and secondary sources of repayment on construction
loans.  Construction loans aggregated $178.2 million at December 31,
2009.





Commercial Loans.Commercial
business lending is a primary focus of our lending activities.  At
December 31, 2009, our commercial loan portfolio equaled $183.3 million or 14.9%
of total loans.  Commercial loans include both secured and unsecured
loans for working capital, expansion and other business
purposes.  Short-term working capital loans generally are secured by
accounts receivable, inventory and/or equipment.  The Bank also makes
term commercial loans secured by equipment and real estate.  Lending
decisions are based on an evaluation of the financial strength, management and
credit history of the borrower and the quality of the collateral securing the
loan.  With few exceptions, the Bank requires personal guarantees and
secondary sources of repayment.





Commercial
loans generally provide greater yields and reprice more frequently than other
types of loans, such as real estate loans.  More frequent repricing
means that the yields on our commercial loans adjust with changes in interest
rates.





Loans to Individuals.Loans to individuals
include automobile loans, boat and recreational vehicle financing and
miscellaneous secured and unsecured personal loans.  Consumer loans
generally can carry significantly greater risks than other loans, even if
secured, if the collateral consists of rapidly depreciating assets such as
automobiles and equipment.  Repossessed collateral securing a
defaulted consumer loan may not provide an adequate source of repayment of the
loan.  We attempt to manage the risks inherent in consumer lending by
following established credit guidelines and underwriting practices designed to
minimize risk of loss.  At December 31, 2009, loans to individuals
totaled $17.9 million.





Loan Approvals.Our
loan policies and procedures establish the basic guidelines governing our
lending operations.  Generally, the guidelines address the type of
loans that we seek, our target markets, underwriting and collateral
requirements, terms, interest rate and yield considerations and compliance with
laws and regulations.  All loans or credit lines are subject to
approval procedures and amount limitations.  These limitations apply
to the borrower’s total outstanding indebtedness to us, including the
indebtedness of any guarantor.  The policies are reviewed and approved
at least annually.  We supplement our supervision of the loan
underwriting and approval process with periodic internal loan
audits.





Individual
lending authorities are established by the Board of Directors as periodically
requested by management.  All individual lending authorities are
reviewed and approved at least annually by the Board of Directors.




Page
51





The Board
Loan Committee consists of the CEO, President, EVP of Commercial Banking, Chief
Credit Officer and five outside Directors as appointed by the Board of
Directors.  This Committee meets on a monthly basis to review for
approval all loan requests from borrowers with aggregate exposure in excess of
$9.0 million.  As of December 31, 2009, the legal lending limit for
the Bank was approximately $24.4 million.  The Bank also has an
internal bank loan committee comprised of seven members who review all loan
requests with aggregate exposure between $6.0 million and $9.0
million.





ASSET
QUALITY





We
consider asset quality to be of primary importance.  We employ a
formal internal loan review process to ensure adherence to the Lending Policy as
approved by the Board of Directors.  It is the responsibility of each
lending officer to assign an appropriate risk grade to every loan
originated.  Credit Administration, through the loan review process,
validates the accuracy of the initial risk grade assessment.  In
addition, as a given loan’s credit quality improves or deteriorates, it is
Credit Administration’s ultimate responsibility to change the borrower’s risk
grade accordingly.  The function of determining the allowance for loan
losses is fundamentally driven by the risk grade system.  In
determining the allowance for loan losses and any resulting provision to be
charged against earnings, particular emphasis is placed on the results of the
loan review process.  We also give consideration to historical loan
loss experience, the value and adequacy of collateral, economic conditions in
our market area and other factors.  For loans determined to be
impaired, the allowance is based on discounted cash flows using the loan’s
initial effective interest rate or the fair value of the collateral for certain
collateral dependent loans.  This evaluation is inherently subjective
as it requires material estimates, including the amounts and timing of future
cash flows expected to be received on impaired loans that may be susceptible to
significant change.  The allowance for loan losses represents
management’s estimate of the appropriate level of reserve to provide for
potential losses inherent in the loan portfolio.





Our
policy in regard to past due loans normally requires a charge-off to the
allowance for loan losses within a reasonable period after collection efforts
and a thorough review has been completed.  Further collection efforts
are then pursued through various means including legal
remedies.  Loans carried in a nonaccrual status and probable losses
are considered in the determination of the allowance for loan
losses.


Page
52


Nonperforming
Assets





The table
sets forth, for the period indicated, information about our nonaccrual loans,
restructured loans, total nonperforming loans (nonaccrual loans plus
restructured loans), and total nonperforming assets.





At December 31,2009
                
                
                2008
                
                
                2007
                
                
                2006
                
                
                2005(Dollars in thousands)Nonaccrual
      loans
                
                $
                35,535
                
                
                $
                14,433
                
                
                $
                2,052
                
                
                $
                2,636
                
                
                $
                1,408Restructured
      loans (1)
                
                
                2,197
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -Total
      nonperforming loans
                
                
                37,732
                
                
                
                14,433
                
                
                
                2,052
                
                
                
                2,636
                
                
                
                1,408Foreclosed
      assets
                
                
                19,634
                
                
                
                5,745
                
                
                
                775
                
                
                
                895
                
                
                
                280Total
      nonperforming assets
                
                $
                57,366
                
                
                $
                20,178
                
                
                $
                2,827
                
                
                $
                3,531
                
                
                $
                1,688Accruing
      loans past due 90 days or more
                
                $
                -
                
                
                $
                -
                
                
                $
                8
                
                
                $
                -
                
                
                $
                -Allowance
      for loan losses
                
                
                29,638
                
                
                
                18,851
                
                
                
                14,258
                
                
                
                13,040
                
                
                
                11,785Nonperforming
      loans to period end loans
                
                
                3.07
                %
                
                
                1.10
                %
                
                
                0.17
                %
                
                
                0.26
                %
                
                
                0.16
                %Allowance
      for loan losses to period end loans
                
                
                2.41
                %
                
                
                1.43
                %
                
                
                1.20
                %
                
                
                1.26
                %
                
                
                1.36
                %Allowance
      for loan losses to nonperforming loans
                
                
                79
                %
                
                
                131
                %
                
                
                695
                %
                
                
                495
                %
                
                
                837
                %Nonperforming
      assets to total assets
                
                
                3.32
                %
                
                
                1.12
                %
                
                
                0.18
                %
                
                
                0.25
                %
                
                
                0.13
                %





(1) At
December 31, 2009, these restructured loans were also in nonaccrual
status.


Page
53


The
following table sets forth a breakdown of nonperforming loans and foreclosed
assets as of December 31, 2009, by nature of the property.





December 31,Nonperforming loans
                  
                  2009(Amounts in thousands)Residential
      Construction:Speculative
      construction
                  
                  $
                  4,210Land
      acquisition and development
                  
                  
                  11,997Total
      residential construction
                  
                  
                  16,207Commercial
      real estate
                  
                  
                  16,344Commercial
      and industrial
                  
                  
                  3,432Consumer
                  
                  
                  1,749Total
      nonperforming loans
                  
                  $
                  37,732





December 31,Foreclosed assets
                  
                  2009(Amounts in thousands)Residential
      construction, land development and other land
                  
                  $
                  11,101Commercial
      construction
                  
                  
                  2,2061 -
      4 family residential properties
                  
                  
                  4,272Nonfarm
      nonresidential properties
                  
                  
                  1,670Multi
      family properties
                  
                  
                  160Equipment
                  
                  
                  225Total
      foreclosed assets
                  
                  $
                  19,634





Our
financial statements are prepared on the accrual basis of accounting, including
the recognition of interest income on loans, unless we place a loan on
nonaccrual basis.  We account for loans on a nonaccrual basis when we
have serious doubts about the collectability of principal or
interest.  Generally, our policy is to place a loan on nonaccrual
status when the loan becomes past due 90 days.  We also place loans on
nonaccrual status in cases where we are uncertain whether the borrower can
satisfy the contractual terms of the loan agreement.  Amounts received
on nonaccrual loans generally are applied first to principal and then to
interest only after all principal has been collected.  Restructured
loans are those for which concessions, including the reduction of interest rates
below a rate otherwise available to that borrower or the deferral of interest or
principal, have been granted due to the borrower’s weakened financial
condition.  We record interest on restructured loans at the
restructured rates, as collected, when we anticipate that no loss of original
principal will occur.





The
recorded investment in loans that were considered individually impaired at
December 31, 2009 totaled $40.2 million.  Of these $40.2 million in
loans considered individually impaired at December 31, 2009, there were $37.7
million of nonaccrual loans and $2.5 million of potential problem
loans.  At that time, the largest nonaccrual balance of any one
borrower was $7.0 million, with the average balance for the one hundred
twenty-eight nonaccrual loans being $295 thousand.  At December 31,
2009, the recorded investment in impaired loans requiring a valuation allowance
based on individual analysis were $29.1 million, with a corresponding valuation
allowance of $9.8 million.





In
addition to nonperforming loans, there were $45.9 million of loans at December
31, 2009, for which management has concerns regarding the ability of the
borrowers to meet existing repayment terms, compared with $19.7 million at
December 31, 2008.  Approximately 38% of these potential problem loans
at December 31, 2009 were related to residential construction and development
lending.  The increase in potential problem loans is primarily due to
an increase in residential construction and development loans that were
downgraded due to the borrower’s exposure to the housing
market.  Potential problem loans are primarily classified as
substandard for regulatory purposes and reflect the distinct possibility, but
not the probability, that the Company will not be able to collect all amounts
due according to the contractual terms of the loan
agreement.  Although these loans have been identified as potential
problem loans, they may never become delinquent, nonperforming or
impaired.  Additionally, these loans are generally secured by
residential real estate or other assets, thus reducing the potential for loss
should they become nonperforming.  Potential problem loans are
considered in the determination of the adequacy of the allowance for loan
losses.




Page
54





Foreclosed
assets consist of real estate acquired through foreclosure, repossessed assets
and idled properties.  At December 31, 2009 foreclosed assets totaled
$19.6 million, or 1.14%, of total assets, and consisted of one hundred
twenty-seven properties.  The largest dollar value of a foreclosed
property at December 31, 2009 was $2.9 million.  The majority of these
foreclosed assets at December 31, 2009 are located in North Carolina (76%) with
the remainder located mostly in Florida (15%) and South Carolina
(9%).  We have reviewed recent appraisals of these properties and
believe that the fair values, less estimated costs to sell, equal or exceed
their carrying value.





In the
tables and discussion below, the following trends are illustrated: 1)
significant declines in the outstanding balances of the Company’s speculative
residential construction and land acquisition and development loan segments of
$41.0 million, or 43%, and $8.7 million, or 13%, respectively; 2) moderating
delinquency trend since year-end 2008; 3) increasing levels of loans classified
substandard or doubtful year over year and 4) shift in potential problem
loans.  There has been a shift in the components of potential problem
loans from residential construction and development to commercial real
estate.





The
following table illustrates the trends in the outstanding balances of these
higher risk loan segments.





December 31,
                  
                  
                  December 31,2009
                  
                  
                  2008(Amounts in millions)Residential
      construction:Speculative
      construction
                  
                  $
                  53.3
                  
                  
                  $
                  94.3Land
      acquisition and development
                  
                  
                  58.3
                  
                  
                  
                  67.0Lot
      inventory
                  
                  
                  29.5
                  
                  
                  
                  33.8Total
                  
                  $
                  141.1
                  
                  
                  $
                  195.1





Furthermore,
we monitor certain performance and credit metrics related to these higher risk
loan segments, including the aging of the underlying loans in these
segments.  As of December 31, 2009, speculative construction loans on
our books more than twelve months amounted to $34.1 million, or 64%, of the
total speculative residential construction loan portfolio.  Land
acquisition and development loans on our books for more than twenty-four months
at December 31, 2009 amounted to $48.8 million, or 84%, of that portfolio
segment.


Page
55


We also
monitor credit risk migration and delinquency trends in the ongoing evaluation
and assessment of credit risk exposure in the overall loan
portfolio.  The following table presents quarterly trends in loans
classified substandard or doubtful, loan delinquencies, and nonperforming
loans.





December 31,
                      
                      
                      December 31,2009
                      
                      
                      2008(Amounts in millions)$
                      
                      
                      % of Total
                        Loans
                      
                      
                      $
                      
                      
                      % of Total
                        LoansLoans
      classified substandard or doubtful
                      
                      $
                      83.6
                      
                      
                      
                      6.80
                      %
                      
                      $
                      34.1
                      
                      
                      
                      2.59
                      %Loans
      delinquencies 30 days or more past due
                      
                      $
                      29.7
                      
                      
                      
                      2.48
                      %
                      
                      $
                      33.0
                      
                      
                      
                      2.51
                      %Nonperforming
      loans
                      
                      $
                      37.7
                      
                      
                      
                      3.07
                      %
                      
                      $
                      14.4
                      
                      
                      
                      1.10
                      %





Classified
loans increased $49.5 million, or 145%, from December 31, 2008 to December 31,
2009, while total delinquencies decreased by $3.3 million, or 11%, during the
same period.  Because of the continued economic stress and malaise, we
undertook a comprehensive review of loan grades in the fourth quarter, resulting
in further adjustments to our assigned risk grades on various
loans.





Analysis
of Allowance for Loan Losses





Our
allowance for loan losses (“ALLL”) is established through charges to earnings in
the form of a provision for loan losses.  We increase our allowance
for loan losses by provisions charged to operations and by recoveries of amounts
previously charged off and we reduce our allowance by loans charged
off.  We evaluate the adequacy of the allowance monthly.  In
addition, on a monthly basis our Board Loan Committee reviews our loan portfolio
and conducts an evaluation of our credit quality.  The Board Loan
Committee reports directly to the Board of Directors.  Quarterly, the
Board of Directors reviews the loan loss provision and the adequacy of the
allowance for loan losses.  In evaluating the adequacy of the
allowance, we consider the growth, composition and industry diversification of
the portfolio, historical loan loss experience, current delinquency levels,
trends in past dues and classified assets, adverse situations that may affect a
borrower’s ability to repay, estimated value of any underlying collateral,
prevailing economic conditions and other relevant factors deriving from our
history of operations.  In addition, regulatory agencies, as an
integral part of their examination process, periodically review our allowance
for loan losses and may require us to make adjustments for estimated losses
based upon judgments different from those of our management.





We use
our risk grading program, as described under “ASSET QUALITY,” to facilitate our
evaluation of probable inherent loan losses and the adequacy of the allowance
for loan losses.  In this program, risk grades are initially assigned
by loan officers, reviewed by Credit Administration, and tested by our internal
loan review function.  Third party loan reviews are conducted at
various times to supplement internal efforts.  The testing program
includes an evaluation of a sample of new loans, large loans, loans that are
identified as having potential credit weaknesses, loans past due 90 days or
more, and nonaccrual loans as well as other factors randomly
assigned.  We strive to maintain our loan portfolio in accordance with
conservative loan underwriting policies that result in loans specifically
tailored to the needs of our market area.  Every effort is made to
identify and minimize the credit risks associated with such lending
strategies.  We have no foreign loans and we do not engage in lease
financing or highly leveraged transactions.





We follow
a loan review program designed to evaluate the credit risk in our loan
portfolio.  Through this loan review process, we maintain an
internally classified watch list that helps management assess the overall
quality of the loan portfolio and the adequacy of the allowance for loan
losses.  In establishing the appropriate classification for specific
assets, management considers, among other factors, the estimated value of the
underlying collateral, the borrower's ability to repay, the borrower's payment
history and the current status.  As a result of this process, certain
loans are categorized as substandard, doubtful or loss and reserves are
allocated based on management's judgment, objective criteria and historical
experience.




Page
56





The
Bank’s format for the calculation of ALLL begins with the evaluation of loans
under impairment guidelines.  For the purposes of evaluating loans for
impairment, loans are considered impaired when it is considered probable that
all amounts due under the contractual terms of the loan will not be collected
when due (minor shortfalls in amount or timing excepted).  The Bank
has established policies and procedures for identifying loans that should be
considered for impairment.  Loans are reviewed through multiple means
such as delinquency management, credit risk reviews, watch and criticized loan
monitoring meetings and general account management.  Loans that are
outside of the Bank’s established criteria for evaluation may be considered for
impairment testing when management deems the risk sufficient to warrant this
approach.  For loans determined to be impaired, the specific allowance
is based on the most appropriate of the three measurement methods: present value
of expected future cash flows, fair value of collateral, or the observable
market price of a loan method.  While management uses the best
information available to make evaluations, future adjustments to the allowance
may be necessary if conditions differ substantially from the assumptions used in
making the evaluations.  Once a loan is considered impaired, it is not
included in the determination of the general loss component of the allowance,
even if no specific allowance is considered necessary.





In
addition to the evaluation of loans for impairment, we calculate the loan loss
exposure on the remaining loans (not evaluated for impairment) by applying the
applicable historical loan loss experience factors to each major segment
(residential construction, commercial real estate, commercial and
industrial/other and consumer) broken down by loan credit grade.  The
Bank also utilizes various other factors to further evaluate the portfolio for
risk.  The other factors utilized include the rate of loan growth,
policy exceptions, account officer experience, interest rate trends and various
economic factors.  These factors are examined for trends and the risk
that they represent to the Bank’s loan portfolio.  Each of these other
factors is assigned a level of risk and this risk factor is applied to only
those loans not evaluated for impairment.  The ALLL calculation for
specific loss and general loss exposure are aggregated to arrive at the
approximate allowance level for our loan portfolio.





The
Company has evaluated the regulatory guidance on this matter on an ongoing basis
and has made applicable enhancements to our processes for determining our
allowance for loan losses.  During 2009, we made refinements to our
methodology for the calculation of ALLL by focusing more specifically on risk
grades within our major loan segments.  While management believes that
it uses the best information available to establish the allowance for loan
losses, future adjustments to the allowance may be necessary and results of
operations could be adversely affected if circumstances differ substantially
from the assumptions used in making the determinations.  Furthermore,
while the Company believes the allowance for loan losses has been established in
conformity with accounting principles generally accepted in the United States,
there can be no assurance that regulators, in reviewing our portfolio, will not
require adjustments to our allowance for loan losses.  In addition,
because future events affecting borrowers and collateral cannot be predicted
with certainty, there can be no assurance that the existing allowance for loan
losses is adequate or that increases will not be necessary should the quality of
any loans deteriorate as a result of the factors discussed
herein.  Any material increase in the allowance for loan losses may
adversely affect our financial condition and results of operations.





In 2009
we experienced significant increases in nonperforming loans and net charge-offs,
primarily related to our residential construction and land development loan
portfolio segments and businesses that support the housing
industry.  This deterioration in our asset quality was brought on by
weakness in the housing market and an overall slowdown in housing purchase
activity, particularly in new construction.  Nonperforming loans
increased by $23.3 million or 161.4% during 2009 from $14.4 million, or 1.10% of
total loans, at year-end 2008 to $37.7 million, or 3.07% of total loans, as of
December 31, 2009.  Of these $37.7 million in nonperforming loans, 47%
are related to residential construction and land development activities,
directly or indirectly.  Our allowance for loan losses at December 31,
2009 was $29.6 million and represented 2.41% of total loans and 0.79 times
nonperforming loans.  Our allowance for loan losses at December 31,
2008 of $18.9 million represented 1.43% of total loans and 1.31 times
nonperforming loans.  The $10.7 million increase in our allowance for
loan losses year-over-year was primarily due to increased volume of impaired
loans and increased severity of credit loss exposure.  There were
$10.1 million more impaired loans that required increases in valuation
allowances of $7.0 million year-over-year.  In addition to the impact
of impaired loans, our historical loss experience grew significantly during 2009
as our net charge offs increased 5.5 times to 1.82% of average loans in 2009
from 0.28% of average loans in 2008.


Page
57


The
following table describes the allocation of the allowance for loan losses among
various categories of loans and certain other information for the dates
indicated.  The allocation is made for analytical purposes only and is
not necessarily indicative of the categories in which future losses may
occur.





At December 31,2009
                
                
                2008
                
                
                2007Amount (3)
                
                
                % of Total
                  Loans(1)
                
                
                Amount
                
                
                % of Total
                  Loans(1)
                
                
                Amount
                
                
                % ofTotal
                  Loans(1)(Dollars in thousands)Residential
      mortgage loans
                
                $
                9,503
                
                
                
                32.2
                %
                
                $
                5,221
                
                
                
                29.9
                %
                
                $
                4,046
                
                
                
                26.9
                %Commercial
      mortgage loans
                
                
                5,782
                
                
                
                37.0
                %
                
                
                3,670
                
                
                
                31.9
                %
                
                
                2,975
                
                
                
                32.8
                %Construction
      loans
                
                
                8,629
                
                
                
                14.5
                %
                
                
                4,428
                
                
                
                19.8
                %
                
                
                3,225
                
                
                
                21.8
                %Commercial
      and industrial loans
                
                
                5,203
                
                
                
                14.9
                %
                
                
                3,524
                
                
                
                16.9
                %
                
                
                2,854
                
                
                
                16.6
                %Loans
      to individuals
                
                
                421
                
                
                
                1.4
                %
                
                
                1,058
                
                
                
                1.5
                %
                
                
                1,158
                
                
                
                1.9
                %Unallocated
      (2)
                
                
                100
                
                
                
                -
                %
                
                
                950
                
                
                
                -
                %
                
                
                -
                
                
                
                -
                %Total
                
                $
                29,638
                
                
                
                100.0
                %
                
                $
                18,851
                
                
                
                100.0
                %
                
                $
                14,258
                
                
                
                100.0
                %





At December 31,2006
                  
                  
                  2005Amount
                  
                  
                  % of Total
                    Loans(1)
                  
                  
                  Amount
                  
                  
                  % of Total
                    Loans(1)(Dollars in thousands)Residential
      mortgage loans
                  
                  $
                  1,771
                  
                  
                  
                  25.4
                  %
                  
                  $
                  1,394
                  
                  
                  
                  28.0
                  %Commercial
      mortgage loans
                  
                  
                  4,173
                  
                  
                  
                  34.8
                  %
                  
                  
                  3,151
                  
                  
                  
                  33.0
                  %Construction
      loans
                  
                  
                  3,240
                  
                  
                  
                  20.5
                  %
                  
                  
                  2,454
                  
                  
                  
                  18.1
                  %Commercial
      and industrial loans
                  
                  
                  2,099
                  
                  
                  
                  17.2
                  %
                  
                  
                  1,784
                  
                  
                  
                  17.5
                  %Loans
      to individuals
                  
                  
                  553
                  
                  
                  
                  2.1
                  %
                  
                  
                  956
                  
                  
                  
                  3.4
                  %Unallocated
                  
                  
                  1,204
                  
                  
                  
                  -
                  %
                  
                  
                  2,046
                  
                  
                  
                  -
                  %Total
                  
                  $
                  13,040
                  
                  
                  
                  100.0
                  %
                  
                  $
                  11,785
                  
                  
                  
                  100.0
                  %





(1)
            Represents
      total of all outstanding loans in each category as a percentage of total
      loans outstanding.


(2)
            During
      2007, the ALLL methodology was revised to comply with the Interagency
      Policy Statement on the ALLL. As a result the unallocated portion of the
      allowance decreased due to the methodology enhancements.
              During
      2008, an unallocated segment was re-established as an additional
      qualitative factor due to the current economic environment presenting
      potential loss exposures in excess of our historical loss
      rates.


(3)
            The
      method of calculating the allowance was revised for 2009 and later years
      with greater emphasis placed on credit grade and loan
      categories.





In the
above allocation table, the increases in the allocations of our allowance for
loan losses in comparing year-end 2009 and year-end 2008 were in those loan
categories primarily related to residential construction and land development
loan portfolio segments and businesses related to the housing
industry.  As our methodology for calculating ALLL was revised during
2007 through 2009, we have reclassified certain allocations to make these
comparisons consistent in their presentation.




Page
58





The
following table presents for the periods indicated information regarding changes
in our allowance for loan losses.





As of or for the Years Ended December 31,2009
                
                
                2008
                
                
                2007
                
                
                2006
                
                
                2005(Dollars in thousands)Balance
      at beginning of period
                
                $
                18,851
                
                
                $
                14,258
                
                
                $
                13,040
                
                
                $
                11,785
                
                
                $
                12,537Charge-offs:Residential
      mortgage loans
                
                
                8,161
                
                
                
                921
                
                
                
                974
                
                
                
                248
                
                
                
                566Commercial
      mortgage loans
                
                
                1,753
                
                
                
                165
                
                
                
                -
                
                
                
                68
                
                
                
                -Construction
      loans
                
                
                7,757
                
                
                
                1,452
                
                
                
                140
                
                
                
                130
                
                
                
                4Commercial
      and industrial loans
                
                
                5,719
                
                
                
                702
                
                
                
                239
                
                
                
                508
                
                
                
                349Loans
      to individuals
                
                
                1,243
                
                
                
                594
                
                
                
                541
                
                
                
                600
                
                
                
                443Total
      charge-offs
                
                
                24,633
                
                
                
                3,834
                
                
                
                1,894
                
                
                
                1,554
                
                
                
                1,362Recoveries:Residential
      mortgage loans
                
                
                131
                
                
                
                113
                
                
                
                86
                
                
                
                142
                
                
                
                41Commercial
      mortgage loans
                
                
                1
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -Construction
      loans
                
                
                182
                
                
                
                4
                
                
                
                7
                
                
                
                -
                
                
                
                3Commercial
      and industrial loans
                
                
                971
                
                
                
                28
                
                
                
                63
                
                
                
                36
                
                
                
                35Loans
      to individuals
                
                
                135
                
                
                
                117
                
                
                
                181
                
                
                
                121
                
                
                
                72Total
      recoveries
                
                
                1,420
                
                
                
                262
                
                
                
                337
                
                
                
                299
                
                
                
                151Net
      charge-offs
                
                
                (23,213
                )
                
                
                (3,572
                )
                
                
                (1,557
                )
                
                
                (1,255
                )
                
                
                (1,211
                )Provision
      for loan losses
                
                
                34,000
                
                
                
                8,165
                
                
                
                2,775
                
                
                
                2,510
                
                
                
                950Allowance
      for loans acquired in purchase transactions, net
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                (491
                )Balance
      at end of period
                
                $
                29,638
                
                
                $
                18,851
                
                
                $
                14,258
                
                
                $
                13,040
                
                
                $
                11,785Total
      loans outstanding
                
                
                1,230,275
                
                
                $
                1,314,811
                
                
                $
                1,188,438
                
                
                $
                1,029,816
                
                
                $
                868,827Average
      loans outstanding
                
                
                1,272,087
                
                
                $
                1,279,041
                
                
                $
                1,114,677
                
                
                $
                958,001
                
                
                $
                837,467Allowance
      for loan losses to loans outstanding
                
                
                2.41
                %
                
                
                1.43
                %
                
                
                1.20
                %
                
                
                1.27
                %
                
                
                1.36
                %Ratio
      of net loan charge-offs to average loans outstanding
                
                
                1.82
                %
                
                
                0.28
                %
                
                
                0.14
                %
                
                
                0.13
                %
                
                
                0.14
                %


Page
59


INVESTMENT
ACTIVITIES





Our
investment portfolio plays a primary role in management of liquidity and
interest rate sensitivity and, therefore, is managed in the context of the
overall balance sheet.  The securities portfolio generates
approximately 15% of our interest income and serves as a necessary source of
liquidity.





Management
attempts to deploy investable funds into instruments that are expected to
increase the overall return of the portfolio given the current assessment of
economic and financial conditions, while maintaining acceptable levels of
capital, and interest rate and liquidity risk.





The
following table summarizes the amortized cost, gross unrealized gains and losses
and the resulting fair value of securities at the dates indicated.





AmortizedCost
                          
                          
                          Gross
                            Unrealized
                            Gains
                          
                          
                          Gross
                            Unrealized
                            Losses
                          
                          
                          Fair Value(Amounts
      in thousands)December 31, 2009Securities
      available for sale:U.
      S. government agencies
                          
                          $
                          57,441
                          
                          
                          $
                          407
                          
                          
                          $
                          560
                          
                          
                          $
                          57,288Mortgage-backed
      securities
                          
                          
                          176,543
                          
                          
                          
                          5,813
                          
                          
                          
                          256
                          
                          
                          
                          182,100Municipals
                          
                          
                          64,797
                          
                          
                          
                          1,564
                          
                          
                          
                          102
                          
                          
                          
                          66,259Trust
      preferred securities
                          
                          
                          4,252
                          
                          
                          
                          -
                          
                          
                          
                          1,376
                          
                          
                          
                          2,876Common
      stocks and mutual funds
                          
                          
                          3,418
                          
                          
                          
                          141
                          
                          
                          
                          295
                          
                          
                          
                          3,264Other
                          
                          
                          1,000
                          
                          
                          
                          -
                          
                          
                          
                          7
                          
                          
                          
                          993$
                          307,451
                          
                          
                          $
                          7,925
                          
                          
                          $
                          2,596
                          
                          
                          $
                          312,780Securities
      held to maturity:U.
      S. government agencies
                          
                          $
                          2,500
                          
                          
                          $
                          35
                          
                          
                          $
                          -
                          
                          
                          $
                          2,535Mortgage-backed
      securities
                          
                          
                          1,175
                          
                          
                          
                          44
                          
                          
                          
                          -
                          
                          
                          
                          1,219Municipals
                          
                          
                          7,244
                          
                          
                          
                          185
                          
                          
                          
                          3
                          
                          
                          
                          7,426$
                          10,919
                          
                          
                          $
                          264
                          
                          
                          $
                          3
                          
                          
                          $
                          11,180December 31, 2008Securities
      available for sale:U.
      S. government agencies
                          
                          $
                          76,061
                          
                          
                          $
                          2,183
                          
                          
                          $
                          37
                          
                          
                          
                          78,207Mortgage-backed
      securities
                          
                          
                          196,386
                          
                          
                          
                          4,268
                          
                          
                          
                          194
                          
                          
                          
                          200,460Municipals
                          
                          
                          2,393
                          
                          
                          
                          19
                          
                          
                          
                          7
                          
                          
                          
                          2,405Trust
      preferred securities
                          
                          
                          4,250
                          
                          
                          
                          49
                          
                          
                          
                          232
                          
                          
                          
                          4,067Common
      stocks and mutual funds
                          
                          
                          3,822
                          
                          
                          
                          4
                          
                          
                          
                          209
                          
                          
                          
                          3,617Other
                          
                          
                          1,000
                          
                          
                          
                          -
                          
                          
                          
                          290
                          
                          
                          
                          710$
                          283,912
                          
                          
                          $
                          6,523
                          
                          
                          $
                          969
                          
                          
                          $
                          289,466Securities
      held to maturity:U.
      S. government agencies
                          
                          $
                          25,500
                          
                          
                          $
                          340
                          
                          
                          $
                          -
                          
                          
                          $
                          25,840Mortgage-backed
      securities
                          
                          
                          1,792
                          
                          
                          
                          26
                          
                          
                          
                          -
                          
                          
                          
                          1,818Municipals
                          
                          
                          7,939
                          
                          
                          
                          149
                          
                          
                          
                          215
                          
                          
                          
                          7,873$
                          35,231
                          
                          
                          $
                          515
                          
                          
                          $
                          215
                          
                          
                          $
                          35,531December 31, 2007Securities
      available for sale:U.
      S. government agencies
                          
                          $
                          72,922
                          
                          
                          $
                          1,754
                          
                          
                          $
                          5
                          
                          
                          $
                          74,671Mortgage-backed
      securities
                          
                          
                          62,782
                          
                          
                          
                          428
                          
                          
                          
                          500
                          
                          
                          
                          62,710Municipals
                          
                          
                          2,391
                          
                          
                          
                          5
                          
                          
                          
                          8
                          
                          
                          
                          2,388Trust
      preferred securities
                          
                          
                          4,253
                          
                          
                          
                          -
                          
                          
                          
                          143
                          
                          
                          
                          4,110Common
      stocks and mutual funds
                          
                          
                          2,813
                          
                          
                          
                          24
                          
                          
                          
                          -
                          
                          
                          
                          2,837Other
                          
                          
                          1,000
                          
                          
                          
                          -
                          
                          
                          
                          290
                          
                          
                          
                          710$
                          146,161
                          
                          
                          $
                          2,211
                          
                          
                          $
                          946
                          
                          
                          $
                          147,426Securities
      held to maturity:U.
      S. government agencies
                          
                          $
                          58,794
                          
                          
                          $
                          89
                          
                          
                          $
                          419
                          
                          
                          $
                          58,464Mortgage-backed
      securities
                          
                          
                          2,197
                          
                          
                          
                          8
                          
                          
                          
                          30
                          
                          
                          
                          2,175Municipals
                          
                          
                          8,821
                          
                          
                          
                          125
                          
                          
                          
                          121
                          
                          
                          
                          8,825$
                          69,812
                          
                          
                          $
                          222
                          
                          
                          $
                          570
                          
                          
                          $
                          69,464


Page
60


The
following table presents the carrying values, fair values, intervals of
maturities or repricings and weighted average yields of our investment portfolio
at December 31, 2009.





2009Amortized Cost
                      
                      
                      Fair Value
                      
                      
                      WeightedAverage
                        Yield(Amount in thousands)
                      
                      
                      (1)Securities available for
    sale:U.
      S. government agenciesDue
      after one but within five years
                      
                      
                      14,750
                      
                      
                      
                      15,013
                      
                      
                      
                      4.36
                      %Due
      after five but within ten years
                      
                      
                      5,000
                      
                      
                      
                      5,121
                      
                      
                      
                      5.49
                      %Due
      after ten years
                      
                      
                      37,691
                      
                      
                      
                      37,154
                      
                      
                      
                      5.09
                      %57,441
                      
                      
                      
                      57,288
                      
                      
                      
                      4.94
                      %Mortgage-backed
      securitiesDue
      within one year
                      
                      
                      11
                      
                      
                      
                      11
                      
                      
                      
                      5.97
                      %Due
      after one but within five years
                      
                      
                      2,261
                      
                      
                      
                      2,299
                      
                      
                      
                      3.87
                      %Due
      after five but within ten years
                      
                      
                      79,569
                      
                      
                      
                      83,124
                      
                      
                      
                      4.69
                      %Due
      after ten years
                      
                      
                      94,702
                      
                      
                      
                      96,666
                      
                      
                      
                      4.23
                      %176,543
                      
                      
                      
                      182,100
                      
                      
                      
                      4.43
                      %MunicipalsDue
      within one year
                      
                      
                      3,995
                      
                      
                      
                      4,013
                      
                      
                      
                      3.22
                      %Due
      after one but within five years
                      
                      
                      7,286
                      
                      
                      
                      7,409
                      
                      
                      
                      6.26
                      %Due
      after five but within ten years
                      
                      
                      15,939
                      
                      
                      
                      16,036
                      
                      
                      
                      4.21
                      %Due
      after ten years
                      
                      
                      37,577
                      
                      
                      
                      38,801
                      
                      
                      
                      6.78
                      %64,797
                      
                      
                      
                      66,259
                      
                      
                      
                      5.87
                      %Trust
      preferred securitiesDue
      after ten years
                      
                      
                      4,252
                      
                      
                      
                      2,876
                      
                      
                      
                      4.14
                      %4,252
                      
                      
                      
                      2,876
                      
                      
                      
                      4.14
                      %Common
      stock and mututal fundsDue
      after ten years
                      
                      
                      3,418
                      
                      
                      
                      3,264
                      
                      
                      
                      4.01
                      %3,418
                      
                      
                      
                      3,264
                      
                      
                      
                      4.01
                      %OtherDue
      after one but within five years
                      
                      
                      1,000
                      
                      
                      
                      993
                      
                      
                      
                      1.28
                      %1,000
                      
                      
                      
                      993
                      
                      
                      
                      1.28
                      %Total
      securities available for saleDue
      within one year
                      
                      
                      4,006
                      
                      
                      
                      4,024
                      
                      
                      
                      3.23
                      %Due
      after one but within five years
                      
                      
                      25,297
                      
                      
                      
                      25,714
                      
                      
                      
                      4.74
                      %Due
      after five but within ten years
                      
                      
                      100,508
                      
                      
                      
                      104,281
                      
                      
                      
                      4.65
                      %Due
      after ten years
                      
                      
                      177,640
                      
                      
                      
                      178,761
                      
                      
                      
                      4.92
                      %$
                      307,451
                      
                      
                      $
                      312,780
                      
                      
                      
                      4.80
                      %Securities held to
maturity:U.
      S. government agenciesDue
      within one year
                      
                      $
                      2,500
                      
                      
                      $
                      2,535
                      
                      
                      
                      4.95
                      %2,500
                      
                      
                      
                      2,535
                      
                      
                      
                      4.95
                      %Mortgage-backed
      securitiesDue
      within one year
                      
                      
                      1
                      
                      
                      
                      1Due
      after one but within five years
                      
                      
                      671
                      
                      
                      
                      694
                      
                      
                      
                      4.60
                      %Due
      after five but within ten years
                      
                      
                      48
                      
                      
                      
                      52
                      
                      
                      
                      6.38
                      %Due
      after ten years
                      
                      
                      455
                      
                      
                      
                      472
                      
                      
                      
                      5.11
                      %1,175
                      
                      
                      
                      1,219
                      
                      
                      
                      4.87
                      %MunicipalsDue
      within one year
                      
                      
                      2,254
                      
                      
                      
                      2,287
                      
                      
                      
                      1.52
                      %Due
      after one but within five years
                      
                      
                      704
                      
                      
                      
                      752
                      
                      
                      
                      5.21
                      %Due
      after five but within ten years
                      
                      
                      2,256
                      
                      
                      
                      2,310
                      
                      
                      
                      7.55
                      %Due
      after ten years
                      
                      
                      2,030
                      
                      
                      
                      2,077
                      
                      
                      
                      5.63
                      %7,244
                      
                      
                      
                      7,426
                      
                      
                      
                      4.91
                      %Total
      securities held to maturityDue
      within one year
                      
                      
                      4,755
                      
                      
                      
                      4,823
                      
                      
                      
                      6.24
                      %Due
      after one but within five years
                      
                      
                      1,375
                      
                      
                      
                      1,446
                      
                      
                      
                      4.91
                      %Due
      after five but within ten years
                      
                      
                      2,304
                      
                      
                      
                      2,362
                      
                      
                      
                      7.53
                      %Due
      after ten years
                      
                      
                      2,485
                      
                      
                      
                      2,549
                      
                      
                      
                      5.53
                      %$
                      10,919
                      
                      
                      $
                      11,180
                      
                      
                      
                      6.18
                      %





(1)Yields on tax-exempt
investments have been adjusted to a taxable equivalent basis using federal and
state tax rates of 34% and 6.9%, respectively, less estimated disallowed
interest expense.




Page
61





At
December 31, 2009, there were no securities of any issuer (other than U.S.
government agencies) that exceeded 10% of the Company’s stockholders’
equity.





Derivative
Financial Instruments





A
derivative is a financial instrument that derives its cash flows, and therefore
its value, by reference to an underlying instrument, index or reference
rate.  These instruments primarily consist of interest rate swaps,
caps, floors, financial forward and futures contracts and options written or
purchased.  Derivative contracts are written in amounts referred to as
notional amounts.  Notional amounts only provide the basis for
calculating payments between counterparties and do not represent amounts to be
exchanged between parties and are not a measure of financial
risks.  Credit risk arises when amounts receivable from counterparties
exceed amounts payable.  We control our risk of loss on derivative
contracts by subjecting counterparties to credit reviews and approvals similar
to those used in making loans and other extensions of credit.





We have
used interest rate swaps, caps and floors in the management of interest rate
risk.  Interest rate swaps are contractual agreements between two
parties to exchange a series of cash flows representing interest
payments.  A swap allows both parties to alter the re-pricing
characteristics of assets or liabilities without affecting the underlying
principal positions.  Through the use of a swap, assets and
liabilities may be transformed from fixed to floating rates, from floating rates
to fixed rates, or from one type of floating rate to another.  At
December 31, 2009, interest rate swap arrangements with total notional amounts
of $85.0 million, with terms ranging up to five years, were
outstanding.  In addition, we had $22.5 million notional of interest
rate caps with up to fifty months remaining until maturity at year
end.  These instruments help protect the Company from changes in
interest rates by allowing us to receive payments from the counterparty on these
contracts when the referenced rate falls outside the level specified in the
agreement.





The
Company is exposed to credit-related losses in the event of nonperformance by
the counterparties to these agreements.  The Company controls the
credit risk of its financial contracts through credit approvals, limits and
monitoring procedures, and does not expect any counterparties to fail their
obligations.  Although the Company deals only with primary dealers, a
nonrecurring loss of $440 thousand was included in noninterest income during the
third quarter of 2008 related to the value of certain derivative positions on
our balance sheet due to the bankruptcy and technical default of Lehman
Brothers, the counterparty in the contracts.  Lehman Brothers held
$1.0 million of the Company’s U.S. Government Agency investment securities as
collateral in connection with certain terminated derivative contracts at
December 31, 2008.  During the second quarter of 2009, the $1.0
million in collateral was written off as the Company’s ability to recover the
value of the collateral became more in question.  During the third
quarter of 2009, we recovered $408 thousand from the sale and assignment of our
creditor claims in the Lehman bankruptcy to a third party.





A
discussion of derivatives is presented in Note 17 to our consolidated financial
statements, which are presented under Item 8 in this Form 10-K.





Sources
of Funds





Deposit
Activities





We
provide a range of deposit services, including non-interest-bearing checking
accounts, interest-bearing checking and savings accounts, money market accounts
and certificates of deposit.  These accounts generally earn interest
at rates established by management based on competitive market factors and our
desire to increase or decrease certain types or maturities of
deposits.  We have used brokered deposits and out-of-market deposits
as funding sources.  As of December 31, 2009, we have $214.7 million
of brokered deposits and $99 thousand of out-of-market
deposits.  However, we strive to establish customer relationships to
attract core deposits in non-interest-bearing and other transactional accounts
and thus to reduce our costs of funds.


Page
62


The
following table sets forth for the periods indicated the average balances
outstanding and average interest rates for each of our major categories of
deposits:





For the Years Ended December 31,2009
                
                
                2008
                
                
                2007Average
                
                
                Average
                
                
                Average
                
                
                Average
                
                
                Average
                
                
                AverageAmount
                
                
                Rate
                
                
                Amount
                
                
                Rate
                
                
                Amount
                
                
                Rate(Dollars in thousands)Interest-bearing
      NOW and money market accounts
                
                $
                466,667
                
                
                
                1.45
                %
                
                $
                510,357
                
                
                
                2.24
                %
                
                $
                441,716
                
                
                
                3.51
                %Time
      deposits $100,000 or more
                
                
                193,505
                
                
                
                2.50
                %
                
                
                137,841
                
                
                
                4.86
                %
                
                
                311,125
                
                
                
                4.54
                %Other
      time deposits
                
                
                486,721
                
                
                
                3.04
                %
                
                
                428,950
                
                
                
                3.86
                %
                
                
                169,236
                
                
                
                5.25
                %Total
      interest-bearing deposits
                
                
                1,146,893
                
                
                
                2.30
                %
                
                
                1,077,148
                
                
                
                3.22
                %
                
                
                922,077
                
                
                
                4.18
                %Demand
      and other non-interest-bearing deposits
                
                
                107,461
                
                
                
                
                
                
                
                104,978
                
                
                
                
                
                
                
                108,874Total
      average deposits
                
                $
                1,254,354
                
                
                
                2.11
                %
                
                $
                1,182,126
                
                
                
                2.93
                %
                
                $
                1,030,951
                
                
                
                3.74
                %





The
following table presents the amounts and maturities of our certificates of
deposit with balances of $100,000 or more at December 31, 2009:




At December 31, 2009(In thousands)Remaining
      MaturityLess
      than three months
                  
                  $
                  16,359Three
      to six months
                  
                  
                  18,970Six
      to twelve months
                  
                  
                  30,396Over
      twelve months
                  
                  
                  112,400Total
                  
                  $
                  178,125




Borrowings





To
supplement deposits, our primary source of funding, the Company utilizes
borrowings for loan growth and other liquidity needs.  The following
is a summary of our borrowings at December 31, 2009 and 2008:





2009
                  
                  
                  2008(Amounts in thousands)Short-term
      borrowingsFHLB
      advances
                  
                  $
                  31,250
                  
                  
                  $
                  62,000Federal
      funds purchased
                  
                  
                  -
                  
                  
                  
                  -Term
      Auction Facility
                  
                  
                  -
                  
                  
                  
                  60,000Repurchase
      agreements
                  
                  
                  14,861
                  
                  
                  
                  23,197Other
      borrowed funds
                  
                  
                  39,366
                  
                  
                  
                  -$
                  85,477
                  
                  
                  $
                  145,197Long-term
      borrowingsFHLB
      advances
                  
                  $
                  73,226
                  
                  
                  $
                  92,139Term
      repurchase agreements
                  
                  
                  80,000
                  
                  
                  
                  90,000Jr.
      subordinated debentures
                  
                  
                  45,877
                  
                  
                  
                  45,877$
                  199,103
                  
                  
                  $
                  228,016




Page
63




Short
term advances from the FHLB are collateralized as described below and are
scheduled to be repaid within one year based on the terms of the individual
borrowing.  Securities sold under agreements to repurchase are
scheduled to be repaid within one year based on the terms of the individual
borrowing, or provided solely as an accommodation to our
customers.  Customer repurchase agreements are collateralized by U.S.
government agency obligations and generally mature within ninety days from the
transaction date.  The Company purchases federal funds through
unsecured lines of credit with various banks aggregating $102.0
million.  Federal funds purchased are subject to restrictions limiting
the frequency and term of advances, are payable on demand and bear interest
based upon the daily federal funds rate.





As an
additional source of funding, the Company has long term borrowings including
long term advances from the FHLB, term repurchase agreements from other
commercial and investment banks and debt associated with the issuance of trust
preferred securities.  Total FHLB advances outstanding of $104.5
million at December 31, 2009 are collateralized by loans with a carrying amount
of $77.4 million, which approximates market value, and investment securities
with a market value of $49.5 million.  The Company also has term
repurchase lines of $100.0 million from various institutions that were
collateralized by investment securities having a carrying value of $107.1
million.  Certain of these agreements contain embedded interest rate
or call options that may be exercised by us or the counterparty.  The
following table presents the maturities for long term FHLB advances and term
repurchase agreements.





Long term borrowings
                      
                      At December 31, 2009FHLB Advances
                      
                      
                      Term RepoYears of maturity
                      
                      Interest Rate
                      
                      
                      Amount
                      
                      
                      Interest Rate
                      
                      
                      Amount(In
      thousands)
                      
                      
                      
                      
                      
                      (In
      thousands)2011
                      
                      
                      1.56
                      %
                      
                      
                      16,250
                      
                      
                      
                      -
                      
                      
                      
                      -2012
                      
                      
                      3.84
                      %
                      
                      
                      5,000
                      
                      
                      
                      4.56
                      %
                      
                      
                      20,0002013
                      
                      
                      3.46
                      %
                      
                      
                      10,000
                      
                      
                      
                      -
                      
                      
                      
                      -2014
                      
                      
                      4.17
                      %
                      
                      
                      25,000
                      
                      
                      
                      -
                      
                      
                      
                      -Thereafter
                      
                      
                      3.14
                      %
                      
                      
                      16,976
                      
                      
                      
                      3.51
                      %
                      
                      
                      60,000$
                      73,226
                      
                      
                      
                      
                      
                      
                      $
                      80,000





In
November 2003, Southern Community Capital Trust II (“Trust II”), a newly formed
subsidiary of the Company, issued 3,450,000 shares of 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 Company is amortizing the issuance
costs of these securities over their contractual life of thirty
years.  The unamortized balance of these issuance costs at December
31, 2008 was $1.3 million.  The proceeds from the Trust II Securities
were utilized to purchase junior subordinated debentures from the Bank under the
same terms and conditions as the Trust II Securities.  We have the
right to defer payment of interest on the debentures at any time and from time
to time for a period not exceeding five years, provided that no deferral period
extends beyond the stated maturities of the debentures.  Such deferral
of interest payments by the Company will result in a deferral of distribution
payments on the related Trust II Securities.  If we defer the payment
of interest on the debentures, the Company will be precluded from the payment of
cash dividends to shareholders.  The principal uses of the net
proceeds from the sale of the debentures were to provide cash for the
acquisition of The Community Bank, to increase our regulatory capital, and to
support the growth and operations of our subsidiary bank.





In June
2007, $10.0 million of trust preferred securities were placed through Southern
Community Capital Trust III (“Trust III”), as part of a pooled trust preferred
security.  The Trust issuer invested the total proceeds from the sale
of the trust preferred securities in junior subordinated deferrable interest
debentures (the “Junior Subordinated Debentures”) issued by the
Company.  The terms of the trust preferred securities require payment
of cumulative cash distributions quarterly at an annual rate, reset quarterly,
equal to LIBOR plus 1.43%.  During 2008, the Company entered into an
interest rate swap derivative contract with a counterparty that shifted this
debt service from a variable rate to a fixed rate of 4.7% per
annum.  The dividends paid to holders of the trust preferred
securities, which are recorded as interest expense, are deductible for income
tax purposes.  The trust preferred securities are redeemable in 30
years with a five year call provision.  The Company has fully and
unconditionally guaranteed the trust preferred securities through the combined
operation of the debentures and other related documents.  The
Company’s obligation under the guarantee is unsecured and subordinate to senior
and subordinated indebtedness of the Company.  The principal use of
the net proceeds from the sale of the debentures was to provide additional
capital into the Company to fund its operations and continued expansion, and to
maintain the Company’s and the Bank’s status as “well capitalized” under
regulatory guidelines.




Page
64





The
amount of the proceeds generated from the above offerings of trust preferred
securities was $44.5 million.  The amount of proceeds we count as Tier
1 capital cannot comprise more than 25% of our core capital
elements.  For us, this Tier 1 limit was $41.4 million at December 31,
2009.  The $3.1 million in excess of that 25% limitation counts as
Tier 2 supplementary capital on our books.





The
carrying value of the junior subordinated debentures in connection with the two
issues of trust preferred securities described above was $45.9 million at
December 31, 2009.





RECENT
ACCOUNTING PRONOUNCEMENTS





A
discussion of recent accounting pronouncements is presented in Note 2 to our
consolidated financial statements, which are presented under Item 8 in this Form
10-K.





SPECIAL
NOTE REGARDING FORWARD-LOOKING STATEMENTS





Statements
contained in this annual report, which are not historical facts, are
forward-looking statements, as that term is defined in the Private Securities
Litigation Reform Act of 1995.  Amounts herein could vary as a result
of market and other factors.  Such forward-looking statements are
subject to risks and uncertainties which could cause actual results to differ
materially from those currently anticipated due to a number of factors, which
include, but are not limited to, factors discussed in documents filed by the
Company with the Securities and Exchange Commission from time to
time.  Such forward-looking statements may be identified by the use of
such words as “believe,” “expect,” “anticipate,” “should,” “planned,”
“estimated,” and “potential.”  Examples of forward-looking statements
include, but are not limited to, estimates with respect to the financial
condition, expected or anticipated revenue, results of operations and business
of the Company that are subject to various factors which could cause actual
results to differ materially from these estimates.  These factors
include, but are not limited to, general economic conditions, changes in
interest rates, deposit flows, loan demand, real estate values and competition;
changes in accounting principles, policies, or guidelines; changes in
legislation or regulation; and other economic, competitive, governmental,
regulatory and technological factors affecting the Company's operations,
pricing, products and services.





Item
7A. Quantitative and Qualitative Disclosures About Market Risk





See
“MARKET RISK” under Item 7.





Item
8. Financial Statements and Supplementary Data





The
information required by this item is filed herewith.


Page
65








Report
of Independent Registered Public Accounting Firm





To the
Stockholders and the Board of Directors


Southern
Community Financial Corporation and Subsidiary


Winston-Salem,
North Carolina





We have
audited the accompanying consolidated statements of financial condition of
Southern Community Financial Corporation and Subsidiary as of December 31, 2009
and 2008, and the related consolidated statements of operations, comprehensive
income (loss), changes in stockholders’ equity and cash flows for each of the
years in the three-year period ended December 31, 2009.  These
consolidated financial statements are the responsibility of the Company’s
management.  Our responsibility is to express an opinion on these
consolidated financial statements based on our audits.





We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States).  Those standards require
that we plan and perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatement.  An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. An audit also includes assessing the
accounting principles used and significant estimates made by management, as well
as evaluating the overall financial statement presentation.  We
believe that our audits provide a reasonable basis for our opinion.





In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of Southern Community Financial
Corporation and Subsidiary at December 31, 2009 and 2008 and the results of
their operations and their cash flows for each of the years in the three-year
period ended December 31, 2009 in conformity with accounting principles
generally accepted in the United States of America.





We have
also audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the effectiveness of Southern Community
Financial Corporation’s internal control over financial reporting as of December
31, 2009, based on criteria established in Internal Control – Integrated
Framework issued by the Committee of Sponsoring Organizations of the Treadway
Commission, and our report dated March 15, 2010 expressed an unqualified opinion
on the effectiveness of the Company’s internal control over financial
reporting.





/s/
Dixon Hughes PLLC





Raleigh,
North Carolina


March
15, 2010


Page
66


SOUTHERN
COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
 CONSOLIDATED
STATEMENTS OF FINANCIAL CONDITION
 December
31, 2009 and 2008







2009
                
                
                2008(Amounts in thousands, except
                  share data)AssetsCash
      and due from banks
                
                $
                30,184
                
                
                $
                25,215Federal
      funds sold
                
                
                31,269
                
                
                
                2,180Investment
      securities (Note 3)Available
      for sale, at fair value
                
                
                312,780
                
                
                
                289,466Held
      to maturity, (fair value of $11,180 and $35,531at December 31, 2009 and
      2008, respectively)
                
                
                10,919
                
                
                
                35,231Federal
      Home Loan Bank stock
                
                
                9,794
                
                
                
                9,757Loans
      held for sale
                
                
                3,025
                
                
                
                316Loans
      (Note 4)
                
                
                1,230,275
                
                
                
                1,314,811Allowance
      for loan losses (Note 5)
                
                
                (29,638
                )
                
                
                (18,851
                )Net
      Loans
                
                
                1,200,637
                
                
                
                1,295,960Premises
      and equipment (Note 6)
                
                
                42,630
                
                
                
                40,030Goodwill
      (Note 7)
                
                
                -
                
                
                
                49,501Foreclosed
      assets (Note 4)
                
                
                19,634
                
                
                
                5,745Other
      assets (Notes 7 and 14)
                
                
                67,736
                
                
                
                50,377Total
      Assets
                
                $
                1,728,608
                
                
                $
                1,803,778Liabilities
      and Stockholders’ EquityDepositsDemand
                
                $
                118,372
                
                
                $
                102,048Money
      market and NOW
                
                
                567,435
                
                
                
                462,796Savings
                
                
                11,592
                
                
                
                10,616Time
      (Note 8)
                
                
                616,671
                
                
                
                655,292Total
      Deposits
                
                
                1,314,070
                
                
                
                1,230,752Short-term
      borrowings (Note 9)
                
                
                85,477
                
                
                
                147,557Long-term
      borrowings (Notes 9 and 10)
                
                
                199,103
                
                
                
                228,016Other
      liabilities (Note 12)
                
                
                7,961
                
                
                
                9,743Total
      Liabilities
                
                
                1,606,611
                
                
                
                1,616,068Stockholders’
      Equity (Notes 10, 11 and 16)Senior
      Cumulative Perpetual Preferred Stock (Series A), no par value, 1,000,000
      shares authorized; 42,750 shares issued and outstanding  at
      December 31, 2009 and 2008
                
                
                41,060
                
                
                
                40,690Common
      stock, no par value, 30,000,000 shares authorized; issued and outstanding
      16,787,675 shares and 16,769,675 shares at December 31, 2009 and 2008,
      respectively
                
                
                119,282
                
                
                
                119,054Retained
      earnings (accumulated deficit)
                
                
                (41,430
                )
                
                
                24,901Accumulated
      other comprehensive income
                
                
                3,085
                
                
                
                3,065Total
      Stockholders’ Equity
                
                
                121,997
                
                
                
                187,710Commitments
      and contingencies (Notes 13 and 18)Total
      Liabilities and
                  Stockholders’
      Equity
                
                $
                1,728,608
                
                
                $
                1,803,778





See
accompanying notes.


Page
67


SOUTHERN
COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
 CONSOLIDATED
STATEMENTS OF OPERATIONS
 Years
Ended December 31, 2009, 2008 and 2007







2009
                
                
                2008
                
                
                2007(Amounts in thousands, exceptshare and per share data)Interest
      IncomeLoans
                
                $
                74,548
                
                
                $
                82,125
                
                
                $
                86,673Investment
      securities available for sale
                
                
                14,035
                
                
                
                12,378
                
                
                
                8,819Investment
      securities held to maturity
                
                
                877
                
                
                
                2,184
                
                
                
                3,208Federal
      funds sold
                
                
                13
                
                
                
                55
                
                
                
                208Total
      Interest Income
                
                
                89,473
                
                
                
                96,742
                
                
                
                98,908Interest
      ExpenseMoney
      market, savings, and NOW deposits
                
                
                6,787
                
                
                
                11,412
                
                
                
                15,499Time
      deposits
                
                
                19,631
                
                
                
                23,236
                
                
                
                23,024Short-term
      borrowings
                
                
                1,701
                
                
                
                3,808
                
                
                
                4,758Long-term
      borrowings
                
                
                9,607
                
                
                
                10,826
                
                
                
                11,860Total
      Interest Expense
                
                
                37,726
                
                
                
                49,282
                
                
                
                55,141Net
      Interest Income
                
                
                51,747
                
                
                
                47,460
                
                
                
                43,767Provision
      for Loan Losses (Note 5)
                
                
                34,000
                
                
                
                8,165
                
                
                
                2,775Net
      Interest Income After
                  Provision
      for Loan Losses
                
                
                17,747
                
                
                
                39,295
                
                
                
                40,992Non-Interest
      Income (Note 15)
                
                
                12,906
                
                
                
                11,341
                
                
                
                11,329Non-Interest
      ExpenseSalaries
      and employee benefits
                
                
                22,502
                
                
                
                22,038
                
                
                
                21,218Occupancy
      and equipment
                
                
                7,903
                
                
                
                7,679
                
                
                
                7,928Goodwill
      Impairment
                
                
                49,501
                
                
                
                -
                
                
                
                -Other
      (Note 15)
                
                
                20,592
                
                
                
                12,431
                
                
                
                11,752Total
      Non-Interest Expense
                
                
                100,498
                
                
                
                42,148
                
                
                
                40,898Income
      (Loss) Before Income Taxes
                
                
                (69,845
                )
                
                
                8,488
                
                
                
                11,423Income
      Tax Expense (Benefit) (Note 14)
                
                
                (6,686
                )
                
                
                2,634
                
                
                
                3,869Net
      Income (loss)
                
                
                (63,159
                )
                
                
                5,854
                
                
                
                7,554Effective
      dividends on preferred stock (Note 11)
                
                
                2,508
                
                
                
                185
                
                
                
                -Net
      income (loss) available to common shareholders
                
                $
                (65,667
                )
                
                $
                5,669
                
                
                $
                7,554Net
      Income (loss) Per Common ShareBasic
                
                $
                (3.91
                )
                
                $
                0.33
                
                
                $
                0.43Diluted
                
                
                (3.91
                )
                
                
                0.33
                
                
                
                0.43Weighted
      Average Common Shares OutstandingBasic
                
                
                16,787,938
                
                
                
                17,363,395
                
                
                
                17,559,352Diluted
                
                
                16,787,938
                
                
                
                17,398,318
                
                
                
                17,624,399





See
accompanying notes.


Page
68


SOUTHERN
COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
 CONSOLIDATED
STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
 Years
Ended December 31, 2009, 2008 and 2007





2009
                
                
                2008
                
                
                2007(Amounts in thousands)Net
      income (loss)
                
                $
                (63,159
                )
                
                $
                5,854
                
                
                $
                7,554Other
      comprehensive income (loss):Securities
      available for sale:Unrealized
      holding gains on available for sale securities
                
                
                1,012
                
                
                
                4,387
                
                
                
                2,450Tax
      effect
                
                
                (390
                )
                
                
                (1,692
                )
                
                
                (945
                )Reclassification
      of gains recognized in net income
                
                
                (1,236
                )
                
                
                (98
                )
                
                
                -Tax
      effect
                
                
                476
                
                
                
                38
                
                
                
                -Net
      of tax amount
                
                
                (138
                )
                
                
                2,635
                
                
                
                1,505Cash
      flow hedging activities:Unrealized
      holding gains (losses) on cash flow hedging activities
                
                
                354
                
                
                
                (982
                )
                
                
                274Tax
      effect
                
                
                (137
                )
                
                
                343
                
                
                
                (105
                )Loss
      due to counterparty default net of amortization
                
                
                -
                
                
                
                240
                
                
                
                -Reclassification
      of gains recognized in net income, netReclassified
      into income
                
                
                233
                
                
                
                78
                
                
                
                54Tax
      effect
                
                
                (90
                )
                
                
                (29
                )
                
                
                (21
                )Amortization
      of terminated floor contract
                
                
                (373
                )
                
                
                -
                
                
                
                -Tax
      effect
                
                
                144
                
                
                
                -
                
                
                
                -Other
                
                
                58
                
                
                
                -
                
                
                
                -Tax
      effect
                
                
                (23
                )
                
                
                -
                
                
                
                -Net
      of tax amount
                
                
                166
                
                
                
                (350
                )
                
                
                202Net
      postretirement benefit plans adjustment
                
                
                (14
                )
                
                
                (423
                )
                
                
                150Tax
      effect
                
                
                6
                
                
                
                163
                
                
                
                (58
                )Net
      of tax amount
                
                
                (8
                )
                
                
                (260
                )
                
                
                92Total
      other comprehensive income
                
                
                20
                
                
                
                2,025
                
                
                
                1,799Comprehensive
      income (loss)
                
                $
                (63,139
                )
                
                $
                7,879
                
                
                $
                9,353





See
accompanying notes.


Page
69


SOUTHERN
COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
 CONSOLIDATED
STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
 Years
Ended December 31, 2009, 2008 and 2007





AccumulatedRetained
                
                
                Other
                
                
                TotalPreferred
      Stock
                
                
                Common
      Stock
                
                
                Earnings
                
                
                Comprehensive
                
                
                Stockholders'Shares
                
                
                Amount
                
                
                Shares
                
                
                Amount
                
                
                (Deficit)
                
                
                Income
      (Loss)
                
                
                Equity(Amounts
      in thousands, except share data)Balance
      at December 31, 2006
                
                
                -
                
                
                $
                -
                
                
                
                17,405,940
                
                
                $
                119,616
                
                
                $
                17,368
                
                
                $
                (759
                )
                
                $
                136,225Net
      income
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                7,554
                
                
                
                
                
                
                
                7,554Other
      comprehensive income, net of tax
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                1,799
                
                
                
                1,799Common
      shares repurchased
                
                
                -
                
                
                
                -
                
                
                
                (286,972
                )
                
                
                (2,357
                )
                
                
                -
                
                
                
                -
                
                
                
                (2,357
                )Stock
      options exercised including income tax benefit of $559
                
                
                -
                
                
                
                -
                
                
                
                263,414
                
                
                
                1,737
                
                
                
                -
                
                
                
                -
                
                
                
                1,737Restricted
      stock issued
                
                
                -
                
                
                
                -
                
                
                
                17,500
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -Stock-based
      compensation
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                105
                
                
                
                -
                
                
                
                -
                
                
                
                105Cash
      dividends of $0.155 per share
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                (2,724
                )
                
                
                -
                
                
                
                (2,724
                )Balance
      at December 31, 2007
                
                
                -
                
                
                
                -
                
                
                
                17,399,882
                
                
                
                119,101
                
                
                
                22,198
                
                
                
                1,040
                
                
                
                142,339Net
      income
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                5,854
                
                
                
                -
                
                
                
                5,854Other
      comprehensive income, net of tax
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                2,025
                
                
                
                2,025Common
      shares repurchased
                
                
                -
                
                
                
                -
                
                
                
                (733,175
                )
                
                
                (2,700
                )
                
                
                -
                
                
                
                -
                
                
                
                (2,700
                )Stock
      options exercised including income tax benefit of $51
                
                
                -
                
                
                
                -
                
                
                
                73,968
                
                
                
                408
                
                
                
                -
                
                
                
                -
                
                
                
                408Restricted
      stock issued
                
                
                -
                
                
                
                -
                
                
                
                29,000
                
                
                
                44
                
                
                
                -
                
                
                
                -
                
                
                
                44Stock-based
      compensation
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                111
                
                
                
                -
                
                
                
                -
                
                
                
                111Cash
      dividends of $0.16 per share
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                (2,781
                )
                
                
                -
                
                
                
                (2,781
                )Cumulative
      effect of accounting method change
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                (185
                )
                
                
                -
                
                
                
                (185
                )Preferred
      stock transaction:Issuance
      of preferred stock
                
                
                42,750
                
                
                
                42,750
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                42,750Discount
      on preferred stock
                
                
                -
                
                
                
                (2,090
                )
                
                
                -
                
                
                
                2,090
                
                
                
                -
                
                
                
                -
                
                
                
                -Accretion
      of discount
                
                
                -
                
                
                
                30
                
                
                
                -
                
                
                
                -
                
                
                
                (30
                )
                
                
                -
                
                
                
                -Preferred
      stock dividend accrued
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                (155
                )
                
                
                -
                
                
                
                (155
                )Balance
      at December 31, 2008
                
                
                42,750
                
                
                
                40,690
                
                
                
                16,769,675
                
                
                
                119,054
                
                
                
                24,901
                
                
                
                3,065
                
                
                
                187,710Net
      income (loss)
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                (63,159
                )
                
                
                -
                
                
                
                (63,159
                )Other
      comprehensive income, net of tax
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                20
                
                
                
                20Common
      shares repurchased
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -Stock
      options exercised including income tax benefit of $0
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -Restricted
      stock issued
                
                
                -
                
                
                
                -
                
                
                
                18,000
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -Stock-based
      compensation
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                228
                
                
                
                -
                
                
                
                -
                
                
                
                228Cash
      dividends of $0.04 per share
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                (664
                )
                
                
                -
                
                
                
                (664
                )Preferred
      stock transaction:Preferred
      stock dividends
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                (2,138
                )
                
                
                -
                
                
                
                (2,138
                )Preferred
      stock accretion of discount
                
                
                -
                
                
                
                370
                
                
                
                -
                
                
                
                -
                
                
                
                (370
                )
                
                
                -
                
                
                
                -Balance
      at December 31, 2009
                
                
                42,750
                
                
                $
                41,060
                
                
                
                16,787,675
                
                
                $
                119,282
                
                
                $
                (41,430
                )
                
                $
                3,085
                
                
                $
                121,997





See
accompanying notes.


Page
70


SOUTHERN
COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
 CONSOLIDATED
STATEMENTS OF CASH FLOWS
 Years
Ended December 31, 2009, 2008 and 2007





2009
                        
                        
                        2008
                        
                        
                        2007(Amounts in thousands)Cash
      Flows from Operating ActivitiesNet
      income (loss)
                        
                        $
                        (63,159
                        )
                        
                        $
                        5,854
                        
                        
                        $
                        7,554Adjustments
      to reconcile net income to net cash provided by operating
      activities:Depreciation
      and amortization
                        
                        
                        4,131
                        
                        
                        
                        3,817
                        
                        
                        
                        4,184Provision
      for loan losses
                        
                        
                        34,000
                        
                        
                        
                        8,165
                        
                        
                        
                        2,775Net
      proceeds from sales of loans held for sale
                        
                        
                        175,887
                        
                        
                        
                        70,222
                        
                        
                        
                        82,906Originations
      of loans held for sale
                        
                        
                        (176,492
                        )
                        
                        
                        (67,315
                        )
                        
                        
                        (79,897
                        )Gain
      from mortgage banking
                        
                        
                        (2,104
                        )
                        
                        
                        (1,294
                        )
                        
                        
                        (1,343
                        )Stock-based
      compensation
                        
                        
                        228
                        
                        
                        
                        155
                        
                        
                        
                        105Net
      increase in cash surrender value of life insurance
                        
                        
                        (1,101
                        )
                        
                        
                        (841
                        )
                        
                        
                        (670
                        )Realized
      gain on sales of available for sale securities
                        
                        
                        (1,236
                        )
                        
                        
                        (98
                        )
                        
                        
                        -Realized
      loss of equity investment in Silverton Bank
                        
                        
                        404
                        
                        
                        
                        -
                        
                        
                        
                        -Realized
      (gain) loss on sale of premises and equipment
                        
                        
                        (57
                        )
                        
                        
                        74
                        
                        
                        
                        (119
                        )Gain
      (loss) on economic hedges
                        
                        
                        826
                        
                        
                        
                        (934
                        )
                        
                        
                        (79
                        )Deferred
      income taxes
                        
                        
                        (5,836
                        )
                        
                        
                        (2,475
                        )
                        
                        
                        (814
                        )Realized
      (gain) loss on sale of foreclosed assets
                        
                        
                        (196
                        )
                        
                        
                        59
                        
                        
                        
                        (2
                        )OREO
      writedown
                        
                        
                        2,493
                        
                        
                        
                        99
                        
                        
                        
                        -Goodwill
      impairment
                        
                        
                        49,501
                        
                        
                        
                        291
                        
                        
                        
                        -Change
      in assets and liabilities:Increase
      in other assets
                        
                        
                        (10,669
                        )
                        
                        
                        1,706
                        
                        
                        
                        (3,440
                        )Increase
      (decrease) in other liabilities
                        
                        
                        (2,608
                        )
                        
                        
                        926
                        
                        
                        
                        (787
                        )Total
      Adjustments
                        
                        
                        67,171
                        
                        
                        
                        12,557
                        
                        
                        
                        2,819Net
      Cash Provided by Operating Activities
                        
                        
                        4,012
                        
                        
                        
                        18,411
                        
                        
                        
                        10,373Cash
      Flows from Investing Activities(Increase)
      decrease in federal funds sold
                        
                        
                        (29,089
                        )
                        
                        
                        70
                        
                        
                        
                        (1,467
                        )Purchases
      of:Available
      for sale investment securities
                        
                        
                        (215,169
                        )
                        
                        
                        (229,894
                        )
                        
                        
                        (12,301
                        )Held
      to maturity investment securities
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        (1,719
                        )Proceeds
      from maturities and calls of:Available
      for sale investment securities
                        
                        
                        122,115
                        
                        
                        
                        42,593
                        
                        
                        
                        25,660Held
      to maturity investment securities
                        
                        
                        24,309
                        
                        
                        
                        34,568
                        
                        
                        
                        18,266Proceeds
      from sale of:Available
      for sale investment securities
                        
                        
                        69,846
                        
                        
                        
                        49,602
                        
                        
                        
                        -Purchase
      of Federal Home Loan Bank stock
                        
                        
                        (421
                        )
                        
                        
                        (3,613
                        )
                        
                        
                        (5,591
                        )Proceeds
      from sales of Federal Home Loan Bank stock
                        
                        
                        384
                        
                        
                        
                        5,550
                        
                        
                        
                        4,457Net
      (increase) decrease in loans
                        
                        
                        35,421
                        
                        
                        
                        (135,984
                        )
                        
                        
                        (158,513
                        )OREO
      capitalized cost
                        
                        
                        (758
                        )
                        
                        
                        (43
                        )
                        
                        
                        -Purchases
      of premises and equipment
                        
                        
                        (5,962
                        )
                        
                        
                        (4,599
                        )
                        
                        
                        (2,260
                        )Proceeds
      from disposal of premises and equipment
                        
                        
                        59
                        
                        
                        
                        8
                        
                        
                        
                        6Proceeds
      from sale of foreclosed assets
                        
                        
                        10,699
                        
                        
                        
                        1,047
                        
                        
                        
                        1,415Purchase
      of bank-owned life insurance
                        
                        
                        -
                        
                        
                        
                        (10,000
                        )
                        
                        
                        -Net
      Cash Provided by (Used) in Investing Activities
                        
                        
                        11,434
                        
                        
                        
                        (250,695
                        )
                        
                        
                        (132,047
                        )Cash
      Flows from Financing ActivitiesNet
      increase (decrease) in demand deposits and transaction
      accounts
                        
                        
                        119,579
                        
                        
                        
                        (27,523
                        )
                        
                        
                        103,241Net
      increase (decrease) in time deposits
                        
                        
                        (38,621
                        )
                        
                        
                        215,398
                        
                        
                        
                        (82,586
                        )Net
      increase (decrease) in short-term borrowings
                        
                        
                        (59,720
                        )
                        
                        
                        27,425
                        
                        
                        
                        25,024Proceeds
      from long-term borrowings
                        
                        
                        16,250
                        
                        
                        
                        50,000
                        
                        
                        
                        120,238Repayment
      of long-term borrowings
                        
                        
                        (45,163
                        )
                        
                        
                        (77,383
                        )
                        
                        
                        (38,154
                        )Net
      proceeds from issuance of preferred stock
                        
                        
                        -
                        
                        
                        
                        42,750
                        
                        
                        
                        -Net
      proceeds from exercise of stock options
                        
                        
                        -
                        
                        
                        
                        408
                        
                        
                        
                        1,737Cost
      of shares repurchased
                        
                        
                        -
                        
                        
                        
                        (2,700
                        )
                        
                        
                        (2,357
                        )Preferred
      dividends paid
                        
                        
                        (2,138
                        )
                        
                        
                        -
                        
                        
                        
                        -Cash
      dividends paid
                        
                        
                        (664
                        )
                        
                        
                        (2,781
                        )
                        
                        
                        (2,724
                        )Net
      Cash Provided by (used) Financing Activities
                        
                        
                        (10,477
                        )
                        
                        
                        225,594
                        
                        
                        
                        124,419Net
      Increase (decrease) in Cash and Cash Equivalents
                        
                        
                        4,969
                        
                        
                        
                        (6,690
                        )
                        
                        
                        2,745Cash
      and Cash Equivalents, Beginning of Year
                        
                        
                        25,215
                        
                        
                        
                        31,905
                        
                        
                        
                        29,160Cash
      and Cash Equivalents, End of Year
                        
                        $
                        30,184
                        
                        
                        $
                        25,215
                        
                        
                        $
                        31,905





See
accompanying notes.


Page
71


SOUTHERN
COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
 CONSOLIDATED
STATEMENTS OF CASH FLOWS (Continued)
 Years
Ended December 31, 2009, 2008 and 2007





2009
                
                
                2008
                
                
                2007(Amounts
      in thousands)Supplemental
      Disclosures of Cash Flow InformationInterest
      paid on deposits and borrowed funds
                
                $
                40,835
                
                
                $
                46,370
                
                
                $
                55,944Income
      taxes paid
                
                
                754
                
                
                
                5,140
                
                
                
                4,663Supplemental
      Schedule of Noncash Investing and Financing ActivitiesTransfer
      of loans to foreclosed assets
                
                $
                25,902
                
                
                $
                6,082
                
                
                $
                1,294Increase
      (decrease) in fair value of securities available for sale, net of
      tax
                
                
                (138
                )
                
                
                2,635
                
                
                
                1,505Increase
      (decrease) in fair value of cash flow hedges, net of tax
                
                
                166
                
                
                
                (350
                )
                
                
                202Unrealized
      gain on fair value hedges
                
                
                161
                
                
                
                456
                
                
                
                238





See
accompanying notes.


Page
72


SOUTHERN
COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 Years
Ended December 31, 2009, 2008 and 2007





(1)  NATURE
OF OPERATIONS





Southern
Community Bank and Trust (the “Bank”) was incorporated November 14, 1996 and
began banking operations on November 18, 1996.  The Bank is engaged in
general commercial and retail banking principally in Central and Western North
Carolina, operating under the banking laws of North Carolina and the rules and
regulations of the Federal Deposit Insurance Corporation.  In October
2001, Southern Community Financial Corporation (the “Company”) was formed as a
financial holding company for the Bank, and is subject to the rules and
regulations of the Federal Reserve System.  The Bank and the Company
undergo periodic examinations by those regulatory authorities.





(2)  SUMMARY
OF SIGNIFICANT ACCOUNTING POLICIES





The
consolidated financial statements include the accounts of Southern Community
Financial Corporation and its wholly-owned subsidiary, Southern Community Bank
and Trust.  All material intercompany transactions and balances have
been eliminated in consolidation.  Southern Community Financial
Corporation and its subsidiary are collectively referred to herein as the
“Company.”





Use
of Estimates





The
preparation of consolidated financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities, the disclosure of contingent assets and liabilities at
the date of the consolidated financial statements, and the reported amounts of
revenues and expenses during the reporting period.  Actual results
could differ from those estimates.  Material estimates that are
particularly susceptible to significant change relate to the determination of
the allowance for losses on loans.





Cash
and Cash Equivalents





For the
purpose of presentation in the consolidated statements of cash flows, cash and
cash equivalents are defined as those amounts included in the balance sheet
caption “Cash and due from banks,”  which include cash on hand and
amounts due from banks.





Federal
regulations require institutions to set aside specified amounts of cash as
reserves against transaction and time deposits.  As of December 31,
2009, the daily average gross reserve requirement was $9.9 million.





Investment
Securities





Available
for sale securities are carried at fair value and consist of bonds,
mortgage-backed securities and municipal securities not classified as trading
securities or as held to maturity securities.  The cost of debt
securities available for sale is adjusted for amortization of premiums and
accretion of discounts to maturity.  Amortization of premiums,
accretion of discounts, interest and dividend income are included in investment
income.  Unrealized holding gains and losses on available for sale
securities are reported as a net amount in accumulated other comprehensive
income, net of income taxes.  Gains and losses on the sale of
available for sale securities are determined using the specific identification
method.  Bonds and mortgage-backed securities for which the Bank has
the positive intent and ability to hold to maturity are reported at cost,
adjusted for premiums and discounts that are recognized in interest income using
a method that approximates the interest method over the period to
maturity.  Declines in the fair value of individual held to maturity
and available for sale securities below their cost that are other than temporary
would result in a permanent write down of the individual securities to their
fair value if they are credit related.  Such write-downs would be
included in earnings as realized losses.  Declines in fair value of
individual debt securities that are not credit related including securities with
below market interest rates are included in other comprehensive
income.  If the Company intends to sell a security or cannot assert
that it is more likely than not to have to sell the security the loss must be
included as a realized loss regardless of the reason for
impairment.  The classification of securities is generally determined
at the date of purchase.





Federal
Home Loan Bank Stock





The
Company has an investment in the Federal Home Loan Bank of Atlanta which does
not have readily determinable fair value and we do not exercise significant
influence on them.  The Company carries its investment in FHLB at its
cost which is the par value of the stock.


Page
73


SOUTHERN
COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 Years
Ended December 31, 2009, 2008 and 2007





(2)  SUMMARY
OF SIGNIFICANT ACCOUNTING POLICIES (Continued)





Loans
Held for Sale




The
Company originates single family, residential first mortgage loans on a pre-sold
basis.  Loans held for sale are carried at the lower of cost or fair
value in the aggregate as determined by outstanding commitments from
investors.  Upon closing, these loans, together with their servicing
rights, are sold to mortgage loan investors under prearranged
terms.  The Company recognizes certain origination and service release
fees upon the sale, which are included in non-interest income in the
consolidated statement of operations.





Loans





Loans
that management has the intent and ability to hold for the foreseeable future or
until maturity are reported at their outstanding principal adjusted for any
charge-offs, the allowance for loan losses and any deferred fees or costs on
originated loans and unamortized premiums or discounts on purchased
loans.  Loan origination fees and certain direct origination costs are
capitalized and recognized as an adjustment to yield over the life of the
related loan.  Interest on loans is recorded based on the principal
amount outstanding.  The accrual of interest on impaired loans is
discontinued when, in management’s opinion, the borrower may be unable to meet
payments as they become due.  When interest accrual is discontinued,
all unpaid accrued interest is reversed against interest
income.  Interest income is subsequently recognized only to the extent
cash payments are received. Loans are written down or charged off when
management has determined the loan to be uncollectible in part or in
total.





Allowance
for Loan Losses





The
provision for loan losses is based upon management’s estimate of the amount
needed to maintain the allowance for loan losses at a level believed adequate to
absorb probable losses inherent in the loan portfolio.  The Bank’s
format for the calculation of ALLL begins with the evaluation of loans under
impairment guidelines.  For the purposes of evaluating loans for
impairment, loans are considered impaired when it is considered probable that
all amounts due under the contractual terms of the loan will not be collected
when due (minor shortfalls in amount or timing excepted).  The Bank
has established policies and procedures for identifying loans that should be
considered for impairment.  Loans are reviewed through multiple means
such as delinquency management, credit risk reviews, watch and criticized loan
monitoring meetings and general account management.  Loans that are
outside of the Bank’s established criteria for evaluation may be considered for
impairment testing when management deems the risk sufficient to warrant this
approach.  For loans determined to be impaired, the specific allowance
is based on the most appropriate of the three measurement methods: present value
of expected future cash flows, fair value of collateral, or the observable
market price of a loan method.  Once a loan is considered impaired, it
is not included in the determination of the general loss component of the
allowance, even if no specific allowance is considered necessary.  In
addition to the evaluation of loans for impairment, we calculate the loan loss
exposure on the remaining loans (not evaluated for impairment) by applying the
applicable historical loan loss experience factors to each major segment
(residential construction, commercial real estate, commercial and
industrial/other and consumer) broken down by loan credit grade.  The
Bank also utilizes various other factors to further evaluate the portfolio for
risk.  The other factors utilized include the rate of loan growth,
policy exceptions, account officer experience, interest rate trends and various
economic factors.  These factors are examined for trends and the risk
that they represent to the Bank’s loan portfolio.  Each of these other
factors is assigned a level of risk and this risk factor is applied to only
those loans not evaluated for impairment.  The ALLL calculation for
specific loss and general loss exposure are aggregated to arrive at the
approximate allowance level for our loan portfolio.  While management
believes that it uses the best information available to establish the allowance
for loan losses, future adjustments to the allowance may be necessary and
results of operations could be adversely affected if circumstances differ
substantially from the assumptions used in making the
determinations.  Furthermore, while the Company believes the allowance
for loan losses has been established in conformity with generally accepted
accounting principles, there can be no assurance that regulators, in reviewing
the loan portfolio, will not require adjustments to the allowance for loan
losses.  In addition, because future events affecting borrowers and
collateral cannot be predicted with certainty, there can be no assurance that
the existing allowance for loan losses is adequate or that increases will not be
necessary should the quality of any loans deteriorate as a result of the factors
discussed herein.  Any material increase in the allowance for loan
losses may adversely affect the Company’s financial condition and results of
operations.


Page
74


SOUTHERN
COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 Years
Ended December 31, 2009, 2008 and 2007





(2)  SUMMARY
OF SIGNIFICANT ACCOUNTING POLICIES (Continued)





Premises
and Equipment





Land is
carried at cost.  Premises and equipment are stated at cost less
accumulated depreciation and amortization.  Depreciation is calculated
on the straight-line method over the estimated useful lives of the assets which
are 11 to 30 years for buildings and 3 to 7 years for furniture and
equipment.  Leasehold improvements are amortized over the terms of the
respective leases or the estimated useful lives of the improvements, whichever
is shorter.  Repairs and maintenance costs are charged to operations
as incurred and additions and improvements to premises and equipment are
capitalized.  Upon sale or retirement, the cost and related
accumulated depreciation are removed from the accounts and any gains or losses
are reflected in current operations.  Long-lived depreciable assets
are evaluated periodically for impairment when events or changes in
circumstances indicate the carrying amount may not be recoverable.





Foreclosed
Assets





Assets
acquired through, or in lieu of, foreclosure are held for sale and are initially
recorded at fair value less estimated cost to sale at the date of foreclosure,
establishing a new cost basis.  Principal and interest losses existing
at the time of acquisition of such assets are charged against the allowance for
loan losses and interest income, respectively.  Subsequent to
foreclosure, valuations are periodically performed by management and the assets
are carried at the lower of carrying amount or fair value less estimated cost to
sell.  Revenue and expenses from operations and the impact of any
subsequent changes in the carrying value are included in other
expenses.





Goodwill
and Other Intangibles





Goodwill
represents the excess of the cost of an acquisition over the fair value of the
net assets acquired.  Goodwill impairment testing is performed
annually or more frequently if events or circumstances indicate possible
impairment.  An impairment loss is recorded to the extent that the
carrying value of goodwill exceeds its implied fair value.





Intangible
assets with finite lives include core deposits and other
intangibles.  Intangible assets other than goodwill are subject to
impairment testing whenever events or changes in circumstances indicate that the
carrying amount may not be recoverable.  Core deposit intangibles are
amortized on the straight-line method over a period not to exceed 10
years.  Note 7 contains additional information regarding goodwill and
other intangible assets.





Income
Taxes





Deferred
tax assets and liabilities are recognized for the estimated future tax
consequences attributable to differences between the tax bases of assets and
liabilities and their carrying amounts for financial reporting
purposes.  These temporary differences consist primarily of the
allowance for loan losses, differences in the financial statement and income tax
basis in premises and equipment and differences in financial statement and
income tax basis in accrued liabilities.  Deferred tax assets and
liabilities are measured using enacted tax rates in effect for the year in which
the temporary differences are expected to be recovered or
settled.  Deferred tax assets are reduced by a valuation allowance if
it is more likely than not that the tax benefits will not be
realized.  A $2.0 million valuation allowance was established in the
fourth quarter of 2009.





Derivative
Instruments





The
Company utilizes stand-alone derivative financial instruments, primarily in the
form of interest rate swap and option agreements, in its asset/liability
management program.  These transactions involve both credit and market
risk.  The Company uses derivative instruments to mitigate exposure to
adverse changes in fair value or cash flows of certain assets and liabilities
which are required to be carried at fair value.  Derivative
instruments designated in a hedge relationship to mitigate exposure to changes
in the fair value of an asset, liability, or firm commitment attributable to a
particular risk, such as interest rate risk, are considered fair value
hedges.  Derivative instruments designated in a hedge relationship to
mitigate exposure to variability in expected future cash flows, or other types
of forecasted transactions, are considered cash flow
hedges.  Effective January 1, 2009, the Company adopted new reporting
standards for disclosure of derivative instruments information.





See
accompanying notes.


Page
75


SOUTHERN
COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 Years
Ended December 31, 2009, 2008 and 2007





(2)  SUMMARY
OF SIGNIFICANT ACCOUNTING POLICIES (Continued)





Fair
value hedges are accounted for by recording the fair value of the derivative
instrument and the fair value related to the risk being hedged of the hedged
asset or liability on the balance sheet with corresponding offsets recorded in
the income statement.  The adjustment to the hedged asset or liability
is included in the basis of the hedged item, while the fair value of the
derivative is recorded as a freestanding asset or liability.  Actual
cash receipts or payments and related amounts accrued during the period on
derivatives included in a fair value hedge relationship are recorded as
adjustments to the income or expense on the hedged asset or
liability.  Cash flow hedges are accounted for by recording the fair
value of the derivative instrument on the balance sheet as either a freestanding
asset or liability, with a corresponding offset recorded in accumulated other
comprehensive income within stockholders’ equity, net of tax.  Amounts
are reclassified from accumulated other comprehensive income to the income
statement in the period or periods the hedged transaction affects
earnings.  Under both the fair value and cash flow hedge methods,
derivative gains and losses not effective in hedging the change in fair value or
expected cash flows of the hedged item are recognized immediately in the income
statement.





The
Company does not enter into derivative financial instruments for speculative or
trading purposes.  For derivatives that are economic hedges, but are
not designated as hedging instruments or otherwise do not qualify for hedge
accounting treatment, all changes in fair value are recognized in non-interest
income during the period of change.  The net cash settlement on these
derivatives is included in non-interest income.





The
adjustment to the hedged asset or liability is included in the basis of the
hedged item, while the fair value of the derivative is recorded as a
freestanding asset or liability.  Actual cash receipts or payments and
related amounts accrued during the period on derivatives included in a fair
value hedge relationship are recorded as adjustments to the income or expense
recorded on the hedged asset or liability.  Cash flow hedges are
accounted for by recording the fair value of the derivative instrument on the
balance sheet as either a freestanding asset or liability, with a corresponding
offset recorded in accumulated other comprehensive income within stockholders’
equity, net of tax.  Amounts are reclassified from accumulated other
comprehensive income to the income statement in the period or periods the hedged
transaction affects earnings.  Under both the fair value and cash flow
hedge methods, derivative gains and losses not effective in hedging the change
in fair value or expected cash flows of the hedged item are recognized
immediately in the income statement.





The
Company is exposed to credit-related losses in the event of nonperformance by
the counterparties to these agreements.  The Company controls the
credit risk of its financial contracts through credit approvals, limits and
monitoring procedures and agreements that specify collateral levels to be
maintained by the Company and the counterparties.  These collateral
levels are based on the credit rating of the counterparties.  A
nonrecurring loss was recorded in the prior year related to the value of certain
derivative positions on our balance sheet due to the bankruptcy and technical
default of Lehman Brothers, the counterparty in the contracts.  As
part of those derivative contracts, Lehman Brothers held as collateral $1.0
million of the Company’s U.S. Government Agency investment
securities.  The Company filed a claim against Lehman Brothers for
recovery of the collateral and value of the derivative positions.  The
Company wrote off the $1.0 million in collateral held by Lehman during the
second quarter 2009 as legal counsel determined that we had no preferred status
in the Lehman bankruptcy and its realization was uncertain.  Through
the sale and assignment of our creditor claims in the Lehman bankruptcy to a
third party, we recovered $408 thousand which was recorded in noninterest income
during the third quarter of 2009.





The
Company currently has eleven derivative instrument contracts consisting of two
interest rate caps, seven interest rate swaps and two foreign exchange
contracts.  The primary objective for each of these contracts is to
minimize risk, interest rate risk being the primary risk for the interest rate
caps and swaps while foreign exchange risk is the primary risk for the foreign
exchange contracts.  The Company’s strategy is to use derivative
contracts to stabilize and improve net interest margin and net interest income
currently and in future periods.  In order to acquire low cost, long
term fixed rate funding without incurring currency risk, the Company entered
into the foreign exchange contract to convert foreign currency denominated
certificates of deposit into long term dollar denominated time
deposits.  The interest rate on the underlying $10.0 million
certificates of deposit is based on a proprietary index (Barclays Intelligent
Carry Index USD ER) managed by the counterparty (Barclays Bank).  The
currency swap is also based on this proprietary index.  Note 17
contains additional information regarding derivative financial
instruments.





See
accompanying notes.




Page
76


SOUTHERN
COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 Years
Ended December 31, 2009, 2008 and 2007





(2)
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)





Per
Share Data





Basic net
income per common share is computed by dividing net income available to common
shareholders by the weighted average number of shares of common stock
outstanding during each period.  Diluted net income per common share
reflects the potential dilution that could occur if stock options or warrants
were exercised resulting in the issuance of common stock that would then share
in the net income of the Company.  Diluted earnings per common share
is computed by dividing net income available to common shareholders by the
weighted average number of shares of common stock, common stock equivalents and
other potentially dilutive securities using the treasury stock
method.





Basic and
diluted net income per common share have been computed based upon net income
available to common shareholders as presented in the accompanying consolidated
statements of operations divided by the weighted average number of common shares
outstanding or assumed to be outstanding as summarized below:





2009
                  
                  
                  2008
                  
                  
                  2007Weighted
      average number of common shares used in computing basic net income per
      common share
                  
                  
                  16,787,938
                  
                  
                  
                  17,363,395
                  
                  
                  
                  17,559,352Effect
      of dilutive stock options
                  
                  
                  -
                  
                  
                  
                  34,923
                  
                  
                  
                  65,047Weighted
      average number of common shares and dilutive potential common shares used
      in computing diluted net income per common share
                  
                  
                  16,787,938
                  
                  
                  
                  17,398,318
                  
                  
                  
                  17,624,399





For the
years ended December 31, 2009 and 2008, net income (loss) for determining
earnings per common share was reported net income (loss) less the dividend on
preferred stock.  For the year ended December 31, 2007, net income for
determining diluted earnings per common share was the same as reported net
income.  For the years ended December 31, 2009, 2008 and 2007 there
were 706,699, 744,266 and 573,269 options, respectively, that were antidilutive
since the exercise price exceeded the average market price for the
year.  These antidilutive common stock equivalents have been omitted
from the calculation of diluted earnings per common share for their respective
years.





Stock-Based
Compensation





The
Company has certain stock-based employee compensation plans, described more
fully in Note 12.  Effective January 1, 2006, the Company adopted the
modified prospective application method for expensing the value of options and
accordingly did not restate prior period amounts.  Generally accepted
accounting principles require recognition of the cost of employee services
received in exchange for an award of equity instruments in the financial
statements over the period the employee is required to perform the services in
exchange for the award (usually the vesting period).  Compensation
cost for all awards granted after the date of adoption and any unvested awards
that remained outstanding as of the date of adoption are required to be measured
based on the fair value of the award on the grant date.





Comprehensive
Income





Comprehensive
income is defined as the change in equity during a period for non-owner
transactions and comprises net income and other comprehensive
income.  Other comprehensive income includes revenues, expenses, gains
and losses that are excluded from earnings under current accounting
standards.  Components of other comprehensive income for the Company
consist of the unrealized gains and losses, net of taxes, in the Company’s
available for sale securities portfolio, unrealized gains and losses, net of
taxes, in the Company’s cash flow hedge instruments, and the components of
changes in net benefit plan liabilities that are not recognized as benefit
costs.





See
accompanying notes.




Page
77


SOUTHERN
COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 Years
Ended December 31, 2009, 2008 and 2007





(2)
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)





Accumulated
other comprehensive income at December 31, 2009 and 2008 consists of the
following:





2009
                    
                    
                    2008(In thousands)Unrealized
      holding gain  - investment securities available for
      sale
                    
                    $
                    5,329
                    
                    
                    $
                    5,554Deferred
      income taxes
                    
                    
                    (2,054
                    )
                    
                    
                    (2,142
                    )Net
      unrealized holding gain - investment securities available for
      sale
                    
                    
                    3,275
                    
                    
                    
                    3,412Unrealized
      holding gain (loss) - cash flow hedge instruments
                    
                    
                    117
                    
                    
                    
                    (482
                    )Deferred
      income taxes
                    
                    
                    (41
                    )
                    
                    
                    392Net
      unrealized holding gain (loss) - cash flow hedge
    instruments
                    
                    
                    76
                    
                    
                    
                    (90
                    )Postretirement
      benefit plans adjustment
                    
                    
                    (433
                    )
                    
                    
                    (418
                    )Deferred
      income taxes
                    
                    
                    167
                    
                    
                    
                    161Net
      postretirement benefit plans adjustment
                    
                    
                    (266
                    )
                    
                    
                    (257
                    )Total
      accumulated other comprehensive income
                    
                    $
                    3,085
                    
                    
                    $
                    3,065





Segment
Reporting





Management
is required to report selected financial and descriptive information about
reportable operating segments.  Related disclosures about products and
services, geographic areas and major customers are also
required.  Generally, disclosures are required for segments internally
identified to evaluate performance and resource allocation.  In all
material respects, the Company’s operations are entirely within the commercial
banking segment, and the consolidated financial statements presented herein
reflect the results of that segment.  Also, the Company has no foreign
operations or customers.





Risk
and Uncertainties





In the
normal course of its business, the Company encounters two significant types of
risk: economic and regulatory.  The two primary components of economic
risk to the Company are credit risk and market risk.  Credit risk is
the risk of default on the Bank’s loan portfolio that results from borrowers’
failure to make contractually required payments.  Market risk arises
principally from interest rate risk inherent in our lending, investing, deposit
and borrowing activities.





The
Company is subject to the regulations of various government
agencies.  These regulations may change significantly from period to
period.  The Company also undergoes periodic examinations by the
regulatory agencies, which may subject it to further changes
with respect to asset valuations, amounts of required loss allowances or
operating restrictions resulting from the regulators’ judgments based on
information available to them at the time of their examination.





Reclassifications





Certain
amounts reported in prior years have been reclassified to conform to current
year presentation.  Such reclassifications had no effect on income or
equity.





See
accompanying notes.


Page
78


SOUTHERN
COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 Years
Ended December 31, 2009, 2008 and 2007




(2)
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)





Recent
Accounting Pronouncements





The
Company has adopted new disclosures about derivative and hedging activities,
including the underlying derivative instruments.  These disclosures
include a description of the objectives including how and why derivative
instruments are used.  Other disclosures include how derivative
instruments and related hedged items are accounted for and how derivatives and
related hedged items affect an entity’s financial position, financial
performance and cash flows.  Cross-referencing is provided within the
footnotes to improve the reader’s ability to locate information about derivative
instruments.  For additional information, see Note 17 (Derivatives) to
Financial Statements.





The
Company discloses information regarding events that occur after the balance
sheet date but prior to the financial statements being issued or available for
issue.  Financial statements are considered available for issue when
the financial statements are in a complete form that complies with accounting
standards and all approvals necessary, such as management or the Board of
Directors, have been obtained.  The date through which subsequent
events have been evaluated and whether that date is the date the financial
statements were issued or the date they were available for issue has been
disclosed.  For additional information, see Note 22 (Subsequent
Events) to Financial Statements.





The FASB
accounting standards codification and the hierarchy of generally accepted
accounting principles supersedes all non-SEC accounting and reporting standards
and is the source of authoritative U.S. generally accepted accounting principles
recognized by the Financial Accounting Standards Board.  The new
standards superseded prior guidance which was issued in 2008 to establish the
hierarchy of accounting principles.  The Company adopted the
accounting standards codification in the third quarter of 2009 which did not
have a material effect on the Company’s consolidated financial
statements.





Beginning
in the second quarter 2009, the Company provided disclosures of the fair value
of financial instruments in interim reporting periods that were previously only
required to be disclosed in annual financial statements.  Only the
disclosure requirements about fair value of financial instruments in interim
periods was amended and had no impact on the Company’s consolidated statement of
operations and balance sheet.





Current
other-than-temporary impairment guidance for debt securities was amended to make
the guidance more operational and to improve the presentation and disclosure of
other-than-temporary impairments on debt and equity securities in the financial
statements.  This amendment replaces the assertion of intent and
ability to hold an impaired debt security until fair value recovers with
assertions that the holder does not intend to sell the security prior to
recovery and that it is more likely than not the holder will not be required to
sell the impaired security prior to recovery.  The full impairment
loss is recognized in earnings if the holder is unable to make these
assertions.  Otherwise, the credit loss portion of the impairment is
recognized in earnings and the remaining impairment is recognized in other
comprehensive income.  Both the full impairment and credit loss
portion are presented on the face of the statement of
operations.  This amendment also requires additional disclosure in
interim periods.  This amendment is effective for interim and annual
periods ending after June 15, 2009.  The adoption of this amendment in
the second quarter 2009 did not have a material impact on the consolidated
financial statements other than adding expanded disclosures.





The
Company has adopted new disclosure requirements for defined benefit post
retirement pension plan.  The disclosure must include discussion of
investment allocation decisions, major categories of plan assets, fair value
valuation techniques, the tier valuation hierarchy and significant
concentrations of risk in plan assets if any.  The adoption of this
amendment in the fourth quarter 2009 did not have a material impact on the
consolidated financial statements other than adding expanded
disclosures.  For additional information, see Note 12 (Employee and
Director Benefit Plans) to financial statements.





From time
to time there are exposure drafts for proposed statements of financial
accounting standards.  Management considers the effect of the proposed
statements on the consolidated financial statements of the Company and monitors
the status of changes to and proposed effective dates of exposure
drafts.





See
accompanying notes.


Page
79


SOUTHERN
COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 Years
Ended December 31, 2009, 2008 and 2007





(3)  INVESTMENT
SECURITIES





The
following is a summary of the securities portfolio by major classification at
December 31, 2009 and 2008:





2009Amortized Cost
                
                
                Gross Unrealized
                  Gains
                
                
                Gross Unrealized
                  Losses
                
                
                Fair Value(Amount
      in thousands)Securities
      available for sale:U.
      S. government agencies
                
                $
                57,441
                
                
                $
                407
                
                
                $
                560
                
                
                $
                57,288Mortgage-backed
      securities
                
                
                176,543
                
                
                
                5,813
                
                
                
                256
                
                
                
                182,100Municipals
                
                
                64,797
                
                
                
                1,564
                
                
                
                102
                
                
                
                66,259Trust
      preferred securities
                
                
                4,252
                
                
                
                -
                
                
                
                1,376
                
                
                
                2,876Common
      stocks and mutual funds
                
                
                3,418
                
                
                
                141
                
                
                
                295
                
                
                
                3,264Other
                
                
                1,000
                
                
                
                -
                
                
                
                7
                
                
                
                993$
                307,451
                
                
                $
                7,925
                
                
                $
                2,596
                
                
                $
                312,780Securities
      held to maturity:U.
      S. government agencies
                
                $
                2,500
                
                
                $
                35
                
                
                $
                -
                
                
                $
                2,535Mortgage-backed
      securities
                
                
                1,175
                
                
                
                44
                
                
                
                -
                
                
                
                1,219Municipals
                
                
                7,244
                
                
                
                185
                
                
                
                3
                
                
                
                7,426$
                10,919
                
                
                $
                264
                
                
                $
                3
                
                
                $
                11,180





2008Amortized Cost
                
                
                Gross Unrealized
                  Gains
                
                
                Gross Unrealized
                  Losses
                
                
                Fair Value(Amount in thousands)Securities
      available for sale:U.
      S. government agencies
                
                $
                76,061
                
                
                $
                2,183
                
                
                $
                37
                
                
                $
                78,207Mortgage-backed
      securities
                
                
                196,386
                
                
                
                4,268
                
                
                
                194
                
                
                
                200,460Municipals
                
                
                2,393
                
                
                
                19
                
                
                
                7
                
                
                
                2,405Trust
      preferred securities
                
                
                4,250
                
                
                
                49
                
                
                
                232
                
                
                
                4,067Common
      stocks and mutual finds
                
                
                3,822
                
                
                
                4
                
                
                
                209
                
                
                
                3,617Other
                
                
                1,000
                
                
                
                -
                
                
                
                290
                
                
                
                710$
                283,912
                
                
                $
                6,523
                
                
                $
                969
                
                
                $
                289,466Securities
      held to maturity:U.
      S. government agencies
                
                $
                25,500
                
                
                $
                340
                
                
                $
                -
                
                
                $
                25,840Mortgage-backed
      securities
                
                
                1,792
                
                
                
                26
                
                
                
                -
                
                
                
                1,818Municipals
                
                
                7,939
                
                
                
                149
                
                
                
                215
                
                
                
                7,873$
                35,231
                
                
                $
                515
                
                
                $
                215
                
                
                $
                35,531





Proceeds
from sales of available for sale securities during 2009 and 2008 were $69.8
million and $49.6 million, respectively at a gain of $1.2 million and $98
thousand, respectively.  No securities were sold during
2007.  These sells were part of the Companies asset liability
management.





On May 1,
2009, the Office of the Comptroller of the Currency closed Silverton Bank, N.A.
and appointed the FDIC as the receiver to conduct an orderly liquidation of
Silverton through the use of a bridge bank.  The Company recorded a
loss of $404 thousand in the first quarter to write-off its equity investment in
Silverton which was classified as other securities available for sale (under
common stocks and mutual funds) in the above table at December 31,
2008.  The impairment loss on the Company’s equity investment in
Silverton Bank was recorded as a component of non-interest income on the
consolidated statements of operations for the period ended December 31,
2009.





See
accompanying notes.




Page
80


SOUTHERN
COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 Years
Ended December 31, 2009, 2008 and 2007





(3)  INVESTMENT
SECURITIES (Continued)





The
following tables show the gross unrealized losses and fair values for our
investments aggregated by category and length of time that the individual
securities have been in a continuous unrealized loss position as of December 31,
2009 and December 31, 2008.  For available for sale securities, the
unrealized losses relate to four U.S. government agency bonds, two
mortgage-backed securities, twenty municipal and six other
securities.  For held to maturity securities, the unrealized losses
relate to one municipal security.  All investment securities with
unrealized losses are considered by management to be temporarily impaired given
the credit ratings on these investment securities and management’s intent and
ability to hold these securities until recovery.  Should the Company
decide in the future to sell securities in an unrealized loss position, or
determine that impairment of any securities is other than temporary,
irrespective of a decision to sell, an impairment loss would be recognized in
the period such determination is made.





2009Less than 12 Months
                
                
                12 Months or More
                
                
                TotalFair Value
                
                
                Unrealized
                  losses
                
                
                Fair Value
                
                
                Unrealized
                  losses
                
                
                Fair Value
                
                
                Unrealized
                  losses(Amount in thousands)Securities
      available for sale:U.
      S. government agencies
                
                $
                27,131
                
                
                $
                560
                
                
                $
                -
                
                
                $
                -
                
                
                $
                27,131
                
                
                $
                560Mortgage-backed
      securities
                
                
                15,414
                
                
                
                256
                
                
                
                -
                
                
                
                -
                
                
                
                15,414
                
                
                
                256Municipals
                
                
                6,881
                
                
                
                102
                
                
                
                -
                
                
                
                -
                
                
                
                6,881
                
                
                
                102Trust
      preferred securities
                
                
                1,770
                
                
                
                1,230
                
                
                
                1,106
                
                
                
                146
                
                
                
                2,876
                
                
                
                1,376Common
      stocks and mutual funds
                
                
                69
                
                
                
                198
                
                
                
                403
                
                
                
                97
                
                
                
                472
                
                
                
                295Other
                
                
                993
                
                
                
                7
                
                
                
                -
                
                
                
                -
                
                
                
                993
                
                
                
                7Total
      temporarily impaired securities
                
                $
                52,258
                
                
                $
                2,353
                
                
                $
                1,509
                
                
                $
                243
                
                
                $
                53,767
                
                
                $
                2,596Securities
      held to maturity:Municipals
                
                $
                497
                
                
                $
                3
                
                
                $
                -
                
                
                $
                -
                
                
                $
                497
                
                
                $
                3





2008Less than 12 Months
                
                
                12 Months or More
                
                
                TotalFair Value
                
                
                Unrealized
                  losses
                
                
                Fair Value
                
                
                Unrealized
                  losses
                
                
                Fair Value
                
                
                Unrealized
                  losses(Amount in thousands)Securities
      available for sale:U.
      S. government agencies
                
                $
                4,963
                
                
                $
                37
                
                
                $
                -
                
                
                $
                -
                
                
                $
                4,963
                
                
                $
                37Mortgage-backed
      securities
                
                
                15,779
                
                
                
                194
                
                
                
                -
                
                
                
                -
                
                
                
                15,779
                
                
                
                194Municipals
                
                
                742
                
                
                
                7
                
                
                
                -
                
                
                
                -
                
                
                
                742
                
                
                
                7Trust
      preferred securities
                
                
                836
                
                
                
                164
                
                
                
                182
                
                
                
                68
                
                
                
                1,018
                
                
                
                232Common
      stocks and mutual funds
                
                
                340
                
                
                
                209
                
                
                
                -
                
                
                
                -
                
                
                
                340
                
                
                
                209Other
                
                
                -
                
                
                
                -
                
                
                
                710
                
                
                
                290
                
                
                
                710
                
                
                
                290Total
      temporarily impaired  securities
                
                $
                22,660
                
                
                $
                611
                
                
                $
                892
                
                
                $
                358
                
                
                $
                23,552
                
                
                $
                969Securities
      held to maturity:Municipals
                
                $
                1,869
                
                
                $
                81
                
                
                $
                923
                
                
                $
                134
                
                
                $
                2,792
                
                
                $
                215





See
accompanying notes.


Page
81


SOUTHERN
COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 Years
Ended December 31, 2009, 2008 and 2007





(3)  INVESTMENT
SECURITIES (Continued)





In
evaluating investment securities for “other than temporary impairment” losses,
management considers, among other things, (i) the length of time and the extent
to which the investment is in an unrealized loss position, (ii) the financial
condition and near term prospects of the issuer, and (iii) the intent and
ability of the Company to retain its investment in the issuer for a sufficient
period of time to allow for any anticipated recovery of unrealized
loss.  At December 31, 2009, there were three investment securities
with aggregate fair values of $1.5 million in an unrealized loss position for at
least twelve months.  Based on the nature of these securities, we
believe the decline in value to be solely due to changes in interest rates and
the general economic conditions and not deterioration in their credit
quality.  The trust preferred securities had one investment security
in an unrealized loss position for less than 12 months due to changes in the
level of market interest rates and to the lack of an active market in these
securities.  The security has a variable rate based on LIBOR which has
declined steadily throughout 2009.  Based on the nature of these
securities, we believe the decline in value to be solely due to changes in
interest rates and the general economic conditions and not deterioration in
their credit quality.  We have the intention and ability to hold these
securities for a period of time sufficient to allow for their recovery in value
or maturity.  The unrealized losses are reflected in other
comprehensive income.





The
amortized cost and fair values of securities available for sale and held to
maturity at December 31, 2009 by contractual maturity are shown
below.  Actual expected maturities may differ from contractual
maturities because issuers may have the right to call or prepay
obligation.





Securities Available for Sale
                  
                  
                  Securities Held to MaturityAmortized
                    Cost
                  
                  
                  Fair Value
                  
                  
                  Amortized
                    Cost
                  
                  
                  Fair Value(Amount in thousands)Due
      within one year
                  
                  $
                  3,995
                  
                  
                  $
                  4,013
                  
                  
                  $
                  4,754
                  
                  
                  $
                  4,822Due
      after one but through five years
                  
                  
                  22,036
                  
                  
                  
                  22,422
                  
                  
                  
                  704
                  
                  
                  
                  752Due
      after five but through ten years
                  
                  
                  20,939
                  
                  
                  
                  21,157
                  
                  
                  
                  2,256
                  
                  
                  
                  2,310Due
      after ten years
                  
                  
                  75,268
                  
                  
                  
                  75,955
                  
                  
                  
                  2,030
                  
                  
                  
                  2,077Mortgage-backed
      securities
                  
                  
                  176,543
                  
                  
                  
                  182,100
                  
                  
                  
                  1,175
                  
                  
                  
                  1,219Trust
      preferred securities
                  
                  
                  4,252
                  
                  
                  
                  2,876
                  
                  
                  
                  -
                  
                  
                  
                  -Common
      stocks and mutual funds
                  
                  
                  3,418
                  
                  
                  
                  3,264
                  
                  
                  
                  -
                  
                  
                  
                  -Other
                  
                  
                  1,000
                  
                  
                  
                  993
                  
                  
                  
                  -
                  
                  
                  
                  -$
                  307,451
                  
                  
                  $
                  312,780
                  
                  
                  $
                  10,919
                  
                  
                  $
                  11,180





Securities
with carrying values of $33.9 million and $18.6 million and fair values of $35.4
million and $18.9 million at December 31, 2009 and 2008, respectively, were
pledged to secure public deposits as required by law.  Additionally,
at December 31, 2009, securities with carrying values and fair values of $48.8
million and $51.2 million were pledged to secure the Company’s borrowings from
the FHLB.  Securities with carrying values of $111.8 million and fair
values of $114.4 million were pledged for other purposes, primarily to secure
repurchase agreements and derivative positions.





For the
years ended December 31, 2009, 2008 and 2007, income from taxable and nontaxable
securities were $13.1 million and $1.8 million, $14.1 million and $433 thousand,
and $11.6 million and $427 thousand, respectively.





See
accompanying notes.


Page
82


SOUTHERN
COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 Years
Ended December 31, 2009, 2008 and 2007




(3)  INVESTMENT
SECURITIES (Continued)





Federal
Home Loan Bank Stock





As
disclosed separately on our statements of financial condition, the Company has
an investment in Federal Home Loan Bank of Atlanta (“FHLB”) stock of $9.8
million at December 31, 2009 and  2008.  The Company carries
its investment in FHLB at its cost which is the par value of the
stock.  In prior years, member institutions of the FHLB system have
been able to redeem shares in excess of their required investment level at par
on a voluntary basis daily.  On March 6, 2009, FHLB announced changes
in the calculation of member stock requirements (that had the impact of
requiring increased member stock ownership) and changes in its policy toward the
repurchase of excess stock held by members.  Prior to the announcement
the FHLB automatically repurchased excess stock on a daily
basis.  Subsequently, the FHLB will evaluate on a quarterly basis
whether to repurchase excess capital stock from its members.  On
October 30, 2009, the FHLB announced that it will not repurchase excess stock
outstanding at September 30, 2009 and will continue to evaluate their decision
on a quarterly basis.  These steps were taken as capital preservation
measures reflecting a conservative financial management approach in the face of
continued volatility in the financial markets and regulatory
pressures.  After not paying a cash dividend for the fourth quarter
2008 and first quarter 2009, FHLB paid a cash dividend for the second quarter at
an annualized rate of 0.84% in August and for the third quarter 2009 at an
annualized rate of 0.41% in November.  At December 31, 2009 (the most
recent date available), the FHLB was in compliance with all of its regulatory
capital requirements as its total regulatory capital-to-assets ratio was 6.07%
exceeding the 4% requirement, and its risk-based capital rates was 5.45%,
exceeding its 4.0% requirement.  Management believes that our
investment in FHLB stock was not impaired as of December 31, 2009 or December
31, 2008.  There can be no assurance that the impact of recent or
future legislation on the Federal Home Loan Banks will not cause a decrease in
the value of the Company’s investment in FHLB stock.





(4)  LOANS





Following
is a summary of loans at December 31, 2008 and 2007:





2009
                  
                  
                  2008(Amounts in thousands)Residential
      mortgage loans
                  
                  $
                  395,586
                  
                  
                  $
                  393,360Commercial
      mortgage loans
                  
                  
                  455,268
                  
                  
                  
                  419,212Construction
      loans
                  
                  
                  178,239
                  
                  
                  
                  260,549Commercial
      and industrial loans
                  
                  
                  183,319
                  
                  
                  
                  221,231Loans
      to individuals
                  
                  
                  17,863
                  
                  
                  
                  20,459Total
                  
                  $
                  1,230,275
                  
                  
                  $
                  1,314,811





Loans are
primarily made in the Piedmont area of North Carolina.  Real estate
loans can be affected by the condition of the local real estate
market.  Commercial and installment loans can be affected by the local
economic conditions.





The
following is a summary of nonperforming loans and nonperforming assets at
December 31, 2009 and 2008:





2009
                  
                  
                  2008(Amounts in thousands)Nonaccrual
      loans
                  
                  $
                  35,535
                  
                  
                  $
                  14,433Restructured
      loans
                  
                  
                  2,197
                  
                  
                  
                  -Total
      nonperforming loans
                  
                  
                  37,732
                  
                  
                  
                  14,433Foreclosed
      assets
                  
                  
                  19,634
                  
                  
                  
                  5,745Total
      nonperforming assets
                  
                  $
                  57,366
                  
                  
                  $
                  20,178





See
accompanying notes.


Page
83


SOUTHERN
COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 Years
Ended December 31, 2009, 2008 and 2007





(4)  LOANS
(Continued)





The
recorded investment in loans that were considered individually impaired at
December 31, 2009 and 2008 totaled $40.2 million and $23.3 million,
respectively.  At December 31, 2009 and 2008, the recorded investment
in impaired loans requiring a valuation allowance based on individual analysis
were $29.1 million and $19.0 million, respectively, with a corresponding
valuation allowance of $9.8 million and $2.8 million.  No valuation
allowance for the other impaired loans was considered necessary.





The
average recorded investment in certain impaired loans for the years ended
December 31, 2009, 2008, and 2007 was approximately $26.8 million, $15.3 million
and $4.5 million, respectively.  The amount of interest income
recognized on impaired loans during the portion of the year they were considered
impaired for 2009, 2008 and 2007 was $312 thousand, $252 thousand and $412
thousand, respectively.  The interest income foregone for loans in a
nonaccrual status for 2009, 2008 and 2007 was $1.2 million, $879 thousand and
$81 thousand, respectively.





The
Company has granted loans to certain directors and executive officers of the
Company and their related interests.  Such loans are made on
substantially the same terms, including interest rates and collateral, as those
prevailing at the time for comparable transactions with other borrowers and, in
management’s opinion, do not involve more than the normal risk of
collectability.  All loans to directors and executive officers or
their interests are submitted to the Board of Directors for
approval.  A summary of loans to directors and their interests follows
(amounts in thousands):





2009Balance
      at beginning of year
                    
                    $
                    25,585Disbursements
                    
                    
                    13,110Repayments
                    
                    
                    (14,262
                    )Balance
      at end of year
                    
                    $
                    24,433





At
December 31, 2009, the Company had pre-approved but unused lines of credit
totaling $5.5 million to executive officers, directors and their
affiliates.





(5)  ALLOWANCE
FOR LOAN LOSSES





An
analysis of the allowance for loan losses follows:





2009
                  
                  
                  2008
                  
                  
                  2007(Amounts in thousands)Balance
      at beginning of year
                  
                  $
                  18,851
                  
                  
                  $
                  14,258
                  
                  
                  $
                  13,040Provision
      for loan losses
                  
                  
                  34,000
                  
                  
                  
                  8,165
                  
                  
                  
                  2,775Charge-offs
                  
                  
                  (24,633
                  )
                  
                  
                  (3,834
                  )
                  
                  
                  (1,894
                  )Recoveries
                  
                  
                  1,420
                  
                  
                  
                  262
                  
                  
                  
                  337Net
      charge-offs
                  
                  
                  (23,213
                  )
                  
                  
                  (3,572
                  )
                  
                  
                  (1,557
                  )Balance
      at end of year
                  
                  $
                  29,638
                  
                  
                  $
                  18,851
                  
                  
                  $
                  14,258





See
accompanying notes.


Page
84


SOUTHERN
COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 Years
Ended December 31, 2009, 2008 and 2007




(6)  PREMISES
AND EQUIPMENT





Following
is a summary of premises and equipment at December 31, 2009 and
2008:





2009
                  
                  
                  2008(Amounts in thousands)Land
                  
                  $
                  10,693
                  
                  
                  $
                  10,621Buildings
      and leasehold improvements
                  
                  
                  35,274
                  
                  
                  
                  31,185Furniture
      and equipment
                  
                  
                  17,262
                  
                  
                  
                  16,358$
                  63,229
                  
                  
                  $
                  58,164Less
      accumulated depreciation
                  
                  
                  (20,599
                  )
                  
                  
                  (18,134
                  )Total
                  
                  $
                  42,630
                  
                  
                  $
                  40,030





Depreciation
and amortization amounting to $3.4 million in 2009, $3.5 million in 2008 and
$3.7 million in 2007, is included in occupancy and equipment
expense.





(7)  GOODWILL
AND OTHER INTANGIBLES





The
following is a summary of goodwill and other intangible assets at December 31,
2009 and 2008.  Other intangible assets are included in other assets
in the consolidated balance sheet.





2009
                  
                  
                  2008(Amounts in thousands)Goodwill,
      beginning of year
                  
                  $
                  49,501
                  
                  
                  $
                  49,792Goodwill
      impairment
                  
                  
                  (49,501
                  )
                  
                  
                  (291
                  )Goodwill,
      end of year
                  
                  $
                  -
                  
                  
                  $
                  49,501Other
      intangibles - gross
                  
                  $
                  2,177
                  
                  
                  $
                  2,225Less
      accumulated amortization
                  
                  
                  1,288
                  
                  
                  
                  1,070Other
      intangibles - net
                  
                  $
                  889
                  
                  
                  $
                  1,155





Goodwill
represents the excess of the cost of an acquisition over the fair value of the
net assets acquired.  Goodwill impairment testing is performed
annually or more frequently if events or circumstances indicate possible
impairment.  An impairment loss is recorded to the extent that the
carrying value of goodwill exceeds its implied fair value.





In
performing the first step (“Step 1”) of the goodwill impairment testing and
measurement process to identify possible impairment, the estimated fair value of
the reporting unit (determined to be Company-level) was developed using both the
income and market approaches to value the Company.  The income
approach consists of discounting projected long-term future cash flows, which
are derived from internal forecasts and economic expectations for the
Company.  The significant inputs to the income approach include the
long-term target tangible equity to tangible assets ratio and the discount rate,
which is determined utilizing the Company’s cost of capital adjusted for a
company-specific risk factor.  The company-specific risk factor is
used to address the uncertainty of growth estimates and earnings projections of
management.  Under one market approach, a value is calculated from an
analysis of comparable acquisition transactions based on earnings, book value,
assets and deposit premium multiples from the sale of similar financial
institutions.  Another market valuation approach utilizes the current
stock price adjusted by an appropriate control premium as an indicator of fair
market value.  Our annual goodwill testing in May 2008, which was
updated as of December 31, 2008, indicated that the goodwill booked at the time
of the acquisition of The Community Bank continued to properly value the
acquired company and had not been impaired as of December 31,
2008.  No impairment was recorded as a result of goodwill testing
performed during 2008.





See
accompanying notes.


Page
85


SOUTHERN
COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 Years
Ended December 31, 2009, 2008 and 2007





(7)  GOODWILL
AND OTHER INTANGIBLES (continued)





We
updated our Step 1 goodwill impairment testing as of March 31,
2009.  Given the substantial declines in our common stock price,
declining operating results, asset quality trends, market comparables and the
economic outlook for our industry, the results of this Step 1 process indicated
that the Company’s estimated fair value was less than book value, thus requiring
a second step (“Step 2”) of the goodwill impairment test.  Based on
the Step 2 analysis, it was determined that the Company’s fair value did not
support the goodwill recorded at the time of the acquisition of The Community
Bank in January 2004; therefore, the Company recorded a $49.5 million goodwill
impairment charge to write-off the entire amount of goodwill as of March 31,
2009.  This non-cash goodwill impairment charge to earnings was
recorded as a component of non-interest expense on the consolidated statement of
operations.





Amortization
expense associated with acquired intangibles amounted to $265 thousand, $265
thousand and $301 thousand, for 2009, 2008 and 2007,
respectively.  The following table presents estimated future
amortization expense for other intangibles.





Estimated Amortization Expense(Amounts in thousands)For
      the Years Ended December 31:2010
                    
                    $
                    2182011
                    
                    
                    2182012
                    
                    
                    2182013
                    
                    
                    2182014
                    
                    
                    17$
                    889





(8)  DEPOSITS





Time
deposits in denominations of $100,000 or more were approximately $178.1 million
and $163.6 million at December 31, 2009 and 2008, respectively.  At
December 31, 2009, the scheduled maturities of certificates of deposit are as
follows:





$100,000
                    
                    
                    Underand Over
                    
                    
                    $100,000
                    
                    
                    Total(Amounts in thousands)2010
                    
                    $
                    65,725
                    
                    
                    $
                    184,322
                    
                    
                    $
                    250,0472011
                    
                    
                    74,120
                    
                    
                    
                    99,415
                    
                    
                    
                    173,5352012
                    
                    
                    32,654
                    
                    
                    
                    60,215
                    
                    
                    
                    92,8692013
                    
                    
                    1,301
                    
                    
                    
                    15,794
                    
                    
                    
                    17,0952014
                    
                    
                    4,325
                    
                    
                    
                    78,800
                    
                    
                    
                    83,125Thereafter
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -Total
                    
                    $
                    178,125
                    
                    
                    $
                    438,546
                    
                    
                    $
                    616,671





See
accompanying notes.


Page
86


SOUTHERN
COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 Years
Ended December 31, 2009, 2008 and 2007





(9)  BORROWINGS





The
following is a summary of the Company’s borrowings at December 31, 2009 and
2008:





2009
                  
                  
                  2008(Amounts in thousands)Short-term
      borrowingsFHLB
      advances
                  
                  $
                  31,250
                  
                  
                  $
                  62,000Federal
      funds purchased
                  
                  
                  -
                  
                  
                  
                  -Term
      Auction Facility
                  
                  
                  -
                  
                  
                  
                  60,000Repurchase
      agreements
                  
                  
                  14,861
                  
                  
                  
                  23,197Other
      borrowed funds
                  
                  
                  39,366
                  
                  
                  
                  2,360$
                  85,477
                  
                  
                  $
                  147,557Long-term
      borrowingsFHLB
      advances
                  
                  $
                  73,226
                  
                  
                  $
                  92,139Term
      repurchase agreements
                  
                  
                  80,000
                  
                  
                  
                  90,000Jr.
      subordinated debentures
                  
                  
                  45,877
                  
                  
                  
                  45,877$
                  199,103
                  
                  
                  $
                  228,016





At
December 31, 2009, the interest rates on the Federal Home Loan Bank advances
ranged from 0.00% to 4.72% with a weighted average rate of 2.84%.  At
the prior year end, the rates ranged from 0.00% to 5.12% with a weighted average
rate of 3.30%.  The Company has an available line of credit of $431.2
million with the Federal Home Loan Bank of Atlanta for
advances.  These advances are secured by both loans with a carrying
value of $77.4 million and pledged investment securities with a market value of
$51.0 million and lendable collateral value of $49.5 million.





In
December 2007, the Federal Reserve introduced a new liquidity facility, the Term
Auction Facility (TAF), to lengthen the duration of access for depository
institutions to liquidity beyond the overnight access of its discount window
borrowings, to broaden the types of eligible collateral and to reduce the cost
of borrowing from the Fed relative to the federal funds rate.  Under
the TAF, eligible institutions may bid on a pre-determined amount of longer term
funding (for a 28 day period or 84 day period) that is available via auction on
pre-announced dates for subsequent settlement.  The interest rate and
the distribution of the funding to bidding institutions are determined by an
auction.  The TAF allows banks to borrow against a wide range of
collateral, including securities that are not widely pledged in private markets
and bank loans.  The Company borrowed funds from the TAF throughout
2009 but repaid in full the final borrowing in December.  We do not
anticipate any further borrowing from the TAF as the Federal Reserve is in the
process of winding down this program.





The
Company has also entered into long-term financing through term repurchase
agreements with various parties.  At December 31, 2009, the interest
rates on these term repurchase agreements, which are variable rate agreements
based upon LIBOR, range from 2.25% to 4.95%.





Certain
of the FHLB advances and the term repurchase agreements contain embedded
interest rate options.  Some of the options are exercisable by the
holder and relate to converting a floating rate to a fixed
rate.  Other options are held by the bank, and relate to reducing the
interest rate charged should the reference rate fall below a rate specified in
the agreement.  Several of the FHLB advances and term repurchase
agreements contain options which allow them to be called prior to their
contractual maturity.





Under the
caption “Other borrowed funds”, the Company has entered into overnight unsecured
borrowing arrangements with various parties at an interest rate slightly higher
than repurchase agreements.  These arrangements are the obligations of
the parent holding company, not the Bank, and are not FDIC insured.





See
accompanying notes.


Page
87


SOUTHERN
COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 Years
Ended December 31, 2009, 2008 and 2007





(9)  BORROWINGS
(Continued)





The
contractual maturities of the Federal Home Loan Bank advances and term
repurchase agreements at December 31, 2009 are as follows:





FHLB
                  
                  
                  Term RepurchaseAdvances
                  
                  
                  Agreements(Amounts in thousands)Due
      in 2010
                  
                  $
                  31,250
                  
                  
                  $
                  10,000Due
      in 2011
                  
                  
                  16,250
                  
                  
                  
                  -Due
      in 2012
                  
                  
                  5,000
                  
                  
                  
                  20,000Due
      in 2013
                  
                  
                  10,000
                  
                  
                  
                  -Due
      in 2014
                  
                  
                  25,000
                  
                  
                  
                  -Thereafter
                  
                  
                  16,976
                  
                  
                  
                  60,000$
                  104,476
                  
                  
                  $
                  90,000





In
addition to the above advances and term repurchase agreements, the Company also
had repurchase agreements with outstanding balances of $4.9 million and $13.2
million at December 31, 2009 and 2008, respectively, which were for customer
accommodations.  Securities sold under agreements to repurchase
generally mature within ninety days from the transaction date and are
collateralized by U.S. Government Agency obligations.  The Company has
repurchase lines of credit of $100.0 million from various institutions, which
must be adequately collateralized.





The
Company also has lines of credit of $102.0 million from various correspondent
banks to purchase federal funds on a short-term basis.  The Company
had no outstanding balances of federal funds purchased as of December 31,
2009.





(10)
JUNIOR SUBORDINATED DEBENTURES





In
November of 2003, Southern Community Capital Trust II (“Trust II”), wholly owned
by the Company, issued 3,450,000 shares of 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 junior subordinated debentures from the Bank under the same terms and
conditions as the Trust II Securities.  We have the right to defer
payment of interest on the debentures at any time and from time to time for a
period not exceeding five years, provided that no deferral period extends beyond
the stated maturities of the debentures.  Such deferral of interest
payments by the Company will result in a deferral of distribution payments on
the related Trust II Securities.  If we defer the payment of interest
on the debentures, the Company will be precluded from the payment of cash
dividends to shareholders.  The principal uses of the net proceeds
from the sale of the debentures were to provide cash for the acquisition of The
Community Bank, to increase our regulatory capital, and to support the growth
and operations of our subsidiary bank.





See
accompanying notes.


Page
88


SOUTHERN
COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 Years
Ended December 31, 2009, 2008 and 2007





(10)
JUNIOR SUBORDINATED DEBENTURES (Continued)





At
December 31, 2009 and 2008, the Company had outstanding 3.45 million shares of
the trust preferred securities from Trust II used to purchase related junior
subordinated debentures from the Bank, with carrying amounts of $35.1 million
and $35.1 million, respectively.





In June
2007, $10.0 million of trust preferred securities were placed through Southern
Community Capital Trust III (“Trust III”), as part of a pooled trust preferred
security.  The Trust issuer invested the total proceeds from the sale
of the trust preferred securities in junior subordinated deferrable interest
debentures (the “Junior Subordinated Debentures”) issued by the
Company.  The terms of the trust preferred securities require payment
of cumulative cash distributions quarterly at an annual rate, reset quarterly,
equal to LIBOR plus 1.43%.  During 2008, the Company entered into an
interest rate swap derivative contract with a counterparty that shifted this
debt service from a variable rate to a fixed rate of 4.7% per
annum.  The dividends paid to holders of the trust preferred
securities, which are recorded as interest expense, are deductible for income
tax purposes.  The trust preferred securities are redeemable in 30
years with a five year call provision.  The Company has fully and
unconditionally guaranteed the trust preferred securities through the combined
operation of the debentures and other related documents.  The
Company’s obligation under the guarantee is unsecured and subordinate to senior
and subordinated indebtedness of the Company.  The principal use of
the net proceeds from the sale of the debentures was to provide additional
capital into the Company to fund its operations and continued expansion, and to
maintain the Company’s and the Bank’s status as “well capitalized” under
regulatory guidelines.





The
amount of the proceeds generated from the above offerings of trust preferred
securities was $44.5 million.  The amount of proceeds the company
counts as Tier 1 capital cannot comprise more than 25% of our core capital
elements.  For the Company, this Tier 1 limit was $41.4 million at
December 31, 2009.  The $3.1 million in excess of that 25% limitation
counts as Tier 2 supplementary capital on the Company’s books.





(11)  CUMULATIVE
PERPETUAL PREFERRED STOCK





Under the
United States Treasury’s Capital Purchase Program (CPP), the Company issued
$42.75 million in Cumulative Perpetual Preferred Stock, Series A, on December 5,
2008.  In addition, the Company provided warrants to the Treasury to
purchase 1,623,418 shares of the Company’s common stock at an exercise price of
$3.95 per share.  These warrants are immediately exercisable and
expire ten years from the date of issuance.  The preferred stock is
non-voting, other than having class voting rights on certain matters, and pays
cumulative dividends quarterly at a rate of 5% per annum for the first five
years and 9% per annum thereafter.  The preferred shares are
redeemable at the option of the Company subject to regulatory
approval.





Based on
a Black-Scholes options pricing model, the common stock warrants have been
assigned a fair value of $1.29 per share or $2.09 million in the aggregate as of
December 5, 2008.  As a result, $2.09 million has been recorded as the
discount on the preferred stock and will be accreted as a reduction in net
income available for common shareholders over the next five years at
approximately $0.4 million per year.  Correspondingly, $40.66 million
has been assigned to the preferred stock.  Through the discount
accretion over the next five years, the preferred stock will be accreted up to
the redemption amount of $42.75 million.  For purposes of these
calculations, the fair value of the common stock warrants as of December 5, 2008
was estimated using the Black-Scholes option pricing model and the following
assumptions:





Risk-free
      interest rate
              2.70%Expected
      life of warrants
              10
      yearsExpected
      dividend yield
              4.57%Expected
      volatility
              33%





The
Company’s computation of expected volatility is based on daily historical
volatility since December 1998.  The risk-free interest rate is based
on the market yield for ten year U.S. Treasury securities as of December 5,
2008.





As a
condition of the CPP, the Company must obtain consent from the United States
Department of the Treasury to repurchase its common stock or to increase its
cash dividend on its common stock from the September 30, 2008 quarterly level of
$0.04 per common share.  Furthermore, the Company has agreed to
certain restrictions on executive compensation.  Under the American
Recovery and Reinvestment Act of 2009, the Company is limited to using
restricted stock as a form of payment to the top five highest compensated
executives under any incentive compensation programs.





See
accompanying notes.


Page
89


SOUTHERN
COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 Years
Ended December 31, 2009, 2008 and 2007





(12)  EMPLOYEE
AND DIRECTOR BENEFIT PLANS





401(k)
Retirement Plan





The
Company maintains a qualified profit sharing 401(k) Plan for employees of age 21
years or over with at least three months of service.  Under the plan,
employees may contribute up to an annual maximum as determined under the
Internal Revenue Code.  The Bank matched 100% of such contributions
not exceeding 6% of the participants’ compensation through July of
2009.  Beginning August of 2009 the match was decreased to 50% as a
cost reduction measure.  The Board of Directors can also authorize
additional discretionary contributions to the plan.  The plan provides
that employees’ contributions are 100% vested at all times and the Company’s
contributions vest at 20% each year of participation in the plan.  The
expense related to this plan for the years ended December 31, 2009, 2008 and
2007 totaled approximately $716 thousand, $846 thousand and $780 thousand,
respectively.





Employment
Agreements





The
Company has entered into employment agreements with its chief executive officer
and certain other executive officers to ensure a stable and competent management
base.  The agreements provide for a two or three-year term, but the
agreements may annually be extended for an additional year.  The
agreements provide for benefits as spelled out in the contracts and cannot be
terminated by the Board of Directors, except for cause, without prejudicing the
officers’ rights to receive certain vested benefits, including
compensation.  In the event of a change in control of the Company, as
outlined in the agreements, the acquirer will be bound to the terms of the
contracts.As a
condition to the purchase of the Company’s preferred stock by the United States
Treasury Department under the CPP, the Company agreed to certain restrictions on
executive compensation, including limitations on amounts payable to certain
executives under severance arrangements and change in control provisions of
employment contracts and clawback provisions in compensation
plans.  During 2009, Congress and the United States Treasury
Department imposed additional restrictions on executive compensation paid by
participants in the CPP, including a prohibition on severance arrangements with
certain executive officers and limitations on incentive
compensation.





Termination
Agreements





Prior to
2005, the Company entered into termination agreements with substantially all
other employees, which provide for severance pay benefits in the event of a
change in control of the Company which results in the termination of such
employee or diminished compensation, duties or benefits.  As of
December 31, 2009, approximately 34% of the Company’s employees were covered
under such agreements.  As a condition of the Company’s participation
in the United States Treasury’s Capital Purchase Program, the Company agreed to
modify these agreements for the five senior executive officers (SEOs) to
restrict the severance pay benefit the SEOs would receive in the event of a
change in control while the Treasury maintains a preferred stock investment in
the Company.During
2009, Congress and the United States Treasury Department imposed additional
restrictions on executive compensation paid by participants in the CPP,
including a prohibition on severance arrangements with certain executive
officers.




See
accompanying notes.


Page
90


SOUTHERN
COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 Years
Ended December 31, 2009, 2008 and 2007





(12)  EMPLOYEE
AND DIRECTOR BENEFIT PLANS (Continued)





Defined
Benefit Pension Plan





The
Company also has a non-contributory Defined Benefit Pension Plan covering
substantially all employees of an acquired bank, The Community
Bank.  This plan was assumed as part of the purchase of The Community
Bank in January 2004.  Benefits under the plan are based on length of
service and qualifying compensation during the final years of
employment.  Contributions to the plan are based upon the projected
unit credit actuarial funding method to comply with the funding requirements of
the Employee Retirement Income Security Act.  The plan was frozen
effective May 1, 2004.  No contribution was required for the years
ended December 31, 2009, 2008 or 2007.  The changes in benefit
obligations and plan assets, as well as the funded status, actuarial assumptions
and components of net periodic pension cost of the plan at December 31
were:





2009
                            
                            
                            2008
                            
                            
                            2007(Amounts
      in thousands)Change
      in Benefit ObligationBeginning
      of year
                            
                            $
                            890
                            
                            
                            $
                            868
                            
                            
                            $
                            845Actuarial
      loss
                            
                            
                            85
                            
                            
                            
                            6
                            
                            
                            
                            6Interest
      cost
                            
                            
                            56
                            
                            
                            
                            56
                            
                            
                            
                            54Benefits
      paid
                            
                            
                            (44
                            )
                            
                            
                            (40
                            )
                            
                            
                            (37
                            )End
      of year - Benefit obligations
                            
                            $
                            987
                            
                            
                            $
                            890
                            
                            
                            $
                            868Change
      in Fair Value of Plan AssetsBeginning
      of year
                            
                            $
                            873
                            
                            
                            $
                            1,216
                            
                            
                            $
                            1,171Benefits
      paid
                            
                            
                            (44
                            )
                            
                            
                            (40
                            )
                            
                            
                            (37
                            )Return
      on assets
                            
                            
                            168
                            
                            
                            
                            (303
                            )
                            
                            
                            82End
      of year - Fair value
                            
                            $
                            997
                            
                            
                            $
                            873
                            
                            
                            $
                            1,216Amounts
      recognized in the consolidated statementof
      financial condition consist of:Noncurrent
      Asset
                            
                            $
                            10
                            
                            
                            $
                            -
                            
                            
                            $
                            348Noncurrent
      Liability
                            
                            
                            -
                            
                            
                            
                            (17
                            )
                            
                            
                            -Funded
      status
                            
                            $
                            10
                            
                            
                            $
                            (17
                            )
                            
                            $
                            348





Because
the total unrecognized net gain or loss exceeds the greater of 10 percent of the
projected benefit obligation or 10 percent of the pension plan assets, the
excess will be amortized over the average expected future working life of active
plan participants.   As of January 1, 2009, the average expected
future working life of active plan participants was 14 years.  The
components of accumulated other comprehensive income relating to pension
adjustments are entirely comprised of actuarial losses, which amount to $359
thousand, excluding income taxes.




See
accompanying notes.


Page
91


SOUTHERN
COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 Years
Ended December 31, 2009, 2008 and 2007





(12)  EMPLOYEE
AND DIRECTOR BENEFIT PLANS (Continued)





Defined
Benefit Pension Plan (Continued)





Actuarial
assumptions used in accounting for net periodic pension cost were:





2009
                          
                          
                          2008
                          
                          
                          2007(Amounts
      in thousands)Weighted
      average discount rate
                          
                          
                          5.80
                          %
                          
                          
                          6.50
                          %
                          
                          
                          6.50
                          %Weighted
      average rate of increase incompensation
      level
                          
                          
                          N/A
                          
                          
                          
                          N/A
                          
                          
                          
                          N/AWeighted
      average expected long-termrate
      of return on plan assets
                          
                          
                          7.50
                          %
                          
                          
                          7.50
                          %
                          
                          
                          7.50
                          %Components
      of Net Periodic Pension Cost (Benefit)Service
      cost
                          
                          $
                          -
                          
                          
                          $
                          -
                          
                          
                          $
                          -Interest
      cost
                          
                          
                          56
                          
                          
                          
                          56
                          
                          
                          
                          54Expected
      return on plan assets
                          
                          
                          (64
                          )
                          
                          
                          (90
                          )
                          
                          
                          (87
                          )Amortiztion
      of net (gain) loss
                          
                          
                          24
                          
                          
                          
                          -
                          
                          
                          
                          -Net
      periodic pension cost (benefit)
                          
                          $
                          16
                          
                          
                          $
                          (34
                          )
                          
                          $
                          (33
                          )





The
measurement date used for the plan was December 31, 2009.  As of that
date, the pension plan had a funded status with the fair value of plan assets of
$997 thousand compared to an accumulated projected benefit obligation of $987
thousand.  The actual minimum required contribution for the 2010 plan
year has not yet been determined, but no employer contribution is expected to be
made during 2010.





The
overall expected long-term rate of return on assets assumption is based on: (1)
the target asset allocation for plan assets, (2) long-term capital markets
forecasts for asset classes employed and (3) active management excess return
expectations to the extent asset classes are actively managed.





Plan
assets are invested using allocation guidelines as established by the
Plan.  The primary objective is to provide long-term capital
appreciation through investments in equities and fixed income
securities.  These guidelines ensure risk control by maintaining
minimum and maximum exposure in equity and fixed income/cash equivalents
portfolios.  The minimum equity and fixed income/cash equivalents
investment exposure is 35% and 25%, respectively.  The maximum equity
and fixed income/cash equivalents investment exposure is 75% and 65%,
respectively.  The current asset allocation is 61% equity securities
and 39% fixed income securities/cash equivalents, which meets the criteria
established by the Plan.





2009
                    
                    
                    2008Percent
                    
                    
                    
                    
                    
                    PercentMarket
                    
                    
                    of
      Plan
                    
                    
                    Market
                    
                    
                    of
      PlanValue
                    
                    
                    Assets
                    
                    
                    Value
                    
                    
                    AssetsCash
      and equivalents
                    
                    $
                    1
                    
                    
                    
                    -
                    
                    
                    $
                    1
                    
                    
                    
                    -Fixed
      income:Bond
      Funds
                    
                    
                    393
                    
                    
                    
                    39
                    %
                    
                    
                    424
                    
                    
                    
                    49
                    %Equity
      Securities:Mutual
      Funds
                    
                    
                    603
                    
                    
                    
                    61
                    %
                    
                    
                    448
                    
                    
                    
                    51
                    %Total
                    
                    $
                    997
                    
                    
                    
                    100
                    %
                    
                    $
                    873
                    
                    
                    
                    100
                    %


See
accompanying notes.


Page
92


SOUTHERN
COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 Years
Ended December 31, 2009, 2008 and 2007





(12)  EMPLOYEE
AND DIRECTOR BENEFIT PLANS (Continued)





Defined
Benefit Pension Plan (Continued)





All plan
assets, except the money market account, are traded on the open
market.  At December 31, 2009 market values were determined using
quoted prices and current shares owned.  Bond funds currently held in
the plan include long-duration and high yield bond funds and emerging market
debt funds.  Equity securities include large, medium and small sized
companies and equity securities of foreign companies.  The value of
all assets are considered level 1 within the fair value hierarchy as they are
valued with quoted prices for identical assets.  The highest
percentage of any one investment at year end 2009 was 19% which does not
represent a concentration of risk.





Allowable
investment types include both U.S. and international equity and fixed income
funds.  The equity component is composed of common stocks, convertible
notes and bonds, convertible preferred stocks and ADR’s of non U.S. companies as
well as various mutual funds, including government and corporate bonds, large to
mid cap value, growth and world/international equity funds and index
funds.  The fixed income/cash equivalents component is composed of
money market funds, commercial paper, certificates of deposit, U.S. government
and agency securities, corporate notes and bonds, preferred stock and fixed
income securities of foreign governments and corporations.





The
plan's weighted-average asset allocations at December 31, 2009, by asset
category are as follows.





U.S.
      equity
                  
                  
                  54
                  %International
      blend
                  
                  
                  7Fixed
      income and cash equivalents
                  
                  
                  39





Estimated
future benefits payments are shown below (in thousands):





Year
                    
                    Pension Benefits2010
                    
                    $
                    402011
                    
                    
                    392012
                    
                    
                    392013
                    
                    
                    402014
                    
                    
                    462015-2017
                    
                    
                    279





Supplemental
Retirement





The
Company during 2001 implemented a non-qualifying supplemental retirement plan
for certain key executive and senior officers.  The Company has
purchased life insurance policies on the participating officers in order to
provide future funding of benefit payments.  Benefits under the plan
are intended to provide the executive officers with approximately 60% of final
base pay when combined with Social Security benefits and 401(k) Plan deferral
payments.  Such benefits will continue to accrue and be paid
throughout each participant’s life.  The plan also provides for
payment of death or disability benefits in the event a participating officer
becomes permanently disabled or dies prior to attainment of retirement
age.  Provisions of $446 thousand, $405 thousand and $309 thousand in
2009, 2008 and 2007, respectively, were expensed for future benefits to be
provided under this plan.  The accrued liability related to this plan
was approximately $2.1 million and $1.7 million as of December 31, 2009 and
2008, respectively.





During
1994, The Community Bank had established an unfunded Supplemental Executive
Retirement Plan, which is a nonqualified plan that provides additional
retirement benefits to certain key management personnel.  The accrued
liability related to this plan was approximately $796 thousand and $789 thousand
at December 31, 2009 and 2008, respectively.  Total expense for this
plan aggregated $46 thousand for the year ended December 31, 2009, 2008 and
2007.  Payouts for this plan were $95 thousand for years ended
December 31, 2009 and 2008 and are expected to continue at this level until the
plan is terminated.




See
accompanying notes.


Page
93


SOUTHERN
COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 Years
Ended December 31, 2009, 2008 and 2007





(12)  EMPLOYEE
AND DIRECTOR BENEFIT PLANS (Continued)





Defined
Benefit Pension Plan (Continued)





The
Company adopted “Employers’ Accounting for Defined Benefit Pension and Other
Postretirement Plans,” at December 31, 2006.  Under this accounting
guidance, an employer should recognize the over funded or under funded status of
a defined benefit postretirement plan as an asset or liability in its statement
of financial position and to recognize changes in that funded status in the year
in which the changes occur through comprehensive income.  As a result
of the adoption, the Company recorded an additional minimum pension liability of
$433 thousand and a reduction (net of tax) in accumulated other comprehensive
income of $266 thousand.





Deferred
Compensation





The
Company during 2007 implemented a non-qualifying deferred compensation plan for
certain key executive and senior officers whose participation in the Company’s
401(k) plan is limited by Internal Revenue Service regulations.  Under
the plan, participants are entitled to elect to defer from 1% to 25% of current
compensation until their normal retirement date.  The Bank matched
100% of such contributions not exceeding 6% of the participants’ compensation
during 2009 through August 31 and matched 50% on such contributions starting
September 1, 2009 for one executive officer.  The plan provides that
employees’ contributions are 100% vested at all times and the Company’s
contributions vest at 20% for each year of service.  The expense
related to this plan totaled approximately $6 thousand and $10 thousand for the
years ended December 31, 2009 and 2008, respectively.





Employee
Stock Purchase Plan





On
December 19, 2002, the Board approved the creation of, and on February 20, 2003
the Board adopted, the 2002 Employee Stock Purchase Plan (the “2002
ESPP”).  An aggregate of 1,000,000 shares of common stock of the
Company has been reserved for issuance by the Company upon exercise of options
to be granted from time to time under the 2002 ESPP.  The purpose of
the 2002 ESPP is to provide employees of the Company with an opportunity to
purchase shares of the common stock of the Company in order to encourage
employee participation in the ownership and economic success of the
Company.





The 2002
ESPP as originally amended provides employees of the Company the right to
purchase, annually, shares of the Company’s common stock at 95% of fair market
value.  The plan was amended again during 2009 to allow employees the
right to purchase these shares monthly.  The number of shares that can
be purchased in any calendar year by any individual is limited to the lesser of:
(1) shares with a fair market value of $25 thousand; or (2) shares with a fair
market value of 20% of the individual’s annual compensation.  Shares
purchased through the 2002 ESPP must be held by the employee for one year, after
which time the employee is free to dispose of the stock.





For the
years ended December 31, 2009, 2008 and 2007, employees of the Company purchased
47,942, 20,470 and 15,622 shares, respectively, under the
ESPP.  During 2009, the shares purchased for the ESPP were purchased
on the open market.





Stock
Option Plans





During
1997 the Company adopted, with stockholder approval, the 1997 Incentive Stock
Option Plan and the 1997 Nonstatutory Stock Option Plan.  Both plans
were amended in 2000 and in 2001, with stockholder approval, to increase the
number of shares available for grant.  Each of these plans makes
available options to purchase 875,253 shares of the Company’s common
stock.  During 2002 the Company adopted, with stockholder approval in
2003, the 2002 Incentive Stock Option Plan with 350,000 options available and
the 2002 Nonstatutory Stock Option Plan with 150,000 options
available.  During 2006 the Company adopted, with shareholder
approval, the 2006 Nonstatutory Stock Option Plan with 150,000 options
available.  The exercise price of all options granted to date is the
fair value of the Company’s common shares on the date of grant.





All
options had an initial vesting period of five years.  During the first
quarter 2005, the Company vested all unvested stock options.  As a
result of this decision 623,725 non-vested options were accelerated from their
established vesting over a five-year period from date of grant to being fully
vested.  Stock options granted after December 31, 2005 and stock
options granted to advisory board members generally vest over a five-year
period. All unexercised options expire ten years after the date of
grant.




See
accompanying notes.


Page
94


SOUTHERN
COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 Years
Ended December 31, 2009, 2008 and 2007





(12)  EMPLOYEE
AND DIRECTOR BENEFIT PLANS (Continued)





Stock
Option Plans (Continued)





A summary
of the Company’s option plans as of and for the year ended December 31, 2009 is
as follows:





Outstanding Options
                
                
                Exercisable OptionsShares
                  Available for
                  Future Grants
                
                
                Number
                  Outstanding
                
                
                Weighted
                  Average
                  Exercise
                  Price
                
                
                Number
                  Outstanding
                
                
                Weighted
                  Average
                  Exercise
                  PriceAt
      December 31, 2008
                
                
                503,911
                
                
                
                744,266
                
                
                $
                9.58
                
                
                
                668,466
                
                
                $
                9.75Options
      authorized
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -Options
      granted/vested
                
                
                (6,000
                )
                
                
                6,000
                
                
                
                2.78
                
                
                
                6,000
                
                
                
                2.78Options
      exercised
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -Options
      forfeited
                
                
                27,800
                
                
                
                (27,800
                )
                
                
                9.30
                
                
                
                (1,600
                )
                
                
                9.30Options
      expired
                
                
                -
                
                
                
                (15,766
                )
                
                
                10.42
                
                
                
                (15,766
                )
                
                
                10.42At
      December 31, 2009
                
                
                525,711
                
                
                
                706,700
                
                
                $
                9.52
                
                
                
                657,100
                
                
                $
                9.69





The
weighted average remaining life of options outstanding and options exercisable
at December 31, 2009 and 2008 is 4.40 years and 5.27 years,
respectively.  Information pertaining to options outstanding at
December 31, 2009 is as follows:





Number
      of
                              
                              
                              Number
      ofRange of Exercise Prices
                              
                              
                              Options
      Outstanding
                              
                              
                              Options
      Exercisable$2.67
      - $7.15
                              
                              
                              
                              118,690
                              
                              
                              
                              96,190$7.16
      - $10.10
                              
                              
                              
                              292,510
                              
                              
                              
                              279,810$10.11
      - $14.64
                              
                              
                              
                              295,500
                              
                              
                              
                              281,100Outstanding
      at end of year
                              
                              
                              
                              706,700
                              
                              
                              
                              657,100





The
estimated average per share fair value of options granted, using the
Black-Scholes methodology, together with the assumptions used in estimating
those fair values, are displayed below:





2009
                  
                  
                  2008
                  
                  
                  2007Estimated
      fair value of options granted
                  
                  $
                  0.97
                  
                  
                  $
                  0.99
                  
                  
                  $
                  3.40Assumptions
      in estimating average option values:Risk-free
      interest rate
                  
                  
                  2.28
                  %
                  
                  
                  2.45
                  %
                  
                  
                  4.58
                  %Dividend
      yield
                  
                  
                  1.76
                  %
                  
                  
                  4.56
                  %
                  
                  
                  2.22
                  %Volatility
                  
                  
                  36
                  %
                  
                  
                  29
                  %
                  
                  
                  27
                  %Expected
      life
                  
                  5
      years
                  
                  
                  5 -
      7 years
                  
                  
                  7
      years





The total
intrinsic value of options exercised during the years ended December 31, 2009,
and 2008 was none and $131 thousand, respectively.  The aggregate
intrinsic value of options outstanding and options exercisable at December 31,
2009, and 2008 was zero.  As of December 31, 2009, there was $115
thousand of unrecognized compensation cost related to non-vested share-based
compensation arrangements granted under the plans.  That cost is
expected to be recognized over a weighted average period of 1.74
years.




See
accompanying notes.


Page
95


SOUTHERN
COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 Years
Ended December 31, 2009, 2008 and 2007





(12)  EMPLOYEE
AND DIRECTOR BENEFIT PLANS (Continued)





Stock
Option Plans (Continued)





Cash
received from option exercises under all share-based payment arrangements for
the years ended December 31, 2009, 2008 and 2007 was none, $357 thousand and
$1.2 million, respectively.  The tax benefit realized for tax
deductions from option exercise of the share-based payment arrangements for the
years ended December 31, 2009, 2008 and 2007 were none, $51 thousand and $559
thousand, respectively.  Under this plan, the Company expensed $165
thousand, $82 thousand and $67 thousand for the years ended December 31, 2009,
2008 and 2007, respectively.





Restricted
Stock





During
2007 the Company adopted the Southern Community Financial Corporation Restricted
Stock Plan.  The plan initially makes 300,000 shares available to be
issued as restricted stock.  The plan is administered by the
Compensation Committee of the Board of Directors who may authorize the grant of
restricted stock to certain current directors, officers and employees of the
Corporation.  The shares vest over a five year period and are taxable
to the recipient at their option either when received or after the vesting
period at the current fair market value.  The recipient must be
employed with the Company at the end of the five year period or the shares are
forfeited.  For the year ended December 31, 2009, 23,500 shares were
granted and 5,500 shares were forfeited.  During the period from the
inception of the plan through December 31, 2009 a total of 71,500 shares have
now been issued and 7,000 shares have been forfeited, leaving 234,000 shares
available for future grants.  Under this plan, the Company expensed
$63 thousand, $73 thousand and $38 thousand for the years ended December 31,
2009, 2008 and 2007, respectively.





(13)  LEASES





The
Company leases office space and equipment under non-cancelable operating
leases.  Future minimum lease payments under these leases for the
years ending December 31 are as follows (amounts in thousands):





2010
                  
                  $
                  1,0462011
                  
                  
                  8252012
                  
                  
                  4992013
                  
                  
                  3882014
                  
                  
                  249Thereafter
                  
                  
                  1,628$
                  4,635





Total
rental expense for office space and equipment under operating leases are as
follows:





2009
                  
                  
                  2008
                  
                  
                  2007(Amounts
      in thousands)Office
      Space
                  
                  $
                  730
                  
                  
                  $
                  674
                  
                  
                  $
                  757Equipment
                  
                  
                  444
                  
                  
                  
                  560
                  
                  
                  
                  457$
                  1,174
                  
                  
                  $
                  1,234
                  
                  
                  $
                  1,214




See
accompanying notes.


Page
96


SOUTHERN
COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 Years
Ended December 31, 2009, 2008 and 2007





(14)  INCOME
TAXES





The
significant components of the provision for income taxes for the years ended
December 31, 2009, 2008 and 2007 are as follows:





2009
                      
                      
                      2008
                      
                      
                      2007(Amounts
      in thousands)Current
      tax provisionFederal
                      
                      $
                      (693
                      )
                      
                      $
                      4,349
                      
                      
                      $
                      4,079State
                      
                      
                      (157
                      )
                      
                      
                      825
                      
                      
                      
                      604(850
                      )
                      
                      
                      5,174
                      
                      
                      
                      4,683Deferred
      tax provision (benefit)Federal
                      
                      
                      (4,760
                      )
                      
                      
                      (2,085
                      )
                      
                      
                      (731
                      )State
                      
                      
                      (1,076
                      )
                      
                      
                      (455
                      )
                      
                      
                      (83
                      )(5,836
                      )
                      
                      
                      (2,540
                      )
                      
                      
                      (814
                      )Net
      provision for income taxes
                      
                      $
                      (6,686
                      )
                      
                      $
                      2,634
                      
                      
                      $
                      3,869





The
difference between the provision for income taxes and the amounts computed by
applying the statutory federal income tax rate of 34% to income before income
taxes is summarized below:





2009
                    
                    
                    2008
                    
                    
                    2007(Amounts
      in thousands)Tax
      computed at the statutory federal rate
                    
                    $
                    (23,747
                    )
                    
                    $
                    2,886
                    
                    
                    $
                    3,884Increase
      (decrease) resulting from:Goodwill
      impairment
                    
                    
                    16,830
                    
                    
                    
                    -
                    
                    
                    
                    -Valuation
      allowance on deferred tax assets
                    
                    
                    2,000
                    
                    
                    
                    -
                    
                    
                    
                    -State
      income taxes, net of federal benefit
                    
                    
                    (814
                    )
                    
                    
                    244
                    
                    
                    
                    344Tax
      exempt income
                    
                    
                    (1,071
                    )
                    
                    
                    (498
                    )
                    
                    
                    (435
                    )Other
      permanent differences
                    
                    
                    116
                    
                    
                    
                    2
                    
                    
                    
                    7617,061
                    
                    
                    
                    (252
                    )
                    
                    
                    (15
                    )Provision
      (benefit) for income taxes
                    
                    $
                    (6,686
                    )
                    
                    $
                    2,634
                    
                    
                    $
                    3,869


See
accompanying notes.


Page
97


SOUTHERN
COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 Years
Ended December 31, 2009, 2008 and 2007





(14)  INCOME
TAXES (continued)





Deferred
income taxes reflect the net tax effects of temporary differences between the
carrying amounts of assets and liabilities for financial reporting purposes and
the amounts used for income tax purposes.  Significant components of
deferred taxes at December 31, 2009 and 2008 are as follows:





2009
                            
                            
                            2008(Amounts
      in thousands)Deferred
      tax assets relating to:Allowance
      for loan losses
                            
                            $
                            11,427
                            
                            
                            $
                            7,268Deferred
      compensation
                            
                            
                            1,466
                            
                            
                            
                            1,321Derivative
      financial instruments
                            
                            
                            -
                            
                            
                            
                            222Other
                            
                            
                            2,715
                            
                            
                            
                            930Gross
      deferred tax assets
                            
                            
                            15,608
                            
                            
                            
                            9,741Valuation
      allowance
                            
                            
                            (2,000
                            )
                            
                            
                            -Net
      total deferred tax assets
                            
                            
                            13,608
                            
                            
                            
                            9,741Deferred
      tax liabilities relating to:Property
      and equipment
                            
                            
                            (709
                            )
                            
                            
                            (786
                            )Loan
      fees and costs
                            
                            
                            (627
                            )
                            
                            
                            (647
                            )Core
      deposit intangible
                            
                            
                            (326
                            )
                            
                            
                            (392
                            )Prepaid
      expenses
                            
                            
                            (258
                            )
                            
                            
                            (292
                            )Derivative
      financial instruments
                            
                            
                            (233
                            )
                            
                            
                            -Other
                            
                            
                            (65
                            )
                            
                            
                            (71
                            )Accumulated
      other comprehensive income
                            
                            
                            (1,929
                            )
                            
                            
                            (1,772
                            )Total
      deferred tax liabilities
                            
                            
                            (4,147
                            )
                            
                            
                            (3,960
                            )Net
      recorded deferred tax asset
                            
                            $
                            9,461
                            
                            
                            $
                            5,781




See
accompanying notes.


Page
98


SOUTHERN
COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 Years
Ended December 31, 2009, 2008 and 2007





(14)  INCOME
TAXES (Continued)





The
Company adopted FIN 48 (“Accounting for Uncertainty in Income Taxes”) on January
1, 2007.  The Company classifies interest and penalties related to
income tax assessments, if any, in income tax expense in the consolidated
statements of operations.  Tax years 2006 through 2008 are subject to
examination by the Internal Revenue Service and the North Carolina Department of
Revenue.  The Company has approximately $40 thousand accrued for
payment of interest and penalties as of December 31, 2009.





A
reconciliation of the beginning and ending balance of unrecognized tax benefit
is as follows:





2009
                    
                    
                    2008(Amounts
      in thousands)Balance
      at January 1, 2009
                    
                    $
                    157
                    
                    
                    $
                    135Additions
      based on tax positions related to the current year
                    
                    
                    50
                    
                    
                    
                    42Additions
      for tax positions of prior years
                    
                    
                    -
                    
                    
                    
                    -Reductions
      for tax positions of prior years
                    
                    
                    (45
                    )
                    
                    
                    (20
                    )Settlements
                    
                    
                    -
                    
                    
                    
                    -Balance
      at December 31, 2009
                    
                    $
                    162
                    
                    
                    $
                    157





(15)  NON-INTEREST
INCOME AND OTHER NON-INTEREST EXPENSE





The major
components of non-interest income for the years ended December 31, 2009, 2008
and 2007 are as follows:





2009
                  
                  
                  2008
                  
                  
                  2007(Amounts
      in thousands)Service
      charges and fees on deposit accounts
                  
                  $
                  6,246
                  
                  
                  $
                  5,859
                  
                  
                  $
                  4,931Income
      from mortgage banking activities
                  
                  
                  2,104
                  
                  
                  
                  1,294
                  
                  
                  
                  1,343Investment
      brokerage and trust fees
                  
                  
                  1,159
                  
                  
                  
                  1,138
                  
                  
                  
                  1,141Loss
      of equity in Silverton Bank
                  
                  
                  (404
                  )
                  
                  
                  -
                  
                  
                  
                  -SBIC
      income and management fees
                  
                  
                  148
                  
                  
                  
                  60
                  
                  
                  
                  2,103Gain
      and net cash settlement on economic hedges
                  
                  
                  234
                  
                  
                  
                  934
                  
                  
                  
                  79Gain
      on sale of investment securities
                  
                  
                  1,236
                  
                  
                  
                  98
                  
                  
                  
                  -Other
                  
                  
                  2,183
                  
                  
                  
                  1,958
                  
                  
                  
                  1,732Total
                  
                  $
                  12,906
                  
                  
                  $
                  11,341
                  
                  
                  $
                  11,329





The major
components of other non-interest expense for the years ended December 31, 2009,
2008 and 2007 are as follows:





2009
                  
                  
                  2008
                  
                  
                  2007(Amounts
      in thousands)FDIC
      deposit insurance
                  
                  $
                  3,098
                  
                  
                  $
                  806
                  
                  
                  $
                  176Postage,
      printing and office supplies
                  
                  
                  921
                  
                  
                  
                  847
                  
                  
                  
                  865Telephone
      and communication
                  
                  
                  927
                  
                  
                  
                  954
                  
                  
                  
                  866Advertising
      and promotion
                  
                  
                  1,103
                  
                  
                  
                  1,164
                  
                  
                  
                  1,245Data
      processing and other outsourced services
                  
                  
                  746
                  
                  
                  
                  805
                  
                  
                  
                  763Professional
      services
                  
                  
                  2,215
                  
                  
                  
                  1,811
                  
                  
                  
                  1,809Buyer
      incentive plan
                  
                  
                  1,320
                  
                  
                  
                  10
                  
                  
                  
                  -Loss
      on early extinguishment of debt
                  
                  
                  472
                  
                  
                  
                  -
                  
                  
                  
                  -(Gain)
      loss on sales of foreclosed assets
                  
                  
                  (196
                  )
                  
                  
                  59
                  
                  
                  
                  (2
                  )OREO
      writedown
                  
                  
                  2,493
                  
                  
                  
                  99
                  
                  
                  
                  -Other
                  
                  
                  7,493
                  
                  
                  
                  5,876
                  
                  
                  
                  6,030Total
                  
                  $
                  20,592
                  
                  
                  $
                  12,431
                  
                  
                  $
                  11,752


See
accompanying notes.




Page
99


SOUTHERN
COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


Years
Ended December 31, 2009, 2008 and 2007





(16)  REGULATORY
MATTERS





The Bank,
as a North Carolina banking corporation, may pay cash dividends to the Company
only out of retained earnings as determined pursuant to North Carolina banking
laws.  However, regulatory authorities may limit payment of dividends
by any bank when it is determined that such limitation is in the public interest
and is necessary to ensure financial soundness of the bank.  The Bank
is subject to various regulatory capital requirements administered by federal
and state banking agencies.  Failure to meet minimum capital
requirements can initiate certain mandatory and possibly additional
discretionary actions by regulators that, if undertaken, could have a direct
material effect on the Company’s consolidated financial
statements.  Under capital adequacy guidelines and the regulatory
framework for prompt corrective action, the Bank must meet specific capital
guidelines that involve quantitative measures of the Bank’s assets, liabilities,
and certain off-balance sheet items as calculated under regulatory accounting
practices.  The Bank’s capital amounts and classifications are also
subject to qualitative judgments by the regulators about components, risk
weightings, and other factors.





Quantitative
measures established by regulation to ensure capital adequacy require the Bank
to maintain minimum amounts and ratios, as prescribed by regulations, of total
and Tier 1 capital to risk-weighted assets and of Tier 1 capital to average
assets.  As of December 31, 2009 and 2008, the most recent
notification from the FDIC categorized the Bank as well capitalized under the
regulatory framework for prompt corrective action.  To be categorized
as well capitalized, the Bank must maintain minimum amounts and ratios, as set
forth in the table below.  There are no conditions or events since
that notification that management believes have changed the Bank’s
category.  Information regarding the Bank’s capital and capital ratios
is set forth below:





Actual
                
                
                Minimum For Capital
                  Adequacy Purposes
                
                
                Minimum To Be Well
                  Capitalized Under Prompt
                  Corrective ActionAmount
                
                
                Ratio
                
                
                Amount
                
                
                Ratio
                
                
                Amount
                
                
                Ratio(Amounts in thousands)As
      of December 31, 2009Total
      Capital (to Risk-Weighted Assets)
                
                $
                162,977
                
                
                
                11.63
                %
                
                $
                112,200
                
                
                
                8.00
                %
                
                $
                140,200
                
                
                
                10.00
                %Tier
      1 Capital (to Risk-Weighted Assets)
                
                
                145,403
                
                
                
                10.37
                %
                
                
                56,100
                
                
                
                4.00
                %
                
                
                84,100
                
                
                
                6.00
                %Tier
      1 Capital (to Average Assets)
                
                
                145,403
                
                
                
                8.36
                %
                
                
                69,600
                
                
                
                4.00
                %
                
                
                87,000
                
                
                
                5.00
                %As
      of December 31, 2008Total
      Capital (to Risk-Weighted Assets)
                
                $
                165,013
                
                
                
                11.55
                %
                
                $
                114,300
                
                
                
                8.00
                %
                
                $
                142,900
                
                
                
                10.00
                %Tier
      1 Capital (to Risk-Weighted Assets)
                
                
                147,138
                
                
                
                10.30
                %
                
                
                57,200
                
                
                
                4.00
                %
                
                
                85,700
                
                
                
                6.00
                %Tier
      1 Capital (to Average Assets)
                
                
                147,138
                
                
                
                8.42
                %
                
                
                69,900
                
                
                
                4.00
                %
                
                
                87,400
                
                
                
                5.00
                %





The
Company is also subject to these capital requirements.  Information
regarding the Company’s capital and capital ratios is set forth
below:





At December 31, 2009
                  
                  
                  At December 31, 2008Actual
                  
                  
                  ActualAmount
                  
                  
                  Ratio
                  
                  
                  Amount
                  
                  
                  Ratio(Amounts in thousands)Total
      risk-based capital ratio
                  
                  $
                  181,623
                  
                  
                  
                  12.92
                  %
                  
                  $
                  197,790
                  
                  
                  
                  13.80
                  %Tier
      1 risk-based capital ratio
                  
                  
                  159,421
                  
                  
                  
                  11.34
                  %
                  
                  
                  178,489
                  
                  
                  
                  12.46
                  %Leverage
      ratio
                  
                  
                  159,421
                  
                  
                  
                  9.14
                  %
                  
                  
                  178,489
                  
                  
                  
                  10.57
                  %




See
accompanying notes.


Page
100


SOUTHERN
COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


Years
Ended December 31, 2009, 2008 and 2007





(17)  DERIVATIVES





Derivative
Financial Instruments





The
Company utilizes stand-alone derivative financial instruments, primarily in the
form of interest rate swap and option agreements, in its asset/liability
management program.  These transactions involve both credit and market
risk.  The Company uses derivative instruments to mitigate exposure to
adverse changes in fair value or cash flows of certain assets and
liabilities.  Derivative instruments designated in a hedge
relationship to mitigate exposure to changes in the fair value of an asset,
liability, or firm commitment attributable to a particular risk, such as
interest rate risk, are considered fair value hedges.  Derivative
instruments designated in a hedge relationship to mitigate exposure to
variability in expected future cash flows, or other types of forecasted
transactions, are considered cash flow hedges.  Effective January 1,
2009, the Company adopted the new disclosure requirements for derivative
instruments and hedging activities.





Fair
value hedges are accounted for by recording the fair value of the derivative
instrument and the fair value related to the risk being hedged of the hedged
asset or liability on the balance sheet with corresponding offsets recorded in
the income statement.  The adjustment to the hedged asset or liability
is included in the basis of the hedged item, while the fair value of the
derivative is recorded as a freestanding asset or liability.  Actual
cash receipts or payments and related amounts accrued during the period on
derivatives included in a fair value hedge relationship are recorded as
adjustments to the income or expense on the hedged asset or
liability.  Cash flow hedges are accounted for by recording the fair
value of the derivative instrument on the balance sheet as either a freestanding
asset or liability, with a corresponding offset recorded in accumulated other
comprehensive income within stockholders’ equity, net of tax.  Amounts
are reclassified from accumulated other comprehensive income to the income
statement in the period or periods the hedged transaction affects
earnings.  Under both the fair value and cash flow hedge methods,
derivative gains and losses not effective in hedging the change in fair value or
expected cash flows of the hedged item are recognized immediately in the income
statement.





The
Company does not enter into derivative financial instruments for speculative or
trading purposes.  For derivatives that are economic hedges, but are
not designated as hedging instruments or otherwise do not qualify for hedge
accounting treatment, all changes in fair value are recognized in non-interest
income during the period of change.  The net cash settlement on these
derivatives is included in non-interest income.





The
Company is exposed to credit-related losses in the event of nonperformance by
the counterparties to these agreements.  The Company controls the
credit risk of its financial contracts through credit approvals, limits and
monitoring procedures and agreements that specify collateral levels to be
maintained by the Company and the counterparties.  These collateral
levels are based on the credit rating of the counterparties and the value of the
derivatives.  A nonrecurring loss was recorded in the prior year
related to the uncertain realization of the value of certain derivative
positions on our balance sheet due to the bankruptcy and technical default of
Lehman Brothers, the counterparty in the contracts.  As part of those
derivative contracts, Lehman Brothers held as collateral $1.0 million of the
Company’s U.S. Government Agency investment securities.  The Company
filed a claim against Lehman Brothers for recovery of the collateral and value
of the derivative positions.  The Company wrote off the $1.0 million
in collateral held by Lehman during the second quarter 2009 as legal counsel
determined that we had no preferred status in the Lehman bankruptcy and its
realization was uncertain.  Through the sale and assignment of our
creditor claims in the Lehman bankruptcy to a third party, we recovered $408
thousand which was recorded in noninterest income during the third quarter of
2009.





The
Company currently has eleven derivative instrument contracts consisting of two
interest rate caps, seven interest rate swaps and two foreign exchange
contracts.  The primary objective for each of these contracts is to
minimize risk, interest rate risk being the primary risk for the interest rate
caps and swaps while foreign exchange risk is the primary risk for the foreign
exchange contracts.  The Company’s strategy is to use derivative
contracts to stabilize and improve net interest margin and net interest income
currently and in future periods.  In order to acquire low cost, long
term fixed rate funding without incurring currency risk, the Company entered
into the foreign exchange contract to convert foreign currency denominated
certificates of deposit into long term dollar denominated time
deposits.  The interest rate on the underlying $10.0 million
certificates of deposit is based on a proprietary index (Barclays Intelligent
Carry Index USD ER) managed by the counterparty (Barclays Bank).  The
currency swap is also based on this proprietary index.




See
accompanying notes.


Page
101


SOUTHERN
COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


Years
Ended December 31, 2009, 2008 and 2007





(17)
DERIVATIVES (Continued)





Risk
Management Policies - Hedging Instruments





The
primary focus of the Company’s asset/liability management program is to monitor
the sensitivity of the Company’s net portfolio value and net income under
varying interest rate scenarios to take steps to control its
risks.  On a quarterly basis, the Company simulates the net portfolio
value and net income expected to be earned for a period following the date of
simulation.  The simulation is based on a projection of market
interest rates at varying levels and estimates the impact of such market rates
on the levels of interest-earning assets and interest-bearing liabilities during
the measurement period.  Based upon the outcome of the simulation
analysis, the Company considers the use of derivatives as a means of reducing
the volatility of net portfolio value and projected net income within certain
ranges of projected changes in interest rates.  The Company evaluates
the effectiveness of entering into any derivative instrument agreement by
measuring the cost of such an agreement in relation to the reduction in net
portfolio value and net income volatility within an assumed range of interest
rates.





The fair
value of the Company’s derivative assets and liabilities and their related
notional amounts is summarized below.





December 31, 2009
                              
                              
                              December 31, 2008Fair Value
                              
                              
                              Notional
                                Amount
                              
                              
                              Fair Value
                              
                              
                              Notional
                                Amount(Amounts in thousands)Fair
      value hedgesInterest
      rate swaps associated with depositactivities:
      Certificate of Deposit contracts
                              
                              $
                              939
                              
                              
                              $
                              65,000
                              
                              
                              $
                              -
                              
                              
                              $
                              -Currency
      Exchange Contracts
                              
                              
                              (847
                              )
                              
                              
                              10,000
                              
                              
                              
                              (1,080
                              )
                              
                              
                              10,000Cash
      flow hedgesInterest
      rate swaps associated with borrowingactivities:
      Trust Preferred contracts
                              
                              
                              (402
                              )
                              
                              
                              10,000
                              
                              
                              
                              (483
                              )
                              
                              
                              10,000Interest
      rate cap contracts
                              
                              
                              489
                              
                              
                              
                              22,500
                              
                              
                              
                              3
                              
                              
                              
                              10,000$
                              179
                              
                              
                              $
                              107,500
                              
                              
                              $
                              (1,560
                              )
                              
                              $
                              30,000





See Note
20 for additional information on fair values of net derivatives.





Certain
derivative liabilities were collateralized by securities, which are held by the
counterparty or in safekeeping by third parties. The fair value of these
securities at December 31, 2009 was $4.2 million.




See
accompanying notes.


Page
102


SOUTHERN
COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


Years
Ended December 31, 2009, 2008 and 2007





(17)  DERIVATIVES
(Continued)





The
following table further breaks down the derivative positions of the
Company:





For the Year Ended December 31, 2009Asset Derivatives
                          
                          Liability Derivatives2009
                          
                          2009Balance Sheet
                          
                          
                          
                          Balance SheetLocation
                          
                          Fair Value
                          
                          Location
                          
                          Fair Value(Amounts in thousands)Derivatives
      designated ashedging
      instrumentsInterest
      rate options
                          
                          Other
      Assets
                          
                          $
                          489Interest
      rate contracts
                          
                          Other
      Assets
                          
                          $
                          939
                          
                          Other
      Liabilities
                          
                          $
                          402Derivatives
      not designated ashedging
      instrumentsInterest
      rate contracts
                          
                          Other
      Assets
                          
                          
                          -
                          
                          Other
      Liabilities
                          
                          
                          847Total
      derivatives
                          
                          
                          
                          $
                          1,428
                          
                          
                          
                          $
                          1,249Net
      Derivative Asset (Liability)
                          
                          
                          
                          
                          
                          
                          
                          
                          $
                          179





For the Year Ended December 31, 2008Asset Derivatives
                        
                        Liability Derivatives2008
                        
                        2008Balance Sheet
                        
                        
                        
                        Balance SheetLocation
                        
                        Fair Value
                        
                        Location
                        
                        Fair Value(Amounts in thousands)Derivatives
      designated ashedging
      instrumentsInterest
      rate options
                        
                        Other
      Assets
                        
                        $
                        3Interest
      rate contracts
                        
                        
                        
                        
                        
                        
                        Other
      Liabilities
                        
                        $
                        483Derivatives
      not designated ashedging
      instrumentsInterest
      rate contracts
                        
                        Other
      Assets
                        
                        
                        -
                        
                        Other
      Liabilities
                        
                        
                        1,080Total
      derivatives
                        
                        
                        
                        $
                        3
                        
                        
                        
                        $
                        1,563Net
      Derivative Asset (Liability)
                        
                        
                        
                        
                        
                        
                        
                        
                        $
                        (1,560
                        )




See
accompanying notes.


Page
103


SOUTHERN
COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


Years
Ended December 31, 2009, 2008 and 2007





(17)  DERIVATIVES
(Continued)





The
tables below illustrate the effective portion of the gains (losses) recognized
in other comprehensive income and the gains (losses) reclassified from
accumulated other comprehensive income into earnings for the years ended
December 31, 2009 and 2008.





For the Year Ended December 31, 2009Location of Gain or
                                                        
                                                        Amount of Gain or (Loss)Amount of Gain or (Loss)
                                                        
                                                        (Loss) Reclassified from
                                                        
                                                        Reclassified fromRecognized in OCI on
                                                        
                                                        Accumulated OCI
                                                        
                                                        Accumulated OCI intoCash Flow Hedging
                                                        
                                                        Derivative (Effective
                                                        
                                                        into Income
                                                        
                                                        Income (EffectiveRelationships
                                                        
                                                        Portion)
                                                        
                                                        (Effective Portion)
                                                        
                                                        Portion)(Amounts in thousands)Interest
      rate contracts
                                                        
                                                        $
                                                        354
                                                        
                                                        Interest
      Expense
                                                        
                                                        $
                                                        (233
                                                        )





There was
no gain or loss recognized in the income statement due to any ineffective
portion of any cash flow hedging relationship for the year ended December 31,
2009.





For the Year Ended December 31, 2008Location of Gain or
                                            
                                            Amount of Gain or (Loss)Amount of Gain or (Loss)
                                            
                                            (Loss) Reclassified from
                                            
                                            Reclassified fromRecognized in OCI on
                                            
                                            Accumulated OCI
                                            
                                            Accumulated OCI intoCash Flow Hedging
                                            
                                            Derivative (Effective
                                            
                                            into Income
                                            
                                            Income (EffectiveRelationships
                                            
                                            Portion)
                                            
                                            (Effective Portion)
                                            
                                            Portion)(Amounts in thousands)Interest
      rate contracts
                                            
                                            $
                                            (978
                                            )
                                            Interest
      Expense
                                            
                                            $
                                            (43
                                            )





There was
no gain or loss recognized in the income statement due to any ineffective
portion of any cash flow hedging relationship for the year ended December 31,
2008.




See
accompanying notes.


Page
104


SOUTHERN
COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


Years
Ended December 31, 2009, 2008 and 2007





(17)  DERIVATIVES
(Continued)





The
tables below show the location and amount of gains (losses) recognized in
earnings for fair value hedges and other economic hedges for the years ended
December 31, 2009 and 2008.





For
the Year Ended December 31, 2009





Location of Gain or
                                      
                                      Amount of Gain or (Loss)(Loss) Recognized in
                                      
                                      Recognized in Income onDescription
                                      
                                      Income on Derivative
                                      
                                      Derivative(Amounts in thousands)Interest
      rate contracts – Notdesignated
      as hedging instruments
                                      
                                      Other
      income (expense)
                                      
                                      $
                                      234Interest
      Rate Contracts – Fairvalue
      hedging relationships
                                      
                                      Interest
      Income/(Expense)
                                      
                                      $
                                      1,499





For
the Year Ended December 31, 2008





Location of Gain or
                                  
                                  Amount of Gain or (Loss)(Loss) Recognized in
                                  
                                  Recognized in Income onDescription
                                  
                                  Income on Derivative
                                  
                                  Derivative(Amounts in thousands)Interest
      rate contracts - Notdesignated
      as hedging instruments
                                  
                                  Other
      income (expense)
                                  
                                  $
                                  934Interest
      Rate Contracts - Fairvalue
      hedging relationships
                                  
                                  Interest
      Income/(Expense)
                                  
                                  $
                                  1,176





The
maturity dates for the two interest rate cap contracts are November 23, 2010 and
February 18, 2014.  The interest rate swap with borrowing activities
on trust preferred securities has a maturity of September 6,
2012.  The currency exchange contracts have maturity dates of November
26, 2013 and December 26, 2013.  The interest rate swaps with deposit
taking activities on certificates of deposit have maturity dates of February 26,
2024, June 25, 2029, July 9, 2029, July 28, 2024, July 28, 2024 and August 28,
2024.  All of these swaps have the ability to be called by the
counterparty prior to their maturity date.  The primary derivative
activity during 2009 involved the execution of six interest rate swaps and an
interest rate cap.





Certain
derivative liabilities were collateralized by securities, which are held by the
counterparty or in safekeeping by third parties.  The fair value of
these securities was $4.2 million and $2.9 million at December 31, 2009 and
December 31, 2008 respectively.  Collateral calls can be required at
any time that the market value exposure of the contracts is less than the
collateral pledged.  The degree of overcollateralization is dependent
on the derivative contracts to which the Company is a party.





As part
of our banking activities, the Company originates certain residential loans and
commits these loans for sale.  The commitments to originate
residential loans and the sales commitments are freestanding derivative
instruments and are generally funded within 90 days.  The fair value
of these commitments was not significant at December 31, 2009.





Interest
Rate Risk Management - Cash Flow Hedging Instruments





To
mitigate exposure to variability in expected future cash flows resulting from
changes in interest rates, management may enter into interest rate swap and
option agreements.  At December 31, 2009 and 2008, the Company
had an interest rate swap agreement related to a variable-rate obligation that
provides for the Company to pay fixed and receive floating payments related to
the variable rate Trust Preferred Securities (the Trust III
Securities).  The Company also had interest rate option agreements
that provide for payments to the Company in the event interest rates increase or
decrease above or below levels provided in the agreements.  The gains
and losses from such hedges not designated as cash flow hedges are recognized in
non-interest income in the line item net cash settlement and change in fair
value of economic hedges.




See
accompanying notes.


Page
105


SOUTHERN
COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


Years
Ended December 31, 2009, 2008 and 2007





(17)  DERIVATIVES
(Continued)





Interest
Rate Risk Management – Fair Value Hedging Instruments





As part
of interest rate risk management, the Company from time to time has entered into
interest rate swap agreements to convert certain fixed-rate obligations to
floating rates.  At December 31, 2009 and 2008, the Company
had interest rate swap agreements related to fixed-rate obligations that provide
for the Company to pay floating and receive fixed interest payments, certain of
which had been designated as fair value hedges, others of which were not
designated as fair value hedges.  The gains (losses) from such
interest rate swaps that were not designated as accounting hedges are recognized
in non-interest income in the line item net cash settlement and change in fair
value of economic hedges.  Prior to designation as fair value hedges,
the change in the fair value of the interest rate swap agreements were included
in noninterest income.  Subsequent to the designation as fair value
hedges, the changes in the fair value of the interest rate swap and the changes
to the fair value of the hedged CD are included in noninterest
income.  The difference between the changes in the fair values of the
interest rate swaps and the related CDs represents hedge
ineffectiveness.  The Company currently has no fair value hedges for
which hedge effectiveness is evaluated using the “short-cut”
method.





(18)  OFF-BALANCE
SHEET RISK, COMMITMENTS AND CONTINGENCIES





The
Company is a party to financial instruments with off-balance sheet risk in the
normal course of business to meet the financing needs of its
customers.  These financial instruments include commitments to extend
credit and standby letters of credit.  Those instruments involve, to
varying degrees, elements of credit and interest rate risk in excess of the
amount recognized in the balance sheets.  The contract or notional
amounts of those instruments reflect the extent of involvement the Company has
in particular classes of financial instruments.  The Company uses the
same credit policies in making commitments and conditional obligations as it
does for on-balance sheet instruments.





Commitments
to extend credit are agreements to lend to a customer as long as there is no
violation of conditions established in the contract.  Commitments
generally have fixed expiration dates or other termination clauses and may
require payment of a fee.  Since some of the commitments are expected
to expire without being drawn upon, the total commitment amounts do not
necessarily represent future cash requirements.  The Company evaluates
each customer’s creditworthiness on a case-by-case basis.





The
amount of collateral obtained, if deemed necessary by the Company, upon
extension of credit is based on management’s credit evaluation of the
borrower.  Collateral obtained varies but may include real estate,
stocks, bonds and certificates of deposit.





A summary
of the contract amount of the Company’s exposure to off-balance sheet risk as of
December 31, 2009 and 2008 is as follows (amounts in thousands):





2009
                  
                  
                  2008Financial
      instruments whose contract amounts represent credit risk:Loan
      commitments and undisbursed lines of credit
                  
                  $
                  221,853
                  
                  
                  $
                  252,129Undisbursed
      standby letters of credit
                  
                  
                  8,270
                  
                  
                  
                  7,083Undisbursed
      portion of construction loans
                  
                  
                  54,435
                  
                  
                  
                  55,850





The
Company is a party to legal proceedings and potential claims arising in the
normal conduct of business.  Management believes that this litigation
is not material to the financial position or results of operations of the
Company.


See
accompanying notes.


Page
106


SOUTHERN
COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


Years
Ended December 31, 2009, 2008 and 2007





(19)  DISCLOSURES
ABOUT FAIR VALUES OF FINANCIAL INSTRUMENTS





Financial
instruments include cash and due from banks, federal funds sold, investment
securities, loans, bank-owned life insurance, deposit accounts and other
borrowings, accrued interest and derivatives.  Fair value estimates
are made at a specific moment in time, based on relevant market information and
information about the financial instrument.  These estimates do not
reflect any premium or discount that could result from offering for sale at one
time the Company’s entire holdings of a particular financial
instrument.  Because no active market readily exists for a portion of
the Company’s financial instruments, fair value estimates are based on judgments
regarding future expected loss experience, current economic conditions, risk
characteristics of various financial instruments and other
factors.  These estimates are subjective in nature and involve
uncertainties and matters of significant judgment and, therefore, cannot be
determined with precision.  Changes in assumptions could significantly
affect the estimates.





The
following methods and assumptions were used to estimate the fair value of each
class of financial instruments for which it is practicable to estimate that
value:





Cash
and due from banks, federal funds sold and other interest-bearing
deposits





The
carrying amounts for cash and due from banks, federal funds sold and other
interest-bearing deposits approximate fair value because of the short maturities
of those instruments.





Investment
securities





Fair
value for investment securities equals quoted market price if such information
is available.  If a quoted market price is not available, fair value
is estimated using quoted market prices for similar securities.  The
Company utilizes a third party pricing service to provide valuations on its
securities portfolio.  Most of these securities are U.S. government
agency debt obligations and agency mortgage-backed securities traded in active
markets.  The third party valuations are determined based on the
characteristics of each security (such as maturity, duration, rating, etc.) and
in reference to similar or comparable securities.  Due to the nature
and methodology of these valuations, the Company considers these fair value
measurements as Level 2.





Loans





For
certain homogeneous categories of loans, such as residential mortgages, fair
value is estimated using the quoted market prices for securities backed by
similar loans, adjusted for differences in loan characteristics.  The
fair value of other types of loans is estimated by discounting the future cash
flows using the current rates at which similar loans would be made to borrowers
with similar credit ratings and for the same remaining maturities.





Investment
in bank-owned life insurance





The
carrying value of bank-owned life insurance approximates fair value because this
investment is carried at cash surrender value, as determined by the
insurer.





Deposits





The fair
value of demand deposits is the amount payable on demand at the reporting
date.  The fair value of time deposits is estimated based on
discounting expected cash flows using the rates currently offered for deposits
of similar remaining maturities.





Borrowings





The fair
values are based on discounting expected cash flows at the current interest rate
for debt with the same or similar remaining maturities and collateral
requirements.





Accrued
interest





The
carrying amounts of accrued interest approximate fair value.




See
accompanying notes.


Page
107


SOUTHERN
COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


Years
Ended December 31, 2009, 2008 and 2007





(19)  DISCLOSURES
ABOUT FAIR VALUES OF FINANCIAL INSTRUMENTS (Continued)





Derivative
financial instruments





Fair
values for interest rate swap and option agreements are based upon the amounts
required to settle the contracts.  Fair values for commitments to
originate loans held for sale are based on fees currently charged to enter into
similar


agreements.  Fair
values for fixed-rate commitments also consider the difference between current
levels of interest rates and the committed rates.





Financial
instruments with off-balance sheet risk





With
regard to financial instruments with off-balance sheet risk discussed in Note
18, it is not practicable to estimate the fair value of future financing
commitments.





The
carrying amounts and estimated fair values of the Company’s financial
instruments, none of which are held for trading purposes, are as follows at
December 31, 2009 and 2008:





2009
                
                
                2008Carrying
                  amount
                
                
                Estimated fair
                  value
                
                
                Carrying
                  amount
                
                
                Estimated
                  fair value(Amounts in thousands)Financial
      assets:Cash
      and due from banks
                
                $
                30,184
                
                
                $
                30,184
                
                
                $
                25,215
                
                
                $
                25,215Federal
      funds sold and other interest-bearing deposits
                
                
                31,269
                
                
                
                31,269
                
                
                
                2,180
                
                
                
                2,180Investment
      securities available for sale
                
                
                312,780
                
                
                
                312,780
                
                
                
                289,466
                
                
                
                289,466Investment
      securities held to maturity
                
                
                10,919
                
                
                
                11,180
                
                
                
                35,231
                
                
                
                35,531Loans
                
                
                1,200,637
                
                
                
                1,226,248
                
                
                
                1,295,960
                
                
                
                1,304,117Market
      risk/liquidity adjustment
                
                
                -
                
                
                
                (34,055
                )
                
                
                -
                
                
                
                (14,517
                )Net
      loans
                
                
                1,200,637
                
                
                
                1,192,193
                
                
                
                1,295,960
                
                
                
                1,289,600Investment
      in life insurance
                
                
                28,766
                
                
                
                28,766
                
                
                
                27,665
                
                
                
                27,665Accrued
      interest receivable
                
                
                7,403
                
                
                
                7,403
                
                
                
                7,690
                
                
                
                7,690Financial
      liabilities:Deposits
                
                
                1,314,070
                
                
                
                1,334,468
                
                
                
                1,233,112
                
                
                
                1,227,006Short-term
      borrowings
                
                
                85,477
                
                
                
                85,827
                
                
                
                145,197
                
                
                
                145,197Long-term
      borrowings
                
                
                199,103
                
                
                
                203,987
                
                
                
                228,016
                
                
                
                247,223Accrued
      interest payable
                
                
                3,318
                
                
                
                3,318
                
                
                
                6,427
                
                
                
                6,427On-balance
      sheet derivative financial instruments:Interest
      rate swap and option agreements:(Assets)
      Liabilities, net
                
                
                (179
                )
                
                
                (179
                )
                
                
                1,560
                
                
                
                1,560




See
accompanying notes.


Page
108


SOUTHERN
COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


Years
Ended December 31, 2009, 2008 and 2007





(20)
FAIR VALUES OF ASSETS AND LIABILITIES





Effective
January 1, 2008, the Company adopted the new requirement for optional reporting
of financial assets and financial liabilities at fair value.  The
effect of adopting the fair value reporting standards was not material to the
financial statements.





The new
standard defines fair value, establishes a framework for measuring fair value
according to generally accepted accounting principles and expands disclosures
about fair value measurements.  This pronouncement establishes a three
level fair value hierarchy that is fully described below.  While this
standard does not require any financial instruments to be measured at fair
value, the provisions of the statement must be applied in situations where other
accounting pronouncements either permit or require fair value
measurement.  The Company reports fair value on a recurring basis for
certain financial instruments, most notably for available for sale investment
securities and certain derivative instruments.  The Company may be
required, from time to time, to measure certain assets at fair value on a
nonrecurring basis.  These include assets that are measured at the
lower of cost or market that were recognized at fair value which was below cost
at the end of the period.  Assets subject to nonrecurring use of fair
value measurements could include loans held for sale, goodwill, impaired loans
and foreclosed assets.  At December 31, 2009 and December 31, 2008,
the Company had certain impaired loans that are measured at fair value on a
nonrecurring basis.





The
Company groups financial assets and financial liabilities measured at fair value
in three levels, based on the markets in which the assets and liabilities are
traded and the reliability of the assumptions used to determine fair
value.  These levels are:





·
            Level
      1 – Valuations for assets and liabilities traded in active exchange
      markets, such as the New York Stock Exchange.  Level 1 also
      includes U.S. Treasury securities that are traded by dealers or brokers in
      active markets.  Valuations are obtained from readily available
      pricing sources for market transactions involving identical assets or
      liabilities.





·
            Level
      2 – Valuations for assets and liabilities traded in less active dealer or
      broker markets.  Level 2 securities include mortgage-backed
      securities issued by government sponsored entities, municipal bonds and
      corporate debt securities.  Valuations are obtained from third
      party services for similar or comparable assets or
      liabilities.





·
            Level
      3 – Valuations for assets and liabilities that are derived from other
      valuation methodologies,  including option pricing models,
      discounted cash flow models and similar techniques, and not based on
      market exchange, dealer, or brokered traded transactions.  Level
      3 valuations incorporate certain assumptions and projections in
      determining the fair value assigned to such assets or
      liabilities.




See
accompanying notes.


Page
109


SOUTHERN
COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


Years
Ended December 31, 2009, 2008 and 2007





(20)
FAIR VALUES OF ASSETS AND LIABILITIES (Continued)





The table
below presents the balances of assets and liabilities measured at fair value on
a recurring basis.





December 31, 2009Total
                  
                  
                  Level 1
                  
                  
                  Level 2
                  
                  
                  Level 3(Amounts in thousands)Securities
      available for sale:U.
      S. government agencies
                  
                  $
                  57,288
                  
                  
                  $
                  -
                  
                  
                  $
                  57,288
                  
                  
                  $
                  -Mortgage-backed
      securities
                  
                  
                  182,100
                  
                  
                  
                  -
                  
                  
                  
                  182,100
                  
                  
                  
                  -Municipals
                  
                  
                  66,259
                  
                  
                  
                  -
                  
                  
                  
                  66,259
                  
                  
                  
                  -Trust
      preferred securities
                  
                  
                  2,876
                  
                  
                  
                  -
                  
                  
                  
                  2,876
                  
                  
                  
                  -Common
      stocks and mutual funds
                  
                  
                  3,264
                  
                  
                  
                  403
                  
                  
                  
                  -
                  
                  
                  
                  2,861Other
                  
                  
                  993
                  
                  
                  
                  -
                  
                  
                  
                  993
                  
                  
                  
                  -Net
      Derivatives
                  
                  
                  179
                  
                  
                  
                  -
                  
                  
                  
                  1,026
                  
                  
                  
                  (847
                  )





December 31, 2008Total
                  
                  
                  Level 1
                  
                  
                  Level 2
                  
                  
                  Level 3(Amounts in thousands)Securities
      available for sale:U.
      S. government agencies
                  
                  $
                  78,207
                  
                  
                  $
                  -
                  
                  
                  $
                  78,207
                  
                  
                  $
                  -Mortgage-backed
      securities
                  
                  
                  200,460
                  
                  
                  
                  -
                  
                  
                  
                  200,460
                  
                  
                  
                  -Municipals
                  
                  
                  2,405
                  
                  
                  
                  -
                  
                  
                  
                  2,405
                  
                  
                  
                  -Trust
      preferred securities
                  
                  
                  4,067
                  
                  
                  
                  -
                  
                  
                  
                  4,067
                  
                  
                  
                  -Common
      stocks and mutual funds
                  
                  
                  3,617
                  
                  
                  
                  340
                  
                  
                  
                  272
                  
                  
                  
                  3,005Other
                  
                  
                  710
                  
                  
                  
                  -
                  
                  
                  
                  710
                  
                  
                  
                  -Net
      Derivatives
                  
                  
                  (1,560
                  )
                  
                  
                  -
                  
                  
                  
                  (480
                  )
                  
                  
                  (1,080
                  )





The table
below presents reconciliation for the period of January 1, 2009 to December 31,
2009, for all Level 3 assets and liabilities that are measured at fair value on
a recurring basis.





Fair Value Measurements Using Significant Unobservable InputsSecuritiesAvailable for sale
                        
                        
                        Net Derivatives(Dollars in Thousands)Beginning
      Balance January 1, 2009
                        
                        $
                        3,005
                        
                        
                        $
                        (1,080
                        )Total
      realized and unrealized gains or losses:Included
      in earnings
                        
                        
                        -Included
      in other comprehensive income
                        
                        
                        (144
                        )
                        
                        
                        233Purchases,
      issuances and settlements
                        
                        
                        -
                        
                        
                        
                        -Transfers
      in and/or out of Level 3
                        
                        
                        -
                        
                        
                        
                        -Ending
      Balance
                        
                        $
                        2,861
                        
                        
                        $
                        (847
                        )





The
Company utilizes a third party pricing service to provide valuations on its
securities portfolio.  Most of these securities are U.S. government
agency debt obligations and agency mortgage-backed securities traded in active
markets.  The third party valuations are determined based on the
characteristics of each security (such as maturity, duration, rating, etc.) and
in reference to similar or comparable securities.  Due to the nature
and methodology of these valuations, the Company considers these fair value
measurements as Level 2.




See
accompanying notes.


Page
110


SOUTHERN
COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


Years
Ended December 31, 2009, 2008 and 2007





(20) – FAIR VALUES OF ASSETS AND
LIABILITIES (Continued)





The fair
value reporting standards allows an entity to make an irrevocable election to
measure certain financial instruments at fair value.  The changes in
fair value from one reporting period to the next period must be reported in the
income statement with additional disclosures to identify the effect on net
income.  The Company continued to account for securities available for
sale at fair value as reported in prior years.  Derivative activity is
also reported at fair value.  Securities available for sale and
derivative activity are reported on a recurring basis.  Upon adoption
of the fair value reporting standard, no additional financial assets or
liabilities were reported at fair value and there was no material effect on
earnings.





The
Company records loans in the ordinary course of business and does not record
loans at fair value on a recurring basis.  Loans are considered
impaired when it is determined to be probable that all amounts due under the
contractual terms of the loan will not be collected when due.  Loans
considered individually impaired are evaluated and a specific allowance is
established if required based on the most appropriate of the three measurement
methods: present value of expected future cash flows, fair value of collateral,
or the observable market price of a loan method.  A specific allowance
is required if the fair value of the expected repayments or the collateral is
less than the recorded investment in the loan.  At December 31, 2009,
loans with a book value of $40.2 million were evaluated for
impairment.  Of this total, $29.1 million required a specific
allowance totaling $9.8 million for a net fair value of $19.3
million.  At December 31, 2008, loans with a book value of $23.3
million were evaluated for impairment.  Of this total, $19.0 million
required a specific allowance totaling $2.8 million for a net fair value of
$16.2 million.  The methods used to determine the fair value of these
loans were generally either the present value of expected future cash flows or
fair value of collateral and were considered level three.





The table
below presents the balances of assets and liabilities measured at fair value on
a nonrecurring basis.





December 31, 2009Total
                    
                    
                    Level 1
                    
                    
                    Level 2
                    
                    
                    Level 3(Amounts in thousands)Impaired
      loans
                    
                    $
                    19,322
                    
                    
                    $
                    -
                    
                    
                    $
                    -
                    
                    
                    $
                    19,322Foreclosed
      assets
                    
                    
                    19,634
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    19,634





December
      31, 2008Total
                  
                  
                  Level
      1
                  
                  
                  Level
      2
                  
                  
                  Level
      3(Amounts
      in thousands)Impaired
      loans
                  
                  $
                  16,223
                  
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  16,223Foreclosed
      assets
                  
                  
                  5,745
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  5,745




See
accompanying notes.


Page
111


SOUTHERN
COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


Years
Ended December 31, 2009, 2008 and 2007





(21)   PARENT
COMPANY FINANCIAL DATA





Southern
Community Financial Corporation's condensed balance sheets as of December 31,
2009 and 2008 and its related condensed statements of operations and cash flows
for each of the years in the three-year period ended December 31, 2009 are as
follows:





Condensed
Balance Sheets


December
31, 2009 and 2008





2009
                    
                    
                    2008(Amounts in thousands)Assets:Cash
      and due from banks
                    
                    $
                    54,286
                    
                    
                    $
                    31,409Investment
      in subsidiary
                    
                    
                    150,789
                    
                    
                    
                    202,509Investment
      securities available for sale
                    
                    
                    1,211
                    
                    
                    
                    1,223Other
      assets
                    
                    
                    1,253
                    
                    
                    
                    1,298Total
      assets
                    
                    $
                    207,539
                    
                    
                    $
                    236,439Liabilities:Junior
      subordinated debentures
                    
                    $
                    45,877
                    
                    
                    $
                    45,877Other
      liabilities
                    
                    
                    39,665
                    
                    
                    
                    2,852Total
      liabilities
                    
                    
                    85,542
                    
                    
                    
                    48,729Stockholders'
      equityPreferred
      stock
                    
                    
                    41,060
                    
                    
                    
                    40,690Common
      stock
                    
                    
                    119,282
                    
                    
                    
                    119,054Retained
      earnings (accumulated deficit)
                    
                    
                    (41,430
                    )
                    
                    
                    24,901Accumulated
      other comprehensive income (loss)
                    
                    
                    3,085
                    
                    
                    
                    3,065Total
      stockholders' equity
                    
                    
                    121,997
                    
                    
                    
                    187,710Total
      liablilites and stockholders' equity
                    
                    $
                    207,539
                    
                    
                    $
                    236,439





Condensed
Statements of Operations


Years
Ended December 31, 2009, 2008 and 2007





2009
                  
                  
                  2008
                  
                  
                  2007(Amounts
      in thousands)Equity
      in income (loss) of subsidiaries
                  
                  $
                  (60,729
                  )
                  
                  $
                  8,242
                  
                  
                  $
                  9,936Interest
      income
                  
                  
                  433
                  
                  
                  
                  58
                  
                  
                  
                  16Other
      income
                  
                  
                  104
                  
                  
                  
                  128
                  
                  
                  
                  70Interest
      expense
                  
                  
                  (3,723
                  )
                  
                  
                  (3,202
                  )
                  
                  
                  (3,184
                  )Other
      expense
                  
                  
                  (485
                  )
                  
                  
                  (594
                  )
                  
                  
                  (513
                  )Income
      tax benefit
                  
                  
                  1,241
                  
                  
                  
                  1,222
                  
                  
                  
                  1,229Net
      income (loss)
                  
                  
                  (63,159
                  )
                  
                  
                  5,854
                  
                  
                  
                  7,554Effective
      dividend on preferred stock
                  
                  
                  2,508
                  
                  
                  
                  185
                  
                  
                  
                  -Net
      income (loss) available to common shareholders
                  
                  $
                  (65,667
                  )
                  
                  $
                  5,669
                  
                  
                  $
                  7,554




See
accompanying notes.


Page
112


SOUTHERN
COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


Years
Ended December 31, 2009, 2008 and 2007





(21)  PARENT
COMPANY FINANCIAL DATA (Continued)





Condensed
Statements of Cash Flows


Years
Ended December 31, 2009, 2008 and 2007





2009
                        
                        
                        2008
                        
                        
                        2007(Amounts in thousands)Operating
      activities:Net
      income (loss)
                        
                        $
                        (63,159
                        )
                        
                        $
                        5,854
                        
                        
                        $
                        7,554Equity
      in income (loss) of subsidiaries
                        
                        
                        60,729
                        
                        
                        
                        (8,242
                        )
                        
                        
                        (9,936
                        )Amortization
      of debt issuance costs
                        
                        
                        421
                        
                        
                        
                        51
                        
                        
                        
                        51Amortization
      of perferred stock warrants
                        
                        
                        (370
                        )
                        
                        
                        -
                        
                        
                        
                        -(Increase)
      decrease in other assets
                        
                        
                        (1
                        )
                        
                        
                        (23
                        )
                        
                        
                        138Increase
      in other liabilities
                        
                        
                        (2,307
                        )
                        
                        
                        (63
                        )
                        
                        
                        -Net
      cash provided (used) by operating activities
                        
                        
                        (4,687
                        )
                        
                        
                        (2,423
                        )
                        
                        
                        (2,193
                        )Investing
      activities:Cash
      dividend from subsidiary
                        
                        
                        -
                        
                        
                        
                        1,500
                        
                        
                        
                        -Purchase
      of investments
                        
                        
                        -
                        
                        
                        
                        (500
                        )
                        
                        
                        -Net
      cash provided (used) by investing activities
                        
                        
                        -
                        
                        
                        
                        1,000
                        
                        
                        
                        -Financing
      activities:Proceeds
      from issuance of preferred stock
                        
                        
                        -
                        
                        
                        
                        42,750
                        
                        
                        
                        -Increase
      in short term debt
                        
                        
                        39,366
                        
                        
                        
                        2,360
                        
                        
                        
                        -Proceeds
      from issuance of long-term debt
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        10,000Net
      proceeds from issuance of common stock
                        
                        
                        -
                        
                        
                        
                        408
                        
                        
                        
                        1,737Investment
      in bank subsidiary
                        
                        
                        (9,000
                        )
                        
                        
                        (15,000
                        )
                        
                        
                        -Cost
      of shares repurchased
                        
                        
                        -
                        
                        
                        
                        (2,700
                        )
                        
                        
                        (2,357
                        )Dividends
      paid preferred stock
                        
                        
                        (2,138
                        )
                        
                        
                        -
                        
                        
                        
                        -Dividends
      paid common shareholders
                        
                        
                        (664
                        )
                        
                        
                        (2,781
                        )
                        
                        
                        (2,724
                        )Net
      cash provided (used) by financing activities
                        
                        
                        27,564
                        
                        
                        
                        25,037
                        
                        
                        
                        6,656Net
      increase in cash
                        
                        
                        22,877
                        
                        
                        
                        23,614
                        
                        
                        
                        4,463Cash,
      beginning of year
                        
                        
                        31,409
                        
                        
                        
                        7,795
                        
                        
                        
                        3,332Cash,
      end of year
                        
                        $
                        54,286
                        
                        
                        $
                        31,409
                        
                        
                        $
                        7,795





(22)  SUBSEQUENT
EVENTS





Management
has evaluated subsequent events through March 15, 2010, the date the financial
statements were issued and there have been no material subsequent
events.




See
accompanying notes.


Page
113




Item
9. Changes in and Disagreements with Accountants on Accounting and Financial
Disclosure





None.





Item
9A.  Controls and Procedures





Southern
Community Financial Corporation’s management, with the participation of its
Chief Executive Officer and its Chief Financial Officer, has evaluated the
effectiveness of the Company’s disclosure controls and procedures as of December
31, 2009.  Based on that evaluation, the Company’s Chief Executive
Officer and Chief Financial Officer concluded that the Company’s disclosure
controls and procedures were effective as of December 31, 2009.





Management’s
Report On Internal Control Over Financial Reporting





Management
of Southern Community Financial Corporation and Subsidiary (the “Company”) is
responsible for establishing and maintaining effective internal control over
financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the
Securities Exchange Act of 1934.  Internal control over financial
reporting is a process designed to provide reasonable assurance regarding the
reliability of financial reporting and the preparation of financial statements
for external purposes in accordance with U.S. generally accepted accounting
principles.





Under the
supervision and with the participation of management, including the principal
executive officer and principal financial officer, the Company conducted an
evaluation of the effectiveness of internal control over financial reporting,
including controls over the preparation of financial statements, based on the
framework in Internal Control – Integrated Framework issued by the Committee of
Sponsoring Organizations of the Treadway Commission.  Based on this
evaluation under the framework in Internal Control – Integrated Framework,
management of the Company has concluded the Company maintained effective
internal control over financial reporting as of December 31, 2009.





Internal
control over financial reporting cannot provide absolute assurance of achieving
financial reporting objectives because of its inherent
limitations.  Internal control over financial reporting is a process
that involves human diligence and compliance and is subject to lapses in
judgment and breakdowns resulting from human failures.  Internal
control over financial reporting can also be circumvented by collusion or
improper management override.  Because of such limitations, there is a
risk that material misstatements may not be prevented or detected on a timely
basis by internal control over financial reporting.  Also, projections
of any evaluation of effectiveness to future periods are subject to the risk
that controls may become inadequate because of changes in conditions, or that
the degree of compliance with the policies or procedures may
deteriorate.





Management
is also responsible for compliance with laws and regulations relating to safety
and soundness which are designated by the FDIC and the appropriate federal
banking agency.  Management assessed its compliance with these
designated laws and regulations relating to safety and soundness and believes
that the Company complied, in all significant respects, with such laws and
during the year ended December 31, 2009.





Dixon
Hughes PLLC, an independent, registered public accounting firm, has audited the
Company’s consolidated financial statements as of and for the year ended
December 31, 2009 included in this annual report, and has issued an
attestation report on management’s assessment of the effectiveness of the
Company’s internal control over financial reporting as of December 31, 2009,
which is included herein.





Changes
in Internal Controls over Financial Reporting





The
Company assesses the adequacy of its internal control over financial reporting
quarterly and enhances its controls in response to internal control assessments
and internal and external audit and regulatory recommendations.  No
such control enhancements during the quarter ended December 31, 2009 have
materially affected, or are reasonably likely to materially affect, the
Company’s internal control over financial reporting.


Page
114










Report
of Independent Registered Public Accounting Firm





To the
Board of Directors and Stockholders


Southern
Community Bank & Trust





We have
audited Southern Community Financial Corporation and Subsidiary (the
“Company”)’s internal control over financial reporting as of December 31, 2009,
based on criteria established in Internal Control—Integrated Framework issued by
the Committee of Sponsoring Organizations of the Treadway
Commission.  The Company’s management is responsible for maintaining
effective internal control over financial reporting and for its assessment of
the effectiveness of internal control over financial reporting, included in the
accompanying Management’s Annual Report on Internal Control Over Financial
Reporting.  Our responsibility is to express an opinion on the
Company's internal control over financial reporting based on our
audit.





We
conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States).  Those standards require
that we plan and perform the audit to obtain reasonable assurance about whether
effective internal control over financial reporting was maintained in all
material respects.  Our audit included obtaining an understanding of
internal control over financial reporting, assessing the risk that a material
weakness exists, and testing and evaluating the design and operating
effectiveness of internal control based on the assessed risk.  Our
audit also included, performing such other procedures as we considered necessary
in the circumstances.  We believe that our audit provides a reasonable
basis for our opinion.





Because
of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements.  Also, projections of any evaluation
of effectiveness to future periods are subject to the risk that controls may
become inadequate because of changes in conditions, or that the degree of
compliance with the policies or procedures may deteriorate.





In our
opinion, Southern Community Financial Corporation and Subsidiary maintained, in
all material respects, effective internal control over financial reporting as of
December 31, 2009, based on criteria established in Internal Control—Integrated
Framework issued by the Committee of Sponsoring Organizations of the Treadway
Commission.





We have
also audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the consolidated financial statements of
Southern Community Financial Corporation and Subsidiary as of and for the year
ended December, 31, 2009, and our report dated March 15, 2010, expressed an
unqualified opinion on those consolidated financial statements.





/s/
Dixon Hughes PLLC




Raleigh,
North Carolina


March 15,
2010




Page
115





Item 9B.  Other
Information





None.





PART
III





Item 10. Directors, Executive Officers and
Corporate Governance





Incorporated
by reference from the Company's definitive proxy statement, to be filed with the
Securities and Exchange Commission with respect to the Annual Meeting of
Shareholders to be held on May 26, 2010.





Item 11. Executive Compensation





Incorporated
by reference from the Company's definitive proxy statement, to be filed with the
Securities and Exchange Commission with respect to the Annual Meeting of
Shareholders to be held on May 26, 2010.





Item 12. Security Ownership of Certain Beneficial
Owners and Management





Incorporated
by reference from the Company's definitive proxy statement, to be filed with the
Securities and Exchange Commission with respect to the Annual Meeting of
Shareholders to be held on May 26, 2010.





The
following table sets forth equity compensation plan information at December 31,
2009.





Equity
Compensation Plan Information


Plan Category
                          
                          Number of securities to be
                            issued upon exercise
                            of outstanding options
                            warrants and rights
                          
                          
                          Weighted-average
                            exercise price of
                            outstanding options,
                            warrants and rights
                          
                          
                          Number of securities
                            remaining available for
                            future issuance under equity
                            compensation plans
                            (excluding securities
                            reflected in column (a))(a)
                          
                          
                          (b)
                          
                          
                          (c)Equity
      compensation plans approved by security holdersStock
      Option Plans
                          
                          
                          706,700
                          
                          
                          $
                          9.52
                          
                          
                          
                          525,711Employee
      Stock Purchase Plan
                          
                          
                          N/A
                          
                          
                          
                          N/A
                          
                          
                          
                          856,049Equity
      compensation plans not approved by security holdersRestricted
      Stock Plan
                          
                          
                          N/A
                          
                          
                          
                          N/A
                          
                          
                          
                          235,500Total
                          
                          
                          706,700
                          
                          
                          $
                          9.52
                          
                          
                          
                          1,617,260





Item
13. Certain Relationships and Related Transactions, and Director
Independence





Incorporated
by reference from the Company's definitive proxy statement, to be filed with the
Securities and Exchange Commission with respect to the Annual Meeting of
Shareholders to be held on May 26, 2010.





Item 14. Principal Accountant Fees and
Services





Incorporated
by reference from the Company's definitive proxy statement, to be filed with the
Securities and Exchange Commission with respect to the Annual Meeting of
Shareholders to be held on May 26, 2010.




Page
116




PART
IV





Item
15. Exhibits, Financial Statement Schedules





(a)(1) Financial Statements. The following
financial statements and supplementary data are included in Item 8 of this
report.





Financial Statements
                              
                              Form 10-K PageReport
      of Independent Registered Public Accounting Firm
                              
                              66Consolidated
      Statements of Financial Condition as of December 31, 2009 and
      2008
                              
                              67Consolidated
      Statements of Operations for the years endedDecember
      31, 2009, 2008 and 2007
                              
                              68Consolidated
      Statements of Comprehensive Income (Loss) for the years
    endedDecember
      31, 2009, 2008 and 2007
                              
                              69Consolidated
      Statements of Changes in Stockholders’ Equity for the years
      endedDecember
      31, 2009, 2008 and 2007
                              
                              70Consolidated
      Statements of Cash Flows for the years endedDecember
      31, 2009, 2008 and 2007
                              
                              71-72Notes
      to Consolidated Financial Statements
                              
                              73-113





Exhibit No.
              
              DescriptionExhibit
      3.1:
              
              Articles
      of Incorporation (incorporated by reference from Exhibit 3(i) to the
      Current Report on Form 8-K dated October 1, 2001)Exhibit
      3.2:
              
              Bylaws
      (incorporated by reference from Exhibit 3.2 to the Quarter Report on Form
      10-Q for the quarterly ended September 30, 2009)Exhibit
      3.3:
              
              Amendment
      to Articles of Incorporation (incorporated by reference from Exhibit 3.3
      to the Annual Report on Form 10-K for the year ended December 31, 2001
      (“2001 Annual Report”))Exhibit
      4.1:
              
              Specimen
      certificate for Common Stock of Southern Community Financial Corporation
      (incorporated by reference from Exhibit 4 to the Current Report on Form
      8-K dated October 1, 2001)Exhibit
      4.2:
              
              Form
      of 7.95% Junior Subordinated Debenture (incorporated by reference from
      Exhibit 4.2 to the Registration Statement on Form S-3 dated September 26,
      2003, Registration No. 333-109167 (the “S-3 Registration
      Statement”))Exhibit
      4.3:
              
              Form
      of Certificate for 7.95% Trust Preferred Security of Southern Community
      Capital Trust II (incorporated by reference from Exhibit 4.6 to the S-3
      Registration Statement)Exhibit
      10.1:
              
              1997
      Incentive Stock Option Plan of Southern Community Financial Corporation
      (incorporated by reference from Exhibit 10.1 to Amendment Number One to
      the Registration Statement on Form S-2 dated January 10, 2002,
      Registration Number 333-74084 (the “Amended S-2 Registration
      Statement”))Exhibit
      10.2:
              
              1997
      Non-Statutory Stock Option Plan of Southern Community Financial
      Corporation (incorporated by reference from Exhibit 10.2 to the Amended
      S-2 Registration Statement)Exhibit
      10.3:
              
              2002
      Incentive Stock Option Plan of Southern Community Financial Corporation
      (incorporated by reference from Exhibit 10.7 to the Annual Report on Form
      10-K for the year ended December 31, 2003 (“2003 Annual
      Report”))Exhibit
      10.4:
              
              2002
      Non-Statutory Stock Option Plan of Southern Community Financial
      Corporation (incorporated by reference from Exhibit 10.8 to the 2003
      Annual Report)Exhibit
      10.5:
              
              Indenture
      with respect to the Company’s 7.95% Junior Subordinated Debentures
      (incorporated by reference from Exhibit 10.9 to the 2003 Annual
      Report)Exhibit
      10.6:
              
              Amended
      and Restated Trust Agreement of Southern Community Capital Trust II
      (incorporated by reference from Exhibit 10.10 to the 2003 Annual
      Report)Exhibit
      10.7:
              
              Guarantee
      Agreement for Southern Community Capital Trust II (incorporated by
      reference from Exhibit 10.11 to the 2003 Annual
  Report)




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117




Exhibit
      10.8:
              
              Agreement
      as to Expenses and Liabilities with respect to Southern Community Capital
      Trust II (incorporated by reference from Exhibit 10.12 to the 2003 Annual
      Report)Exhibit
      10.9:
              
              2002
      Employee Stock Purchase Plan (incorporated by reference from Exhibit 10.13
      to the 2003 Annual Report)Exhibit
      10.10:
              
              The
      Community Bank Amended and Restated Stock Option Plan for Key Employees
      (incorporated by reference from Exhibit 4.2 to the Registration Statement
      on Form S-8 dated April 29, 2004, Registration Number
      333-114997)Exhibit
      10.11:
              
              2001
      Incentive Stock Option Plan of Southern Community Financial Corporation
      (incorporated by reference from Exhibit 4.2 to the Registration Statement
      on Form S-8 dated April 29, 2004, Registration Number
      333-114993)Exhibit
      10.12:
              
              2001
      Stock Option Plan for Directors of Southern Community Financial
      Corporation (incorporated by reference from Exhibit 4.2 to the
      Registration Statement on Form S-8 dated April 29, 2004, Registration
      Number 333-114991)Exhibit
      10.13:
              
              2006
      Nonstatutory Stock Option Plan of Southern Community Financial Corporation
      (incorporated by reference from Exhibit 4.2 to the Registration Statement
      on Form S-8 dated November 11, 2006, Registration Number
      333-138601)Exhibit
      10.14:
              
              Employment
      Agreement with F. Scott Bauer (incorporated by reference from Exhibit 10.1
      to the Quarterly Report on Form 10-Q for the quarter ended March 31, 2006
      (“2006 First Quarter Form 10-Q”))Exhibit
      10.15:
              
              Employment
      Agreement with Jeff T. Clark (incorporated by reference from Exhibit 10.2
      to the 2006 First Quarter Form 10-Q)Exhibit
      10.16:
              
              Amended
      & Restated Salary Continuation Agreement of F. Scott Bauer
      (incorporated by reference from Exhibit 10.1 to the Quarterly Report on
      Form 10-Q for the quarter ended March 31, 2007 (“2007 First Quarter Form
      10-Q”))Exhibit
      10.17:
              
              Amended
      & Restated Salary Continuation Agreement of Jeff T. Clark
      (incorporated by reference from Exhibit 10.2 to the 2007 First Quarter
      Form 10-Q)Exhibit
      10.18:
              
              Employment
      Agreement with James C. Monroe, Jr. (incorporated by reference to the
      Annual Report of Form 10-K for the year ended December 31,
      2007)Exhibit
      10.19:
              
              Amendment
      Number One to Employment Agreement with F. Scott Bauer (incorporated by
      reference from Exhibit 10.1 to the Quarterly Report on Form 10-Q for the
      quarter ended September 30, 2007 (“2007 Third Quarter Form
      10-Q”))Exhibit
      10.20:
              
              Amendment
      Number One to Employment Agreement with Jeff T. Clark (incorporated by
      reference from Exhibit 10.2 to the 2007 Third Quarter Form
      10-Q)Exhibit
      10.21:
              
              Amendment
      Number One to Employment agreement with James C. Monroe, Jr. (incorporated
      by reference from Exhibit 10.3 to the 2007 Third Quarter Form
      10-Q)Exhibit
      10.22:
              
              Salary
      Continuation Agreement with James C. Monroe, Jr. (incorporated by
      reference from Exhibit 10.22 to the Annual Report on Form 10-K for the
      year ended December 31, 2007)Exhibit
      10.23:
              
              Amendment
      Number One to Salary Continuation Agreement with James C. Monroe, Jr.
      (incorporated by reference from Exhibit 10.23 to the Annual Report on Form
      10-K for the year ended December 31, 2007)Exhibit
      10.24:
              
              Addendum
      A to Split Dollar Agreement with F. Scott Bauer (incorporated by reference
      from Exhibit 10.24 to the Annual Report on Form 10-K for the year ended
      December 31, 2007)Exhibit
      10.25:
              
              Addendum
      A to Split Dollar Agreement with Jeff T. Clark (incorporated by reference
      from Exhibit 10.25 to the Annual Report on Form 10-K for the year ended
      December 31, 2007)Exhibit
      10.26:
              
              Employment
      Agreement with James Hastings (incorporated by reference from Exhibit 10.1
      to the Current report on Form 8-K dated June 17, 2008)Exhibit
      10.27:
              
              Salary
      Continuation Agreement with James Hastings (incorporated by reference from
      Exhibit 10.2 to the Current report on Form 8-K dated June 17,
      2008)Exhibit
      10.28:
              
              Waiver
      Agreement and Acknowledgement with F. Scott Bauer (incorporated by
      reference from Exhibit 10.28 to the Annual Report on Form 10-K for the
      year ended December 31, 2008 the “2008 Annual Report”)Exhibit
      10.29
              
              Waiver
      Agreement and Acknowledgement with Jeffrey T. Clark (incorporated by
      reference from Exhibit 10.29 to the 2008 Annual Report on Form 10-K for
      the year ended December 31, 2008)Exhibit
      10.30
              
              Waiver
      Agreement and Acknowledgement with Robert L. Davis, Jr. (incorporated by
      reference from Exhibit 10.30 to the 2008 Annual Report on Form 10-K for
      the year ended December 31,
2008)




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118




Exhibit
      10.31
            
            Waiver
      Agreement and Acknowledgement with James Hastings (incorporated by
      reference from Exhibit 10.31 to the 2008 Annual Report on Form 10-K for
      the year ended December 31, 2008)Exhibit
      10.32
            
            Waiver
      Agreement and Acknowledgement with James C. Monroe, Jr. (incorporated by
      reference from Exhibit 10.32 to the 2008 Annual Report on Form 10-K for
      the year ended December 31, 2008)Exhibit
      10.33:
            
            Amendment
      Number Two to Employment Agreement with James C. Monroe, Jr. (incorporated
      by reference from Exhibit 10.33 to the 2008 Annual Report on Form 10-K for
      the year ended December 31, 2008)Exhibit
      10.34:
            
            Amendment
      Number One to Salary Continuation Agreement with F. Scott Bauer
      (incorporated by reference from Exhibit 10.34 to the 2008 Annual Report on
      Form 10-K for the year ended December 31, 2008)Exhibit
      10.35:
            
            Amendment
      Number One to Salary Continuation Agreement with Jeff T. Clark
      (incorporated by reference from Exhibit 10.35 to the 2008 Annual Report on
      Form 10-K for the year ended December 31, 2008)Exhibit
      10.36:
            
            Amendment
      Number One to Salary Continuation Agreement with James Hastings
      (incorporated by reference from Exhibit 10.36 to the 2008 Annual Report on
      Form 10-K for the year ended December 31, 2008)Exhibit
      10.37:
            
            Amendment
      Number One to Employment Agreement with James Hastings (incorporated by
      reference from Exhibit 10.37 to the 2008 Annual Report on Form 10-K for
      the year ended December 31, 2008)Exhibit
      10.38:
            
            Amendment
      Number Two to Employment Agreement with F. Scott Bauer (incorporated by
      reference from Exhibit 10.38 to the 2008 Annual Report on Form 10-K for
      the year ended December 31, 2008)Exhibit
      10.39:
            
            Amendment
      Number Two to Employment Agreement with Jeff T. Clark (incorporated by
      reference from Exhibit 10.39 to the 2008 Annual Report on Form 10-K for
      the year ended December 31, 2008)Exhibit
      10.40:
            
            Amendment
      Number One to Salary Continuation Agreement with Robert L. Davis
      (incorporated by reference from Exhibit 10.40 to the 2008 Annual Report on
      Form 10-K for the year ended December 31, 2008)Exhibit
      10.41:
            
            Amendment
      Number Two to Employment Agreement with Robert L. Davis (incorporated by
      reference from Exhibit 10.41 to the 2008 Annual Report on Form 10-K for
      the year ended December 31, 2008)Exhibit
      10.42:
            
            Amendment
      Number Two to Salary Continuation Agreement with James C. Monroe, Jr.
      (incorporated by reference from Exhibit 10.42 to the 2008 Annual Report on
      Form 10-K for the year ended December 31, 2008)Exhibit
      10.43:
            
            Amendment
      Number Three to Employment Agreement with James C. Monroe, Jr.
      (incorporated by reference from Exhibit 10.43 to the 2008 Annual Report on
      Form 10-K for the year ended December 31, 2008)Exhibit
      21:
            
            Subsidiaries
      of the RegistrantExhibit
      23:
            
            Consent
      of Dixon Hughes PLLCExhibit
      31.1:
            
            Rule
      13a-14(a)/15d-14(a) Certification by Chief Executive
    OfficerExhibit
      31.2:
            
            Rule
      13a-14(a)/15d-14(a) Certification by Chief Financial
    OfficerExhibit
      32:
            
            Section
      1350 CertificationsExhibit
      99.1
            
            TARP
      Certification by Chief Executive OfficerExhibit
      99.2
            
            TARP
      Certification by Chief Financial
Officer




Page
119





SIGNATURES





Pursuant
to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
1934, the Registrant has duly caused this report to be signed on behalf of the
undersigned, thereunto duly authorized.





SOUTHERN
      COMMUNITYFINANCIAL
      CORPORATIONDate:
      March 15, 2010
              By:
              /s/ F, Scott BauerF.
      Scott BauerChairman
      and Chief Executive Officer(principal
      executive officer)





Pursuant
to the requirements of the Securities Exchange Act of 1934, this report has been
signed below by the following persons on behalf of the registrant and in the
capacities and on the dates indicated.





SIGNATURE
                                      
                                      TITLE
                                      
                                      DATE/s/
      F. Scott Bauer
                                      
                                      Chairman
      of the Board and ChiefF.
      Scott Bauer
                                      
                                      Executive
      Officer (principal
                                      
                                      March
      15, 2010executive
      officer)/s/
      James Hastings
                                      
                                      Executive
      Vice President and ChiefJames
      Hastings
                                      
                                      Financial
      Officer (principal financialand
      accounting officer)
                                      
                                      March
      15, 2010/s/
      Edward T. Brown
                                      
                                      DirectorEdward
      T. Brown
                                      
                                      
                                      
                                      March
      15, 2010/s/
      James G. Chrysson
                                      
                                      DirectorJames
      G. Chrysson
                                      
                                      
                                      
                                      March
      15, 2010/s/
      James O. Frye
                                      
                                      DirectorJames
      O. Frye
                                      
                                      
                                      
                                      March
      15, 2010/s/
      Matthew G. Gallins
                                      
                                      DirectorMatthew
      G. Gallins
                                      
                                      
                                      
                                      March
      15, 2010/s/
      Beverly H. Godfrey
                                      
                                      DirectorBeverly
      H. Godfrey
                                      
                                      
                                      
                                      March
      15,
2010




Page
120




SIGNATURE
                                          
                                          TITLE
                                          
                                          DATE/s/
      Lynn L. Lane
                                          
                                          DirectorLynn
      L. Lane
                                          
                                          
                                          
                                          March
      15, 2010/s/
      H. Lee Merritt, Jr.
                                          
                                          DirectorH.
      Lee Merritt, Jr.
                                          
                                          
                                          
                                          March
      15, 2010/s/
      Stephen L. Robertson
                                          
                                          DirectorStephen
      L. Robertson
                                          
                                          
                                          
                                          March
      15, 2010/s/
      W. Samuel Smoak
                                          
                                          DirectorW.
      Samuel Smoak
                                          
                                          
                                          
                                          March
      15, 2010DirectorWilliam
      G. Ward, Sr., M.D.
                                          
                                          
                                          
                                          March
      15,
2010




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