SOUTHCOAST FINANCIAL CORP
General           The Company is a South Carolina corporation organized in 1999 under the laws of South Carolina for the purpose of being a holding company for Southcoast Community Bank (the "Bank").  On April 29, 1999,  pursuant to a Plan of Exchange approved by the shareholders,  all of the outstanding shares of capital stock of the Bank  were  exchanged  for  shares of common  stock of the  Company  and the Company  became the owner of all of the  outstanding  capital stock of the Bank. The Company  presently engages in no business other than that of owning the Bank and has no employees.           The Bank is a South Carolina  state bank  incorporated  in June,  1998, which commenced operations as a commercial bank in July, 1998. The Bank operates from its offices in Mt.  Pleasant,  Charleston,  Moncks  Corner,  Johns  Island, Summerville, Goose Creek, and North Charleston, South Carolina.  The main office is  located  at 530  Johnnie  Dodds  Boulevard,  in Mt.  Pleasant;  a second Mt. Pleasant office is located at 602 Coleman  Boulevard;  the Charleston  office is located at 802 Savannah Highway; the Moncks Corner office is located at 337 East Main Street;  the Johns Island  office is located at 2753 Maybank  Highway;  the Summerville  office is located at 302 N. Main Street;  the Goose Creek office is located at 597 Old Mount Holly Road; and the North Charleston  office is located at 8420 Dorchester Road.           The Bank  offers a full  array of  commercial  bank  services.  Deposit services include business and personal checking accounts, NOW accounts,  savings accounts,  money market  accounts,  various term  certificates  of deposit,  IRA accounts, and other deposit services.  Most of the Bank's deposits are attracted from individuals and small businesses. The Bank does not offer trust services.           The Bank  offers  secured  and  unsecured,  short-to-intermediate  term loans,  with  floating and fixed  interest  rates for  commercial,  consumer and residential  purposes.  Consumer loans include,  among others:  car loans,  home equity  improvement  loan  (secured  by first and  second  mortgages),  personal expenditure loans, education loans and overdraft lines of credit. The Bank makes commercial loans to small and middle market businesses.  Commercial loans may be unsecured if they are of short duration and made to a customer with demonstrated ability to pay, but most often they are secured. Collateral for commercial loans may be listed securities,  equipment,  inventory,  accounts  receivable or other business  assets but will usually be local real estate.  The Bank usually  makes commercial  loans to  businesses to provide  working  capital,  expand  physical assets or acquire assets.  Commercial  loans will typically not exceed a 20-year maturity and will usually have regular amortization  payments.  Commercial loans to most business entities require guarantees by their principals.  The Bank also makes loans guaranteed by the U. S. Small Business Administration.           The Bank makes loans secured by real estate  mortgages that are usually for the acquisition,  improvement or construction and development of residential and other  properties.  Residential real estate loans consist primarily of first and second  mortgage  loans on single family homes,  with some mortgage loans on multifamily homes. Loan-to-value ratios for these loans are generally limited to 80%.  Non-farm,  non-residential  loans are secured by business  and  commercial properties acquired using the loan proceeds. Loan-to-value ratios on these loans are also  generally  limited  to 80%.  The  repayment  of both  residential  and business  real estate loans is dependent  primarily on the income and cash flows of the  borrowers,  with the real estate  serving as a secondary or  liquidation source of repayment.           Real estate  construction  loans  typically  consist of  financing  the construction  of 1-4 family  dwellings and some non-farm,  non-residential  real estate.  Usually,  loan-to-value  ratios for these  loans are limited to 80% and permanent  financing  commitments  are required prior to the advancement of loan proceeds.                                         2            Management believes that the loan portfolio is adequately  diversified. There  are no  significant  concentrations  of  loans  made  to  any  particular individuals,  industries or groups of related individuals or industries,  and no foreign  loans.  The loan  portfolio  consists  primarily of mortgage  loans and extensions of credit to businesses  and  individuals  in the Bank's service area within Charleston, Dorchester and Berkeley Counties, South Carolina. The economy of this area is diversified  and does not depend on any single industry or group of related industries.           Other  services  the Bank  offers  include  residential  mortgage  loan origination  services,  safe deposit  boxes,  business  courier  service,  night depository service,  telephone banking,  VISA and MasterCard brand credit cards, tax deposits,  travelers checks and 24-hour automated teller machines.  The ATMs are part of the Pulse, Cirrus, Maestro and Jeanie networks.           At March 1, 2006, the Bank employed 96 persons  full-time.  The Company has no employees.  Management  of the Bank believes that its employee  relations are excellent.  Competition           The Bank competes in the Charleston MSA. As of June 30, 2005, 22 banks, savings and loans, and savings banks with 161 branch  locations  competed in the Charleston  MSA. As of June 30, 2005,  the Bank held 4.29% of total  deposits in the MSA of $7.1 billion.           Banks generally compete with other financial  institutions  through the savings  products and services  offered,  the pricing of services,  the level of service provided,  the convenience and availability of services,  and the degree of expertise  and  personal  concern  with which  services  are  offered.  South Carolina law permits statewide branching by banks and savings institutions,  and many financial  institutions  in the state have branch  networks.  Consequently, commercial  banking  in  South  Carolina  is  highly  competitive.  Furthermore, out-of-state  banks may commence  operations  and compete in the Bank's  primary service area. Many large banking organizations,  several of which are controlled by out-of-state ownership, currently operate in the Bank's market area.           In the conduct of certain areas of its business, the Bank competes with commercial banks, savings and loan associations, credit unions, consumer finance companies,  insurance  companies,  money market mutual funds and other financial institutions, some of which are not subject to the same degree of regulation and restriction  imposed upon the Bank. Many of these competitors have substantially greater  resources and lending limits than the Bank and offer certain  services, such as international  banking  services and trust services,  that the Bank does not provide.  Moreover,  most of these  competitors  have more  numerous  branch offices located throughout their market areas, a competitive  advantage that the Bank  does  not  have to the  same  degree.  Such  competitors  may also be in a position to make more effective use of media advertising,  support services, and electronic technology than can the Bank.           The banking industry is significantly  affected by prevailing  economic conditions as well as by government policies and regulations  concerning,  among other things,  monetary and fiscal affairs,  the housing  industry and financial institutions.  Deposits at banks are influenced by a number of economic factors, including interest rates, competing  instruments,  levels of personal income and savings,  and the extent to which interest on retirement savings accounts is tax deferred.  Lending  activities  are  also  influenced  by a number  of  economic factors,  including  demand  for  and  supply  of  housing,  conditions  in  the construction  industry,  and availability of funds. Primary sources of funds for lending  activities  include savings  deposits,  income from  investments,  loan principal  repayments,   and  proceeds  from  sales  of  loans  to  conventional participating lenders.                                         3                           EFFECT OF GOVERNMENT REGULATION           Bank  holding  companies  and banks  are  extensively  regulated  under federal and state law. To the extent that the  following  information  describes statutory  and  regulatory  provisions,  it is  qualified  in  its  entirety  by reference to such  statutes and  regulations.  Any change in  applicable  law or regulation  may have a material  effect on the  business  of the Company and the Bank.  General           As a bank holding  company under the Bank Holding Company Act ("BHCA"), the  Company  obtained  the  approval of the Board of  Governors  of the Federal Reserve System (the "Federal Reserve") to acquire the Bank and is subject to the regulations of the Federal Reserve. Under the BHCA, the Company's activities and those of its subsidiaries are limited to banking, managing or controlling banks, furnishing  services to or performing  services for its subsidiaries or engaging in any other  activity  which the Federal  Reserve  determines  to be so closely related to banking or managing or controlling  banks as to be a proper  incident thereto. The Company may engage in a broader range of activities if it becomes a "financial  holding company"  pursuant to the  Gramm-Leach-Bliley  Act, which is described below under the caption  "Gramm-Leach-Bliley  Act." The BHCA prohibits the Company  from  acquiring  direct or indirect  control of more than 5% of the outstanding  voting stock or substantially all of the assets of any bank or from merging or  consolidating  with  another  bank  holding  company  without  prior approval of the Federal  Reserve.  Additionally,  the BHCA prohibits the Company from engaging in or from  acquiring  ownership or control of more than 5% of the outstanding voting stock of any company engaged in a non-banking business unless such business is determined by the Federal  Reserve to be so closely  related to banking as to be properly  incident  thereto.  The BHCA generally does not place territorial   restrictions  on  the  activities  of  such  non-banking   related activities.           The Company is also subject to regulation and  supervision by the South Carolina  State Board of Financial  Institutions  (the "State  Board").  A South Carolina bank holding company must provide the State Board with information with respect to the financial  condition,  operations,  management and  inter-company relationships of the holding company and its subsidiaries.  The State Board also may require such other information as is necessary to keep itself informed about whether the  provisions  of South  Carolina law and the  regulations  and orders issued  thereunder  by the State Board have been  complied  with,  and the State Board may examine any bank holding company and its subsidiaries.  Obligations of the Company to its Subsidiary Bank           A number of obligations  and  restrictions  are imposed on bank holding companies  and their  depository  institution  subsidiaries  by Federal  law and regulatory  policy that are designed to reduce  potential  loss  exposure to the depositors of such  depository  institutions  and to the FDIC insurance funds in the event the depository  institution  is in danger of becoming  insolvent or is insolvent.  For example, under the policy of the Federal Reserve, a bank holding company is required to serve as a source of financial strength to its subsidiary depository  institutions and to commit resources to support such institutions in circumstances  where it might not do so absent such  policy.  In  addition,  the "cross-guarantee"  provisions of the Federal  Deposit  Insurance Act, as amended ("FDIA"),  require  insured  depository  institutions  under  common  control to reimburse the FDIC for any loss suffered or reasonably anticipated by either the Savings  Association  Insurance Fund ("SAIF") or the Bank Insurance Fund ("BIF") of the  FDIC  as a  result  of the  default  of a  commonly  controlled  insured depository  institution or for any assistance provided by the FDIC to a commonly controlled  insured  depository  institution in danger of default.  The FDIC may decline to enforce the cross-guarantee provisions if it determines that a waiver is in the best  interest  of the SAIF or the BIF or both.  The FDIC's  claim for damages  is  superior  to  claims  of  shareholders  of the  insured  depository institution  or its holding  company but is subordinate to claims of depositors, secured  creditors and holders of subordinated  debt (other than  affiliates) of the commonly controlled insured depository institutions.                                         4            The FDIA also provides that amounts  received from the  liquidation  or other resolution of any insured  depository  institution by any receiver must be distributed (after payment of secured claims) to pay the deposit  liabilities of the  institution  prior to payment  of any other  general  or  unsecured  senior liability,   subordinated  liability,  general  creditor  or  shareholder.  This provision gives depositors a preference over general and subordinated  creditors and  shareholders  in the event a receiver is appointed to distribute the assets of the Bank.           Any capital  loans by a bank holding  company to any of its  subsidiary banks are  subordinate  in right of payment  to  deposits  and to certain  other indebtedness of such subsidiary  bank. In the event of a bank holding  company's bankruptcy,  any  commitment  by the bank  holding  company  to a  federal  bank regulatory  agency to maintain the capital of a subsidiary  bank will be assumed by the bankruptcy trustee and entitled to a priority of payment.  Capital Adequacy Guidelines for Bank Holding Companies and State Banks           The various federal bank regulators,  including the Federal Reserve and the FDIC have adopted  risk-based and leverage capital  adequacy  guidelines for assessing bank holding company and bank capital adequacy. These standards define what qualifies as capital and establish minimum capital standards in relation to assets and off-balance sheet exposures, as adjusted for credit risks.           Failure to meet capital  guidelines could subject the Bank to a variety of enforcement  remedies,  including the termination of deposit insurance by the FDIC and a prohibition on the taking of brokered deposits.           The risk-based  capital standards of both the Federal Reserve Board and the FDIC explicitly identify  concentrations of credit risk and the risk arising from non-traditional  activities,  as well as an institution's ability to manage these risks,  as  important  factors to be taken into account by the agencies in assessing an institution's overall capital adequacy. The capital guidelines also provide that an institution's exposure to a decline in the economic value of its capital  due to changes in interest  rates be  considered  by the  agencies as a factor in evaluating a bank's capital  adequacy.  The Federal Reserve Board also has issued additional  capital guidelines for bank holding companies that engage in certain trading activities.           The Company and the Bank exceeded all applicable  capital  requirements at December 31, 2005.  Payment of Dividends           The  Company is a legal  entity  separate  and  distinct  from its bank subsidiary.  Most of the  revenues of the  Company  are  expected to result from dividends  paid to the Company by the Bank.  There are statutory and  regulatory requirements  applicable to the payment of dividends by subsidiary banks as well as by the Company to its  shareholders.  It is not anticipated  that the Company will pay cash dividends in the near future.  Certain Transactions by the Company with its Affiliates           Federal  law   regulates   transactions   among  the  Company  and  its affiliates,  including  the  amount of the  Bank's  loans to or  investments  in nonbank affiliates and the amount of advances to third parties collateralized by securities of an affiliate.  Further,  a bank holding company and its affiliates are prohibited  from engaging in certain tie-in  arrangements in connection with any extension of credit, lease or sale of property or furnishing of services.  FDIC Insurance Assessments           Because the Bank's deposits are insured by the BIF, the Bank is subject to insurance assessments imposed by the FDIC. Currently, the assessments imposed on all FDIC deposits for deposit insurance have an effective rate ranging from 0 to 27 basis points per $100 of insured deposits,  depending on the institution's capital position and other supervisory  factors.  However,  because  legislation                                         5   enacted in 1996 requires that both  SAIF-insured and BIF-insured  deposits pay a pro rata portion of the interest due on the obligations  issued by the Financing Corporation  ("FICO").  The FICO  assessment  is adjusted  quarterly  to reflect changes in the assessment  bases of the respective funds based on quarterly Call Report and Thrift Financial Report  submissions.  The Federal Deposit  Insurance Reform Act of 2005 will  change the manner and amount of  insurance  assessments beginning in 2006. The changes are not expected to have a material effect on the Bank in 2006.  Regulation of the Bank           The Bank is subject to regulation  and  examination by the State Board. In  addition,  the Bank is subject to various  other state and federal  laws and regulations,  including state usury laws, laws relating to fiduciaries, consumer credit laws and laws relating to branch banking.  The Bank's loan operations are also subject to certain federal consumer credit laws and regulations promulgated thereunder,  including,  but not limited to: the federal  Truth-In-Lending  Act, governing  disclosures of credit terms to consumer borrowers;  the Home Mortgage Disclosure Act, requiring financial  institutions to provide certain information concerning their mortgage lending; the Equal Credit Opportunity Act and the Fair Housing  Act,  prohibiting  discrimination  on the basis of  certain  prohibited factors in extending  credit;  and the Fair Debt Collection  Act,  governing the manner in which  consumer  debts may be collected by  collection  agencies.  The deposit  operations  of the Bank are also  subject to the Truth in Savings  Act, requiring  certain  disclosures  about  rates  paid  on  savings  accounts;  the Expedited   Funds   Availability   Act,  which  deals  with  disclosure  of  the availability  of funds  deposited in accounts and the  collection  and return of checks by banks;  the Right to Financial  Privacy Act,  which  imposes a duty to maintain  certain   confidentiality   of  consumer  financial  records  and  the Electronic  Funds Transfer Act and  regulations  promulgated  thereunder,  which govern  automatic   deposits  to  and  withdrawals  from  deposit  accounts  and customers'  rights and  liabilities  arising  from the use of  automated  teller machines and other electronic banking services.  The Bank is also subject to the Fair Credit  Reporting  Act,  governing the use and provision of  information to credit  reporting  agencies;  the Bank Secrecy Act,  dealing  with,  among other things, the reporting of certain currency transactions; and the USA Patriot Act, dealing with,  among other things,  requiring  the  establishment  of anti-money laundering  programs including  standards for verifying customer  information at account opening.           The  Bank  is  also  subject  to  the  requirements  of  the  Community Reinvestment  Act (the  "CRA").  The CRA imposes on  financial  institutions  an affirmative  and  ongoing  obligation  to meet the credit  needs of their  local communities,  including low- and moderate-income neighborhoods,  consistent with the safe and sound operation of those institutions. Each financial institution's actual performance in meeting community credit needs is evaluated as part of the examination process, and also is considered in evaluating mergers,  acquisitions and applications to open a branch or facility.  Other Safety and Soundness Regulations           Prompt  Corrective  Action.  The federal  banking  agencies  have broad powers under  current  federal law to take prompt  corrective  action to resolve problems of insured depository institutions.  The extent of these powers depends upon whether the  institutions in question are "well  capitalized,"  "adequately capitalized,"    "undercapitalized,"    "significantly    undercapitalized"   or "critically undercapitalized."           A bank that is "undercapitalized"  becomes subject to provisions of the FDIA:   restricting  payment  of  capital  distributions  and  management  fees; requiring the FDIC to monitor the condition of the bank; requiring submission by the bank of a capital  restoration plan;  prohibiting the acceptance of employee benefit plan deposits; restricting the growth of the bank's assets and requiring prior approval of certain  expansion  proposals.  A bank that is  "significantly undercapitalized" is also subject to restrictions on compensation paid to senior management  of the bank,  and a bank that is  "critically  undercapitalized"  is further subject to  restrictions on the activities of the bank and  restrictions on payments of subordinated debt of the bank. The purpose of these provisions is to require banks with less than adequate capital to act quickly to restore their capital and to have the FDIC move promptly to take over banks that are unwilling or unable to take such steps.                                         6            Brokered Deposits.  Under current FDIC regulations,  "well capitalized" banks may accept brokered deposits without restriction, "adequately capitalized" banks may accept  brokered  deposits  with a waiver  from the FDIC  (subject  to certain  restrictions on payment of rates), while  "undercapitalized"  banks may not accept brokered  deposits.  The regulations  provide that the definitions of "well capitalized", "adequately capitalized" and "undercapitalized" are the same as the  definitions  adopted by the agencies to implement the prompt  corrective action  provisions  described in the  previous  paragraph.  Management  does not believe  that  these  regulations  will have a  material  adverse  effect on the operations of the Bank.  Interstate Banking           Under the Riegle-Neal  Interstate Banking and Branching  Efficiency Act of 1994 the Company and any other  adequately  capitalized  bank holding company located in South  Carolina can acquire a bank located in any other state,  and a bank  holding  company  located  outside  South  Carolina  can acquire any South Carolina-based  bank, in either case subject to certain  deposit  percentage and other restrictions.  Unless prohibited by state law, adequately  capitalized and managed bank holding  companies are permitted to  consolidate  their  multistate bank operations into a single bank subsidiary and to branch  interstate  through acquisitions. De novo branching by an out-of-state bank is permitted only if the laws of the host state expressly permit it. The authority of a bank to establish and operate  branches within a state continue to be subject to applicable  state branching  laws.  South  Carolina law was amended,  effective  July 1, 1996,  to permit such  interstate  branching but not de novo branching by an  out-of-state bank.  Gramm-Leach-Bliley Act           The  Gramm-Leach-Bliley  Act,  which  makes it easier for  affiliations between banks,  securities firms and insurance  companies to take place,  became effective  in March  2000.  The Act  removes  Depression-era  barriers  that had separated  banks and  securities  firms,  and seeks to  protect  the  privacy of consumers' financial information.           Under  provisions of the  legislation  and  regulations  adopted by the appropriate regulators, banks, securities firms and insurance companies are able to structure new affiliations  through a holding company  structure or through a financial subsidiary. The legislation creates a new type of bank holding company called a "financial  holding  company" which has powers much more extensive than those of standard holding companies.  These expanded powers include authority to engage in "financial activities," which are activities that are (1) financial in nature;  (2)  incidental  to  activities  that are  financial in nature;  or (3) complementary  to a  financial  activity  and that do not  impose  a safety  and soundness risk. Significantly,  the permitted financial activities for financial holding  companies include authority to engage in merchant banking and insurance activities,  including insurance portfolio investing. A bank holding company can qualify as a financial holding company and expand the services it offers only if all of its subsidiary depository institutions are well-managed, well-capitalized and  have  received  a  rating  of   "satisfactory"   on  their  last  Community Reinvestment Act examination.           The  legislation  also  creates  another  new type of  entity  called a "financial subsidiary." A financial subsidiary may be used by a national bank or a group of national banks to engage in many of the same activities permitted for a financial holding company, though several of these activities,  including real estate development or investment,  insurance or annuity underwriting,  insurance portfolio  investing and merchant  banking,  are reserved for financial  holding companies.  A bank's  investment  in a financial  subsidiary  affects the way in which the bank calculates its regulatory capital, and the assets and liabilities of financial  subsidiaries  may not be consolidated  with those of the bank. The bank must also be certain that its risk  management  procedures  are adequate to protect it from  financial and  operational  risks created both by itself and by any financial subsidiary.  Further, the bank must establish policies to maintain the separate corporate  identities of the bank and its financial  subsidiary and to prevent each from becoming liable for the obligations of the other.                                         7            The Act also  establishes  the  concept  of  "functional  supervision," meaning that  similar  activities  should be  regulated  by the same  regulator. Accordingly,  the Act spells out the regulatory authority of the bank regulatory agencies,  the Securities and Exchange Commission and state insurance regulators so that each type of activity is  supervised by a regulator  with  corresponding expertise.  The Federal  Reserve Board is intended to be an umbrella  supervisor with the  authority  to  require a bank  holding  company or  financial  holding company  or any  subsidiary  of  either  to  file  reports  as to its  financial condition,  risk management  systems,  transactions with depository  institution subsidiaries  and  affiliates,  and compliance  with any federal law that it has authority to enforce.           Although the Act reaffirms that states are the regulators for insurance activities  of  all  persons,  including   federally-chartered  banks,  the  Act prohibits  states from preventing  depository  institutions and their affiliates from conducting insurance activities.           The Act also  establishes  a minimum  federal  standard  of  privacy to protect the confidentiality of a consumer's  personal financial  information and gives the consumer the power to choose how personal financial information may be used by financial  institutions.           The Act and the  regulations  adopted  pursuant  to the Act  create new opportunities  for the Company to offer  expanded  services to  customers in the future,  though  the  Company  has not yet  determined  what the  nature  of the expanded  services  might be or when the Company might find it feasible to offer them. The Act has increased competition from larger financial  institutions that are  currently  more  capable  than  the  Company  of  taking  advantage  of the opportunity  to  provide a  broader  range of  services.  However,  the  Company continues to believe that its commitment to providing high quality, personalized service to customers will permit it to remain competitive in its market area.  Sarbanes-Oxley Act of 2002           The Sarbanes-Oxley Act became effective in 2002, and mandated extensive reforms and requirements for public companies. The SEC has adopted extensive new regulations  pursuant  to  the  requirements  of  the  Sarbanes-Oxley  Act.  The Sarbanes-Oxley  Act and the SEC's new  regulations  have increased the Company's cost of doing  business,  particularly  its fees for internal and external audit services  and  legal  services,  and the law and  regulations  are  expected  to continue  to do so.  However,  the  Company  does  not  believe  that it will be affected  by  Sarbanes-Oxley  and the  new SEC  regulations  in  ways  that  are materially  different or more  onerous  than those of other public  companies of similar size and in similar businesses.  Legislative Proposals           Proposed  legislation which could significantly  affect the business of banking is  introduced  in Congress  from time to time.  Management  of the Bank cannot predict the future course of such  legislative  proposals or their impact on the Company and the Bank should they be adopted.  Fiscal and Monetary Policy           Banking is a business  which depends to a large extent on interest rate differentials. In general, the difference between the interest paid by a bank on its deposits and its other  borrowings,  and the interest  received by a bank on its loans and  securities  holdings,  constitutes  the major portion of a bank's earnings.  Thus, the earnings and growth of the Company and the Bank are subject to the influence of economic  conditions  generally,  both domestic and foreign, and also to the  monetary  and  fiscal  policies  of the  United  States and its agencies,  particularly the Federal Reserve.  The Federal Reserve  regulates the supply of money through various means,  including open market dealings in United States government  securities,  the discount rate at which banks may borrow from the Federal Reserve,  and the reserve  requirements on deposits.  The nature and timing of any changes in such  policies  and their impact on the Company and the Bank cannot be predicted.  Further Information           Further  information  about the business of the Company and the Bank is set  forth in this  Form  10-K  under  Item 7  -"Management's  Discussion  and Analysis of Financial Condition and Results of Operation."                                         8
Risks Related to Our Industry           We are  subject  to  governmental  regulation  which  could  change and increase our cost of doing business or have an adverse effect on our business.           We  operate  in  a  highly  regulated   industry  and  are  subject  to examination,  supervision  and  comprehensive  regulation by various federal and state  agencies.  Most of this  regulation is designed to protect our depositors and other customers, not our shareholders.  Our compliance with the requirements of these agencies is costly and may limit our growth and restrict certain of our activities,   including,   payment  of  dividends,   mergers  and  acquisitions, investments,  loans and interest rates charged, and locations of offices. We are also subject to capitalization guidelines established by federal authorities and our failure to meet those guidelines  could result in limitations  being imposed on our  activities  or,  in an  extreme  case,  in our  bank's  being  placed in receivership.  We  have  also  recently  been  subjected  to the  extensive  and expensive  requirements imposed on public companies by the Sarbanes-Oxley Act of 2002 and related regulations.           The laws and  regulations  applicable  to the  banking  industry  could change at any time,  and we cannot  predict  the impact of these  changes on our business or profitability.  Because  government  regulation  greatly affects the business  and  financial  results  of all  commercial  banks  and  bank  holding companies,  our cost of compliance could adversely affect our ability to operate profitably.           We are  susceptible  to changes in monetary  policy and other  economic factors which may adversely affect our ability to operate profitably.           Changes in governmental,  economic and monetary policies may affect the ability of our bank to attract  deposits  and make loans.  The rates of interest payable  on  deposits  and  chargeable  on loans are  affected  by  governmental regulation  and fiscal policy as well as by national,  state and local  economic conditions.  All of these  matters  are  outside of our  control  and affect our ability to operate profitably.                            Risks Related to Our Business           We depend on the services of a number of key  personnel,  and a loss of any of those  personnel  could  disrupt  our  operations  and  result in reduced revenues.           The success of our  business  depends to a great extent on our customer relationships. Our growth and development to date have depended in large part on the efforts of our senior  management  team.  These senior officers have primary contact  with  our  customers  and  are  extremely   important  in   maintaining personalized  relationships with our customer base, a key aspect of our business strategy, and in increasing our market presence. The unexpected loss of services of one or more of these key employees  could have a material  adverse  effect on our operations and possibly result in reduced revenues if we were unable to find suitable replacements promptly.           We may be unable to successfully manage our sustained growth..           We began  operating  in July 1998 and have grown from $92.1  million of total  assets at  December  31,  2000 (the end of our first  year of  profitable operations)  to $476.6 million in total assets at December 31, 2005, an increase of 417%.  Although we do not expect to continue to grow as fast in the future as we have in the past, it is our intention to attempt to rapidly  expand our asset base.  In  particular,  we intend to use the funds  raised in our  recent  stock offering to support anticipated increases in our loans.  Additional capital also would  increase our legal lending  limit under federal law,  which in turn would allow us to compete  more  actively  in our market  area for larger  loans.  Our future  profitability  will  depend  in part on our  ability  to  manage  growth successfully.  Our  ability to manage  growth  successfully  will  depend on our ability to maintain cost controls and asset quality while attracting  additional loans and deposits,  as well as on factors beyond our control,  such as economic conditions and interest rate trends.  If we grow too quickly and are not able to control costs and maintain  asset  quality,  growth could  materially  adversely affect our financial performance.                                         9            Our continued pace of growth or regulatory  requirements may require us to raise additional capital in the future, but that capital may not be available when it is needed or be available on favorable terms.           We  anticipate  that our capital  resources  following our recent stock offering  will  satisfy our capital  requirements  for the  foreseeable  future. Nevertheless,  we may need to raise  additional  capital to  support  additional growth or to meet  regulatory  requirements.  Our  ability  to raise  additional capital,  if needed,  will depend,  among other  things,  on  conditions  in the capital  markets  at that  time,  which  are  outside  our  control,  and on our financial  condition and performance.  If we cannot raise additional  capital on acceptable  terms when  needed,  our  ability to further  expand our  operations through internal growth and acquisitions could be limited.           Our net  income  includes  income  from  the  sale of  excess  property acquired in connection with new branch  locations,  and may not be indicative of our future income or our ability to realize gains from our real estate.           In 2004,  we had net gains from the sale of property  and  equipment of $1.1 million resulting primarily from the sale of excess real estate acquired in connection with our establishment of new branch  locations.  Such gains are due, in part,  to the amount of real estate we had to purchase to secure branch sites that we believed were attractive for our  operations,  as well the growth of our markets  and the related  increases  in real  property  values We are not in the business of acquiring real estate for resale, and give no assurance that we will realize any gains from real estate sales in the future.           If our loan customers do not pay us as they have  contracted to, we may experience losses.           Our principal revenue producing  business is making loans. If the loans are not repaid, we will suffer losses.  Even though we maintain an allowance for loan losses, the amount of the allowance may not be adequate to cover the losses we  experience.  We attempt to  mitigate  this risk by a thorough  review of the creditworthiness of loan customers.  Nevertheless, there is risk that our credit evaluations  will  prove  to be  inaccurate  due  to  changed  circumstances  or otherwise.           Our business is concentrated in Greater  Charleston,  and a downturn in the economy of the  Charleston  area, a decline in  Charleston  area real estate values or other events in our market area may adversely affect our business.           Substantially all of our business is located in the Greater  Charleston area.  As a result,  our financial  condition  and results of operations  may be affected by changes in the Charleston  economy.  A prolonged  period of economic recession,  a general  decline in  Charleston  area real estate  values or other adverse economic  conditions in Charleston may result in decreases in demand for our  services,  increases in  nonpayment  of loans and decreases in the value of collateral  securing  loans.  The  existence  of  adverse  economic  conditions, declines in real  estate  values or the  occurrence  of other  adverse  economic conditions in Charleston and South Carolina could have a material adverse effect on our business, future prospects, financial condition or results of operations.           We  operate  in an area  susceptible  to  hurricane  and other  weather related damage which could disrupt our business and reduce our profitability.           Nearly all of our  business  and our  customers  are located in coastal South Carolina,  an area that often experiences damage from hurricanes and other weather  phenomena.  We  attempt to  mitigate  such risk with  insurance  and by requiring  insurance  on property  taken as  collateral.  However,  catastrophic weather  damage to a large  portion of our market area could  cause  substantial disruptions to our business and our customers' businesses which would reduce our profitability for some period.           We face strong  competition from larger,  more established  competitors which may adversely affect our ability to operate profitably.                                         10            We encounter strong competition from financial  institutions  operating in the greater Charleston,  South Carolina area. In the conduct of our business, we also compete with credit  unions,  insurance  companies,  money market mutual funds and other  financial  institutions,  some of which are not  subject to the same  degree  of  regulation  as  we  are.  Many  of  these   competitors   have substantially  greater  resources and lending  abilities  than we have and offer services,  such as investment banking,  trust and international banking services that we do not provide.  We believe that we have competed,  and will continue to be  able  to  compete,  effectively  with  these  institutions  because  of  our experienced   bankers  and  personalized   service,  as  well  as  through  loan participations and other strategies and techniques.  However,  we cannot promise that we are  correct  in our  belief.  If we are wrong,  our  ability to operate profitably may be negatively affected.           Technological  changes  affect  our  business,  and we may  have  fewer resources than many of our competitors to invest in technological improvements.           The   financial   services   industry   continues   to  undergo   rapid technological  changes  with  frequent  introductions  of new  technology-driven products and services.  In addition to enabling financial  institutions to serve clients better, the effective use of technology may increase  efficiency and may enable financial institutions to reduce costs. Our future success may depend, in part,  upon our ability to use technology to provide  products and services that provide  convenience to customers and to create  additional  efficiencies in our operations.  We may need to make significant  additional capital  investments in technology in the future,  and we may not be able to  effectively  implement new technology-driven   products  and  services.   Many  of  our  competitors   have substantially greater resources to invest in technological improvements.           Our  profitability and liquidity may be affected by changes in interest rates and economic conditions.           Our  profitability  depends upon our net interest income,  which is the difference between interest earned on our interest-bearing assets, such as loans and investment securities, and interest expense on interest-bearing liabilities, such as deposits  and  borrowings.  Our net  interest  income will be  adversely affected  if market  interest  rates  change  such that the  interest  we pay on deposits and borrowings  increases  faster than the interest earned on loans and investments.  Interest rates, and  consequently  our results of operations,  are affected by general  economic  conditions  (domestic and foreign) and fiscal and monetary policies.  Monetary and fiscal policies may materially affect the level and direction of interest  rates.  Beginning in June 2004 through  January 2006, the  Federal  Reserve has raised  rates 14 times for a total  increase of 3.50%. Increases  in  interest   rates   generally   decrease  the  market   values  of interest-bearing  investments and loans held and therefore may adversely  affect our liquidity and earnings.  Increased  interest rates also generally affect the volume of  mortgage  loan  originations,  the  resale  value of  mortgage  loans originated  for resale,  and the ability of borrowers to perform under  existing loans of all types.                          Risks Related to Our Common Stock           Our common  stock has a limited  trading  market,  which may limit your ability to sell your stock.           Our common  stock is traded on the  Nasdaq  National  Market  under the symbol "SOCB." Since January 1, 2005, the average weekly trading volume has been approximately  6,200 shares.  Accordingly,  a  shareholder  who wishes to sell a large  number of shares may  experience a delay in selling the shares or have to sell them at a lower price in order to sell them promptly.           We may issue additional securities, which could affect the market price of our common stock and dilute your ownership.           We may issue  additional  securities to raise  additional  capital,  to support growth, or to make acquisitions. Sales of a substantial number of shares of our common  stock,  or the  perception  by the market  that those sales could occur, could cause the market price of our common stock to decline or could make it more difficult for us to raise capital through the sale of common stock or to use our common stock in future acquisitions.                                         11            We do not plan to pay cash dividends in the foreseeable future.           We do not plan to pay cash dividends in the foreseeable future. We plan to use the funds that might  otherwise be  available to pay  dividends to expand our business.           Declaration  and payment of dividends are within the  discretion of our board of directors.  Our bank will be our most likely source of funds with which to pay cash dividends. Our bank's declaration and payment of future dividends to us are within the discretion of the bank's board of directors, and are dependent upon its earnings,  financial condition,  its need to retain earnings for use in the business and any other pertinent  factors.  Payment of dividends by our bank is also subject to various regulatory requirements.           Provisions in our articles of incorporation  and South Carolina law may discourage  or prevent  takeover  attempts,  and these  provisions  may have the effect of reducing the market price for our stock.           Our articles of incorporation  include several provisions that may have the  effect  of  discouraging  or  preventing  hostile  takeover  attempts,  and therefore  of  making  the  removal  of  incumbent  management  difficult.   The provisions  include  staggered terms for our board of directors and requirements of supermajority  votes to approve certain business  transactions.  In addition, South Carolina law contains  several  provisions that may make it more difficult for a third party to acquire  control of us without the approval of our board of directors,  and may make it more  difficult  or  expensive  for a third party to acquire a majority of our  outstanding  common  stock.  To the extent that these provisions are effective in discouraging or preventing  takeover attempts,  they may tend to reduce the market price for our stock.           Our  common  stock  is  not  insured,  so you  could  lose  your  total investment.           Our common stock is not a deposit, savings account or obligation of our bank and is not  insured by the Federal  Deposit  Insurance  Corporation  or any other  government  agency.  Should our  business  fail you could lose your total investment.
The  Company is neither an  accelerated  filer nor a large  accelerated filer  as  defined  in  Rule  12b-2  of the  Securities  Exchange  Act of  1934. Accordingly, this item is not applicable to it.
The Company owns the real property at 530 Johnnie Dodds Boulevard,  Mt. Pleasant,  South Carolina,  where its main offices are located. The Company also owns the  following  properties  in  Charleston  and Berkeley  Counties of South Carolina,  where its branch  offices are  located:  602 Coleman  Boulevard,  Mt. Pleasant; 802 Savannah Highway, Charleston; 337 East Main Street, Moncks Corner; 2753 Maybank Highway,  Johns Island;  597 Old Mount Holly Road, Goose Creek; and 8420 Dorchester Road, North  Charleston.  The Company leases the property at 203 N. Main Street,  Summerville,  South Carolina. All properties are believed to be well suited for the Company's needs.
The Bank is from  time to time a party  to  various  legal  proceedings arising in the ordinary  course of business,  but  management of the Bank is not aware  of  any  pending  or  threatened   litigation  or  unasserted  claims  or assessments  that are  expected  to  result in  losses,  if any,  that  would be material to the Company's business and operations.
No matters  were  submitted  to a vote of security  holders  during the fourth quarter of 2005.                                         12                                        PART II  Item     5. Market for Registrant's  Common Equity,  Related Stockholder Matters          and Issuer Purchases of Equity Securities.  The  information set forth under the caption "Common Stock and Dividends" in the Registrant's  Annual Report to Shareholders for the year ended December 31, 2005 (the "2005 Annual Report"), which information is set forth in Exhibit 13 to this Form 10-K, is incorporated herein by reference.  Securities Authorized for Issuance Under Equity Compensaton Plans  The  information  required by Item 201(d) of Regulation S-K is set forth in Item 12 of this Form 10-K.  Unregistered Sales of Equity Securities  Other than as previously disclosed in its Forms 10-Q for the quarters ended June 30, 2005 and September 30, 2005, the Company did not sell any securities  during the year ended December 31, 2005 that were not  registered  under the Securities Act.  Purchases of Equity Securities by the Company and Affiliated Purchasers  Neither  the  Company  nor any  "affiliated  purchaser"  as defined in 17 C.F.R. 240.10b-18(a)(3)  purchased  any  shares or units of any class of the  Company's equity securities that is registered  pursuant to Section 12 of the Exchange Act during the fourth  quarter  of 2005.  Accordingly,  no  disclosure  is  required pursuant to 17 C.F.R. Section 229.703.
The information  set forth under the caption  "Selected  Consolidated  Financial Data" in the 2005 Annual Report, which information is set forth in Exhibit 13 to this Form 10-K, is incorporated herein by reference.
The  information  set  forth  under the  caption  "Management's  Discussion  and Analysis" in the 2005 Annual Report,  which  information is set forth in Exhibit 13 to this Form 10-K, is incorporated herein by reference.
The information set forth under the captions  "Management's  Discussion and  Analysis -- Market Risk - Interest  Rate  Sensitivity"  and "-- Off Balance Sheet Arrangements" in the 2005 Annual Report, which information is set forth in Exhibit 13 to this Form 10-K, is incorporated herein by reference.
The Consolidated Financial Statements,  including Notes thereto, in the 2005  Annual  Report,  which are set forth in Exhibit 13 to this Form 10-K,  are incorporated herein by reference.  Item  9.  Changes  In and  Disagreements  With  Accountants  on  Accounting  and           Financial Disclosure.           Not Applicable.
Based on the evaluation required by 17 C.F.R. Section  240.13a-15(b) or 240.15d-15(b) of the Company's disclosure controls and procedures (as defined in 17  C.F.R.  Sections  240.13a-15(e)  or  240.15d-15(e)),   the  Company's  chief executive  officer and chief financial  officer concluded that such controls and procedures,  as of the end of the period  covered by this  annual  report,  were effective.                                         13            No disclosure is required under 17 C.F.R.  Section  229.308 (a) or (b). There  has been no change  in the  Company's  internal  control  over  financial reporting during the most recent fiscal quarter that has materially affected, or is reasonably likely to materially  affect,  the Company's internal control over financial reporting.
No  information  was  required to be disclosed in a Form 8-K during the fourth quarter of 2005 that was not so disclosed.                                      PART III
The information set forth under the captions  "Election of Directors -- Directors and Nominees" "-- Executive Officers," and "Committees of the Board of Directors -- Audit Committee," and "Section 16(a) Beneficial Ownership Reporting Compliance" in registrant's definitive proxy statement filed with the Commission for the 2006 Annual  Meeting of  Shareholders  (the "2006 Proxy  Statement")  is incorporated herein by reference.           Audit Committee Financial Expert           The Company's  board of directors has determined  that the Company does not have an "audit committee  financial expert," as that term is defined by Item 401(h) of Regulation S-K promulgated by the Securities and Exchange  Commission, serving on its audit committee.  The Company's audit committee is a committee of directors who are elected by the  shareholders  and who are  independent  of the Company and its  management.  After reviewing the experience and training of all of the  Company's  independent  directors,  the board of directors has concluded that  no  independent  director  meets  the  SEC's  very  demanding  definition. Therefore, it would be necessary to find a qualified individual willing to serve as both a  director  and  member of the  audit  committee  and have that  person elected  by the  shareholders  in order to have an  "audit  committee  financial expert" serving on the Company's audit committee.  The Company's audit committee is,  however,  authorized to use  consultants  to provide  financial  accounting expertise in any instance where members of the committee believe such assistance would be useful. Accordingly, the Company does not believe that it needs to have an "audit committee financial expert" on its audit committee.  Audit Committee           The  Company  has a  separately  designated  standing  audit  committee established  pursuant to Section 3(a)(58)(A) of the Exchange Act. The members of the audit committee are Tommy B. Baker, William A. Coates, and James H. Sexton.           Code of Ethics           The  Company  has  adopted a code of ethics  (as  defined  by 17 C.F.R. 229.406) that applies to its principal executive officer and principal financial officer.  The Company will provide a copy of the code of ethics, free of charge, to any person upon written request to Robert M. Scott, Executive Vice President, SouthCoast  Financial  Corporation,  530 Johnnie Dodds Boulevard,  Mt. Pleasant, South Carolina 29464.
The information set forth under the caption  "Management  Compensation" in the 2006 Proxy  Statement  is  incorporated  herein by  reference;  provided, however,  the information set forth under the captions "--Board Committee Report on Executive  Compensation" and "--Shareholder  Return Performance Graph" is not incorporated herein by reference.
The  information  set forth under the captions "Security  Ownership  of Certain  Beneficial  Owners" and "Security  Ownership of Management" in the 2006 Proxy Statement is incorporated herein by reference.                                         14                         Equity Compensation Plan Information           The following  table sets forth  aggregated  information as of December 31, 2005 about all of the Company's  compensation  plans  (including  individual compensation  arrangements)  under which  equity  securities  of the Company are authorized for issuance:   Plan category                   Number of securities         Weighted-average             Number of securities                                 to be issued upon            exercise price of            remaining available                                 exercise of                  outstanding options,         for future issuance                                 outstanding options,         warrants and rights          under equity                                 warrants and rights                                       compensation plans                                                                                           (excluding securities                                                                                           reflected in column(a))                                 (a)                          (b)                          (c) - ------------------------------- ---------------------------- ---------------------------- ----------------------------     Equity compensation plans approved by security holders                        15,125                       16.82                           20,809  Equity compensation plans not approved by security holders                        -0-                         -0-                              -0-                                         ------                       -----                           ------ Total                                   15,125                       16.82                           20,809                                         ======                       =====                           ======   The foregoing  table does not include  information  about the 200,000  shares of common stock reserved for issuance pursuant to the Company's 2005 Employee Stock Purchase Plan, which will be voted on by shareholders at the 2006 Annual Meeting of  Shareholders.  The  information  set forth  under the caption  "Approval  of Employee Stock Purchase Plan" in the 2006 Proxy Statement is incorporated herein by reference.
The information set forth under the caption "Certain  Relationships and Related  Transactions"  in the 2006 Proxy  Statement is  incorporated  herein by reference.
The  information  set forth  under  the  captions  "Independent  Public Accountants  -  Fees  Paid  to  Independent  Auditors"  and  "--Audit  Committee Pre-Approval  of  Audit  and  Permissible   Non-Audit  Services  of  Independent Auditors" in the 2006 Proxy Statement is incorporated herein by reference.                                      PART IV
(a)(1)   - Report of Independent Registered Public Accounting Firm          - Consolidated Balance Sheets          - Consolidated Statements of Income          - Consolidated Statements of Shareholders Equity and Comprehensive            Income          - Consolidated Statements of Cash Flows          - Notes to Consolidated Financial Statements    (2)   Financial Statement Schedules - None    (3)   Exhibits                                         15   Exhibit No.                Description - -----------                ----------- 3.1            Articles of Incorporation of Registrant(1) 3.2            Bylaws of Registrant(1) 4.1            Form of Common Stock Certificate(3) 10.1           1999 Stock Option Plan(2) 10.2           Form of Stock Option Agreement(3) 10.3           Purchase Agreement among the Registrant, Southcoast Capital Trust                I and Bayview Financial  Trading Group,  L.P., dated as of May 3,                2002 (4) 10.4           Amended and Restated  Declaration of Trust among the  Registrant,                Wells Fargo Delaware Trust  Company,  Wells Fargo Bank,  National                Association,  L. Wayne Pearson,  Robert A. Daniel, Jr. and Robert                M. Scott, dated as of May 3, 2002 (4) 10.5           Indenture  between  Registrant  and Wells  Fargo  Bank,  National                Association, dated as of May 3, 2002 (4) 10.6           Guarantee  Agreement between the Registrant and Wells Fargo Bank,                National Association, dated as of May 3, 2002 (4) 10.7           Registrant's Junior Subordinated  Deferrable Interest Debentures,                dated as of May 3, 2002 (4) 10.8           Purchase Agreement among the Registrant, Southcoast Capital Trust                II and Trapeza CDO, LLC, dated as of December 16, 2002(5) 10.9           Amended and Restated Trust Agreement among  Southcoast  Financial                Corporation,  The  Bank  of  New  York,  The  Bank  of  New  York                (Delaware),  L. Wayne Pearson,  Paul D. Hollen, III and Robert M.                Scott, dated as of December 16, 2002(5) 10.10          Junior Subordinated  Indenture between Registrant and The Bank of                New York, dated as of December 16, 2002(5) 10.11          Guarantee  Agreement between Registrant and The Bank of New York,                dated as of December 16, 2002(5) 10.12          Floating Rate Junior  Subordinated Note, dated as of December 16,                2002(5) 10.13          Form of Employment  Agreements between the Company and each of L.                Wayne Pearson, Paul D. Hollen, III, Robert M. Scott and Robert A.                Daniel, Jr., dated as of August 12, 2003, and William B. Seabrook                dated as of July 15, 2004(6) 10.14          Southcoast  Financial  Corporation  2005 Employee  Stock Purchase                Plan (7) 10.15          Junior  Subordinated  Indenture between Registrant and Wilmington                Trust Company dated as of August 5, 2005 (8) 10.16          Guarantee  Agreement  between  Registrant  and  Wilmington  Trust                Company, dated as of August 5, 2005 (8) 10.17          Placement  Agreement among Registrant,  Southcoast  Capital Trust                III and Credit Suisse First Boston LLC dated as of August 5, 2005                (8) 13             Portions of the Annual Report to Shareholders for the Year  Ended                December 31, 2005 incorporated by reference into this Form 10-K 21             Subsidiaries of Registrant (8) 23             Consent of Accountants 31.1           13a-14(a)/15d-14(a) Certifications of Chief Executive Officer 31.2           13a-14(a)/15d-14(a) Certifications of Chief Financial Officer 32             Section 1350 Certifications - ---------------------- (1)  Incorporated by reference to exhibits to Form 10-SB filed April 10, 1999. (2)  Incorporated  by  reference  to  exhibits to Form 10-KSB for the year ended      December 31, 1999. (3)  Incorporated  by  reference  to  exhibits to Form 10-KSB for the year ended      December 31, 2000. (4)  Incorporated  by reference to exhibits to Form 10-QSB for the quarter ended      March 31, 2002. (5)  Incorporated  by  reference  to  exhibits to Form 10-KSB for the year ended      December 31, 2002. (6)  Incorporated  by  reference  to exhibits to Form SB-2 filed  August 3, 2003      (File No. 333-108480). (7)  Incorporated  by reference to exhibits to Form S-8, filed September 9, 2005      (File No. 333-128197) (8)  Incorporated  by  reference  to exhibits to Form S-1 filed  August 12, 2005      (File No. 333-128247)                                         16                                       SIGNATURE           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 its behalf by the undersigned, thereunto duly authorized.                          Southcoast Financial Corporation   March 29, 2006                By: s/L. Wayne Pearson                                  -----------------------------------------------                                    L. Wayne Pearson                                    Chairman and Chief Executive Officer                                  By: s/Robert M. Scott                                   ----------------------------------------------                                    Robert M. Scott                                    Executive Vice President                                    (Principal Financial and Principal                                     Accounting 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 - ---------                                -----                                              ----      - --------------------------               Director                                           March __, 2006 Tommy B. Baker  s/William A. Coates - --------------------------               Director                                           March 29, 2006 William A. Coates  s/Paul D. Hollen, III - --------------------------               Executive Vice President, Director                 March 28, 2006 Paul D. Hollen, III  s/Stephen F. Hutchinson - --------------------------               Director                                           March 29, 2006 Stephen F. Hutchinson  s/L. Wayne Pearson - --------------------------               Chairman, Chief Executive Officer, Director        March 27, 2006 L. Wayne Pearson  s/Robert M. Scott - --------------------------               Executive Vice President, Chief Financial          March 27, 2006 Robert M. Scott                          Officer, Principal Accounting Officer, Director  s/James H. Sexton - --------------------------               Director                                           March 29, 2006 James H. Sexton  s/James P. Smith - --------------------------               Director                                           March 25, 2006 James P. Smith                                            17                                     EXHIBIT INDEX  Exhibit No.                Description - -----------                -----------  3.1            Articles of Incorporation of Registrant(1) 3.2            Bylaws of Registrant(1) 4.1            Form of Common Stock Certificate(3) 10.1           1999 Stock Option Plan(2) 10.2           Form of Stock Option Agreement(3) 10.3           Purchase Agreement among the Registrant, Southcoast Capital Trust                I and Bayview Financial  Trading Group,  L.P., dated as of May 3,                2002 (4) 10.4           Amended and Restated  Declaration of Trust among the  Registrant,                Wells Fargo Delaware Trust  Company,  Wells Fargo Bank,  National                Association,  L. Wayne Pearson,  Robert A. Daniel, Jr. and Robert                M. Scott, dated as of May 3, 2002 (4) 10.5           Indenture  between  Registrant  and Wells  Fargo  Bank,  National                Association, dated as of May 3, 2002 (4) 10.6           Guarantee  Agreement between the Registrant and Wells Fargo Bank,                National Association, dated as of May 3, 2002 (4) 10.7           Registrant's Junior Subordinated  Deferrable Interest Debentures,                dated as of May 3, 2002 (4) 10.8           Purchase Agreement among the Registrant, Southcoast Capital Trust                II and Trapeza CDO, LLC, dated as of December 16, 2002(5) 10.9           Amended and Restated Trust Agreement among  Southcoast  Financial                Corporation,  The  Bank  of  New  York,  The  Bank  of  New  York                (Delaware),  L. Wayne Pearson,  Paul D. Hollen, III and Robert M.                Scott, dated as of December 16, 2002(5) 10.10          Junior Subordinated  Indenture between Registrant and The Bank of                New York, dated as of December 16, 2002(5) 10.11          Guarantee  Agreement between Registrant and The Bank of New York,                dated as of December 16, 2002(5) 10.12          Floating Rate Junior  Subordinated Note, dated as of December 16,                2002(5) 10.13          Form of Employment  Agreements between the Company and each of L.                Wayne Pearson, Paul D. Hollen, III, Robert M. Scott and Robert A.                Daniel, Jr., dated as of August 12, 2003, and William B. Seabrook                dated as of July 15, 2004(6) 10.14          Southcoast  Financial  Corporation  2005 Employee  Stock Purchase                Plan (7) 10.15          Junior  Subordinated  Indenture between Registrant and Wilmington                Trust Company dated as of August 5, 2005 (8) 10.16          Guarantee  Agreement  between  Registrant  and  Wilmington  Trust                Company, dated as of August 5, 2005 (8) 10.17          Placement  Agreement among Registrant,  Southcoast  Capital Trust                III and Credit Suisse First Boston LLC dated as of August 5, 2005                (8) 13             Portions of the Annual Report to Shareholders for the Year  Ended                December 31, 2005 incorporated by reference into this Form 10-K 21             Subsidiaries of Registrant (8) 23             Consent of Accountants 31.1           13a-14(a)/15d-14(a) Certifications of Chief Executive Officer 31.2           13a-14(a)/15d-14(a) Certifications of Chief Financial Officer 32             Section 1350 Certifications - ---------------------- (1)  Incorporated by reference to exhibits to Form 10-SB filed April 10, 1999. (2)  Incorporated  by  reference  to  exhibits to Form 10-KSB for the year ended      December 31, 1999. (3)  Incorporated  by  reference  to  exhibits to Form 10-KSB for the year ended      December 31, 2000. (4)  Incorporated  by reference to exhibits to Form 10-QSB for the quarter ended      March 31, 2002. (5)  Incorporated  by  reference  to  exhibits to Form 10-KSB for the year ended      December 31, 2002. (6)  Incorporated  by  reference  to exhibits to Form SB-2 filed  August 3, 2003      (File No. 333-108480). (7)  Incorporated  by reference to exhibits to Form S-8, filed September 9, 2005      (File No. 333-128197) (8)  Incorporated  by  reference  to exhibits to Form S-1 filed  August 12, 2005      (File No. 333-128247)                                          18    EX-13 2 sthcst10k06exhibit13.txt                                     Exhibit 13                    Portions of Southcoast Financial Corporation                        2005 Annual Report to Shareholders                            Incorporated by Reference                                  into Form 10-K                   SOUTHCOAST FINANCIAL CORPORATION AND SUBSIDIARY                        Selected Consolidated Financial Data       The following  table sets forth our selected  consolidated  financial data. The financial  data for the five years ended  December 31, 2005 are derived from our  audited  financial  statements.  You should read the  consolidatd  selected financial  data in  conjunction  with  "Management's  Discussion and Analysis of Financial  Condition  and Results of  Operations,"  our  consolidated  financial statements and accompanying notes and other financial data included elsewhere in this document.                                                                                      Year Ended December 31,                                                                                   -----------------------                                                              2005            2004           2003            2002          2001                                                              ----            ----           ----            ----          ---- Income Statement Data:         Net interest income ..............................    $    13,914     $    10,692     $     7,858     $     5,458     $     4,236   Provision for loan losses ........................            865           1,146             735             480             321   Noninterest income ...............................          2,725           2,700           1,711           1,767           1,137   Noninterest expense ..............................          9,243           7,966           6,171           4,866           4,043   Income taxes .....................................          2,342           1,298             959             732             363   Net income .......................................    $     4,189     $     2,982     $     1,704     $     1,147     $       646  Per Share Data: (1)   Net income-basic .................................    $      1.17     $      0.91     $      0.83     $      0.62     $      0.39   Net income-diluted ...............................           1.17            0.90            0.82            0.60            0.39   Book value at period end .........................    $     14.80     $     11.19     $     10.30     $      6.88     $      6.27  Balance sheet Data:   Total assets .....................................    $   476,599     $   366,103     $   253,217     $   181,169     $   124,309   Total loans (net of unearned income) (2) .........        385,201         308,621         202,536         145,068         101,077   Total deposits ...................................        311,554         258,153         166,212         132,655          81,856   Other borrowings .................................         88,655          69,345          52,445          34,845          30,400   Shareholders' equity .............................         73,315          36,571          33,410          12,709          11,549  Performance Ratios:   Return on average assets .........................           1.04%           0.98%           0.79%           0.78%           0.59%   Return on average stockholders' equity ...........           9.28%           8.56%          10.43%           9.45%           6.69%   Net interest margin ..............................           3.69%           3.78%           3.90%           4.02%           4.21%  Asset quality ratios:   Allowance to period-end loans ....................           1.14%           1.15%           1.18%           1.21%           1.25%   Allowance to nonperforming loans .................         747.14%         368.13%       8,931.58%       1,625.86%         149.07%   Nonperforming assets to total assets .............           0.12%           0.27%           0.04%           0.06%           0.66%   Net charge-offs to average loans .................           0.00%           0.05%           0.01%           0.03%           0.05%  Capital Ratios:   Tier 1 risk-weighted assets ......................          27.79%          17.32%          23.08%          12.53%          12.58%   Total to risk-weighted assets ....................          29.03%          18.55%          24.48%          18.75%          13.90%   Leverage capital ratio ...........................          21.36%          13.64%          18.35%          11.59%          10.57%   Total equity to total assets .....................          15.38%           9.99%          13.19%           7.01%           9.29%    (1)  All per share data has been  adjusted for the 10% stock  dividends in 2001,      2002, 2003, 2004 and 2005 and an additional 5% stock dividend in 2003.  (2)  Includes loans held for sale and is not net of allowance for loan losses.                      SOUTHCOAST FINANCIAL CORPORATION AND SUBSIDIARY                       Management's Discussion and Analysis    The  following  discussion  is  intended  to  assist  you in  understanding  the financial   condition  and  results  of   operations  of  Southcoast   Financial Corporation  and  subsidiaries  and  should  be read  in  conjunction  with  the consolidated financial statements and related notes included in this report. All per share data in this  discussion  has been  adjusted  to reflect the 10% stock dividends  declared  in  April  2003,  2004  and  2005,  as well as the 5% stock dividend  declared in July 2003.  Many of the amounts  and  percentages  in this section have been rounded for convenience of  presentation,  but actual recorded amounts have been used in computations. Accordingly, some information may appear not to compute accurately.                                      Overview  We grew  significantly  in 2004 and 2005.  The growth and  maturity  of existing branches coupled with our ongoing marketing efforts resulted in a 33.4% increase in average  earning assets in 2005 after a 40.2% increase in 2004.  Although the interest rate  environment  that prevailed  during most of 2004 and 2005 reduced our net interest margins slightly,  total net interest income for 2005 was 30.1% higher than 2004 and 36.1% higher in 2004 than in 2003.  Noninterest income rose by $25,373, or .9%, in 2005, while in 2004 noninterest income rose $988,600,  or 57.8% as a result of the sale of excess real estate.  Noninterest  expenses also rose  substantially  in 2005 and 2004,  by 16.0% and  29.1%  respectively,  as a result primarily of increased  salaries and benefits due to additional  staffing for new and  existing  offices  as well as  increases  in levels  of salary  and benefits.  All of these factors helped us achieve a 40.5% increase in net income for 2005 and a 75.0% increase for 2004.                            Critical Accounting Policies  We have adopted  various  accounting  policies  which govern the  application of accounting principles generally accepted in the United States in the preparation of our financial statements. Our significant policies are described in the notes to the consolidated financial statements.  Certain  accounting  policies involve  significant  judgments and assumptions by management  which have a material impact on the carrying value of certain assets and liabilities.  Management  considers such accounting  policies to be critical accounting  policies.  The judgments and assumptions used by management in these critical  accounting  policies  are  based on  historical  experience  and other factors, which are believed to be reasonable under the circumstances. Because of the nature of the judgments and assumptions  made by management,  actual results could differ from these  judgments  and  estimates,  which could have a material impact on the carrying  values of our assets and  liabilities and our results of operations.  We believe the  allowance for loan losses is a critical  accounting  policy that requires the most significant judgments and estimates used in preparation of our consolidated financial statements.  Refer to the discussion under the "Allowance for Loan Losses"  heading under  "Comparison  of Years Ended  December 31, 2005, 2004 and 2003" below and to Note 1 to our consolidated  financial statements for a detailed  description of our estimation process and methodology related to the allowance for loan losses.                                          2                    SOUTHCOAST FINANCIAL CORPORATION AND SUBSIDIARY                       Management's Discussion and Analysis  Comparison of Years Ended December 31, 2005, 2004 and 2003                                Results of Operations                                       General  We had net income from  operations  for the year ended December 31, 2005 of $4.2 million,  or $1.17 per basic  share,  compared  to net income for the year ended December 31, 2004 of $3.0 million or $0.91 per basic share.  We had net interest income of $13.9  million for 2005 as compared to $10.7 million for 2004. We also had noninterest income  (principally  service charges,  gains on sale of assets, fees and  commissions)  of $2.7  million in 2005 and $2.7  million  in 2004.  We provided  $865,000 and $1.1 million to our allowance for loan losses in 2005 and 2004,  respectively,  and had  noninterest  expenses  (principally  salaries and benefits,  occupancy,  equipment  and  business  development  expenses)  of $9.2 million in 2005 and $8.0 million in 2004.  We had net income from  operations  for the year ended December 31, 2004 of $3.0 million,  or $0.91 per basic  share,  compared  to net income for the year ended December 31, 2003 of $1.7 million or $0.83 per basic share.  We had net interest income of $10.7  million for 2004 as compared to $7.9 million for 2003.  We also had noninterest income  (principally  service charges,  gains on sale of assets, fees and  commissions)  of $2.7  million in 2004 and $1.7  million  in 2003.  We provided  $1.1 million and $735,000 to our allowance for loan losses in 2004 and 2003,  respectively,  and had  noninterest  expenses  (principally  salaries and benefits,  occupancy  and  equipment  expenses) of $8.0 million in 2004 and $6.2 million in 2003.                                 Net Interest Income  During the year ended December 31, 2005, net interest  income was $13.9 million. For the year ended  December 31, 2004,  net interest  income was $10.7  million. This  increase was  primarily  attributable  to an increase in volume as average interest  earning assets increased to $377.4 million in 2005 from $282.9 million in 2004. The increase in volume was attributable to the growth of our commercial and residential lending and the continued maturing of the branch network as well as the opening of new  branches.  The average yield on interest  earning  assets increased  from  5.87% to 6.33%  from 2004 to 2005,  while the  average  cost of interest  bearing  liabilities  increased from 2.47% to 3.09%.  The net yield on average interest earning assets decreased from 3.78% in 2004 to 3.69% in 2005.  During the year ended December 31, 2004, net interest  income was $10.7 million. For the year ended December 31, 2003, net interest income was $7.9 million. This increase was primarily attributable to an increase in volume as average interest earning assets  increased to $282.9 million in 2004 from $201.7 million in 2003. The increase in volume was attributable to the growth of our commercial  lending and the continued  maturing of the branch  network as well as the opening of new branches.  The average yield on interest  earning assets decreased from 6.18% to 5.87% from 2003 to 2004, while the average cost of interest bearing  liabilities decreased from 2.61% to 2.47%.  The net yield on average interest earning assets decreased from 3.90% in 2003 to 3.78% in 2004.                                           3                    SOUTHCOAST FINANCIAL CORPORATION AND SUBSIDIARY                       Management's Discussion and Analysis                           Net Interest Income - continued  The following tables set forth, for the periods indicated,  information  related to our average  balance sheet and its average yields on assets and average rates paid on  liabilities.  Such yields and rates are  derived by dividing  income or expense by the average balance of the corresponding assets or liabilities.                                                   For the year ended            For the year ended             For the year ended                                                 December 31, 2005             December 31, 2004              December 31, 2003                                           ---------------------------    ---------------------------   ----------------------------                                            Average    Income/   Yield/   Average    Income/    Yield/   Average    Income/   Yield/ (Dollars in thousands)                    Balance(1)  Expense   Rate     Balance(1) Expense    Rate    Balance(1)  Expense    Rate                                           ---------- ---------  -----    ---------- --------   -----   ---------- ---------  ------ Assets:              Federal funds sold ................    $  11,497   $    340  2.96%    $  8,447   $     91    1.07%  $  12,468  $     130    1.04%    Taxable investments ...............       29,628      1,308  4.42       24,565        928    3.78      12,575        420    3.34    Non-taxable investments ...........          882         34  3.91        4,984         58    1.15          -          -       -    Loans (2) (3) .....................      335,389     22,206  6.62      244,861     15,519    6.34     176,688     11,911    6.74                                           ---------   --------           --------   --------           ---------  ---------      Total earning assets ............      377,396     23,889  6.33      282,857     16,596    5.87     201,731     12,461    6.18                                           ---------   --------           --------   --------           ---------  ---------    Other assets ......................       27,268                        20,163                         13,041                                           ---------                      --------                      ---------      Total assets ....................    $ 404,664                      $303,020                      $ 214,772                                           =========                      ========                      ========= Liabilities:    Savings deposits ..................    $  58,081        824  1.42     $ 50,414        639     1.27  $  37,116        429    1.16    Time deposits .....................      194,534      6,233  3.20      136,197      3,222     2.37    100,774      2,482    2.46    FHLB borrowings ...................       54,218      1,933  3.56       40,810      1,489     3.65     27,245      1,163    4.27    Subordinated debt .................       15,554        985  6.33       11,369        554     4.87     11,372        529    4.66                                           ---------   --------           --------   --------           ---------  ---------    Total interest bearing      liabilities .....................      322,387      9,975  3.09      238,790      5,904     2.47    176,507      4,603    2.61                                                       --------                      --------                      ---------    Noninterest bearing      demand deposits .................       34,587                        27,626                         20,462    Other liabilities .................        2,547                         1,773                          1,467                                           ---------                      --------                      ---------      Total liabilities ...............      359,521                       268,189                        198,436                                           ---------                      --------                      ---------    Shareholders' equity ..............       45,143                        34,831                         16,336                                           ---------                      --------                      ---------      Total liabilities and         shareholders' equity .........     $404,664                    $   303,020                      $214,772                                            ========                    ===========                      ======== Net interest spread (4) ..............                           3.24%                            3.40%                        3.57% Net interest income and    net yield on earning assets (5) ...               $ 13,914    3.69%              $ 10,692      3.78%           $  7,858     3.90%                                                      ========                       ========                      ======== Interest free funds supporting    earning assets (6) ................    $  55,009                      $ 44,067                      $  25,224                                           =========                      ========                      =========  (1)  Average balances are computed on a daily basis. (2)  Does not include nonaccruing loans. (3)  Includes loan fees of $1.4 million in 2005,  $1.2 million in 2004, and $1.1      million in 2003. (4)  Total interest earning assets yield less total interest bearing liabilities      rate. (5)  Net interest income divided by total interest earning assets. (6)  Total interest earning assets less total interest bearing liabilities.                                          4                    SOUTHCOAST FINANCIAL CORPORATION AND SUBSIDIARY                       Management's Discussion and Analysis                           Net Interest Income - continued  The  following  table  presents  changes in our net  interest  income  which are primarily a result of changes in the volumes and rates of our  interest  earning assets and interest bearing liabilities.                                                                   Analysis of Changes in Net Interest Income                                                                ------------------------------------------                                                For the year ended December 31, 2005          For the year ended December 31, 2004                                              versus the year ended December 31, 2004(1)   versus the year ended December 31, 2003(1)                                              ------------------------------------------   ------------------------------------------                                                                                   Net                                          Net  (Dollars in thousands)                            Volume         Rate         Change          Volume         Rate          Change                                                    ------         ----         ------          ------         ----          ------ Interest income:           Federal funds sold ....................       $    32        $   217        $   249        $   (42)       $     3        $   (39)    Taxable investments ...................           191            189            380            401            106            507    Non-taxable investments ...............           (47)            24            (23)            58              -             58    Net loans(2) ..........................         5,738            949          6,687          4,595           (987)         3,608                                                  -------        -------        -------        -------        -------        -------      Total interest income ...............         5,914          1,379          7,293          5,012           (878)         4,134                                                  -------        -------        -------        -------        -------        ------- Interest expense:    Savings deposits ......................            97             88            185            154             55            209    Time deposits .........................         1,380          1,631          3,011            874           (135)           739    FHLB advances .........................           489            (45)           444            594           (268)           326    Subordinated debt .....................           204            227            431              -             26             26                                                  -------        -------        -------        -------        -------        -------      Total interest expense ..............         2,170          1,901          4,071          1,622           (322)         1,300                                                  -------        -------        -------        -------        -------        -------        Net interest income ...............       $ 3,744        $  (522)       $ 3,222        $ 3,390        $  (556)       $ 2,834                                                  =======        =======        =======        =======        =======        ======= - -------  (1)  Volume-rate  changes  have  been  allocated  to each  category  based  on a      consistent basis between rate and volume. (2)  Includes loan fees of $1.4 million in 2005,  $1.2 million in 2004, and $1.1      million in 2003.  During 2006,  management  expects that interest rates will not radically change. Therefore,  any  improvements in net interest income for 2006 are expected to be largely  the  result  of  increases  in the  volume  and  changes  in the mix of interest-earning  assets and liabilities.  Management expects to continue to use aggressive  marketing  strategies  to increase our bank's  market share for both deposits and quality  loans within its service  areas in the  Charleston,  South Carolina   metropolitan  area.  These  strategies  involve  offering  attractive interest  rates and continuing  our bank's  commitment to providing  outstanding customer service.                       Market Risk - Interest Rate Sensitivity  Market risk is the risk of loss from adverse changes in market prices and rates. Our market risk  arises  principally  from  interest  rate risk  inherent in our lending,  deposit and borrowing  activities.  Management  actively  monitors and manages its interest rate risk exposure. Although we manage other risks, such as credit quality and liquidity  risk in the normal course of business,  management considers  interest  rate risk to be our most  significant  market risk and this risk  could  potentially  have the  largest  material  effect  on our  financial condition and results of operations.  Other types of market risk such as foreign currency exchange risk and commodity price risk do not affect us directly.  Achieving  consistent  growth in net interest  income is the primary goal of our asset/liability function. We attempt to control the mix and maturities of assets and  liabilities  to achieve  consistent  growth in net interest  income despite changes  in  market  interest  rates.  We seek to  accomplish  this  goal  while maintaining   adequate  liquidity  and  capital.   Our  asset/liability  mix  is sufficiently  balanced  so that the effect of  interest  rates  moving in either direction is not expected to be material over time.  Interest rate sensitivity  management is concerned with the timing and magnitude of  repricing  assets  compared  to  liabilities  and is an  important  part  of asset/liability  management.  It is the objective of interest  rate  sensitivity management to generate  stable growth in net interest  income and to control the risks  associated  with interest rate movement.  Management  constantly  reviews interest rate risk exposure and the expected  interest rate  environment so that adjustments in interest rate sensitivity can be made in a timely manner.                                          5                    SOUTHCOAST FINANCIAL CORPORATION AND SUBSIDIARY                       Management's Discussion and Analysis                 Market Risk - Interest Rate Sensitivity - continued  Our  bank's  Asset/Liability  Committee  uses a  simulation  model to  assist in achieving  consistent growth in net interest income while managing interest rate risk.  The model takes into account  interest rate changes as well as changes in the mix and volume of assets and  liabilities.  The model  simulates  our bank's balance sheet and income statement under several  different rate scenarios.  The model's  input (such as  interest  rates and levels of loans and  deposits)  are updated  on a  quarterly  basis in order to obtain  the most  accurate  forecast possible.  The forecast  presents  information  over a twelve-month  period.  It reports a base case in which  interest  rates  remain flat and  variations  that occur when rates  increase or decrease 100, 200 and 300 basis points.  According to the  model  as of  December  31,  2005,  our bank is  positioned  so that net interest income would increase $572,000,  and net income would increase $351,000 if rates were to rise 100 basis  points in the next twelve  months.  Conversely, net  interest  income would  decline  $894,000,  and net income  would  decrease $549,000 if  interest  rates were to decline 100 basis  points.  Computation  of prospective effects of hypothetical  interest rate changes are based on numerous assumptions,  including  relative  levels  of  market  interest  rates  and loan prepayment,  and  should not be relied  upon as  indicative  of actual  results. Further,  the  computations  do not  contemplate  any  actions  our  bank  could undertake  in response to changes in interest  rates or the effects of responses by others, including borrowers and depositors.  The "Interest  Sensitivity Analysis" table below indicates that, on a cumulative basis through twelve months,  repricing rate sensitive liabilities exceeded rate sensitive assets,  resulting in a liability  sensitive  position at December 31, 2005 of $1.8  million  for a  cumulative  gap ratio of  (0.38%).  When  interest sensitive  liabilities exceed interest sensitive assets for a specific repricing "horizon", a negative interest sensitivity gap results. The gap is positive when interest sensitive assets exceed interest sensitive liabilities. For a bank with a negative gap,  such as our bank,  rising  interest  rates would be expected to have a  negative  effect on net  interest  income  and  falling  rates  would be expected to have the opposite effect.  The  table  below   reflects  the  balances  of   interest-earning   assets  and interest-bearing  liabilities  at the  earlier of their  repricing  or  maturity dates.  Amounts  of fixed  rate  loans are  reflected  at the  earlier  of their contractual  maturity  date or the  date at  which  the  loans  may be  repriced contractually.  Interest-earning  deposits in other banks are  reflected  in the deposits'   maturity   dates.   Repurchase   agreements,   FHLB  borrowings  and subordinated debt are reflected in the earliest  contractual  repricing interval due to  the  immediately  available  nature  of  these  funds.  Interest-bearing liabilities with no contractual maturity,  such as interest-bearing  transaction accounts and savings deposits,  are reflected in the earliest repricing interval due to contractual  arrangements  which give  management the opportunity to vary the rates paid on these deposits within a 30-day or shorter period. However, our bank is under no obligation to vary the rates paid on those deposits  within any given  period.  Fixed rate time  deposits  are  reflected  at their  contractual maturity dates. Fixed rate advances are reflected at their contractual  maturity dates,  and  variable  rate  advances are  reflected  in the earliest  repricing interval  since they were  borrowed  under the daily  rate  credit  option,  and reprice daily.                                          6                    SOUTHCOAST FINANCIAL CORPORATION AND SUBSIDIARY                       Management's Discussion and Analysis                 Market Risk - Interest Rate Sensitivity - continued  Interest Sensitivity Analysis                                                                            After Three                        Greater                                                               Within       Through             One            Than                                                               Three         Twelve           Through          Five   (Dollars in thousands)                                      Months        Months          Five Years        Years           Total                                                               ------        ------          ----------        -----           ----- Assets Interest earning assets:          Interest earning deposits in other banks ........      $   3,572      $        -        $       -         $     -       $   3,572    Federal funds sold ..............................         16,964               -                -               -          16,964    Investment securities ...........................          6,352           1,000           23,753           4,098          35,203    Loans Held for Sale .............................          9,275               -                -               -           9,275 Loans:      Fixed rate ....................................         10,548          25,083           23,716          26,661          86,008      Variable rate .................................        117,257          64,409           99,855           8,397         289,918                                                           ---------       ---------        ---------       ---------       ---------        Total earning assets ........................        163,968          90,492          147,324          39,156         440,940                                                           ---------       ---------        ---------       ---------       --------- Liabilities Interest bearing liabilities:    Interest bearing deposits:      Interest bearing transaction accounts .........          2,906           1,237           11,133               -          15,276      Savings and money market ......................          7,859           2,957           26,615               -          37,431      Time deposits $100M and over ..................         52,641          74,219           34,441               -         161,301      Other time deposits ...........................         25,715          30,947            2,131               -          58,793                                                           ---------       ---------        ---------       ---------       ---------        Total interest bearing deposits .............         89,121         109,360           74,320               -         272,801    Subordinated debt and FHLB advances .............         47,655          10,000           17,000          14,000          88,655                                                           ---------       ---------        ---------       ---------       ---------        Total interest bearing liabilities ..........      $ 136,776       $ 119,360        $  91,320       $  14,000       $ 361,456                                                           =========       =========        =========       ---------       --------- Interest sensitivity gap ...........................      $  27,192       $ (28,868)       $  56,004       $  25,156                                                           =========        =========       =========       ========= Cumulative interest sensitivity gap ................      $  27,192       $  (1,676)       $  54,328       $  79,484                                                           =========        =========       =========       ========= Ratio of cumulative gap to    total earning assets ............................           6.17%         (0.38%)           12.32%          18.03%                               Provision for Loan Losses  The allowance  for loan losses,  established  through  charges to expense in the form of a provision for loan losses,  allows for estimated loan losses  inherent in our loan  portfolio.  Loan  losses or  recoveries  are  charged  or  credited directly to the  allowance.  The level of the allowance for loan losses is based on  management's  judgment as to the amount  required  to maintain an  allowance adequate to provide for  probable  losses  which have been  incurred in the loan portfolio as of the balance sheet date, although the exact amount of such losses and the specific  loans cannot be  identified  yet. We provided  $865,000,  $1.1 million and $735,000 to the allowance  during the years ended December 31, 2005, 2004 and 2003,  respectively.  The increases in the reserve for loan losses were attributable to the increase in loans outstanding.                                 Noninterest Income  Noninterest  income,  which  consists  primarily  of  service  fees  on  deposit accounts,  gains and fees on loans sold,  other fee income and gains on sales of securities  and fixed assets,  increased by $25,373 for the year ended  December 31, 2005.  The increase is primarily  the result of an increase in gains on sale of mortgages loans and investment  securities,  offset by a decrease in gains on sale property and  equipment.  For the year ended  December 31, 2004 compared to December 31, 2003, total noninterest income increased by $988,600,  primarily as a result of gains on sales of  securities  and fixed  assets of $1.2  million in 2004 compared to no gains in 2003,  and  increases in fees on deposit  accounts, which were offset by decreases  in gains on sale of mortgage  loans from 2003 to 2004.                                         7                    SOUTHCOAST FINANCIAL CORPORATION AND SUBSIDIARY                       Management's Discussion and Analysis                                Noninterest Expenses  Noninterest expenses, which consist primarily of salaries and employee benefits, net occupancy,  and furniture and equipment  expenses,  totaled $9.2 million for the year ended  December 31, 2005 as compared to $8.0 million for the year ended December 31, 2004. For the year ended December 31, 2004 compared to December 31, 2003  total  noninterest  expenses  increased  $1.8  million.  The  increase  in noninterest  expenses in both periods was due to normal  increases in salary and benefits,  increases  in staff,  facilities  and business  development  expenses needed to support the increase in assets and the opening of new branch offices.                                    Income Taxes  We recorded a tax expense of $ 2.3  million,  $1.3  million and $959,177 for the years ended  December  31,  2005,  2004 and 2003,  respectively.  We account for income taxes under SFAS No. 109, "Accounting for Income Taxes." Certain items of income and expense (principally  provision for loan losses and depreciation) are included in one reporting period for financial  accounting  purposes and another for income tax purposes.  Our  effective tax rates for 2005,  2004 and 2003 were 35.85%, 30.33% and 36.01% respectively.                                 Financial Condition                                Investment Portfolio  As of December 31, 2005, our investment  portfolio comprised  approximately 6.7% of our total assets.  The following table  summarizes the carrying value amounts of available-for-sale securities held by us at December 31, 2005, 2004 and 2003. Available-for-sale  securities  are stated at  estimated  fair value.  We had no securities which were held to maturity at December 31, 2005, 2004 or 2003.                          Securities Portfolio Composition                                                                                   December 31,                                                                                 ------------                                                       2005                          2004                          2003                                                       ----                          ----                          ----                                                        Net                           Net                           Net                                                     Unrealized                    Unrealized                    Unrealized                                                      Holding                        Holding                       Holding                                             Book     Gain/       Fair     Book      Gain/       Fair     Book      Gain/       Fair (Dollars in thousands)                     Value     (Loss)     Value    Value      (Loss)     Value    Value     (Loss)      Value                                            -----     ------     -----    -----      ------     -----    -----     ------      ----- Available-for-sale              U.S. government agencies ...........   $11,484   $  (167)    11,317   $ 6,496   $   (16)   $ 6,480   $ 7,685   $   (18)   $ 7,667    Mortgage-backed ....................    16,002      (267)    15,735    13,545       212     13,757    11,133       188     11,321    Non-taxable investments ............     2,331       (47)     2,284       401         -        401         -         -          -    Other investments ..................     2,093        54      2,147     1,100         -      1,100     1,000         5      1,005                                           -------   -------    -------   -------   -------    -------   -------   -------    -------      Total ............................   $31,910   $  (427)   $31,483   $21,542   $   196    $21,738   $19,818   $   175    $19,993                                           =======   =======    =======   =======   =======    =======   =======   =======    =======                                          8                    SOUTHCOAST FINANCIAL CORPORATION AND SUBSIDIARY                       Management's Discussion and Analysis                    Securities Portfolio Composition - continued  The  following  table  presents   maturities  and  weighted  average  yields  of securities   available-for-sale   at  December  31,   2005.   Available-for-sale securities are stated at estimated fair value. There were no  available-for-sale securities  with  maturities in time periods not presented in the table.  Equity securities have no maturity and are shown as a separate category.  Yields on tax exempt obligations have not been computed on a tax equivalent basis.  Securities Portfolio Maturities and Yields                                                               December 31, 2005                                                               -----------------                                                               Fair (Dollars in thousands)                                        Value        Yield                                                               -----        ----- U.S. government agency obligations    Due within one year ...............................       $   988       2.75%    Due from one to five years ........................        10,329       4.26                                                              -------       ----      Total ...........................................       $11,317       4.13%                                                              =======       ==== Mortgage-backed    Due after five to ten years .......................       $   866       3.40%    Due after ten years ...............................        14,869       4.90                                                              -------       ----      Total ...........................................       $15,735       4.81%                                                              =======       ==== U. S. States and political subdivisions    Due after ten years ...............................       $ 2,284       5.74%                                                              =======       ==== Other investments    Equity securities with no maturities ..............       $ 2,147       3.58%                                                              =======       ====                                   Loan Portfolio  Management believes the loan portfolio is adequately  diversified.  There are no significant concentrations of loans in any particular individuals or industry or group of related  individuals  or  industries,  and there are no foreign  loans. Nearly all of the loans are to borrowers  in, or secured by real estate  located in or near our market area.  The amounts of loans  outstanding  are shown in the following table according to type of loan for the following dates:                             Loan Portfolio Composition                                                                                          December 31,                                                                                       ------------ (Dollars in thousands)                                2005             2004              2003              2002               2001                                                       ----             ----              ----              ----               ----       Commercial ...............................        $ 167,993         $ 144,908         $ 113,621         $  78,793         $  45,435 Real estate - construction ...............           41,616            46,928            21,671            16,826               103 Real estate - mortgage ...................          162,716           101,216            62,543            35,649            46,553 Consumer .................................            3,601             3,559             4,274             5,117             4,861                                                   ---------         ---------         ---------         ---------         ---------      Total loans .........................          375,926           296,611           202,109           136,385            96,952 Less allowance for loan losses ...........           (4,270)           (3,404)           (2,377)           (1,656)           (1,215)                                                   ---------         ---------         ---------         ---------         ---------      Total net loans .....................        $ 371,656         $ 293,207         $ 199,732         $ 134,729         $  95,737                                                   =========         =========         =========         =========         =========   A certain degree of risk is inherent in the extension of credit.  Management has established  loan and credit  policies  designed  to control  both the types and amounts of risks  assumed  and to  ultimately  minimize  losses.  Such  policies include   limitations  on   loan-to-collateral   values  for  various  types  of collateral,  requirements for appraisals of real estate collateral, problem loan management  practices and collection  procedures,  and nonaccrual and charge-off guidelines.                                           9                    SOUTHCOAST FINANCIAL CORPORATION AND SUBSIDIARY                       Management's Discussion and Analysis                       Loan Portfolio Composition - continued  Commercial loans primarily represent loans made to businesses and may be made on either a secured or an unsecured basis.  Approximately  44.7% of our bank's loan portfolio  at December 31, 2005 was composed of  commercial  loans.  When taken, collateral  may  consist  of  liens  on  receivables,   equipment,  inventories, furniture and fixtures and other business assets, but will usually be local real estate.  Commercial  loans are usually  made to  businesses  to provide  working capital,  expand  physical  assets or  acquire  assets.  Commercial  loans  will generally  not  exceed  a  20-year   maturity  and  will  usually  have  regular amortization  payments.  Commercial  loans  to most  business  entities  require guarantees of their  principals.  Commercial  lending involves  significant risk because  repayment  usually  depends on the cash flows generated by a borrower's business, and the debt service capacity of a business can deteriorate because of downturns  in national  and local  economic  conditions,  as well as  situations particular to a borrower's  business or industry.  To control risk,  initial and continuing financial analysis of a borrower's financial information is required.  Real  estate  construction  loans  represent  11.1%  of the loan  portfolio  and typically consist of financing the construction of 1-4 family dwellings and some non-farm,  non-residential real estate. Usually, loan-to-cost ratios are limited to 80% and permanent financing commitments are required prior to the advancement of loan proceeds.  Loans secured by real estate mortgages comprised nearly 43.3% of our bank's loan portfolio at December 31, 2005.  Residential real estate loans consist mainly of first and second mortgages on single family homes, with some multifamily  loans. Loan-to-value  ratios  for  these  instruments  are  generally  limited  to 80%. Non-farm,   non-residential   loans  are  secured  by  business  and  commercial properties acquired using the loan proceeds and having loan-to-value ratios that are  generally  limited to 80%. The repayment of both  residential  and business real estate  loans is  dependent  primarily  on the income and cash flows of the borrowers,  with the real estate serving as a secondary or liquidation source of repayment.  The change in our bank's loan mix at December 31, 2005 from December 31, 2004 is the direct result of  management's  decision to retain some of the variable rate mortgage loans  originated by our bank in our loan portfolio.  We still sell the majority of our mortgage loans in order to fund higher yielding commercial loans and the continuation of a strong  commercial  lending presence in the Charleston area.               Maturity and Interest Sensitivity Distribution of Loans           The following table sets forth the maturity  distribution of our loans, by type,  at December 31, 2005, as well as the type of interest  requirement  on such loans.                                                                                            Over One                                                                                           Year             Over                                                                        One Year         Through            Five (Dollars in thousands)                                                  or Less        Five Years          Years             Total                                                                         -------        ----------          -----             -----      Commercial .................................................          $ 48,013          $ 18,819          $101,161          $167,993 Real estate - construction .................................            15,842             4,243            21,531            41,616 Real estate - mortgage .....................................            32,052            17,836           112,828           162,716 Consumer ...................................................               958             1,536             1,107             3,601                                                                       --------          --------          --------          --------                                                                       $ 96,865            42,434          $236,627          $375,926                                                                       ========          ========          ========          ======== Predetermined rate, maturity greater      than one year .........................................                            $ 23,716          $ 26,504          $ 50,220 Variable rate or maturity within one year ..................          $ 96,865          $ 18,719          $210,123          $325,706                                           10                    SOUTHCOAST FINANCIAL CORPORATION AND SUBSIDIARY                       Management's Discussion and Analysis                      Nonperforming Loans, Other Problem Assets  When a loan is 90 days past due on  interest  or  principal  or there is serious doubt  as to  collectibility,  the  accrual  of  interest  income  is  generally discontinued  unless  the  estimated  net  realizable  value  of  collateral  is sufficient to assure the  likelihood of collection of the principal  balance and accrued interest.  When the  collectibility of a significant amount of principal is in serious  doubt,  the principal  balance is reduced to the  estimated  fair value of  collateral  by a charge-off  to the  allowance for loan losses and any subsequent collections are credited first to the remaining principal balance and then to the allowance for loan losses as a recovery of the amount charged off. A nonaccrual loan is not returned to accrual status unless  principal and interest are current and the borrower  has  demonstrated  the ability to continue  making payments as agreed.  At December 31, 2005, we had $571,455 of  nonaccrual  loans and there  were no loans 90 days or more past due as to  principal  or  interest that were not included in nonaccrual loans and no restructured  loans. The gross interest  income which would have been recorded  under the original terms of the loans  amounted to $40,035 in 2005. No interest on  nonaccruing  loans or on any accruing loans which were contractually 90 days or more past due as to principal or interest  payments was included in net income for 2005. At December 31, 2004, we had $924,668 of nonaccrual loans and there were no loans 90 days or more past due as to principal or interest that were not included in nonaccrual  loans.  We had no restructured loans as of December 31, 2005 or 2004.  The following table presents  information on nonperforming loans and real estate acquired in settlement of loans:                                                                                                 December 31,                                                                                              ------------                                                                    2005           2004           2003           2002            2001                                                                    ----           ----           ----           ----            ---- (Dollars in thousands) Nonperforming loans:         Non accrual loans .....................................        $  571         $  925       $     27       $    102         $  815   Past due 90 days or more ..............................             -              -              -              -              -   Other restructured loans ..............................             -              -              -              -              -                                                                  ------         ------       --------       --------         ------      Total nonperforming loans ..........................           571            925             27            102            815 Real estate acquired in settlement   of loans ..............................................             -             70             70              -              -                                                                  ------         ------       --------       --------         ------      Total nonperforming assets .........................        $  571         $  995       $     97       $    102         $  815                                                                  ======         ======       ========       ========         ====== Nonperforming assets as a   percentage of loans and   other real estate .....................................          0.15%          0.34%          0.05%          0.07%          0.84% Allowance for loan losses as a   percentage of nonperforming loans .....................        747.14%        368.13%      8,931.58%      1,625.86%        149.07%                                Potential Problem Loans  Management identifies and maintains a list of potential problem loans. These are loans that are still accruing interest and are not included in nonaccrual status and are not past due 90 days or more. A loan is added to the  potential  problem list when management becomes aware of information about possible credit problems of the borrower  which raises  serious doubts as to the ability of such borrower to comply with the current loan repayment terms.  There were no loans determined by management to be potential problem loans at December 31, 2005.                                  Real Estate Owned  We did not have any real estate owned  pursuant to  foreclosure  at December 31, 2005 and had $70,000 at  December  31,  2004.  Real  estate  owned is  initially recorded at the lower of net loan principal balance or its estimated fair market value  less  estimated  selling  costs.  The  estimated  fair  market  value  is determined by appraisal at the time of acquisition.                                           11                    SOUTHCOAST FINANCIAL CORPORATION AND SUBSIDIARY                       Management's Discussion and Analysis                              Allowance for Loan Losses  The  allowance  for loan  losses is  increased  by direct  charges to  operating expense.  Losses on loans are  charged  against the  allowance  in the period in which  management has determined that it is more likely than not such loans have become uncollectible. Recoveries of previously charged off loans are credited to the allowance.  The table,  "Summary of Loan Loss  Experience,"  summarizes loan balances at the end of each period indicated,  averages for each period, changes in the allowance  arising from charge-offs and recoveries by loan category,  and additions to the allowance which have been charged to expense.  In  reviewing  the adequacy of the  allowance  for loan losses at each year end, management takes into  consideration  the historical loan losses we experienced, current economic conditions affecting the ability of our borrowers to repay, the volume of loans and the trends in delinquent,  nonaccruing and potential problem loans, and the quality of collateral  securing  nonperforming and problem loans. After charging off all known losses, management considers the allowance for loan losses  adequate to cover its estimate of inherent  losses in the loan portfolio as of December 31, 2005.  In calculating the amount required in the allowance for loan losses,  management applies a consistent  methodology  that is updated  quarterly.  The  methodology utilizes a loan risk grading  system and detailed  loan reviews to assess credit risks  and  the  overall  quality  of the  loan  portfolio,  as  well  as  other off-balance  sheet credit risks such as loan  commitments and standby letters of credit. Also, the calculation provides for management's  assessment of trends in national and local economic  conditions that might affect the general quality of the loan  portfolio.  Regulators  review the adequacy of the  allowance for loan losses as part of their  examination of our bank and may require  adjustments to the  allowance  based  upon  information  available  to them at the  time of the examination.  The allowance is not allocated to different segments of the portfolio. We charge losses  from  any  segment  of  the  portfolio  to  the  allowance  without  any allocation.  Summary of Loan Loss Experience                                                                                           Year Ended December 31,                                                                                        -----------------------                                                                 2005            2004          2003            2001          2000                                                                 ----            ----          ----            ----          ----  (Dollars in thousands)       Total loans outstanding at end of period ...............     $ 375,926       $ 296,611      $ 202,109      $ 136,385      $  96,952                                                              =========       =========      =========      =========      ========= Average amount of loans outstanding ....................     $ 335,389       $ 244,861      $ 176,688      $ 117,825      $  91,175                                                              =========       =========      =========      =========      ========= Balance of allowance for loan losses at    beginning of year ...................................     $   3,404       $   2,376      $   1,656      $   1,215      $     941 Loans charged off ......................................             2             122             16             39             47                                                              ---------       ---------      ---------      ---------      ---------    Total charge-offs ...................................             2             122             16             39             47 Recoveries of loans previously charged-off .............             3               4              1              -              -                                                              ---------       ---------      ---------      ---------      --------- Net charge-offs ........................................            (1)            118             15             39             47 Additions to allowance charged to expense ..............           865           1,146            735            480            321                                                              ---------       ---------      ---------      ---------      --------- Balance of allowance for loan losses at    end of year .........................................     $   4,270       $   3,404      $   2,376      $   1,656      $   1,215                                                              =========       =========      =========      =========      ========= Ratios    Net charge-offs during period to average      loans outstanding during period ...................          0.00%           0.05%          0.01%          0.03%          0.05%    Net charge-offs to loans at end of period ...........          0.00%           0.04%          0.01%          0.03%          0.05%    Allowance for loan losses to average loans ..........          1.27%           1.39%          1.34%          1.41%          1.33%    Allowance for loan losses to loans at      end of period .....................................          1.14%           1.15%          1.18%          1.21%          1.25%    Allowance for loan losses to nonperforming      loans at end of period ............................        747.14%         368.13%      8,931.58%      1,625.86%        149.07%    Net charge-offs to allowance for loan losses ........         (0.02)%          3.47%          0.63%          2.36%          3.86%    Net charge-offs to provision for loan losses ........         (0.12)%         10.30%          2.04%          8.13%         14.64%                                            12                    SOUTHCOAST FINANCIAL CORPORATION AND SUBSIDIARY                       Management's Discussion and Analysis                                      Deposits  The  average  amounts and the  average  rates we paid on deposits  for the years ended December 31, 2005, 2004 and 2003 are summarized below:                                                                                   Year Ended December 31,                                                                                -----------------------                                                              2005                        2004                          2003                                                              ----                        ----                          ----                                                                    Average                     Average                      Average (Dollars in thousands)                                  Amount    Rate Paid        Amount     Rate Paid          Amount    Rate Paid                                                         ------    ---------        ------     ---------          ------    ---------        Noninterest bearing demand ........................   $ 34,587       0.00%        $ 27,626        0.00%        $ 20,462        0.00% Interest bearing transaction accounts .............     14,852       0.48           13,317        0.48           11,618        0.46 Savings ...........................................     43,229       1.74           37,098        1.55           25,498        1.48 Time deposits - $100,000 and over .................    138,195       2.85           85,828        2.31           38,921        2.48 Other time deposits ...............................     56,339       3.35           50,369        2.45           61,854        2.50                                                       --------                    --------                     --------      Total deposits ...............................   $287,202       2.46%        $214,238        1.80%        $158,353        1.84%                                                       ========                    ========                     ========   As of December 31, 2005,  we had $161.3  million in time deposits of $100,000 or more,  including  $100.1 million of brokered  certificates of deposit.  Of these time deposits,  approximately  $52.6 million had maturities within three months, $27.7 million had  maturities  over three through six months,  $46.6 million had maturities  over six through twelve months and $34.4 million had maturities over twelve months. Wholesale deposits (certificates of deposit held by corporations, banks,  credit  unions,  etc., on a national  level)  totaled $4.3 million as of December 31, 2005,  compared to $9.4 million in 2004.  We continued  our funding decision made in 2004 to further  reduce  wholesale  deposits  while  increasing brokered  certificates of deposit.  This decision was based on lower rates being paid on brokered certificates of deposit than wholesale deposits. Since brokered certificates  of deposit are  considered  time  deposits  $100,000  and over and wholesale  certificates  of deposit  are other time  deposits,  our  deposit mix reflects an increase in time  deposits  $100,000 and over in 2005 and a decrease in  other  time  deposits.  It is a common  industry  practice  not to  consider wholesale  deposits and time deposits $100,000 and over as core deposits because their retention can be expected to be heavily  influenced by rates offered,  and therefore they have the  characteristics of shorter-term  purchased funds. These deposits  involve  the  maintenance  of  an  appropriate  matching  of  maturity distribution and a diversification  of sources of cash to achieve an appropriate level of liquidity.  Such deposits are generally more volatile and interest rate sensitive than other deposits.                           Junior Subordinated Debentures  In two  separate  transactions  in 2002 and  another  transaction  in  2005,  we established  Southcoast Capital Trusts I, II and III (the "Capital Trusts"),  as non-consolidated  subsidiaries.  The Capital  Trusts  issued and sold a total of 21,655 floating rate securities,  with $1,000  liquidation  amount per security. Institutional  buyers bought 21,000 of the floating rate securities  denominated as preferred  securities  and we bought the other 655 floating  rate  securities which are denominated as common  securities.  The proceeds of those sales, $21.7 million,  were  used by the  Capital  Trusts  to buy  $21.7  million  of  junior subordinated  debentures from us which are reported on our consolidated  balance sheets.  Our $655,000  investment in the common securities of the Capital Trusts is included in "Other assets" on our consolidated  balance sheets. The preferred securities  of the  Capital  Trusts  totaling  $21.7  million  qualify as Tier 1 capital under Federal Reserve Board guidelines, subject to limitations. See Note 10 to the consolidated financial statements for more information about the terms of the junior subordinated debentures.  Debt issuance costs, net of accumulated  amortization,  from junior subordinated debentures  totaled  $357,088  at December  31,  2005 and are  included in other assets on the  consolidated  balance sheet.  Amortization of debt issuance costs from junior subordinated  debentures totaled $13,363 for each of the years ended December 31, 2005, 2004 and 2003, respectively and is reported in other expenses on the consolidated income statement.                                          13                    SOUTHCOAST FINANCIAL CORPORATION AND SUBSIDIARY                       Management's Discussion and Analysis                               Contractual Obligations  The following  table shows the payments due on our  contractual  obligations for the periods shown as of December 31, 2005.                                                                                      Payments due by period                                                                                   ---------------------- (Dollars in thousands)                                    Total           <1 year         1-3 years        3-5 years        >5 years                                                           -----           -------         ---------        ---------        --------       Long-term debt obligations ....................          $88,655          $25,000          $10,000          $18,000          $35,655 Operating lease obligations ...................              112               48               48               16                -                                                          -------          -------          -------          -------          -------          Total ................................          $88,767          $25,048          $10,048          $18,016          $35,655                                                          =======          =======          =======          =======          =======                                 Short-Term Borrowings  At December 31, 2005,  2004 and 2003, we had  outstanding  borrowings due within one year of $25.0  million,  $9  million  and  $100,000  respectively.  With the exception  of $10.0  million  outstanding  at  December  31,  2005,  $2  million outstanding  at December 31, 2004 and $100,000  outstanding at December 31, 2003 on which the interest rates were fixed at 2.91%,  7.07% and 5.84%  respectively, all of the short-term  borrowings were at variable  interest  rates,  which were 4.44% at December  31,  2005,  a weighted  average rate of 2.44% at December 31, 2004, and 1.15% at December 31,2003. All of the short-term  borrowings were from the  Federal  Home Loan Bank of Atlanta  ("FHLBA")  and were  collateralized  by lender  stock  and  residential  mortgage  loans.  The  maximum  amount  of such borrowings at any month end was $67.0  million for 2005,  $58.0 million for 2004 and $41.1 million for 2003. The  approximate  average amount of such  borrowings and average  weighted  interest rate was $54.2 million and 3.56% for 2005, $40.8 million and 3.65% for 2004 and $27.6 million and 4.22%for 2003, respectively.                             Return on Equity and Assets  The  following  table shows the return on assets (net income  divided by average assets),  return on equity  (net  income  divided by average  equity),  dividend payout ratio (dividends  declared per share divided by net income per share) and equity to assets ratio (average  equity divided by average total assets) for the years ended December 31, 2005, 2004 and 2003.                                                   Year ended December 31,                                                  -----------------------                                             2005          2004           2003                                             ----          ----           ----         Return on assets ...............    1.04%         0.98%          0.79%         Return on equity ...............    9.28%         8.56%         10.43%         Dividend payout ratio ..........    0.00%         0.00%          0.00%         Equity to asset ratio ..........   11.16%        11.49%          7.61%  The  return on assets  and  return on  equity  improved  from 2004 to 2005.  The issuance of new common stock at the end of 2005 increased the average equity for 2005 by $10.3  million or 29.61%.  Earnings  did not  increase at the same rate, and,  consequently  our  return on equity  has  decreased.  Our return on assets increases  as we become more  efficient  in growing  our assets.  We have opened seven branch offices since June 1998. In each case, we have incurred substantial pre-opening and start up expenses which have reduced net income. We plan to open an additional  branch in late 2006, and we may open additional  branches when it appears that doing so would be advantageous to us. Any such additional  openings will be likely to have a negative impact on earnings, at least temporarily.                                      Liquidity  The most manageable  sources of liquidity are composed of liabilities,  with the primary focus on liquidity  management  being on the ability to obtain  deposits within our bank's service area. Core deposits (total deposits less  certificates of deposit for $100,000 or more, wholesale and brokered time deposits) provide a relatively  stable  funding  base and were equal to 48.2% of total  deposits  at December 31, 2005. Asset liquidity is provided from several  sources,  including amounts due from banks and federal funds sold and funds from maturing loans. Our bank is a member of the FHLBA and, as such,  has the  ability to borrow  against the security of its 1-4 family residential mortgage loans. At December 31, 2005, our bank had borrowed $67.0 million from the FHLBA and had the ability to borrow an additional $6.0 million from the FHLBA based on a predetermined  formula. Our bank also has $8.8 million available through lines of credit with other banks as an  additional  source of  liquidity  funding.  At  December  31,  2005,  we had outstanding  commitments to make up to $53.0 million in loans as well as standby letters of credit of  $400,938.  Management  believes  that our  bank's  overall liquidity  sources are  adequate  to meet its  operating  needs in the  ordinary course of business.                                         14                    SOUTHCOAST FINANCIAL CORPORATION AND SUBSIDIARY                       Management's Discussion and Analysis                                  Capital Resources  Our equity  capital  increased  by $36.7  million  during  2005 as the result of proceeds from a stock offering of 1,610,000 shares,  netting $32.3 million,  the issuance of 70,559 shares of stock through an employee  stock  purchase plan and the exercise of stock options, netting $678,662 and net operating income of $4.2 million,  offset by a net decrease of unrealized  gains/losses in the investment portfolio  of  $379,537.  A 10% stock  dividend in 2005  caused a transfer  from retained earnings to common stock of $3.3 million.  The transfer represented the amount in retained earnings at the time of the dividend. Book value per share at December 31, 2005 was $14.80 as compared to $11.19 at December 31, 2004.  The Federal  Reserve  Board and bank  regulatory  agencies  require bank holding companies  and financial  institutions  to maintain  capital at adequate  levels based on a percentage of assets and off-balance  sheet  exposures,  adjusted for risk weights ranging from 0% to 100%. Under the risk-based standard,  capital is classified into two tiers. Our Tier 1 capital  consists of common  shareholders' equity minus certain intangible assets plus junior  subordinated debt subject to certain  limitations.  Tier 2 capital  consists of the allowance for loan losses subject to certain limitations. A bank holding company's qualifying capital base for purposes of its  risk-based  capital ratio consists of the sum of its Tier 1 and Tier 2 capital. The regulatory minimum requirements are 4% for Tier 1 and 8% for total  risk-based  capital.  We and our bank are also  required  to maintain capital at a minimum level based on quarterly average assets,  which is known as the leverage  ratio.  Only the  strongest  bank holding  companies and banks are allowed to maintain capital at the minimum  requirement.  All others are subject to maintaining ratios 100 to 200 basis points above the minimum.  As of December 31, 2005, we and our subsidiary bank exceeded our capital  requirements as shown in the following table.                                                                                           Capital Ratios                                                                                        --------------                                                                                        Well Capitalized      Adequately Capitalized (Dollars in thousands)                                              Actual               Requirement                Requirement                                                                     ------               -----------                -----------                                                              Amount     Ratio        Amount        Ratio       Amount     Ratio                                                              ------     -----        ------        -----       ------     ----- Our Bank          Total capital (to risk-weighted assets) ............      $39,034     12.03%      $32,453       10.00%      $25,962      8.00%   Tier 1 capital (to risk-weighted assets) ...........       35,194     10.84%       19,472        6.00%       12,981      4.00%   Tier 1 capital (to average assets) .................       35,194      8.22%       21,403        5.00%       17,122      4.00% Southcoast Financial Corporation   Total capital (to risk-weighted assets) ............      $99,547     29.03%          N/A         N/A       $27,432      8.00%(1)   Tier 1 capital (to risk-weighted assets) ...........       95,277     27.79%          N/A         N/A        13,716      4.00%(1)   Tier 1 capital (to average assets) .................       95,277     21.36%          N/A         N/A        17,842      4.00%(1)  - ----- (1) Minimum requirements for bank holding companies. Bank holding companies with higher levels of risks, or that are  experiencing  or  anticipating  significant growth, are also expected to maintain capital well above the minimums.                           Off-Balance Sheet Arrangements  At  December  31,  2005,  we had issued  commitments  to extend  credit of $52.9 million for home equity lines of credit, construction loans and commercial lines of credit. The commitments expire over periods from six months to ten years.  Standby letters of credit totaled $400,938 at December 31, 2005. Past experience indicates that many of these commitments to extend credit and standby letters of credit will expire unused. However, through our various sources of liquidity, we believe  that we will have the  necessary  resources  to fund these  obligations should  the  need  arise.  See  Note 16 to the  consolidated  audited  financial statements for further information about financial  instruments with off-balance sheet risk.  We are not involved in other off-balance sheet contractual relationships, and we have no unconsolidated related entities that have off-balance sheet arrangements or  transactions  that could result in liquidity  needs or other  commitments or significantly impact earnings.                                           15                    SOUTHCOAST FINANCIAL CORPORATION AND SUBSIDIARY                       Management's Discussion and Analysis                                      Inflation  Since the assets and  liabilities  of a bank are  primarily  monetary  in nature (payable in fixed,  determinable amounts), the performance of a bank is affected more by changes in interest rates than by inflation.  Interest  rates  generally increase as the rate of inflation increases,  but the magnitude of the change in rates may not be the same as the magnitude of the change in inflation.  While the effect of inflation on banks is normally not as  significant as is its influence  on those  businesses  which  have  large  investments  in  plant  and inventories, it does have an effect. During periods of high inflation, there are normally  corresponding  increases in the money supply,  and banks will normally experience  above-average  growth in assets,  loans and deposits.  Also, general increases in the prices of goods and services will result in increased operating expenses.                                           16                           REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM    Board of Directors Southcoast Financial Corporation and Subsidiaries Mt. Pleasant, South Carolina   We have  audited the  accompanying  consolidated  balance  sheets of  Southcoast Financial  Corporation and Subsidiaries  (the "Company") as of December 31, 2005 and 2004 and the related consolidated statements of income, shareholders' equity and comprehensive  income and cash flows for each of the years in the three year period ended December 31, 2005. 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  audits to  obtain  reasonable  assurance  about  whether  the consolidated  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  consolidated  financial  position  of Southcoast Financial  Corporation and Subsidiaries at December 31, 2005 and 2004 and the results of their  operations and cash flows for each of the years in the three year period  ended  December  31,  2005,  in  conformity  with  accounting principles generally accepted in the United States of America.    Elliott Davis, LLC Columbia, South Carolina February 3, 2006                                            17                    SOUTHCOAST FINANCIAL CORPORATION AND SUBSIDIARIES                             Consolidated Balance Sheets                                                                                                                December 31,                                                                                                             ------------                                                                                                     2005                    2004                                                                                                     ----                    ---- Assets    Cash and due from banks ...........................................................           $  14,377,737            $  11,853,273 Federal funds sold ................................................................              16,964,000                4,236,000                                                                                               -------------            -------------         Cash and cash equivalents ..................................................              31,341,737               16,089,273  Investment securities    Available for sale .............................................................              31,482,927               21,738,335    Federal Home Loan Bank stock, at cost ..........................................               3,720,100                3,093,100 Loans held for sale ...............................................................               9,275,492               12,009,550 Loans, net ........................................................................             371,656,054              293,206,968 Property and equipment, net .......................................................              19,898,188               14,843,884 Other assets ......................................................................               9,224,867                5,122,013                                                                                               -------------            -------------         Total assets ...............................................................           $ 476,599,365            $ 366,103,123                                                                                               =============            =============  Liabilities and shareholders' equity Deposits    Noninterest bearing ............................................................           $  38,753,579            $  27,954,739    Interest bearing ...............................................................             272,800,370              230,198,544                                                                                               -------------            -------------         Total deposits .............................................................             311,553,949              258,153,283  Advances from Federal Home Loan Bank ..............................................              67,000,000               58,000,000 Junior subordinated debentures ....................................................              21,655,000               11,345,000 Other liabilities .................................................................               3,075,871                2,034,091                                                                                               -------------            -------------         Total liabilities ..........................................................             403,284,820              329,532,374                                                                                               -------------            -------------  Commitments and contingencies - Notes 11 and 16 Shareholders' equity    Common stock, no par value, 20,000,000 shares authorized,      4,954,210 and 2,970,663 shares issued in 2005 and      2004, respectively ...........................................................              70,267,702               34,080,782 Retained earnings .................................................................               3,300,753                2,364,340 Accumulated other comprehensive income (loss) .....................................                (253,910)                 125,627                                                                                               -------------            -------------         Total shareholders' equity .................................................              73,314,545               36,570,749                                                                                               -------------            -------------         Total liabilities and shareholders' equity .................................           $ 476,599,365            $ 366,103,123                                                                                               =============            =============        The accompanying notes are an integral part of these consolidated financial statements.                                          18                   SOUTHCOAST FINANCIAL CORPORATION AND SUBSIDIARIES                          Consolidated Statements of Income                                                                                                 For the years ended December 31,                                                                                             --------------------------------                                                                                       2005               2004              2003                                                                                       ----               ----              ---- Interest income        Loans and fees on loans .............................................         $22,206,089         $15,519,379         $11,910,923    Investment securities, taxable ......................................           1,342,552             985,308             420,743    Federal funds sold ..................................................             340,320              90,742             130,011                                                                                  -----------         -----------         -----------        Total interest income ...........................................          23,888,961          16,595,429          12,461,677 Interest expense    Deposits ............................................................           7,057,332           3,861,181           2,911,120    Advances from Federal Home Loan Bank ................................           1,932,780           1,488,737           1,164,364    Junior subordinated debentures ......................................             984,820             553,646             527,916                                                                                  -----------         -----------         -----------        Total interest expense ..........................................           9,974,932           5,903,564           4,603,400                                                                                  -----------         -----------         -----------        Net interest income .............................................          13,914,029          10,691,865           7,858,277 Provision for loan losses ..............................................             865,067           1,146,495             735,000                                                                                  -----------         -----------         -----------        Net interest income after provision for loan losses .............          13,048,962           9,545,370           7,123,277 Noninterest income    Service fees on deposit accounts ....................................             926,587             947,932             893,926    Gain on sale of mortgage loans ......................................             551,411             396,464             628,019    Gain on sale of investment securities ...............................              79,794              21,689                   -    Gain on sale of property and equipment ..............................             988,498           1,163,485                   -    Other ...............................................................             179,022             170,369             189,394                                                                                  -----------         -----------         -----------        Total noninterest income ........................................           2,725,312           2,699,939           1,711,339                                                                                  -----------         -----------         ----------- Noninterest expenses    Salaries and employee benefits ......................................           5,711,173           4,889,216           3,800,401    Occupancy ...........................................................             602,947             451,274             387,399    Furniture and equipment .............................................             688,373             688,812             652,072    Advertising and public relations ....................................             246,234             197,023             100,274    Professional fees ...................................................             367,418             308,574             267,780    Travel and entertainment ............................................             271,519             251,823             203,283    Telephone, postage and supplies .....................................             342,337             312,722             262,969    Insurance ...........................................................             139,429             123,341             110,591    Other operating .....................................................             873,804             742,846             386,427                                                                                  -----------         -----------         -----------        Total noninterest expenses ......................................           9,243,234           7,965,631           6,171,196                                                                                  -----------         -----------         -----------        Income before income taxes ......................................           6,531,040           4,279,678           2,663,420 Income tax expense .....................................................           2,341,647           1,297,957             959,177                                                                                  -----------         -----------         -----------        Net income ......................................................         $ 4,189,393         $ 2,981,721         $ 1,704,243                                                                                  ===========         ===========         =========== Basic net income per common share(1) ...................................                1.17         $      0.91         $      0.83                                                                                  ===========         ===========         =========== Diluted net income per common share(1) .................................                1.17         $      0.90         $      0.82                                                                                  ===========         ===========         =========== Weighted average number of common    shares outstanding(1)      Basic .............................................................           3,582,908           3,260,475           2,042,180                                                                                  ===========         ===========         ===========      Diluted ...........................................................           3,587,165           3,306,925           2,090,696                                                                                  ===========         ===========         ===========  - ----------- (1) Adjusted for the effects of stock dividends       The accompanying notes are an integral part of these consolidated financial statements.                                          19                   SOUTHCOAST FINANCIAL CORPORATION AND SUBSIDIARIES      Consolidated Statements of Shareholders' Equity and Comprehensive Income                   Years ended December 31, 2005, 2004 and 2003                                                                                                         Accumulated                                                             Common Stock                                 other             Total                                                             ------------               Retained      comprehensive     shareholders'                                                        Shares          Amount          earnings       income (loss)        equity                                                        ------          ------          --------       -------------        ------       Balance, December 31, 2002 ....................       1,321,996     $ 12,329,437     $    338,794     $     41,221     $ 12,709,452                                                                                                                        ------------   Net income ..................................               -                -        1,704,243                -        1,704,243   Other comprehensive income:     Unrealized holding gains on       securities available for sale,       net of taxes of $59,928 .................               -                -                -           71,163           71,163                                                                                                                        ------------   Comprehensive income ........................                                                                           1,775,406   Stock dividends (15%) .......................         205,016        2,043,037       (2,043,037)               -                -   Stock offering (net of offering     costs of $1,669,716) ......................       1,104,000       18,754,284                -                -       18,754,284   Exercise of stock options ...................          52,373          246,826                -                -          246,826   Employee stock purchase plan ................           3,116           36,943                -                -           36,943   Repurchase of stock .........................          (6,000)        (112,500)               -                -         (112,500)                                                       ---------     ------------     ------------     ------------     ------------ Balance, December 31, 2003 ....................       2,680,501       33,298,027                -          112,384       33,410,411                                                                                                                        ------------   Net income ..................................                                          2,981,721                        2,981,721   Other comprehensive income:     Unrealized holding gains on       securities available for sale,       net of taxes of $14,857 .................                                                             27,524           27,524     Less reclassification adjustment       for gains included in net income,       net of taxes of $7,408 ..................                                                            (14,281)         (14,281)                                                                                                                        ------------   Comprehensive income ........................                                                                           2,994,964   Exercise of stock options ...................          14,082           60,288                                             60,288   Employee stock purchase plan ................           6,488          105,086                                            105,086   Stock dividends (10%) .......................         269,592          617,381         (617,381)                                -                                                       ---------     ------------     ------------     ------------     ------------ Balance, December 31, 2004 ....................       2,970,663       34,080,782        2,364,340          125,627       36,570,749   Net income ..................................                                         4,189,393                         4,189,393   Other comprehensive income:     Unrealized holding losses on       securities available for sale,       net of tax benefit of $270,275 ..........                                                           (326,873)        (326,873)     Less reclassification adjustment       for gains included in net income,       net of taxes of $27,130 .................                                                            (52,664)         (52,664)                                                                                                                        ------------   Comprehensive income ........................                                                                           3,809,856   Stock dividend (10%) ........................         302,988        3,252,980       (3,252,980)                                -   Stock offering (net of offering     costs of $2,359,722) ......................       1,610,000       32,255,278                                         32,255,278   Exercise of stock options ...................          55,166          335,350                                            335,350   Issuance of stock ...........................           8,350          202,738                                            202,738   Employee stock purchase plan ................           7,043          140,574                                            140,574                                                       ---------     ------------     ------------     ------------     ------------ Balance, December 31, 2005 ....................       4,954,210     $ 70,267,702     $  3,300,753     $   (253,910)    $ 73,314,545                                                       =========     ============     ============     ============     ============        The accompanying notes are an integral part of these consolidated financial statements.                                           20                   SOUTHCOAST FINANCIAL CORPORATION AND SUBSIDIARIES                        Consolidated Statements of Cash Flows                                                                                                For the years ended December 31,                                                                                             --------------------------------                                                                                       2005               2004                2003                                                                                       ----               ----                ---- Operating activities        Net income .............................................................     $   4,189,393      $   2,981,721      $   1,704,243    Adjustments to reconcile net income to net cash      used for operating activities        Deferred income taxes ..............................................        (1,030,024)          (207,053)          (175,663)        Provision for loan losses ..........................................           865,067          1,146,495            735,000        Depreciation and amortization ......................................           574,063            571,133            492,102        Origination of loans held for sale .................................       (60,945,036)       (40,438,086)       (48,098,007)        Proceeds from sale of loans held for sale ..........................        63,679,094         28,855,536         56,353,566        Gain on sale of investment securities ..............................           (79,794)           (21,689)                 -        Gain on sale of property and equipment .............................          (988,498)        (1,163,485)                 -        Decrease (increase) in other assets ................................          (245,415)           398,716         (1,304,549)        Increase (decrease) in other liabilities ...........................         1,041,780           (420,361)            21,100                                                                                 -------------      -------------      -------------           Net cash provided by (used for) operating activities .............         7,060,630         (8,297,073)         9,727,792                                                                                 -------------      -------------      -------------  Investing activities    Proceeds from maturities/calls of available for sale securities ........         7,238,962         12,090,348                                                                                                                           7,154,359    Proceeds from sale of available for sale securities ....................         2,775,067         21,361,689                  -    Purchase of available for sale securities ..............................       (20,311,026)       (35,194,416)       (21,086,552)    Purchase of Federal Home Loan Bank stock ...............................        (2,494,500)        (2,458,100)          (890,000)    Sale of Federal Home Loan Bank stock ...................................         1,867,500          1,420,000            150,000    Increase in loans, net .................................................       (79,314,153)       (94,621,267)       (65,807,969)    Purchase of property and equipment .....................................        (7,005,850)       (10,493,569)        (1,821,383)    Purchase of bank owned life insurance ..................................        (2,600,000)                 -                  -    Proceeds from sale of property and equipment ...........................         2,391,228          5,694,035                  -                                                                                 -------------      -------------      -------------           Net cash used for investing activities ...........................       (97,452,772)      (102,201,280)       (82,301,545)                                                                                 -------------      -------------      -------------  Financing activities    Net increase in deposits ...............................................        53,400,666         91,940,876         33,556,990    Increase in other borrowings ...........................................         9,000,000         16,900,000         17,600,000    Proceeds from junior subordinated debentures ...........................        10,310,000                  -                  -    Repurchase of common stock .............................................                 -                  -           (112,500)    Proceeds from stock offering, net ......................................        32,255,278                  -         18,754,284    Proceeds from exercise of stock options ................................           335,350             60,288            246,826    Issuance of stock ......................................................           202,738                  -                  -    Proceeds from employee stock purchase plan .............................           140,574            105,086             36,943                                                                                 -------------      -------------      -------------           Net cash provided by financing activities ........................       105,644,606        109,006,250         70,082,543                                                                                 -------------      -------------      -------------           Net increase (decrease) in cash and cash equivalents .............        15,252,464         (1,492,103)        (2,491,210)  Cash and cash equivalents, beginning of year ..............................        16,089,273         17,581,376         20,072,586                                                                                 -------------      -------------      -------------  Cash and cash equivalents, end of year ....................................     $  31,341,737      $  16,089,273      $  17,581,376                                                                                 =============      =============      ============= Cash paid for    Interest ...............................................................     $   9,429,973      $   5,306,323      $   4,733,898                                                                                 =============      =============      =============    Income taxes ...........................................................     $   2,083,102      $   1,353,700      $   1,006,950                                                                                 =============      =============      =============        The accompanying notes are an integral part of these consolidated financial statements.                                          21                   SOUTHCOAST FINANCIAL CORPORATION AND SUBSIDIARIES                    Notes to Consolidated Financial Statements    NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND ACTIVITIES  Southcoast Financial Corporation (the "Company") is a South Carolina corporation organized  in 1999 for the  purpose of being a holding  company  for  Southcoast Community  Bank (the  "Bank").  During 2004,  Southcoast  Investments,  Inc. was formed as a wholly-owned subsidiary of the Company. Southcoast Investments, Inc. was formed  primarily to hold  properties of the Company and Bank. The Company's primary  purpose is that of owning the Bank.  The  Company is  regulated  by the Federal  Reserve  Board.  The  consolidated  financial  statements  include  the accounts of the  Company  and its  subsidiaries.  All  significant  intercompany accounts and transactions  have been eliminated in  consolidation.  The Bank was incorporated  in 1998 and operates as a South Carolina  chartered bank providing full banking services to its customers. The Bank is subject to regulation by the South Carolina  State Board of Financial  Institutions  and the Federal  Deposit Insurance Corporation.  During 2005, the Company formed Southcoast Capital Trust III for the purpose of issuing trust preferred  securities.  Southcoast  Capital Trust I and II were  formed in 2002 for the same  purpose.  In  accordance  with current accounting guidance,  the Trusts are not consolidated in these financial statements.  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  and  disclosure  of  contingent  assets and liabilities as of the date of the financial  statements and the reported amounts of income and expenses during the reporting periods. Actual results could differ from those estimates.  Concentrations of Credit Risk - Financial instruments, which potentially subject the Company to  concentrations  of credit  risk,  consist  principally  of loans receivable,  investment  securities,  federal  funds sold and  amounts  due from banks.  The Company makes loans to individuals and small businesses for various personal and commercial  purposes primarily in the South Carolina counties of Charleston, Berkeley,  and Dorchester.  The Company's loan portfolio is not  concentrated in loans  to any  single  borrower  or a  relatively  small  number  of  borrowers. Additionally,  management is not aware of any concentrations of loans to classes of  borrowers  or  industries  that  would be  similarly  affected  by  economic conditions  except for loans  secured  by  commercial  real  estate and non real estate loans and  residential  1-4 family  dwellings.  These  concentrations  of commercial  loans  and  1-4  family  dwelling  loans  totaled  $167,992,872  and $162,716,005,  respectively,  at December 31, 2005,  representing 229% and 222%, respectively,  of total  equity  and 45% and  44%,  respectively,  of net  loans receivable.  In  addition  to  monitoring  potential  concentrations  of loans to  particular borrowers or groups of borrowers,  industries and geographic regions, management monitors  exposure to credit risk from  concentrations  of lending  products and practices such as loans that subject borrowers to substantial  payment increases (e.g.  principal  deferral periods,  loans with initial  interest-only  periods, etc), and loans with high loan-to-value  ratios.  Management has determined that there is no concentration of credit risk associated with its lending policies or practices.  Additionally,  there are industry  practices  that could subject the Company to  increased  credit risk should  economic  conditions  change over the course of a loan's life. For example,  the Company makes variable rate loans and fixed rate  principal-amortizing  loans with maturities  prior to the loan being fully paid (i.e.  balloon  payment  loans).  These  loans are  underwritten  and monitored to manage the associated risks.  Therefore,  management  believes that these particular practices do not subject the Company to unusual credit risk.  The Company's  investment  portfolio consists  principally of obligations of the United States, its agencies or its corporations and general obligation municipal securities.  In the opinion of Management,  there is no  concentration of credit risk  in  its  investment  portfolio.   The  Company  places  its  deposits  and correspondent  accounts  with  and  sells  its  federal  funds  to high  quality institutions.  Management  believes credit risk  associated  with  correspondent accounts is not significant.                                           22                   SOUTHCOAST FINANCIAL CORPORATION AND SUBSIDIARIES                    Notes to Consolidated Financial Statements  NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND ACTIVITIES - continued  Investment  Securities  - The Company  accounts  for  investment  securities  in accordance  with  Statement of Financial  Accounting  Standards  (SFAS) No. 115, "Accounting  for  Certain  Investments  in  Debt  and  Equity  Securities".  The Statement  requires  investments in equity and debt  securities to be classified into three categories:       Available-for-sale: These are securities which are not classified as either      held to maturity or as trading securities. These securities are reported at      fair market value.  Unrealized gains and losses are reported, net of income      taxes, as separate  components of shareholders'  equity  (accumulated other      comprehensive  income).  Gains or losses on  dispositions of securities are      based on the difference  between the net proceeds and the adjusted carrying      amount of the securities  sold, using the specific  identification  method.      Premiums and discounts are amortized into interest  income by a method that      approximates a level yield.       Held-to-maturity:  These  are debt  securities  which the  Company  has the      ability and intent to hold until maturity.  These  securities are stated at      cost, adjusted for amortization of premiums and the accretion of discounts.      The Company has no held to maturity securities.       Trading: These are securities which are bought and held principally for the      purpose of selling in the near future.  Trading  securities are reported at      fair market value,  and related  unrealized gains and losses are recognized      in the income statement. The Company has no trading securities.  Loans  Held-for-Sale  - Loans held for sale consist of 1 - 4 family  residential mortgage  loans.  They are  reported at the lower of cost or market  value on an aggregate loan basis. Net unrealized  losses,  if any, are recognized  through a valuation  allowance.  Gains or  losses  realized  on the  sales  of  loans  are recognized at the time of sale and are determined by the difference  between the net sales proceeds and the carrying value of loans sold.  Loans,  Interest  and Fee  Income on Loans - Loans are  stated at the  principal balance outstanding.  The allowance for loan losses is deducted from total loans in the balance sheet. Interest income is recognized on an accrual basis over the term of the loan based on the principal amount outstanding.  Loans are  generally  placed on  non-accrual  status when  principal or interest becomes  contractually  ninety  days past due,  or when  payment  in full is not anticipated.  When a loan is placed on non-accrual status,  interest accrued but not received is generally reversed against interest income. If collectibility is in doubt,  cash  receipts  on  non-accrual  loans are not  recorded  as interest income,  but are used to reduce  principal.  Loans are not  returned  to accrual status unless  principal and interest are current and the borrower  demonstrates the ability to continue making payments as agreed.  Loans on non-accrual  status as well as real estate  acquired  through  foreclosure  or deed taken in lieu of foreclosure are considered non-performing assets.  Allowance for Loan Losses - The  provision for loan losses  charged to operating expenses  reflects the amount deemed  appropriate  by management to establish an adequate  reserve to meet the  estimated  losses  inherent in the  current  loan portfolio.  Management's judgment is based on periodic and regular evaluation of individual  loans,  the overall risk  characteristics  of the various  portfolio segments,  past experience with losses, and prevailing and anticipated  economic conditions.  Loans which are determined to be uncollectible  are charged against the allowance.  The provision for loan losses and recoveries on loans previously charged off are added to the allowance.  The  Company  accounts  for  impaired  loans in  accordance  with SFAS No.  114, "Accounting by Creditors for Impairment of a Loan".  This standard requires that all lenders  value each loan at the loan's fair value if it is probable that the lender will be unable to collect all amounts due  according  to the terms of the loan  agreement.  Fair value may be  determined  based upon the present value of expected cash flows,  market price of the loan,  if  available,  or value of the underlying collateral.  Expected cash flows are required to be discounted at the loan's effective interest rate.  Under SFAS No. 114, as amended by SFAS No. 118, when the ultimate collectibility of an impaired  loan's  principal  is in doubt,  wholly or  partially,  all cash receipts are applied to principal.  Once the reported principal balance has been reduced to zero,  future cash  receipts are applied to interest  income,  to the extent that any interest has been  foregone.  Further cash receipts are recorded as recoveries of any amounts previously charged off.  A loan is also considered  impaired if its terms are modified in a troubled debt restructuring.  For these accruing  impaired loans,  cash receipts are typically applied to principal and interest receivable in accordance with the terms of the restructured loan agreement.  Interest income is recognized on these loans using the accrual method of accounting.                                           23                   SOUTHCOAST FINANCIAL CORPORATION AND SUBSIDIARIES                    Notes to Consolidated Financial Statements  NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND ACTIVITIES - continued  As of December 31, 2005 and 2004, the Company's  impaired loans were  equivalent to nonaccrual loans, as discussed in Note 6.  Property and  Equipment - Property,  furniture and equipment are stated at cost, net  of   accumulated   depreciation.   Depreciation   is  computed   using  the straight-line  method over the  estimated  useful  lives of the related  assets. Maintenance and repairs are charged to operations,  while major improvements are capitalized.   Upon  retirement,   sale,  or  other  disposition  the  cost  and accumulated  depreciation are eliminated from the accounts,  and gain or loss is included in income from operations.  Debt Issuance Costs - Issuance  costs  associated  with the junior  subordinated debentures  are  amortized  over the life of the debt  using  the  straight-line method, which approximates the effective yield method.  Income Taxes - The financial statements have been prepared on the accrual basis. When income and  expenses are  recognized  in  different  periods for  financial reporting  purposes  versus for  purposes of computing  income  taxes  currently payable, deferred taxes are provided on such temporary differences.  The Company accounts  for income  taxes in  accordance  with SFAS No. 109,  "Accounting  for Income  Taxes".  Under SFAS No. 109,  deferred  tax assets and  liabilities  are recognized  for the expected  future tax  consequences  of events that have been recognized  in the financial  statements or tax return.  Deferred tax assets and liabilities  are  measured  using the  enacted  tax rates  expected  to apply to taxable income in the years in which those temporary differences are expected to be realized or settled.  Advertising  Expense -  Advertising  and public  relations  costs are  generally expensed as incurred. External costs incurred in producing media advertising are expensed the first time the advertising takes place.  External costs relating to direct mailing costs are expensed in the period in which the direct mailings are sent. Advertising and public relations costs of $246,234,  $197,023 and $100,274 were included in the Company's  results of operations  for 2005,  2004 and 2003, respectively.  Net Income Per Common  Share - Net income per common  share is  computed  on the basis of the weighted average number of common shares  outstanding in accordance with SFAS No. 128,  "Earnings per Share".  The treasury  stock method is used to compute the effect of stock  options on the  weighted  average  number of common shares  outstanding  for  diluted  earnings  per share.  The Board of  Directors declared and paid a ten percent stock  dividend in June 2005 and in May 2004 and 2003,  and a five percent stock  dividend in August 2003. Per share amounts have been retroactively restated to reflect the stock dividends.  Statement of Cash Flows - For purposes of  reporting  cash flows,  cash and cash equivalents  are defined as those amounts  included in the balance sheet caption "Cash and Due From Banks" and "Federal  Funds  Sold." Cash and cash  equivalents have an original maturity of three months or less.  Fair Value of  Financial  Instruments  - SFAS No. 107,  "Disclosures  About Fair Value of  Financial  Instruments,"  as amended by SFAS No. 119 and SFAS No. 133, requires disclosure of fair value information for financial instruments, whether or not recognized in the balance  sheet,  when it is practicable to estimate the fair value. SFAS No. 107 defines a financial  instrument as cash, evidence of an ownership  interest in an entity or  contractual  obligations  which require the exchange of cash or other financial instruments.  Certain items are specifically excluded from the disclosure requirements, including the Company's common stock. In addition,  other nonfinancial  instruments such as property and equipment and other assets and liabilities are not subject to the disclosure requirements.  The  following  methods and  assumptions  were used by the Company in estimating fair values of financial instruments as disclosed herein:      Cash and due from  banks - The  carrying  amounts  reported  in the  balance     sheets  for cash and due from  banks  (cash  on  hand,  due from  banks  and     interest bearing deposits with other banks) approximate their fair values.      Federal funds sold - The carrying  amounts of federal funds sold approximate their fair values.      Investment  securities  available  for  sale - Fair  values  for  investment securities available for sale are based on quoted market prices.                                           24                   SOUTHCOAST FINANCIAL CORPORATION AND SUBSIDIARIES                    Notes to Consolidated Financial Statements  NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND ACTIVITIES - continued  Fair Value of Financial Instruments (continued)       Federal  Home Loan Bank stock - The  carrying  amounts of Federal Home Loan      Bank stock approximate their fair values.       Loans  held  for  sale - The  carrying  amounts  of  loans  held  for  sale      approximate their fair values.       Loans - For variable rate loans that reprice  frequently and for loans that      mature within three months,  fair values are based on carrying values. Fair      values  for all  other  loans  are  estimated  using  discounted  cash flow      analyses,  with  interest  rates  currently  being  offered  for loans with      similar  terms to  borrowers  of similar  credit  quality.  Fair values for      impaired  loans  are  estimated  using  discounted  cash flow  analyses  or      underlying collateral values, where applicable.       Deposits  -  The  fair  values  disclosed  for  deposits  with  no  defined      maturities is equal to their  carrying  amounts which  represent the amount      payable on demand. The carrying amounts for variable rate, fixed-term money      market  accounts  approximate  their fair value at the reporting date. Fair      values  for  fixed-rate  certificates  of  deposit  are  estimated  using a      discounted  cash flow  calculation  that applies  interest rates  currently      being offered on certificates to a schedule of aggregated  expected monthly      maturities.       Advances from the Federal Home Loan Bank and Junior subordinated debentures      - For other  borrowings that reprice  frequently,  fair values are based on      carrying  values.  Fair values for all other borrowings are estimated using      discounted  cash flow  analyses,  based on the Bank's  current  incremental      borrowing rates for similar types of borrowing arrangements.       Off-balance  sheet  instruments - Fair values of off-balance  sheet lending      commitments  are based on fees  currently  charged  to enter  into  similar      agreements,  taking into account the remaining  terms of the agreements and      the counterparties' credit standing.  Stock Based Compensation - The Company has a stock-based  employee  compensation plan which is further  described  in Note 18. The Company  accounts for the plan under the recognition and measurement  principles of Accounting Principles Board ("APB") Opinion No. 25,  "Accounting for Stock Issued to Employees," and related Interpretations.  No stock-based employee  compensation cost is reflected in net income,  as all stock options  granted  under these plans had an exercise  price equal to the market value of the  underlying  common stock on the date of grant. There were 22,990 options granted in 2004. There were no options granted in 2005 or 2003. The following  table  illustrates the effect on net income and earnings per share as if the Company had applied the fair value recognition provisions of Financial  Accounting Standards Board ("FASB") Statement of Financial Accounting Standards  ("SFAS")  No.  123,  Accounting  for  Stock-Based  Compensation,   to stock-based employee compensation for options granted in 2004.                                                                                             For the years ended December 31,                                                                                          --------------------------------                                                                                2005                    2004               2003                                                                                ----                    ----               ----     Net income, as reported .......................................         $     4,189,393         $    2,981,721        $    1,704,243 Deduct:  Total stock-based employee   compensation expense determined   under fair value based method   for all awards, net of related tax effects ..................                       -                 91,113                     -                                                                         ---------------         --------------         -------------  Pro forma net income ..........................................         $     4,189,393         $    2,890,608        $    1,704,243                                                                         ===============         ==============         =============  Earnings per share:   Basic - as reported .........................................         $          1.17         $         0.91         $        0.83                                                                         ===============         ==============         =============   Basic - pro forma ...........................................         $          1.17         $         0.89         $        0.83                                                                         ===============         ==============         =============    Diluted - as reported .......................................         $          1.17         $         0.90         $        0.82                                                                         ===============         ==============         =============   Diluted - pro forma .........................................         $          1.17         $         0.87         $        0.82                                                                         ===============         ==============         =============                                           25                   SOUTHCOAST FINANCIAL CORPORATION AND SUBSIDIARIES                    Notes to Consolidated Financial Statements  NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND ACTIVITIES - continued  Stock Based Compensation  (continued) - In calculating the pro forma disclosures (adjusted for the effects of expensing  the options),  the fair value of options granted is  estimated  as of the date  granted  using the  Black-Scholes  option pricing model with the following weighted-average assumptions used for grants in 2004: dividend yield of 0 percent; expected volatility of 13 percent;  risk-free interest rate of 5.90 percent; and expected life of 5 years.  Recently Issued Accounting Pronouncements - The following is a summary of recent authoritative  pronouncements that affect accounting,  reporting, and disclosure of financial information by the Company:  In December  2004, the Financial  Accounting  Standards  Board  ("FASB")  issued Statement of Financial  Accounting  Standards  ("SFAS") No. 123 (revised  2004), "Share-Based  Payment"  ("SFAS  No.  123(R)").  SFAS  No.  123(R)  will  require companies to measure all employee  stock-based  compensation awards using a fair value method and record such expense in its financial  statements.  In addition, the adoption of SFAS No. 123(R) requires  additional  accounting and disclosures related to the  income  tax and cash flow  effects  resulting  from  share-based payment arrangements. For the Company, SFAS No. 123(R) is effective beginning as of the first  interim  reporting  period in 2006.  SFAS No.  123(R)  allows  for adoption  using  either  the  modified  prospective  or  modified  retrospective methods. The Company anticipates using the modified prospective method when this statement is adopted in the first quarter of 2006. The Company has evaluated the impact upon adoption of SFAS No. 123(R) and has concluded that the adoption will not have a material  impact on financial  position or results of operations upon adoption.  In April 2005,  the  Securities  and Exchange  Commission's  Office of the Chief Accountant  and its Division of  Corporation  Finance  issued  Staff  Accounting Bulletin ("SAB") No. 107 to provide  guidance  regarding the application of SFAS No.  123(R).  SAB  No.  107  provides   interpretive  guidance  related  to  the interaction  between SFAS No. 123(R) and certain SEC rules and  regulations,  as well as the  staff's  views  regarding  the  valuation  of  share-based  payment arrangements for public companies.  SAB No. 107 also reminds public companies of the  importance  of  including  disclosures  within  filings  made  with the SEC relating to the accounting for share-based  payment  transactions,  particularly during the transition to SFAS No. 123(R).  In December 2004, the FASB issued SFAS No. 153, "Exchanges of Nonmonetary Assets - - an amendment  of APB Opinion No. 29".  The standard is based on the  principle that exchanges of nonmonetary  assets should be measured based on the fair value of the assets  exchanged and eliminates  the exception  under ABP Opinion No. 29 for an exchange of similar  productive  assets and replaces it with an exception for exchanges of nonmonetary  assets that do not have  commercial  substance.  A nonmonetary  exchange has  commercial  substance if the future cash flows of the entity are expected to change  significantly  as a result of the  exchange.  The standard is effective  for  nonmonetary  exchanges  occurring in fiscal  periods beginning  after June 15, 2005. The adoption of SFAS 153 is not expected to have a material impact on the Company's financial position or results of operations.  In May  2005,  the FASB  issued  SFAS No.  154,  "Accounting  Changes  and Error Corrections  - a  replacement  of APB Opinion No. 20 and FASB  Statement No. 3". SFAS No. 154  establishes  retrospective  application as the required method for reporting a change in accounting principle, unless it is impracticable, in which case the changes  should be applied to the latest  practicable  date  presented. SFAS No. 154 also  requires that a correction of an error be reported as a prior period adjustment by restating prior period financial  statements.  SFAS No. 154 is effective for  accounting  changes and  corrections  of errors made in fiscal years beginning after December 15, 2005.  In March 2004,  the FASB issued  Emerging  Issues Task Force  ("EITF") Issue No. 03-1,  "The Meaning of  Other-Than-Temporary  Impairment and its  Application to Certain Investments".  This issue addresses the meaning of  other-than-temporary impairment and its application to investments classified as either available for sale or held to  maturity  under SFAS No. 115 and it also  provides  guidance on quantitative  and  qualitative  disclosures.   The  disclosure  requirements  in paragraph 21 of this Issue were  effective for annual  financial  statements for fiscal  years  ending  after  December  15, 2003 and were adopted by the Company effective December 31, 2003.  The recognition and measurement guidance in paragraphs 6-20 of this Issue was to be applied to  other-than-temporary  impairment evaluations in reporting periods beginning  after June 15,  2004,  but was delayed by FASB action in October 2004 through the issuance of a proposed FASB Staff Position  ("FSP") on the issue. In July  2005,  the FASB  issued  FSP FAS  115-1 and FAS  124-1 - "The  Meaning  of Other-Than-Temporary  Impairment and its  Application  to Certain  Investments". This final guidance eliminated  paragraphs 10-18 of EITF-03-1  (paragraphs 19-20 have no material  impact on the  financial  position or results of operations of the Company) and will be effective for other-than-temporary  impairment analysis conducted  in periods  beginning  after  December  15,  2005.  The  Company  has evaluated  the impact  that the  adoption of FSP FAS 115-1 and FAS 124-1 and has concluded  that the  adoption  will  not have a  material  impact  on  financial position and results of operations upon adoption.                                         26                   SOUTHCOAST FINANCIAL CORPORATION AND SUBSIDIARIES                    Notes to Consolidated Financial Statements  NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND ACTIVITIES - continued  Recently Issued  Accounting  Pronouncements  (continued) - In December 2005, the FASB  issued FSP SOP  94-6-1,  "Terms of Loan  Products  that May Give Rise to a Concentration of Credit Risk". The disclosure  guidance in this FSP is effective for interim and annual  periods  ending after  December 19, 2005. The FSP states that the terms of  certain  loan  products  may  increase a  reporting  entity's exposure to credit risk and thereby may result in a concentration of credit risk as that term is used in SFAS No. 107, either as an individual product type or as a group of products  with similar  features.  SFAS No. 107 requires  disclosures about each significant concentration,  including "information about the (shared) activity, region, or economic characteristic that identifies the concentration." The  FSP  suggests   possible  shared   characteristics   on  which  significant concentrations may be determined which include, but are not limited to borrowers subject to significant payment increases,  loans with terms that permit negative amortization and loans with high loan-to-value ratios.  This FSP requires  entities to provide the disclosures  required by SFAS No. 107 for loan products that are  determined  to represent a  concentration  of credit risk in accordance with the guidance of this FSP for all periods presented.  The Company adopted this disclosure standard effective December 31, 2005.  Other  accounting  standards  that have been  issued or  proposed by the FASB or other standards-setting  bodies that do not require adoption until a future date are not  expected  to  have a  material  impact  on the  consolidated  financial statements upon adoption.  Risks and  Uncertainties  - In the normal  course of its  business  the  Company encounters two significant  types of risks:  economic and regulatory.  There are three main  components of economic  risk:  interest  rate risk,  credit risk and market risk. The Company is subject to interest rate risk to the degree that its interest-bearing  liabilities  mature or  reprice  at  different  speeds,  or on different bases, than its  interest-earning  assets.  Credit risk is the risk of default on the  Company's  loan and  investment  portfolios  that  results  from borrower's  inability or unwillingness to make contractually  required payments. Market  risk  reflects  changes  in the  value of  collateral  underlying  loans receivable and the valuation of real estate held by the Company.  The  Company is subject to the  regulations  of various  governmental  agencies. These  regulations can and do 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  and  operating  restrictions  from  the  regulators' judgments  based  on  information  available  to  them  at  the  time  of  their examination.  Reclassifications   -  Certain  captions  and  amounts  in  the  2004  and  2003 consolidated  financial  statements  were  reclassified to conform with the 2005 presentation.   NOTE 2 - STOCK OFFERING  The Company completed a stock offering during the fourth quarter of 2005 whereby 1,610,000 shares of the Company's  common stock were issued.  The offering price was $21.50 per share to the public and $20.21 per share to the underwriters. The gross proceeds from the offering were  $34,615,000  and expenses  related to the offering  totaled  $2,359,722.  The proceeds will be used to support future loan production  and asset  growth,  branch  expansion in new and  existing  markets, potential acquisitions, and for other general corporate purposes.   NOTE 3 - RESTRICTIONS ON CASH AND DUE FROM BANKS  The Bank is required to maintain average reserve balances,  computed by applying prescribed  percentages to its various types of deposits,  either at the bank or on deposit with the Federal  Reserve Bank. At December 31, 2005 and 2004,  these required reserves were met by vault cash.                                            27                   SOUTHCOAST FINANCIAL CORPORATION AND SUBSIDIARIES                    Notes to Consolidated Financial Statements  NOTE 4 - FEDERAL FUNDS SOLD  When the Bank's cash reserves (Note 3) are in excess of the required amount,  it may lend the excess to other banks on a daily basis. As of December 31, 2005 and 2004, federal funds sold amounted to $16,964,000 and $4,236,000, respectively.   NOTE 5 - INVESTMENT SECURITIES The amortized cost and fair value of investment securities are as follows:                                                                                          December 31, 2005                                                                                       -----------------                                                                                       Gross Unrealized                                                          Amortized                    ----------------                   Estimated                                                             Cost                 Gains                Losses             Fair Value                                                             ----                 -----                ------             ----------      Available for sale    Federal agencies ........................           $11,484,093          $          -           $   166,682           $11,317,411    Mortgage backed .........................            16,001,927                 4,338               271,837            15,734,428    Municipal securities ....................             2,330,462                     -                46,469             2,283,993    Other ...................................             2,093,389                53,706                     -             2,147,095                                                        -----------           -----------           -----------           -----------      Total .................................           $31,909,871           $    58,044           $   484,988           $31,482,927                                                        ===========           ===========           ===========           ===========                                                                                         December 31, 2004                                                                                       -----------------                                                                                       Gross Unrealized                                                          Amortized                    ----------------                   Estimated                                                             Cost                 Gains                Losses             Fair Value Available for sale                                          ----                 -----                ------             ----------      Federal agencies .......................               $ 6,495,891           $    10,870           $    26,921           $ 6,479,840 Mortgage backed ........................                13,545,157               230,779                18,242            13,757,694 Other ..................................                 1,500,996                     -                   195             1,500,801                                                        -----------           -----------           -----------           -----------   Total ................................               $21,542,044           $   241,649           $    45,358           $21,738,335                                                        ===========           ===========           ===========           ===========   The following table shows gross unrealized losses and fair value,  aggregated by investment category,  and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2005.  Available for Sale                                                 Less than                    Twelve months                                             twelve months                      or more                           Total                                             -------------                      -------                           -----                                                       Unrealized                       Unrealized                         Unrealized                                      Fair value         losses        Fair value         losses         Fair value           losses                                      ----------         ------        ----------         ------         ----------           ------        Federal agencies .............      $ 6,440,840      $    45,677      $ 4,876,570      $   121,005      $11,317,410      $   166,682 Mortgage backed ..............       14,372,580          225,292          865,804           46,545       15,238,384          271,837 Municipal ....................        2,283,993           46,469                -                -        2,283,993           46,469                                     -----------      -----------      -----------      -----------      -----------      -----------    Total ......................      $23,097,413      $   317,438      $ 5,742,374      $   167,550      $28,839,787      $   484,988                                     ===========      ===========      ===========      ===========      ===========      ===========   Securities classified as  available-for-sale  are recorded at fair market value. Approximately  34.9% of the unrealized  losses,  or five individual  securities, consisted of securities in a continuous loss position for twelve months or more. The Company has the ability and intent to hold these  securities until such time as the value recovers or the securities mature.  The Company believes,  based on industry analyst reports and credit ratings,  that the deterioration in value is attributable  to  changes  in market  interest  rates  and is not in the  credit quality  of  the  issuer  and   therefore,   these  losses  are  not  considered other-than-temporary.                                          28                   SOUTHCOAST FINANCIAL CORPORATION AND SUBSIDIARIES                    Notes to Consolidated Financial Statements  NOTE 5 - INVESTMENT SECURITIES - continued  The amortized costs and fair values of investment  securities available for sale at December 31, 2005 by contractual maturity,  are shown in the following table. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay  obligations with or without call or prepayment penalties.                                                           Amortized       Fair                                                            Cost          Value                                                            ----          ----- Under one year .....................................   $ 1,000,000   $   988,440 Due after one but within five years ................    10,484,093    10,328,970 Due after ten years ................................     2,330,462     2,283,993 Mortgage backed ....................................    16,001,927    15,734,428 Equity securities with no maturity .................     2,093,389     2,147,096                                                        -----------   -----------   Total investment securities available-for-sale ...   $31,909,871   $31,482,927                                                        ===========   ===========  Investment  securities  with an  aggregate  amortized  cost of  $27,228,927  and estimated fair value of $26,785,033 at December 31, 2005, were pledged to secure public deposits and for other purposes, as required or permitted by law.  Gross realized gains on sales of available-for-sale  securities were $79,794 and $21,689 in 2005 and 2004,  respectively.  There were no gross realized losses on available-for-sale  securities  in 2005  or  2004.  Proceeds  from  the  sale of securities totaled $2,775,067 and $21,361,689 in 2005 and 2004, respectively.  Federal Home Loan Bank stock, at cost - The Bank, as a member institution of the Federal  Home Loan Bank  (FHLB),  is required  to own capital  stock in the FHLB based generally upon the balance of residential  mortgage loans pledged and FHLB borrowings.  The stock is pledged to secure  FHLB  borrowings.  No ready  market exists for this stock, and it has no quoted market value. However, redemption of this stock has historically been at par value.   NOTE 6 - LOANS  The composition of loans by major loan category is presented below:                                                           December 31,                                                          ------------                                                   2005                 2004                                                   ----                 ---- Commercial ...........................       $ 167,992,872        $ 144,908,102 Real estate - construction ...........          41,615,445           46,927,786 Real estate - mortgage ...............         162,716,005          101,215,971 Consumer .............................           3,601,296            3,559,079                                              -------------        -------------                                                375,925,618          296,610,938 Allowance for loan losses ............          (4,269,564)          (3,403,970)                                              -------------        -------------                                              $ 371,656,054        $ 293,206,968                                              =============        =============  At December 31, 2005 and 2004,  non-accrual loans totaled $571,455 and $924,668, respectively. The gross interest income which would have been recorded under the original terms of non-accrual  loans amounted to $40,035,  $50,441,  and $630 in 2005, 2004 and 2003, respectively.  Impaired loans were equivalent to nonaccrual loans in terms of principal  balance and foregone interest for the periods ended December  31, 2005,  2004 and 2003.  As of December  31,  2005,  loans  totaling $91,203,017  were pledged to the FHLB as collateral for borrowings from the FHLB (see Note 9).  The following is a summary of the activity  within the allowance for loan losses for the periods presented:                                                      December 31,                                                     ------------                                         2005            2004            2003                                         ----            ----            ---- Balance, beginning of year ......    $ 3,403,970    $ 2,376,516     $ 1,656,260 Provision for loan losses .......        865,067      1,146,495         735,000 Net (charge-offs) recoveries ....            527       (119,041)        (14,744)                                      -----------    -----------     ----------- Balance, end of year ............    $ 4,269,564    $ 3,403,970     $ 2,376,516                                      ===========    ===========     ===========                                          29                   SOUTHCOAST FINANCIAL CORPORATION AND SUBSIDIARIES                    Notes to Consolidated Financial Statements  NOTE 7 - PROPERTY AND EQUIPMENT  Components of property and equipment are as follows:                                                                           Estimated              December 31,                                                                       Useful Lives        2005              2004                                                                      -------------    -------------     -------------        Land ..........................................................                    $   5,839,821     $   5,973,554    Furniture and equipment .......................................    3 - 10 years        4,774,742         3,422,797    Buildings and improvements ....................................    5 - 40 years        8,788,856         6,124,933    Construction in process                                                                2,754,563         1,306,426                                                                                       -------------     -------------                                                                                          22,157,982        16,827,710    Less accumulated depreciation .................................                        2,259,794         1,983,826                                                                                       -------------     -------------      Total property and equipment ................................                    $  19,898,188     $  14,843,884                                                                                       =============     =============   Construction in process consists of an operations  facility adjacent to the main branch (see Note 11).  Depreciation  expense for the years  ended  December  31, 2005, 2004 and 2003 was $618,816, $564,789, and $463,654, respectively.  In 2005, the Company sold the second and third floors of its main office and the furniture and equipment  associated with the space.  The cost of the assets sold was $1,360,884 and resulted in a gain of $639,116.  In 2004, the Company and its investment subsidiary fully or partially sold three parcels of property. Two of the properties had been purchased for planned future branch expansion,  and the third property was acquired through foreclosure.  The two  properties  fully sold had a cost of  $4,410,333  and resulted in a gain on sale  of  $686,564.  A third  property  was  purchased  for  $1,202,168  and the right-of-way portion of this property was sold for $597,138, resulting in a gain of $476,921.  The total of these gains is  reflected as a separate  line item on the consolidated statement of income.  NOTE 8 - DEPOSITS  The following is a detail of deposit accounts:                                                             December 31,                                                            ------------                                                       2005              2004                                                       ----              ---- Noninterest bearing deposits .............       $ 38,753,579       $ 27,954,739 Interest bearing   NOW ....................................         15,275,844         15,700,757   Money market ...........................         33,838,885         33,815,358   Savings ................................          3,592,002          2,677,272   Time, less than $100,000 ...............         58,793,451         52,783,908   Time, $100,000 and over ................        161,300,188        125,221,249                                                  ------------       ------------     Total deposits .......................       $311,553,949       $258,153,283                                                  ============       ============  Interest  expense on time  deposits  greater  than  $100,000  was  approximately $4,630,000, $1,856,826 and $966,207 in 2005, 2004 and 2003, respectively.  At  December  31, 2005 and 2004,  the Bank had  approximately  $104,447,000  and $84,586,000,  respectively,  in time deposits from customers  outside its market area. This includes  $100,122,000  and $75,214,000 in brokered  deposits in 2005 and 2004, respectively.  At December 31, 2005 the scheduled maturities of time deposits are as follows:       2006                                            $   183,521,793      2007                                                 23,732,738      2008                                                 12,043,650      2009                                                    600,379      2010                                                    195,079                                                      ---------------                                                       $   220,093,639                                         30                   SOUTHCOAST FINANCIAL CORPORATION AND SUBSIDIARIES                    Notes to Consolidated Financial Statements  NOTE 9 - ADVANCES FROM FEDERAL HOME LOAN BANK  Advances  from  Federal  Home Loan  Bank are  collateralized  by FHLB  stock and pledges of certain residential mortgage loans and are summarized as follows:                                                                                                  December 31,                                                                                               ------------    Maturity                                   Rate                                       2005                2004    --------                    --------------------------------------                    ----                ----        June 2005                   Variable (2.44% at December 31, 2004)              $             -      $    7,000,000    June 2007                   Variable (2.01% at December 31, 2004)                            -           8,000,000    June 2006                   Variable (4.44% at December 31, 2005)                   15,000,000                   -    May 2005                                        7.07%                                        -           2,000,000    September 2006                                  2.91%                               10,000,000          10,000,000    September 2008                                  3.01%                               10,000,000          10,000,000    June 2010                                       3.88%                               11,000,000                   -    September 2010                                  5.55%                                7,000,000           7,000,000    February 2011                                   4.31%                                4,500,000           4,500,000    March 2013                                      2.91%                                7,500,000           7,500,000    June 2014                                       3.92%                                2,000,000           2,000,000                                                                                   ---------------      --------------                                                                                   $    67,000,000      $   58,000,000                                                                                   ===============      ==============   Each of the fixed rate advances are subject to early  termination  options.  The Federal  Home Loan Bank  reserves the right to  terminate  each  agreement at an earlier date.   NOTE 10 - JUNIOR SUBORDINATED DEBENTURES  On May 3,  2002,  December  16,  2002,  and August 5,  2005,  in three  separate transactions,  Southcoast  Capital Trust I, II, and III (the "Capital  Trusts"), non-consolidated  subsidiaries of the Company, issued and sold a total of 21,655 floating rate  securities,  with a $1,000  liquidation  amount per security (the "Capital  Securities").  Institutional  buyers  bought  21,000  of  the  Capital Securities  denominated as preferred securities and the Company bought the other 655 Capital Securities which are denominated as common securities.  The proceeds of those  sales,  $21.7  million,  were used by the Capital  Trusts to buy $21.7 million of junior subordinated debentures from the Company which are reported on its consolidated balance sheets. The Company's $655,000 investment in the common securities  of  the  Capital  Trusts  is  included  in  "Other  assets"  on  its consolidated  balance  sheets.  The preferred  securities of the Capital  Trusts totaling  $21.0 million  qualify as Tier 1 capital  under Federal  Reserve Board guidelines, subject to limitations.  Debt issuance costs, net of accumulated  amortization,  from junior subordinated debentures  totaled  $357,088 at December  31,  2005,  and are included in other assets on the  consolidated  balance sheet.  Amortization of debt issuance costs from junior  subordinated  debentures totaled $13,363 for the years end December 31, 2005,  2004, and 2003, and is reported in other  noninterest  expense on the consolidated statements of income.  The Capital  Securities in the first  transaction  accrue and pay  distributions annually  at a rate per  annum  equal to the  three-month  LIBOR  plus 375 basis points,  which was 7.804 percent at December 31, 2005.  This rate may not exceed 12 percent  through  July 2007.  The  distribution  rate  payable on the Capital Securities is cumulative and payable  quarterly in arrears.  The Company has the right,  subject to events of  default,  to defer  payments  of  interest  on the Capital Securities for a period not to exceed 20 consecutive  quarterly periods, provided  that no extension  period may extend  beyond the maturity date of June 30, 2032.                                         31                   SOUTHCOAST FINANCIAL CORPORATION AND SUBSIDIARIES                    Notes to Consolidated Financial Statements  NOTE 10 - JUNIOR SUBORDINATED DEBENTURES - continued  The Capital  Securities in the second  transaction  accrue and pay distributions quarterly  at a rate per annum  equal to the  three-month  LIBOR  plus 335 basis points,  which was 7.877 percent at December 31, 2005.  This rate may not exceed 12 percent through December 2007. The  distribution  rate payable on the Capital Securities is cumulative and payable  quarterly in arrears.  The Company has the right,  subject to events of  default,  to defer  payments  of  interest  on the Capital Securities for a period not to exceed 20 consecutive  quarterly periods, provided  that no  extension  period may  extend  beyond  the  maturity  date of December 16, 2032.  The Capital  Securities in the third  transaction  accrue and pay  distributions quarterly  at a rate per annum  equal to the  three-month  LIBOR  plus 150 basis points,  which was 6.027 percent at December 31, 2005.  This rate may not exceed 12 percent through December 2007. The  distribution  rate payable on the Capital Securities is cumulative and payable  quarterly in arrears.  The Company has the right,  subject to events of  default,  to defer  payments  of  interest  on the Capital Securities for a period not to exceed 20 consecutive  quarterly periods, provided  that no  extension  period may  extend  beyond  the  maturity  date of December 16, 2035.  The Company has no current  intention to exercise its right to defer payments of interest  on the  Capital  Securities.  The Capital  Securities  mature or are  mandatorily  redeemable upon maturity on June 30,  2032,  December  16, 2032,  and August 5, 2005  respectively,  or upon earlier  optional  redemption as provided in the indenture.  The Company has the right to redeem the Capital Securities in whole or in part, on or after June 30, 2007,  December  16, 2007,  and August 5, 2010.  The Company may also redeem the capital  securities prior to such dates upon occurrence of specified  conditions and the payment of a redemption premium.   NOTE 11 - COMMITMENTS AND CONTINGENCIES  The Company is party to  litigation  and claims  arising in the normal course of business.  Management,  after consultation with legal counsel, believes that the liabilities,  if any,  arising  from  such  litigation  and  claims  will not be material to the Company's financial position.  At December 31, 2005,  the Company has an operations  center under  construction adjacent to the main branch. The Company believes  construction will be complete in the spring of 2006.  Estimated  additional  costs to complete the  operations center are approximately $622,806 as of December 31, 2005.  The  Company is a member in  Triangle  Mezzanine  LLC  ("TM").  TM  manages  the Triangle  Mezzanine Fund, LLP, which is a private equity fund,  intended to take advantage of a Small Business Administration leveraged financing program.  As of December 31, 2005,  the Company has an investment of $250,000 in the fund included in other assets, with an additional $250,000 commitment.   NOTE 12 - UNUSED LINES OF CREDIT  At December  31, 2005,  the Bank had unused lines of credit to purchase  federal funds  totaling  $8,800,000  from  unrelated  banks.  These  lines of credit are available  on a one to seven day basis for  general  corporate  purposes  of the Bank. The lenders have reserved the right to withdraw the lines at their option. The  Company  may also  borrow  from  the  Federal  Home  Loan  Bank  based on a predetermined  formula.  Borrowings on this line totaled $67,000,000 at December 31, 2005.  Additional  funds of $5,962,414 were available on the line.  Advances are  subject to  approval  by the  Federal  Home Loan Bank and may  require  the Company to pledge additional collateral. As discussed in Note 6, the Company has pledged $91,203,017 in loans as collateral for these borrowings.                                          32                   SOUTHCOAST FINANCIAL CORPORATION AND SUBSIDIARIES                    Notes to Consolidated Financial Statements  NOTE 13 - LEASES  During April 2003,  the Company  entered into a lease  agreement  for its branch location  in  Summerville.  The lease  began on May 1, 2003,  and has an initial five-year term. Additionally, the lease has renewal options for three additional five-year  terms.  The lease requires  monthly payments of $4,000 for the entire initial lease term.  Beginning  with the first  renewal  period and each renewal period  thereafter,  the  monthly  rent will be  increased  by the amount of the previous  calendar  year's increase in the Consumer Price Index beginning on the first day of the lease  renewal  year,  or $200,  whichever  is greater.  Rental expense under this lease and included in the  consolidated  statements of income totaled $48,000 for the years ended December 31, 2005 and 2004, respectively.  Minimal future rental  payments  under  non-cancelable  operating  leases having remaining  terms in excess of one year,  for each of the next four  years in the aggregate are:        2006                                                             $   48,000      2007                                                                 48,000      2008                                                                 16,000                                                                       ----------      Total minimum future rental payments                             $  112,000                                                                       ==========   NOTE 14 - INCOME TAXES  The following  summary of the provision for income taxes  includes tax deferrals which arise from temporary  differences  in the  recognition of certain items of revenue and expense for tax and financial reporting purposes for the years ended December 31:                                                                                 2005                   2004                    2003                                                                              ----                   ----                    ---- Income taxes currently payable       Federal ..................................................            $ 2,596,817             $ 1,384,609             $   980,787   State ....................................................                222,283                 120,401                  84,274                                                                         -----------             -----------             -----------                                                                           2,819,100               1,505,010               1,065,061 Deferred tax provision (benefit) ...........................               (477,453)               (207,053)               (175,663) Change in valuation allowance ..............................                      -                       -                  69,779                                                                         -----------             -----------             -----------     Provision ..............................................            $ 2,341,647             $ 1,297,957             $   959,177                                                                         ===========             ===========             ===========   The income tax effect of  cumulative  temporary  differences  for  deferred  tax assets (liabilities) at December 31, are as follows:                                                                                                                December 31,                                                                                                             ------------                                                                                                   2005                      2004                                                                                                   ----                      ----    Allowance for loan losses ....................................................               $ 1,441,157                $ 1,152,098 Unrealized loss (gain) on investment securities ..............................                   172,480                    (70,665) Depreciation .................................................................                  (431,003)                  (465,403) Prepaid expenses .............................................................                  (117,018)                         - Other ........................................................................                    37,432                      9,565                                                                                              -----------                -----------     Net deferred tax asset ...................................................               $ 1,103,048                $   625,595                                                                                              ===========                ===========   The net deferred tax asset is reported in other assets in the balance  sheets at December 31, 2005 and 2004.                                          33                   SOUTHCOAST FINANCIAL CORPORATION AND SUBSIDIARIES                    Notes to Consolidated Financial Statements  NOTE 14 - INCOME TAXES - continued  The  provision  for  income  taxes is  reconciled  to the  amount of income  tax computed at the federal  statutory  rate on income  before  income taxes for the years ended December 31, as follows:                                                           2005                          2004                           2003                                                        ----                          ----                           ----                                              Amount            %             Amount            %            Amount             %                                              ------       ----------         ------       ---------         ------        --------        Tax expense at statutory rate .........   $ 2,220,554             34%    $ 1,455,091             34%    $   905,563             34% Increase (decrease) in taxes   resulting from:   State bank tax (net of federal     benefit) ..........................       146,707              2          87,045              2          55,621              2 Officer's life insurance ..............       180,336              3         118,864              2          13,974              1 Nonqualified stock options ............      (213,253)            (3)        (70,791)            (1)              -              - Other tax preference items ............         7,303              -        (292,252)            (7)        (15,981)            (1)                                           -----------    -----------     -----------    -----------     -----------    -----------      Tax provision (benefit) ...........   $ 2,341,647             36%    $ 1,297,957             30%    $   959,177             36%                                           ===========    ===========     ===========    ===========     ===========    ===========   NOTE 15 - RELATED PARTY TRANSACTIONS  Directors,  executive  officers and their  affiliates  are customers of and have banking  transactions  with the Bank in the ordinary  course of business.  These transactions were made on substantially the same terms including  interest rates and  collateral,  as those  prevailing  at the time for  comparable  arms-length transactions.  A summary of loan transactions with directors and executive officers,  including their affiliates, are as follows:                                                             December 31,                                                            ------------                                                      2005               2004                                                      ----               ---- Balance, beginning of year ..............        $ 5,961,165        $ 2,998,044   New loans .............................                  -          2,978,422   Repayments ............................          5,795,504            (15,301)                                                  -----------        ----------- Balance, end of year ....................        $   165,661        $ 5,961,165                                                  ===========        ===========  Deposits by directors and executive  officers,  including their  affiliates,  at December 31, 2005 and 2004 approximated $1,023,318 and $608,685, respectively.   NOTE 16 - FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK  The Bank is 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.  They involve,  to varying  degrees,  elements of credit and interest rate risk in excess of the amount recognized in the balance sheets.  The Bank's exposure to credit loss in the event of  nonperformance  by the other party to the financial  instrument for  commitments to extend credit and standby letters  of  credit  is  represented  by  the   contractual   amounts  of  those instruments.  The Bank uses the same credit  policies in making  commitments and conditional  obligations as it does for on-balance sheet instruments.  A summary of the Bank's commitments is as follows:                                                              December 31,                                                             ------------                                                       2005               2004                                                       ----               ---- Commitments to extend credit .............        $52,986,918        $40,402,501 Standby letters of credit ................            400,938            883,260                                          34                   SOUTHCOAST FINANCIAL CORPORATION AND SUBSIDIARIES                    Notes to Consolidated Financial Statements  NOTE 16 - FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK - continued  Commitments  to extend  credit are  agreements  to lend to a customer as long as there is no violation of any material  condition  established  in the  contract. Commitments  generally have fixed expiration dates or other termination  clauses and may require the payment of a fee. The Bank evaluates each customer's  credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on management's  credit evaluation  of  the  borrower.   Collateral  varies  but  may  include  accounts receivable,  inventory,  property,  plant  and  equipment,  and  commercial  and residential real estate.  Standby  letters of credit  are  conditional  commitments  issued by the Bank to guarantee  the  performance  of a customer  to a third  party.  The credit  risk involved in issuing  letters of credit is essentially  the same as that involved in extending  loan  facilities to customers.  Collateral  varies but may include accounts receivable,  inventory,  equipment, marketable securities and property. Since letters of credit are expected to expire without being drawn upon, they do not necessarily  represent  future cash  requirements  and the fair value of any liability associated with letters of credit is insignificant.   NOTE 17 - EMPLOYEE BENEFIT PLAN  The Company  maintains a 401(k) Plan for the benefit of all eligible  employees. Upon ongoing  approval of the Board of Directors,  the Company matches  employee contributions  equal to 50  percent of the first six  percent  of  compensation, subject to certain  adjustments  and  limitations.  Additionally,  all  eligible employees receive a three percent  contribution from the Company.  Contributions made to the Plan in 2005,  2004 and 2003  amounted  to  $113,158,  $134,713  and $126,488, respectively.   NOTE 18 - STOCK OPTION PLAN  During 2000, the Board of Directors approved a stock option plan for the benefit of the  directors,  officers and  employees.  The Board may grant  options at an option price per share not less than the fair market value on the date of grant. All options  granted to officers and employees vest  immediately and expire five years from the grant date.  A summary of the  status of the plan and  changes  during the year is  presented below (all shares have been adjusted for stock dividends):                                                                   2005                      2004                        2003                                                                ----                      ----                        ----                                                                     Weighted-                 Weighted-                    Weighted-                                                                      Average                   Average                      Average                                                                     Exercise                  Exercise                     Exercise                                                           Shares     Price        Shares       Price        Shares          Price                                                           ------     -----        ------       -----        ------          -----        Outstanding at beginning of year ..................        74,842  $  8.88         67,342     $  5.24       131,266        $  5.40 Granted ...........................................             -        -         22,990       16.82             -              - Exercised .........................................       (59,717)    6.87        (15,490)       3.89       (63,840)          3.89 Forfeited or expired ..............................            -                       -                        (84)          4.66                                                       -----------             -----------               ----------- Outstanding at end of year ........................        15,125    16.82         74,842        8.88        67,342           5.24                                                       ===========             ===========               =========== Options exercisable at year end ...................        15,125    16.82         74,842        8.88        67,342           5.24                                                       ===========             ===========               =========== Shares available for grant ........................        20,809                  20,809                    43,800                                                       ===========             ===========               ===========  The plan is administered by the Board of Directors or by a committee  designated by the Board.  The plan  provides  that if the shares of common  stock  shall be subdivided  or  combined  into a greater or  smaller  number of shares or if the Company  shall  issue  any  shares of common  stock as a stock  dividend  on its outstanding  common stock, the number of shares of common stock deliverable upon the exercise of options  shall be increased  or decreased  proportionately,  and appropriate adjustments shall be made in the purchase price per share to reflect such subdivision, combination or stock dividend.                                          35                   SOUTHCOAST FINANCIAL CORPORATION AND SUBSIDIARIES                    Notes to Consolidated Financial Statements  NOTE 19 - EMPLOYEE STOCK PURCHASE PLAN  During  2000,  the Board of  Directors  approved  a five  year  non-compensatory Employee Stock Purchase Plan for the benefit of officers and employees. The plan was replaced in 2005 with an  identical  plan which  expires in 2010.  Beginning July 1, 2000,  officers and employees were allowed to have payroll  withholdings for the purpose of buying Company stock. The purchase price is 85 percent of the closing  quoted  market price of the first or last  business day of the quarter, whichever is less.  Shares for the quarter are purchased  during the first month of the following  quarter.  During 2005 and 2004,  the Company  issued 7,043 and 6,488 shares of common stock, respectively, under these plans.   NOTE 20 - NET INCOME PER COMMON SHARE  Earnings  per share - basic is computed by dividing  net income by the  weighted average  number of common  shares  outstanding.  Earnings per share - diluted is computed by dividing net income by the weighted  average number of common shares outstanding  and dilutive  common  share  equivalents  using the treasury  stock method.  Dilutive common share  equivalents  include common shares issuable upon exercise of outstanding stock options.                                                                                               For the years ended December 31,                                                                                            --------------------------------                                                                                   2005                 2004                  2003                                                                                   ----                 ----                  ----   Basic earnings per share:      Net income available to common shareholders ......................            $4,189,393            $2,981,721            $1,704,243                                                                               ==========            ==========            ==========  Average common shares outstanding - basic ........................             3,582,908             3,260,475             2,042,180                                                                               ==========            ==========            ==========  Basic earnings per share .........................................            $     1.17            $     0.91            $     0.83                                                                               ==========            ==========            ==========  Diluted earnings per share:  Net income available to common shareholders ......................            $4,189,393            $2,981,721            $1,704,243                                                                               ==========            ==========            ==========  Average common shares outstanding - basic ........................             3,582,908             3,260,475             2,042,180  Incremental shares from assumed conversion  of stock options ................................................                 4,257                46,450                48,516                                                                               ----------            ----------            ----------  Average common shares outstanding - diluted ......................             3,587,165             3,306,925             2,090,696                                                                               ==========            ==========            ==========  Diluted earnings per share .......................................            $     1.17            $     0.90            $     0.82                                                                               ==========            ==========            ==========   NOTE 21 - DIVIDENDS  The Board of Directors  declared and paid a ten percent  stock  dividend in June 2005 and May 2004 and 2003,  and a five percent  stock  dividend in August 2003. All stock dividends were recorded at fair market value to the extent of retained earnings  available.  All balance  sheet amounts and per share amounts have been adjusted to reflect these dividends.  There are no current  plans to  initiate  payment of cash  dividends  and future dividend  policy will depend on the Company's  earnings,  capital  requirements, financial  condition  and  other  factors  considered  relevant  by the Board of Directors. The Bank is restricted in its ability to pay dividends to the Company under the laws and regulations of the State of South Carolina.  Generally, these restrictions  allow the Bank to pay dividends from current  earnings without the prior  written  consent of the South  Carolina  Commissioner  of Banking,  if it received a satisfactory rating at its most recent examination.                                          36                   SOUTHCOAST FINANCIAL CORPORATION AND SUBSIDIARIES                    Notes to Consolidated Financial Statements  NOTE 22 - REGULATORY MATTERS  The Company and the Bank are subject to various regulatory capital  requirements administered  by the  federal  banking  agencies.  Failure  of the  Bank to meet minimum  capital  requirements  can  initiate  certain  mandatory,  and possible additional discretionary actions by regulators that, if undertaken, could have a direct  material  effect  on the  Bank's  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 classification  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 (set forth in the table below)  of total  and Tier 1  capital  to  risk-weighted  assets,  and of Tier 1 capital to average assets.  Management  believes,  as of December 31, 2005, that the Company and the Bank meet all capital  adequacy  requirements  to which they are subject.  As of  December  31,  2005,  the  most  recent  notification  of the  regulators categorized  the Bank as well  capitalized  under the  regulatory  framework for prompt  corrective  action.  There  are  no  conditions  or  events  since  that notification that management believes have changed the institution's category.  The following  table  summarizes the capital  ratios and the regulatory  minimum requirements for the Company and the Bank.                                                                                                                      To Be Well-                                                                                                                Capitalized Under                                                                                            For Capital         Prompt Corrective                                                                     Actual              Adequacy Purposes      Action Provisions                                                                     ------              -----------------      -----------------   (Dollars in thousands)                                     Amount        Ratio       Amount        Ratio      Amount      Ratio                                                              ------        -----       ------        -----      ------      -----   December 31, 2005   The Company           Total capital (to risk-weighted assets) .............   $  99,547       29.03%    $  27,432      8.00%(1)       N/A         N/A    Tier 1 capital (to risk-weighted assets) ............      95,277       27.79        13,716      4.00 (1)       N/A         N/A    Tier 1 capital (to average assets) ..................      95,277       21.36        17,842      4.00 (1)       N/A         N/A    The Bank    Total capital (to risk-weighted assets) .............   $  39,034       12.03%    $  25,962      8.00%      $ 32,453       10.00%    Tier 1 capital (to risk-weighted assets) ............      35,194       10.84        12,981      4.00         19,472        6.00    Tier 1 capital (to average assets) ..................      35,194        8.22        17,122      4.00         21,403        5.00    December 31, 2004   The Company    Total capital (to risk-weighted assets) .............   $  51,192       18.55%    $  22,078      8.00%(1)        N/A         N/A    Tier 1 capital (to risk-weighted assets) ............      47,789       17.32        11,039      4.00 (1)        N/A         N/A    Tier 1 capital (to average assets) ..................      47,789       13.64        14,010      4.00 (1)        N/A         N/A    The Bank    Total capital (to risk-weighted assets) .............   $  33,202       12.67%    $  20,960      8.00%      $ 26,200       10.00%    Tier 1 capital (to risk-weighted assets) ............      30,253       11.55        10,480      4.00         15,720        6.00    Tier 1 capital (to average assets) ..................      30,253        9.30        13,012      4.00         16,265        5.00     (1) Minimum  requirements for bank holding  companies.  Bank holding companies   with  higher  levels  of  risks,  or that  are  experiencing  or  anticipating   significant  growth,  are also  expected  to maintain  capital  well above the   minimums.                                         37                   SOUTHCOAST FINANCIAL CORPORATION AND SUBSIDIARIES                    Notes to Consolidated Financial Statements  NOTE 23 - ESTIMATED FAIR VALUE OF FINANCIAL INSTRUMENTS  The estimated fair values of the Company's financial instruments were as follows (amounts in thousands):                                                                                                 December 31,                                                                                              ------------                                                                                   2005                               2004                                                                                   ----                               ----                                                                        Carrying           Fair            Carrying            Fair                                                                         Amount            Value            Amount             Value                                                                         ------            -----            ------             ----- Financial assets:         Cash and due from banks .................................          $ 14,378          $ 14,378          $ 11,853          $ 11,853    Federal funds sold ......................................            16,964            16,964             4,236             4,236    Investment securities ...................................            35,203            35,203            24,831            24,831    Loans held for sale .....................................             9,275             9,275            12,010            12,010    Loans, gross ............................................           375,926           372,589           296,611           296,277 Financial liabilities:    Deposits ................................................           311,554           309,935           258,153           258,432    Advances from Federal Home Loan Bank ....................            67,000            66,237            58,000            57,011    Junior subordinated debentures ..........................            21,655            21,655            11,345            11,345                                                                         Notional            Fair          Notional             Fair                                                                        Amount            Value           Amount             Value                                                                        ------            -----           ------             ----- Financial instruments with off- Balance sheet risk:      Commitments to extend credit ...............................         $ 52,987         $        -           $40,403        $        - Standby letters of credit ..................................              401                  -               883                 -   NOTE 24 - PARENT COMPANY FINANCIAL INFORMATION  Following is condensed financial information of Southcoast Financial Corporation (parent company only):                              CONDENSED BALANCE SHEETS                                                                                                                December 31,                                                                                                             ------------                                                                                                    2005                     2004                                                                                                    ----                     ---- ASSETS       Cash ........................................................................               $39,512,689               $ 3,599,633    Investments available for sale ..............................................                 1,147,095                   100,050    Investment in subsidiaries ..................................................                35,195,382                30,684,212    Loans, net ..................................................................                 7,184,516                 5,650,478    Property and equipment, net .................................................                 9,516,814                 5,708,687    Other assets ................................................................                 2,420,310                 2,172,689                                                                                                -----------               -----------        Total assets ............................................................               $94,976,806               $47,915,749                                                                                                ===========               =========== LIABILITIES AND SHAREHOLDERS' EQUITY    Accounts payable ............................................................               $     7,261               $         -    Junior subordinated debentures ..............................................                21,655,000                11,345,000    Shareholders' equity ........................................................                73,314,545                36,570,749                                                                                                -----------               -----------        Total liabilities and shareholders' equity ..............................               $94,976,806               $47,915,749                                                                                                ===========               ===========                                           38                   SOUTHCOAST FINANCIAL CORPORATION AND SUBSIDIARIES                    Notes to Consolidated Financial Statements  NOTE 24 - PARENT COMPANY FINANCIAL INFORMATION - continued                           CONDENSED STATEMENTS OF INCOME                                                                                              For the years ended December 31,                                                                                           --------------------------------                                                                                   2005                 2004                 2003                                                                                   ----                 ----                 ---- Income        Other ............................................................         $   977,918          $   896,805          $   461,012                                                                               -----------          -----------          -----------                                                                                   977,918              896,805              461,012 Expenses ............................................................           1,859,101            1,252,942              724,308                                                                               -----------          -----------          -----------    Loss before income taxes .........................................            (881,183)            (356,137)            (263,296) Income tax benefit ..................................................            (126,164)             202,718               94,786                                                                               -----------          -----------          -----------    Loss before equity in undistributed net      income of subsidiaries .........................................            (755,019)            (153,419)            (168,510) Equity in undistributed net income of subsidiaries ..................           4,944,412            3,135,140            1,872,753                                                                               -----------          -----------          -----------        Net income ...................................................         $ 4,189,393          $ 2,981,721          $ 1,704,243                                                                               ===========          ===========          ===========                          CONDENSED STATEMENTS OF CASH FLOWS                                                                                                For the years ended December 31,                                                                                             --------------------------------                                                                                     2005                2004                 2003                                                                                     ----                ----                 ---- Operating Activities        Net income ..........................................................       $  4,189,393        $  2,981,721        $  1,704,243    Adjustments to reconcile net income to net cash      provided by operating activities        Equity in undistributed net income of subsidiaries ..............         (4,944,412)         (3,135,140)         (1,872,753)        Provision for loan losses .......................................            (14,688)             75,000                   -        Gain on sale of property and equipment ..........................           (293,382)           (476,921)                  -        Depreciation ....................................................             75,190              14,030                   -        Increase in other assets ........................................           (247,622)           (201,415)           (907,424)        Increase (decrease) in other liabilities ........................              7,261                (873)            (19,623)                                                                                ------------        ------------        ------------          Net cash used for operating activities ........................         (1,228,260)           (743,598)         (1,095,557)                                                                                ------------        ------------        ------------ Investing activities    Cash contribution to subsidiaries ...................................                  -            (100,000)        (10,000,000)    Proceeds from sale of available for sale securities .................                  -           9,992,461                   -    Purchase of available for sale securities ...........................           (993,339)         (5,096,089)         (4,996,422)    Increase in loans, net ..............................................         (1,519,350)         (2,978,422)         (2,747,056)    Purchase of property and equipment ..................................         (3,883,317)         (3,892,899)           (966,306)    Proceeds from sale of property and equipment ........................            293,382             643,594                   -                                                                                ------------        ------------        ------------          Net cash provided (used) by investing activities ..............         (6,102,624)         (1,431,355)        (18,709,784)                                                                                ------------        ------------        ------------ Financing activities    Proceeds from junior subordinated debentures ........................         10,310,000                   -                   -    Proceeds from sale of stock, net ....................................         32,255,278                   -          18,754,284    Proceeds from exercise of stock options .............................            335,350             105,086             246,826    Proceeds from employee stock purchase plan ..........................            140,574              60,288              36,943     Issuance of common stock ...........................................            202,738    Repurchase of common stock ..........................................                  -                   -            (112,500)                                                                                ------------        ------------        ------------          Net cash provided by financing activities .....................         43,243,940             165,374          18,925,553                                                                                ------------        ------------        ------------          Net change in cash ............................................         35,913,056          (2,009,579)           (879,788) Cash, beginning of year ................................................          3,599,633           5,609,212           6,489,000                                                                                ------------        ------------        ------------ Cash, end of year ......................................................       $ 39,512,689        $  3,599,633        $  5,609,212                                                                                ============        ============        ============                                            39                   SOUTHCOAST FINANCIAL CORPORATION AND SUBSIDIARIES                    Notes to Consolidated Financial Statements  NOTE 25 - QUARTERLY DATA (UNAUDITED)                                                                       2005                                       2004                                                                    ----                                       ---- (Dollars in thousands                            Fourth      Third     Second     First      Fourth     Third     Second      First except per share)                                Quarter    Quarter    Quarter   Quarter     Quarter   Quarter    Quarter    Quarter                                                  -------    -------    -------   -------     -------   -------    -------    -------          Interest income ............................     $6,883     $6,191     $5,566     $5,250     $4,773     $4,336     $3,964     $3,522 Interest expense ...........................      3,042      2,598      2,232      2,103      1,741      1,537      1,439      1,187                                                  ------     ------     ------     ------     ------     ------     ------     ------  Net interest income ........................      3,841      3,593      3,334      3,147      3,032      2,799      2,525      2,335  Provision for loan losses ..................        285        265        144        171        679        222         95        150                                                  ------     ------     ------     ------     ------     ------     ------     ------  Net interest income after   provision for loan losses ................      3,556      3,328      3,190      2,976      2,353      2,577      2,430      2,185 Noninterest income .........................      1,349        459        451        466      1,584        443        358        315 Noninterest expenses .......................      2,696      2,229      2,222      2,097      2,535      1,987      1,839      1,604                                                  ------     ------     ------     ------     ------     ------     ------     ------  Income before taxes ........................      2,209      1,558      1,419      1,345      1,402      1,033        949        896 Income tax expense .........................        896        524        466        456        398        327        294        279                                                  ------     ------     ------     ------     ------     ------     ------     ------  Net income .................................     $1,313     $1,034     $  953     $  889     $1,004     $  706     $  655     $  617                                                  ======     ======     ======     ======     ======     ======     ======     ======  Earnings per share:   Basic ....................................     $ 0.30       0.31       0.29       0.27       0.31       0.22       0.20       0.19   Diluted ..................................     $ 0.30       0.31       0.29       0.27       0.30       0.21       0.20       0.19                                           40                    SOUTHCOAST FINANCIAL CORPORATION AND SUBSIDIARY                                  Corporate Data                             Common Stock and Dividends  The  common  stock of the  Company  is  traded  over-the-counter  on the  Nasdaq National  Market under the symbol  "SOCB." The reported  high and low bid prices for  each  quarter  of 2005  and 2004 are  shown  in the  following  table.  The quotations reflect  inter-dealer  prices,  without retail mark-up,  mark-down or commission and may not represent actual transactions.               2005                                        Low*          High*                                                      ---------      ---------      Fourth Quarter                                  $   21.50      $   24.85      Third Quarter                                   $   21.50      $   26.00      Second Quarter                                  $   21.36      $   26.90      First Quarter                                   $   20.68      $   23.52               2004       Fourth Quarter                                  $   23.05      $   24.68      Third Quarter                                   $   19.09      $   22.82      Second Quarter                                  $   17.86      $   20.91      First Quarter                                   $   18.19      $   21.23 - ------------------ *Amounts adjusted to reflect a 10% stock dividend paid June 24, 2005 and May 28, 2004.  As of February 29, 2006, there were approximately 1,850 holders of record of the Company's common stock,  excluding individual  participants in security position listings.  The Company  has never paid any cash  dividends,  and to support  its  continued capital  growth,  does not expect to pay cash dividends in the near future.  The dividend  policy of the  Company is subject  to the  discretion  of the Board of Directors and depends upon a number of factors,  including  earnings,  financial conditions,  cash needs and general business  conditions,  as well as applicable regulatory  considerations.  At present, the Company's principal source of funds with which it could pay  dividends  is dividend  payments  from the Bank.  South Carolina  banking  regulations  require the prior  written  consent of the South Carolina  Commissioner of Banking for the payment of cash dividends  unless such dividends  are paid out of the bank's  current  earnings and the bank received a satisfactory rating on its most recent examination.     EX-23 3 sthcst10ksb06exhibit23.txt                                     Exhibit 23              CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM  Board of Directors Southcoast Financial Corporation       We  consent  to  the  incorporation  by  reference  into  the  Registration Statements on Form S-8 filed by Southcoast  Financial  Corporation in connection with the Southcoast Financial Corporation 2005 Employee Stock Purchase Plan (No. 333-128197) and the Southcoast Financial Corporation 1999 Stock Option Plan (No. 333-106154)  of our Report  dated  February 3, 2006, included in the  Southcoast Financial Corporation Annual Report on Form 10-K for the year ended December 31, 2005.                                                   s/Elliott Davis, LLC  ELLIOTT DAVIS, LLP Columbia, South Carolina March 29, 2006       EX-31.1 4 sthcst10k06exhibit31-1.txt                                   CERTIFICATIONS                                                                     Exhibit 31.1  I, L. Wayne Pearson, certify that:  1.   I have reviewed  this annual  report on Form 10-K of  Southcoast  Financial      Corporation;  2.   Based on my knowledge, this report does not contain any untrue statement of      a material  fact or omit to state a  material  fact  necessary  to make the      statements made, in light of the circumstances  under which such statements      were made,  not  misleading  with  respect  to the  period  covered by this      report;  3.   Based on my  knowledge,  the  financial  statements,  and  other  financial      information  included  in  this  report,  fairly  present  in all  material      respects the financial  condition,  results of operations and cash flows of      the registrant as of, and for, the periods presented in this report;  4.   The  registrant's  other  certifying  officer  and  I are  responsible  for      establishing and maintaining disclosure controls and procedures (as defined      in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:       a)   designed  such  disclosure  controls  and  procedures,  or caused such           disclosure   controls  and   procedures  to  be  designed   under  our           supervision,  to ensure  that  material  information  relating  to the           registrant,  including its consolidated subsidiaries, is made known to           us by others within those entities,  particularly during the period in           which this report is being prepared;       c)   evaluated the  effectiveness of the registrant's  disclosure  controls           and procedures and presented in this report our conclusions  about the           effectiveness of the disclosure controls and procedures, as of the end           of the period covered by this report based on such evaluation;  and       d)   disclosed  in this  report  any  change in the  registrant's  internal           control over financial reporting that occurred during the registrant's           most recent fiscal quarter (the registrant's  fourth fiscal quarter in           the case of an annual  report)  that has  materially  affected,  or is           reasonably  likely to materially  affect,  the  registrant's  internal           control over financial reporting; and  5.   The registrant's  other certifying  officer and I have disclosed,  based on      our most recent evaluation of internal control over financial reporting, to      the registrant's auditors and the audit committee of the registrant's board      of directors (or persons performing the equivalent functions):       a)   all significant  deficiencies and material weaknesses in the design or           operation  of internal  control  over  financial  reporting  which are           reasonably  likely to  adversely  affect the  registrant's  ability to           record, process, summarize and report financial information; and       b)   any fraud, whether or not material,  that involves management or other           employees who have a  significant  role in the  registrant's  internal           control over financial reporting.    Date: March 29, 2006                       s/L. Wayne Pearson - ------------------------------             -------------------------------------                                            L. Wayne Pearson                                            Chief Executive Officer       EX-31.2 5 sthcst10k06exhibit31-2.txt                                   CERTIFICATIONS                                                                     Exhibit 31.2  I, Robert M. Scott, certify that:  1.   I have reviewed  this annual  report on Form 10-K of  Southcoast  Financial      Corporation;  2.   Based on my knowledge, this report does not contain any untrue statement of      a material  fact or omit to state a  material  fact  necessary  to make the      statements made, in light of the circumstances  under which such statements      were made,  not  misleading  with  respect  to the  period  covered by this      report;  3.   Based on my  knowledge,  the  financial  statements,  and  other  financial      information  included  in  this  report,  fairly  present  in all  material      respects the financial  condition,  results of operations and cash flows of      the registrant as of, and for, the periods presented in this report;  4.   The  registrant's  other  certifying  officer  and  I are  responsible  for      establishing and maintaining disclosure controls and procedures (as defined      in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:       a)   designed  such  disclosure  controls  and  procedures,  or caused such           disclosure   controls  and   procedures  to  be  designed   under  our           supervision,  to ensure  that  material  information  relating  to the           registrant,  including its consolidated subsidiaries, is made known to           us by others within those entities,  particularly during the period in           which this report is being prepared;       c)   evaluated the  effectiveness of the registrant's  disclosure  controls           and procedures and presented in this report our conclusions  about the           effectiveness of the disclosure controls and procedures, as of the end           of the period covered by this report based on such evaluation;  and       d)   disclosed  in this  report  any  change in the  registrant's  internal           control over financial reporting that occurred during the registrant's           most recent fiscal quarter (the registrant's  fourth fiscal quarter in           the case of an annual  report)  that has  materially  affected,  or is           reasonably  likely to materially  affect,  the  registrant's  internal           control over financial reporting; and  5.   The registrant's  other certifying  officer and I have disclosed,  based on      our most recent evaluation of internal control over financial reporting, to      the registrant's auditors and the audit committee of the registrant's board      of directors (or persons performing the equivalent functions):       a)   all significant  deficiencies and material weaknesses in the design or           operation  of internal  control  over  financial  reporting  which are           reasonably  likely to  adversely  affect the  registrant's  ability to           record, process, summarize and report financial information; and       b)   any fraud, whether or not material,  that involves management or other           employees who have a  significant  role in the  registrant's  internal           control over financial reporting.    Date:  March 29, 2006                      s/Robert M. Scott - ------------------------------             -------------------------------------                                            Robert M. Scott                                            Chief Financial Officer       EX-32 6 sthcst10ksb06exhibit32.txt                                                                         Exhibit 32                  CERTIFICATIONS PURSUANT TO 18 U.S.C. SECTION 1350        The  undersigned,  who are  the  chief  executive  officer  and  the  chief financial  officer of SouthCoast  Financial  Corporation  each hereby  certifies that,  to the best of his  knowledge,  the  accompanying  Form 10-K for the year ended December 31, 2005,  fully complies with the  requirements of Section 13(a) or 15(d) of the Securities  Exchange Act of 1934 and that information  contained in the report fairly presents, in all material respects, the financial condition and results of operations of the issuer.  March 29, 2006                                      s/L. Wayne Pearson                                     --------------------------------------------                                     L. Wayne Pearson                                     Chief Executive Officer                                       s/Robert M. Scott                                     --------------------------------------------                                     Robert M. Scott                                     Chief Financial Officer      -----END PRIVACY-ENHANCED MESSAGE-----