SOUTHCOAST FINANCIAL CORP - FORM 10-Q

Attached files

file	filename
EX-31.1 - EXHIBIT 31.1 - SOUTHCOAST FINANCIAL CORP	ex31-1.htm
EX-31.2 - EXHIBIT 31.2 - SOUTHCOAST FINANCIAL CORP	ex31-2.htm
EX-32 - EXHIBIT 32 - SOUTHCOAST FINANCIAL CORP	ex32.htm

U.S. SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended September 30, 2015

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF

THE SECURITIES EXCHANGE ACT OF 1934

For the Transition Period from _________to_________

Commission File No.

0-25933

SOUTHCOAST FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

South Carolina		57-1079460
(State or other jurisdiction		(I.R.S. Employer
of incorporation or organization)		Identification No.)

530 Johnnie Dodds Boulevard

Mt. Pleasant, South Carolina 29464

(Address of principal executive offices)

843-884-0504

(Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.

YES [ X] NO [ ]

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

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

Large accelerated filer [ ]		Accelerated filer [ ]
Non-accelerated filer [ ] (Do not check if a smaller reporting company)		Smaller reporting company [ X ]

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

YES [ ] NO [ X ]

State the number of shares outstanding of each of the issuer's classes of common stock as of the latest practicable date.

7,103,751 shares of common stock, no par value, as of October 31, 2015

SOUTHCOAST FINANCIAL CORPORATION

INDEX

PART I - FINANCIAL INFORMATION	Page No.

Item 1. Financial Statements (Unaudited)

Condensed Consolidated Balance Sheets – September 30, 2015 and December 31, 2014	2

Condensed Consolidated Statements of Income – Nine months ended September 30, 2015 and 2014	3

Condensed Consolidated Statements of Income – Three months ended September 30, 2015 and 2014	4

Condensed Consolidated Statements of Comprehensive Income – Nine and three months ended September 30, 2015 and 2014	5

Condensed Consolidated Statements of Changes in Shareholders' Equity – Nine months ended September 30, 2015 and 2014	6

Condensed Consolidated Statements of Cash Flows - Nine months ended September 30, 2015 and 2014	7

Notes to Condensed Consolidated Financial Statements	8-32

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations	33-46

Item 3. Quantitative and Qualitative Disclosures About Market Risk	46

Item 4. Controls and Procedures	46


PART II - OTHER INFORMATION

Item 1. Legal Proceedings	47

Item 6. Exhibits	47

Signatures	47

Exhibit Index	48

SOUTHCOAST FINANCIAL CORPORATION

Condensed Consolidated Balance Sheets

PART I - FINANCIAL INFORMATION

Item 1 - Financial Statements

(Dollars in thousands)

	September 30,			December 31,
	2015			2014
	(Unaudited)
Assets
Cash and cash equivalents:
Cash and due from banks	$	20,042		$	33,572

Investment securities
Available for sale		32,946			35,269
Federal Home Loan Bank Stock, at cost		3,059			4,000

Loans held for sale		707			-

Loans, net of allowance of $4,772 and $5,602		382,756			358,546

Premises and equipment, net		19,458			20,455
Other real estate owned, net		2,777			3,686
Company owned life insurance		13,224			12,984
Deferred tax asset, net		4,277			5,636
Other assets		2,677			2,685

Total assets	$	481,923		$	476,833

Liabilities
Deposits
Noninterest-bearing	$	60,456		$	48,700
Interest-bearing		290,457			282,334

Total deposits		350,913			331,034

Federal funds purchased		3,030			3,065
Securities sold under agreements to repurchase		874			737
Federal Home Loan Bank Borrowings		62,000			80,000
Junior subordinated debentures		10,310			10,310
Other liabilities		3,395			4,382

Total liabilities		430,522			429,528

Shareholders’ Equity
Common stock (no par value; 20,000,000 shares authorized; 7,103,751 shares issued and outstanding at September 30, 2015 and 7,096,574 at December 31, 2014)		54,694			54,643
Accumulated deficit		(2,679	)		(6,200	)
Accumulated other comprehensive loss		(614	)		(1,138	)

Total shareholders’ equity		51,401			47,305

Total liabilities and shareholders’ equity	$	481,923		$	476,833

See Notes to Condensed Consolidated Financial Statements

SOUTHCOAST FINANCIAL CORPORATION

Condensed Consolidated Statements of Income

(Unaudited)

(Dollars in thousands)

	For the Nine Months Ended
	September 30,
	2015			2014
Interest income
Loans, including fees	$	13,804		$	12,703
Taxable securities		611			725
Tax exempt securities		109			113
Cash and federal funds sold		33			24

Total interest income		14,557			13,565

Interest expense
Deposits and borrowings		2,574			2,706

Net interest income		11,983			10,859
Provision for loan losses		(900	)		-

Net interest income after provision for loan losses		12,883			10,859

Noninterest income
Service fees on deposit accounts		1,159			1,118
Gain on sale of mortgage loans held for sale		121			27
Company owned life insurance earnings		240			245
Gain on sale of available for sale securities		-			109
Gain on sale of premises and equipment		750			-
Other		163			131
Total noninterest income		2,433			1,630

Noninterest expenses
Salaries and employment benefits		5,495			4,880
Occupancy		801			870
Furniture and equipment		1,273			1,267
Software		37			54
Insurance		388			457
Professional fees		941			547
Telephone, postage, and supplies		247			245
Gain on sale of other real estate owned		(118	)		(340	)
Other real estate owned impairment provision, and other expenses, net of rental income		16			112
Other operating expenses		739			891

Total noninterest expenses		9,819			8,983

Income before income taxes		5,497			3,506
Income tax expense		1,976			1,121

Net income	$	3,521		$	2,385

Basic net income per common share	$	.50		$	.34

Diluted net income per common share	$	.50		$	.34

Weighted average shares outstanding
Basic		7,102,498			7,089,630

Diluted		7,102,498			7,089,630

See Notes to Condensed Consolidated Financial Statements

SOUTHCOAST FINANCIAL CORPORATION

Condensed Consolidated Statements of Income

(Unaudited)

(Dollars in thousands)

	For the Three Months Ended
	September 30,
	2015		2014
Interest income
Loans, including fees	$	4,729	$	4,286
Taxable securities		196		222
Tax exempt securities		33		37
Cash and federal funds sold		10		8

Total interest income		4,968		4,553

Interest expense
Deposits and borrowings		869		897

Net interest income		4,099		3,656
Provision for loan losses		-		-

Net interest income after provision for loan losses		4,099		3,656

Noninterest income
Service fees on deposit accounts		397		380
Gain on sale of mortgage loans held for sale		60		6
Company owned life insurance earnings		80		82
Other		61		44
Total noninterest income		598		512

Noninterest expenses
Salaries and employment benefits		1,842		1,431
Occupancy		256		285
Furniture and equipment		412		424
Software		10		11
Insurance		128		157
Professional fees		515		171
Telephone, postage, and supplies		87		77
Gain on sale of other real estate owned		-		(184	)
Other real estate owned impairment provision, and other expenses, net of rental income		12		51
Other operating expenses		322		315

Total noninterest expenses		3,584		2,738

Income before income taxes		1,113		1,430
Income tax expense		443		397

Net income	$	670	$	1,033

Basic net income per common share	$	.09	$	.15

Diluted net income per common share	$	.09	$	.15

Weighted average shares outstanding
Basic		7,103,751		7,093,132

Diluted		7,103,751		7,093,132

See Notes to Condensed Consolidated Financial Statements

SOUTHCOAST FINANCIAL CORPORATION

Condensed Consolidated Statements of Comprehensive Income

(Unaudited)

	For the Nine Months Ended
	September 30,
	2015			2014
Net income	$	3,521		$	2,385

Other comprehensive income:
Unrealized gains on available for sale securities		819			1,097
Tax effect		(295	)		(394	)
Reclassification of gains included in net income		-			(109	)
Tax effect		-			39
Total other comprehensive income		524			633

Comprehensive income	$	4,045		$	3,018

	For the Three Months Ended
	September 30,
	2015			2014
Net income	$	670		$	1,033

Other comprehensive income:
Unrealized gains (losses) on available for sale securities		442			(12	)
Tax effect		(159	)		5
Total other comprehensive income (loss)		283			(7	)

Comprehensive income	$	953		$	1,026

See Notes to Condensed Consolidated Financial Statements

SOUTHCOAST FINANCIAL CORPORATION

Condensed Consolidated Statements of Changes in Shareholders' Equity

For the nine months ended September 30, 2015 and 2014

(Unaudited)

(Dollars in thousands)	Common Stock				Accumulated			Accumulated Other Comprehensive
	Shares		Amount		Deficit			Loss			Total

Balance, January 1, 2014		7,082,062	$	54,544	$	(9,937	)	$	(2,038	)	$	42,569

Comprehensive income						2,385			633			3,018

Employee stock purchase plan		11,070		75		.-			-			75

Balance, September 30, 2014		7,093,132	$	54,619	$	(7,552	)	$	(1,405	)	$	45,662

Balance, January 1, 2015		7,096,574	$	54,643	$	(6,200	)	$	(1,138	)	$	47,305

Comprehensive income						3,521			524			4,045

Employee stock purchase plan		7,177		51		.-			-			51

Balance, September 30, 2015		7,103,751	$	54,694	$	(2,679	)	$	(614	)	$	51,401

See Notes to Condensed Consolidated Financial Statements

SOUTHCOAST FINANCIAL CORPORATION

Condensed Consolidated Statements of Cash Flows

(Unaudited)

(Amounts in thousands)	For the Nine Months Ended
	September 30,
	2015			2014
Operating activities
Net income	$	3,521		$	2,385
Adjustments to reconcile net income to net cash provided by operating activities
Decrease in deferred income taxes		1,064			964
Provision for loan losses		(900	)		-
Depreciation and amortization		584			642
Discount accretion and premium amortization		109			102
Gain on sales of available for sale securities		-			(109	)
Gain on sale of other real estate owned		(118	)		(340	)
Change in deferred gain on sale of other real estate owned		45			95
Impairment charges on other real estate owned		-			6
Originations of loans held for sale		(8,219	)		(1,254	)
Proceeds from sales of loans held for sale		7,633			1,295
Gain on sale of mortgage loans held for sale		(121	)		(27	)
Gain on sale of premises and equipment		(750	)		-
Company owned life insurance earnings		(240	)		(245	)
Decrease (increase) in other assets		8			(39	)
Increase (decrease) in other liabilities		(986	)		58
Net cash provided by operating activities		1,630			3,533

Investing activities
Calls, maturities, and paydowns of investment securities available-for-sale		3,032			5,060
Purchases of investment securities available for sale		-			(3,000	)
Sales of investment securities available-for-sale		-			3,229
Purchases of Federal Home Loan Bank stock		(1,299	)		(878	)
Sales of Federal Home Loan Bank stock		2,240			957
Net increase in loans		(22,635	)		(22,837	)
Purchases of premises and equipment		(132	)		(97	)
Proceeds from sales of premises and equipment		1,295			-
Proceeds from sales of other real estate owned		307			1,144
Capital expenditures related to other real estate owned		-			(14	)
Net cash used by investing activities		(17,192	)		(16,436	)

Financing activities
Net increase in deposits		19,879			8,051
Increase (decrease) in federal funds purchased		(35	)		4,855
Increase (decrease) in securities sold under agreements to repurchase		137			(9	)
Proceeds from Federal Home Loan Bank Borrowings		35,000			29,000
Paydowns of Federal Home Loan Bank Borrowings		(53,000	)		(28,000	)
Net proceeds from issuances of stock		51			75
Net cash provided by financing activities		2,032			13,972
Increase (decrease) in cash and cash equivalents		(13,530	)		1,069
Cash and cash equivalents, beginning of period		33,572			28,460
Cash and cash equivalents, end of period	$	20,042		$	29,529
Cash paid for:
Interest	$	2,627		$	2,911
Income taxes	$	931			133
Supplemental noncash investing and financing activities:
Real estate acquired in settlement of loans	$	-		$	747
Change in unrealized losses on available-for-sale securities	$	(819	)	$	(988	)
Loans to finance sales of other real estate owned	$	(675	)	$	(1,045	)

See Notes to Condensed Consolidated Financial Statements

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 1 - Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Regulation S-X of the Securities and Exchange Commission. Accordingly they do not include all information and notes required by generally accepted accounting principles for complete financial statements. However, in the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included.

Note 2 - Organization

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”). 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. The Company presently engages in no business other than that of owning the Bank and another subsidiary, Southcoast Investment Corporation, and has no employees.

On August 14, 2015, the Company entered into a definitive agreement with BNC Bancorp ("BNC") the holding company for Bank of North Carolina, pursuant to which BNC will acquire all of the common stock of the Company in a stock transaction valued at approximately $95.5 million, based on the closing price of BNC common stock on August 13, 2015. Under the terms of the agreement, which has been approved by the Boards of Directors of both companies, the Company's shareholders will receive shares of BNC common stock based upon the volume weighted average price of BNC common stock for a 20-day trading period prior to the closing of the merger ("VWAP"), subject to minimum and maximum exchange ratios as follow: if the VWAP immediately prior to the merger is equal to or greater than $22.00, then each share of the Company’s common stock will be converted into 0.6068 shares of BNC common stock; if the VWAP immediately prior to the merger is less than $22.00 but greater than $19.00, then each share of the Company’s common stock will be converted into $13.35 payable in shares of BNC common stock (with the exchange ratio equal to $13.35 divided by the VWAP); and if the VWAP is equal to or less than $19.00, then each share of the Company’s common stock will be converted into 0.7026 shares of BNC common stock. The transaction, which is subject to regulatory approval, the approval of the shareholders of the Company, and other customary conditions, is expected to close in the first quarter of 2016.

Note 3 - Net Income Per Share

Basic earnings per common share is net income divided by the weighted average number of common shares outstanding during the period. Earnings and dividends per share are restated for all stock splits and stock dividends through the date of issuance of the financial statements, if any. The Company had no potentially dilutive shares during the periods presented in this report.

Note 4 – Recently Issued Accounting Standards

There were no recently issued authoritative pronouncements that had a material impact on the Company’s accounting, reporting, or disclosures of financial information as of September 30, 2015.

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 5 – Investment Securities

The amortized cost and fair value of investment securities are as follows:

(Amounts in thousands)	September 30, 2015
	Amortized		Gross Unrealized				Estimated
	Cost		Gains		Losses		Fair Value
Available for sale
Mortgage backed
Government sponsored enterprises	$	22,259	$	75	$	86	$	22,248
Municipal securities		3,431		243		-		3,674
Other		8,215		56		1,247		7,024

Total	$	33,905	$	374	$	1,333	$	32,946

	December 31, 2014
	Amortized		Gross Unrealized				Estimated
	Cost		Gains		Losses		Fair Value
Available for sale
Mortgage backed
Government sponsored enterprises	$	24,915	$	103	$	80	$	24,938
Municipal securities		3,924		260		-		4,184
Other		8,208		37		2,098		6,147
Total	$	37,047	$	400	$	2,178	$	35,269

The following tables show 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 September 30, 2015 and December 31, 2014.

Available for Sale

(Amounts in thousands)	September 30, 2015
	Less than				Twelve Months
	Twelve Months				or More				Total
			Unrealized				Unrealized				Unrealized
	Fair Value		Losses		Fair Value		Losses		Fair Value		Losses

Mortgage backed	$	14,474	$	86	$	-	$	-	$	14,474	$	86
Other		-		-		2,468		1,247		2,468		1,247

Total	$	14,474	$	86	$	2,468	$	1,247	$	16,942	$	1,333

	December 31, 2014
	Less than				Twelve Months
	Twelve Months				or More				Total
			Unrealized				Unrealized				Unrealized
	Fair Value		Losses		Fair Value		Losses		Fair Value		Losses

Mortgage backed	$	-	$	-	$	15,990	$	80	$	15,990	$	80
Other		-		-		1,610		2,098		1,610		2,098

Total	$	-	$	-	$	17,600	$	2,178	$	17,600	$	2,178

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 5 – Investment Securities – (continued)

Securities classified as available-for-sale are recorded at fair market value. Unrealized losses on securities in a continuous loss position for twelve months or more totaled $1,247,000, or 94% of unrealized losses, and $2,178,000, or 100% of unrealized losses, at September 30, 2015 and December 31, 2014, respectively. The majority of the unrealized losses for both periods related to Other securities, which were comprised of three individual securities. It is more likely than not that the Company will not be required to sell these securities before recovery of their amortized cost. Unrealized losses on Other securities declined by approximately $851,000 at September 30, 2015 when compared to December 31, 2014, primarily due to an $844,000 reduction in unrealized losses on an individual security. This security trades infrequently, but its increased valuation was based on a recent trade.

The unrealized loss attributable to Other securities primarily relates to valuations on two individual collateralized debt obligations which consist of pooled trust preferred securities. The Company believes, based on industry analyst reports, credit ratings, and third party other-than-temporary loss impairment evaluations, that the deterioration in the value of these securities is attributable to a combination of the lack of liquidity in both of these securities and credit quality concerns for one of the two securities. These securities are considered Level 3 securities in the fair value hierarchy as they both trade in less than liquid markets.

One of the Company’s collateralized debt obligations with an amortized cost of approximately $1,827,000 and fair value of approximately $1,209,000 is receiving contractual interest payments, while the other with an amortized cost of approximately $1,738,000 and fair value of approximately $1,157,000 is credited with payment-in-kind interest in lieu of cash interest payments. Due to the over-collateralized credit position of the security currently receiving interest payments, no other-than-temporary impairment was recognized on this security. Payment-in-kind interest consists of capitalization of interest amounts due on a security. In accordance with terms outlined in its offering circular, the security not currently paying interest has its deferred interest capitalized and added to the principal balance of the security. Future interest payments are accrued on these larger principal balances. The Company has discontinued the accrual of interest on this security due to its payment-in-kind status.

Payment-in-kind interest was triggered on this security due to deferrals of interest payments by individual issuers within the pool of issuers. Individual issuers are allowed to defer their interest payments for a period of up to five years. The security is divided into several tranches, with the A tranche securities being the most senior in terms of payment priority and Income Notes being the least senior. The Company owns notes in the C tranche of the security. Each tranche must pass an overcollateralization test in order for note holders in subordinate tranches to receive their contractual interest payments. The overcollateralization test is based on total performing collateral in the pool divided by total outstanding debt within the tranche. The senior most pool failing its overcollateralization test will receive principal paydowns on its outstanding notes in addition to contractual interest payments in order to cure its failure. These additional payments will be diverted from note holders in subordinate tranches who will instead receive payment-in-kind interest. At September 30, 2015, there was $233,628,000 of performing collateral in the pool. The table below summarizes balance and overcollateralization data for the individual tranches at September 30, 2015.

(Amounts in thousands)

Tranche	Current Balance		Required Overcollateralization %			Current Overcollateralization %
A	$	169,266		128.00	%		139.03	%
B		37,934		115.00	%		113.57	%
C		48,376		106.20	%		92.08	%
D		28,537		100.30	%		82.83	%
Income Notes		18,000	N/A			N/A

As shown above, tranches B and below currently fail their overcollateralization test. According to the structured payment terms as described in the offering circular for this security, interest payments are currently being diverted from tranches subordinate to B to pay down total principal balances in the B tranche. If and when these payments reduce the principal balance in the B tranche by enough to pass its overcollateralization requirement, the C tranche securities will begin to receive contractual interest payments, and additional payments will be diverted from subordinate tranches in order to meet its overcollateralization requirement. This payment structure, known as a waterfall, is designed to continue until all tranches meet their overcollateralization requirement. However, this outcome is dependent on the level of future interest deferrals and defaults by individual issuers. Any shortfalls to contractual principal and interest payments due will be borne in reverse order of payment priority, with the most subordinate tranche having the largest loss and the senior most tranche having the smallest loss. As a note holder in the C tranche of this structure, the Company’s principal and interest claims are subordinate to the principal and interest claims of note holders in the A and B tranches. More specifically, the Company and other C note holders would stand to lose 100% of their principal and interest before note holders in the B tranche lost their first dollar, and B note holders would lose 100% of their investment before A note holders experienced any loss.

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 5 – Investment Securities – (continued)

The Company engaged a firm specializing in security valuations to evaluate the security receiving payment-in-kind interest for other-than- temporary impairment (“OTTI”). This firm uses the OTTI evaluation model to compare the present value of expected cash flows to the previous estimate to measure whether there are any adverse changes in cash flows during the quarter. The OTTI model considers the structure and term of the trust preferred security and the financial condition of the underlying issuers. Specifically, the model details interest rates, principal balances of note classes and issuers, the timing and amount of interest and principal payments of the underlying issuers, and the allocation of the payments to the note classes. The allocation of payments to the note classes follows the payment priority hierarchy for the individual tranches. The OTTI evaluation prepared as of September 30, 2015 predicts the Company will resume receipt of its contractual principal and interest payments during 2016, which is when the B tranche is projected to pass its overcollateralization test. These projections are based on assumptions developed from current financial data for the underlying issuers and may change in subsequent periods based on future financial data which could alter the assumptions.

The current estimate of expected cash flows is based on the most recent trustee reports and any other relevant information including announcements of interest payment deferrals or defaults of the underlying issuers. The OTTI evaluation model assumes no recoveries on defaults. The result of the firm’s analysis indicated approximately $176,000 of credit loss as of March 31, 2011, which was recognized as an other-than-temporary loss in the first quarter of 2011 and reported in noninterest income. No credit losses had been recognized on these securities prior to 2011, and there have been no changes to credit losses recognized in earnings for any subsequent periods. Due to the credit loss recognized on this security, the Company has not accrued into interest income any of the payment-in-kind interest due on the security. Consequently, the security’s payment-in-kind interest is not reflected in the book value of the security. Total other-than-temporary impairment in accumulated other comprehensive income was $372,000 for the security (Security B in the table below) at September 30, 2015.

The following table provides certain relevant details on each of our collateralized debt obligations as of September 30, 2015, including the book value, fair value, and unrealized losses on the securities, as well as certain information about the overall pools and the current status of their underlying issuers. “Excess Subordination” is a measure of the excess performing collateral in the pool beyond the total level of debt outstanding in the pool with an equal or greater level of preference in the payment structure. It is expressed in the tables below as a percentage of performing collateral. It represents the percentage reduction in performing collateral that would precede an inability of the security to make contractually required payments to the Company.

September 30, 2015
(Amounts in thousands)
	Security A			Security B

Book Value	$	1,827		$	1,738
Fair Value	$	1,209		$	1,157
Unrealized Loss	$	618		$	581
Number of underlying financial institution issuers		45			38
Number of deferrals and defaults		7			11
Additional expected deferrals/ defaults*		N/A			0/1
Excess Subordination as a percentage of performing collateral^		33.13	%		N/A

* No assessment of these numbers was made for Security A as it was not modeled for cash flows due to its current payment status and its excess subordination. For Security B, this includes issuers for which there is an estimated probability of deferral or default of 50% or greater. None of the remaining performing collateral was projected as a future deferral or default, due to low Texas ratios; one deferring issuer was projected to default.

^Security B is in a support tranche and has no excess subordination.

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 5 – Investment Securities – (continued)

The credit quality of the collateralized debt obligations is directly related to the financial strength and ability to make contractual interest payments of the underlying issuers in these securities, most of which are banks or bank holding companies. As such, these securities may show additional OTTI in future periods if the financial condition of the underlying issuers further deteriorates.

The amortized costs and fair values of investment securities available for sale at September 30, 2015 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.

(Amounts in thousands)	Amortized		Fair
	Cost		Value
Due after one but within five years	$	440	$	459
Due after five but within ten years		2,455		2,638
Due after ten years		4,601		3,443
Mortgage backed		22,259		22,248
Equity securities with no maturity		4,150		4,158

Total investment securities available-for-sale	$	33,905	$	32,946

Investment securities with an aggregate amortized cost of $19,903,000 and estimated fair value of $20,008,000 at September 30, 2015, were pledged to secure public deposits and for other purposes, as required or permitted by law.

Investment securities with an aggregate amortized cost of $1,438,000 and estimated fair value of $1,433,000 at September 30, 2015, were pledged to secure securities sold under agreements to repurchase.

Investment securities with an aggregate amortized cost of $22,777,000 and estimated fair value of $22,809,000 at December 31, 2014, were pledged to secure public deposits and for other purposes, as required or permitted by law.

Investment securities with an aggregate amortized cost of $2,591,000 and estimated fair value of $2,593,000 at December 31, 2014, were pledged to secure securities sold under agreements to repurchase.

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 6 - Loans

The composition of loans by major loan category is presented below:

(Dollars in thousands)	September 30,			December 31,
	2015			2014
Real estate secured loans:
Residential 1-4 Family	$	239,463		$	217,518
Multifamily		4,716			5,108
Commercial		89,179			87,906
Construction and land development		32,363			29,060

Total real estate secured loans		365,721			339,592
Commercial and industrial		18,597			22,022
Consumer		2,862			2,206
Other		348			328
Total gross loans		387,528			364,148
Allowance for loan losses		(4,772	)		(5,602	)
	$	382,756		$	358,546

The Company uses a numerical grading system from 1 to 9 to assess the credit risk inherent in its loan portfolio, with Grade 1 loans having the lowest credit risk and Grade 9 loans having the highest credit risk. Loans with credit grades from 1 to 5 are considered passing grade, or acceptable, loans. Loans with grades from 6 to 9 are considered to have less than acceptable credit quality. Generally, impaired loans have credit grades of 7 or higher. Following is a listing and brief description of the various risk grades. The grading of individual loans may involve the use of estimates.

Credit Grade	Description
1	Loans secured by cash collateral.
2	Loans secured by readily marketable collateral.
3	Top quality loans with excellent repayment sources and no significant identifiable risk of collection.
4	Acceptable loans with adequate repayment sources and little identifiable risk of collection.
5	Acceptable loans with signs of weakness as to repayment or collateral, but with mitigating factors that minimize the risk of loss.
6	Watch List or Special Mention loans with underwriting tolerances and/or exceptions with no mitigating factors that may, due to economic or other factors, increase the risk of loss.
7	Classified substandard loans inadequately protected by the paying capacity or net worth of the obligor, or of the collateral with weaknesses that jeopardize the liquidation of the debt.
8	Classified doubtful loans in which collection or liquidation in full is highly improbable.
9	Classified loss loans that are uncollectible and of such little value that continuance as an asset is not warranted.

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 6 – Loans - (Continued)

The following tables provide a summary of our credit risk profile by loan categories as of September 30, 2015 and December 31, 2014 (including nonaccrual loans).

(Dollars in thousands)

Credit Risk Profile by Creditworthiness Category

As of September 30, 2015 and December 31, 2014

	Real Estate Secured
	Residential 1-4 Family				Multi Family				Commercial				Construction and Land Development
	2015		2014		2015		2014		2015		2014		2015		2014
Grade
1	$	-	$	-	$	-	$	-	$	-	$	-	$	-	$	-
2		-		-		-		-		-		-		-		-
3		128,598		107,353		1,290		1,350		18,559		14,965		14,940		11,197
4		58,206		56,164		1,065		1,111		29,220		28,180		9,049		7,310
5		45,308		46,873		2,028		2,309		32,107		33,081		7,659		9,571
6		1,507		1,587		333		-		4,663		2,042		61		269
7		5,655		4,930		-		338		4,630		9,638		654		703
8		189		611		-		-		-		-		-		10
9		-		-		-		-		-		-		-		-

Total	$	239,463	$	217,518	$	4,716	$	5,108	$	89,179	$	87,906	$	32,363	$	29,060

	Non-Real Estate Secured
	Commercial				Consumer				Other				Total
	2015		2014		2015		2014		2015		2014		2015		2014
Grade
1	$	508	$	2,223	$	376	$	397	$	-	$	-	$	884	$	2,620
2		2		-		-		-		-		-		2		-
3		2,298		2,205		939		480		91		94		166,715		137,644
4		7,878		6,628		373		220		233		181		106,024		99,794
5		6,186		9,589		1,059		977		24		53		94,371		102,453
6		788		18		-		-		-		-		7,352		3,916
7		937		1,359		115		132		-		-		11,991		17,100
8		-		-		-		-		-		-		189		621
9		-		-		-		-		-		-		-		-

Total	$	18,597	$	22,022	$	2,862	$	2,206	$	348	$	328	$	387,528	$	364,148

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 6 – Loans - (Continued)

The following tables provide a summary of past due loans by loan category as of September 30, 2015 and December 31, 2014.

(Dollars in thousands)

Past Due Loans

For the Periods Ended September 30, 2015 and December 31, 2014

September 30, 2015	30-59 Days Past Due		60-89 Days Past Due		Greater Than 90 Days		Total Past Due		Current		Total Loans Receivable		Recorded Investment > 90 Days and Accruing
Real Estate Secured
1-4 Family Residential	$	1,288	$	1,263	$	1,522	$	4,073	$	235,390	$	239,463	$	-
Multifamily Residential		-		-		-		-		4,716		4,716		-
Commercial Real Estate		542		-		470		1,012		88,167		89,179		45
Construction and Land Development		44		-		-		44		32,319		32,363		-
Non-Real Estate Secured														-
Commercial and Industrial		67		-		50		117		18,480		18,597		-
Consumer and Other		258		30		11		299		2,911		3,210		-

Total	$	2,199	$	1,293	$	2,053	$	5,545	$	381,983	$	387,528	$	45

December 31, 2014	30-59 Days Past Due		60-89 Days Past Due		Greater Than 90 Days		Total Past Due		Current		Total Loans Receivable		Recorded Investment > 90 Days and Accruing
Real Estate Secured
1-4 Family Residential	$	1,748	$	955	$	1,972	$	4,675	$	212,843	$	217,518	$	-
Multifamily Residential		-		-		-		-		5,108		5,108		-
Commercial Real Estate		794		1,930		1,073		3,797		84,109		87,906		-
Construction and Land Development		-		52		10		62		28,998		29,060		-
Non- Real Estate Secured														-
Commercial and Industrial		235		66		146		447		21,575		22,022		-
Consumer and Other		8		15		13		36		2,498		2,534		-

Total	$	2,785	$	3,018	$	3,214	$	9,017	$	355,131	$	364,148	$	-

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 6 – Loans - (Continued)

The following table provides a summary of nonaccrual loans as of September 30, 2015 and December 31, 2014.

(Dollars in thousands)

	September 30,		December 31,
	2015		2014

1-4 Family Residential	$	2,403	$	2,956
Multifamily Residential		-		-
Commercial Real Estate		1,554		1,096
Construction and Land Development		-		10
Commercial and Industrial		562		859
Consumer and Other		12		48

Total	$	4,531	$	4,969

At September 30, 2015 and December 31, 2014, nonaccrual loans totaled $4.5 million and $5.0 million, respectively. The gross interest income that would have been recorded under the original terms of nonaccrual loans totaled $186,000 and $685,000 for the nine months ended September 30, 2015 and 2014, respectively. At September 30, 2015 and December 31, 2014, impaired loans (which include nonaccrual loans and troubled debt restructurings (TDRs)) totaled $5.5 million and $5.6 million, respectively. The recorded investment in impaired loans individually evaluated for impairment, which include nonaccrual loans over $250,000 and TDRs, totaled $3.8 million and $3.9 million at September 30, 2015 and December 31, 2014, respectively. At September 30, 2015 loans over ninety days past due and still accruing interest totaled $45,000. There were no such loans at December 31, 2014.

At September 30, 2015 and December 31, 2014, all TDRs, including those on nonaccrual status, totaled $2 million and $3.9 million, respectively. The gross interest income that would have been recognized on TDRs according to the original loan terms during the nine months ended September 30, 2015 totaled approximately $38,000; actual interest income recognized on these loans according to the restructured terms totaled $33,000. The gross interest income that would have been recognized on TDRs according to the original loan terms during the year ended December 31, 2014 totaled approximately $38,000; actual interest income recognized on these loans according to the restructured terms totaled approximately $11,000. During the quarter ended September 30, 2015, there were no loans that had their original loan terms restructured, and no loans that had previously had their original terms restructured went into nonaccrual. Also during the quarter ended September 30, 2015, two loans totaling $139,000, that had their original loan terms restructured, were charged off, and no loans that had their original terms restructured paid off. TDRs did not have a material effect on the allowance for loan losses as of September 30, 2015 or December 31, 2014.

The following tables provide a year to date analysis of activity within the allowance for loan losses.

(Dollars in thousands)	September 30,			September 30,
	2015			2014

Balance, beginning of year	$	5,602		$	6,041
Provision for loan losses		(900	)		-
Net (chargeoffs), recoveries		70			(103	)

Balance, end of quarter	$	4,772		$	5,938

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 6 – Loans - (Continued)

	For the Nine Months Ended September 30, 2015
	Beginning Balance		Charge Offs			Recoveries		Provisions			Ending Allowance for Loan Losses
(Dollars in thousands)											General Reserves		Specific Reserves		Total

Real Estate Secured
1-4 Family Residential	$	1,595	$	(73	)	$	-	$	161		$	1,641	$	42	$	1,683
Multifamily Residential		61		-			144		(178	)		27		-		27
Commercial Real Estate		1,424		-			190		(710	)		904		-		904
Construction and Land Development		312		-			21		(119	)		214		-		214
Non-Real Estate Secured
Commercial and Industrial		496		(261	)		11		131			377		-		377
Consumer and Other		32		(6	)		44		(49	)		21		-		21
Other
Other General Reserves		1,363		-			-		(67	)		1,296		-		1,296
Unallocated		319		-			-		(69	)		250		-		250
Total	$	5,602	$	(340	)	$	410	$	(900	)	$	4,730	$	42	$	4,772

	For the Nine Months Ended September 30, 2014
	Beginning Balance		Charge Offs			Recoveries		Provisions			Ending Allowance for Loan Losses
(Dollars in thousands)											General Reserves		Specific Reserves		Total

Real Estate Secured
1-4 Family Residential	$	1,829	$	(52	)	$	46	$	(231	)	$	1,524	$	68	$	1,592
Multifamily Residential		58		(113	)		-		153			98		-		98
Commercial Real Estate		1,031		(106	)		1		594			1,520		-		1,520
Construction and Land Development		585		(114	)		19		(201	)		289		-		289
Non-Real Estate Secured
Commercial and Industrial		690		(42	)		213		(286	)		575		-		575
Consumer and Other		24		(1	)		46		(36	)		33		-		33
Other
Other General Reserves		1,339		-			-		14			1,353		-		1,353
Unallocated		485		-			-		(7	)		478		-		478
Total	$	6,041	$	(428	)	$	325	$	-		$	5,870	$	68	$	5,938

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 6 – Loans - (Continued)

	For the Three Months Ended September 30, 2015
	Beginning Balance		Charge Offs			Recoveries		Provisions			Ending Allowance for Loan Losses
(Dollars in thousands)											General Reserves		Specific Reserves		Total
Real Estate Secured
1-4 Family Residential	$	1,397	$	(38	)	$	-	$	324		$	1,641	$	42	$	1,683
Multifamily Residential		80		-			-		(53	)		27		-		27
Commercial Real Estate		837		-			-		67			904		-		904
Construction and Land Development		448		-			3		(237	)		214		-		214
Non-Real Estate Secured
Commercial and Industrial		547		(180	)		1		9			377		-		377
Consumer and Other		29		-			-		(8	)		21		-		21
Other
Other General Reserves		1,380		-			-		(84	)		1,296		-		1,296
Unallocated		268		-			-		(18	)		250		-		250
Total	$	4,986	$	(218	)	$	4	$	-		$	4,730	$	42	$	4,772

	For the Three Months Ended September 30, 2014
	Beginning Balance		Charge Offs			Recoveries		Provisions			Ending Allowance for Loan Losses
(Dollars in thousands)											General Reserves		Specific Reserves		Total
Real Estate Secured
1-4 Family Residential	$	1,280	$	-		$	37	$	275		$	1,524	$	68	$	1,592
Multifamily Residential		197		(113	)		-		14			98		-		98
Commercial Real Estate		1,096		-			1		423			1,520		-		1,520
Construction and Land Development		633		(58	)		1		(287	)		289		-		289
Non-Real Estate Secured
Commercial and Industrial		713		-			32		(170	)		575		-		575
Consumer and Other		21		-			1		11			33		-		33
Other
Other General Reserves		1,451		-			-		(98	)		1,353		-		1,353
Unallocated		646		-			-		(168	)		478		-		478
Total	$	6,037	$	(171	)	$	72	$	-		$	5,870	$	68	$	5,938

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 6 – Loans - (Continued)

	For the Year Ended December 31, 2014
	Beginning Balance		Charge Offs			Recoveries		Provisions			Ending Allowance for Loan Losses
(Dollars in thousands)											General Reserves		Specific Reserves		Total
Real Estate Secured
1-4 Family Residential	$	1,829	$	(52	)	$	46	$	(228	)	$	1,532	$	63	$	1,595
Multi Family Residential		58		(155	)		11		147			61		-		61
Commercial Real Estate		1,031		(159	)		342		210			1,424		-		1,424
Construction and Land Development		585		(114	)		21		(180	)		312		-		312
Non-Real Estate Secured
Commercial and Industrial		690		(42	)		218		(370	)		496				496
Consumer and Other		24		(1	)		46		(37	)		32		-		32
Other
Other General Reserves		1,339		-			-		24			1,363		-		1,363
Unallocated		485		-			-		(166	)		319		-		319
Total	$	6,041	$	(523	)	$	684	$	(600	)	$	5,539	$	63	$	5,602

Impaired loans with a balance of $250,000 or more are evaluated individually for impairment. All other loans are collectively evaluated for impairment. The following tables provide summaries and totals of loans individually and collectively evaluated for impairment as of September 30, 2015 and December 31, 2014.

Loans Receivable:	As of September 30, 2015
(Dollars in thousands)	Individually evaluated for impairment		Collectively evaluated for impairment		Total
Real Estate Secured
1-4 Family Residential	$	1,964	$	237,499	$	239,463
Multifamily Residential		-		4,716		4,716
Commercial Real Estate		1,473		87,706		89,179
Construction and Land Development		-		32,363		32,363
Non-Real Estate Secured
Commercial and Industrial		402		18,195		18,597
Consumer and Other		-		3,210		3,210
Total	$	3,839	$	383,689	$	387,528

Loans Receivable:	As of December 31, 2014
(Dollars in thousands)	Individually evaluated for impairment		Collectively evaluated for impairment		Total
Real Estate Secured
1-4 Family Residential	$	2,251	$	215,267	$	217,518
Multifamily Residential		-		5,108		5,108
Commercial Real Estate		1,096		86,810		87,906
Construction and Land Development		-		29,060		29,060
Non-Real Estate Secured
Commercial and Industrial		545		21,477		22,022
Consumer and Other		-		2,534		2,534
Total	$	3,892	$	360,256	$	364,148

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 6 – Loans - (Continued)

(Dollars in thousands)

Impaired Loans
For the Nine Months ended September 30, 2015

	Unpaid Principal Balance		Recorded Investment (1)		Related Allowance		Life to Date Charge offs		Average Recorded Investment		Interest Income Recognized

With no related allowance recorded
1-4 Family Residential	$	1,590	$	1,469	$	-	$	121	$	1,491	$	33
Multifamily Residential		-		-		-		-		-		-
Commercial Real Estate		1,473		1,473		-		-		1,528		-
Construction and Land Development		-		-		-		-		-		-
Commercial and Industrial		402		402		-		-		421		-
Consumer and Other		-		-		-		-		-		-

With an allowance recorded
1-4 Family Residential	$	495	$	495	$	42	$	-	$	504	$	-
Multifamily Residential		-		-		-		-		-		-
Commercial Real Estate		-		-		-		-		-		-
Construction and Land Development		-		-		-		-		-		-
Commercial and Industrial		-		-		-		-		-		-
Consumer and Other		-		-		-		-		-		-

Total
1-4 Family Residential	$	2,085	$	1,964	$	42	$	121	$	1,995	$	33
Multifamily Residential		-		-		-		-		-		-
Commercial Real Estate		1,473		1,473		-		-		1,528		-
Construction and Land Development		-		-		-		-		-		-
Commercial and Industrial		402		402		-		-		421		-
Consumer and Other		-		-		-		-		-		-

Total	$	3,960	$	3,839	$	42	$	121	$	3,944	$	33

(1) Impaired balance; excludes accrued interest receivable and deferred fees and costs due to immateriality.

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 6 – Loans - (Continued)

(Dollars in thousands)

Impaired Loans
For the Nine Months Ended September 30, 2014

	Unpaid Principal Balance		Recorded Investment (1)		Related Allowance		Life to Date Charge offs		Average Recorded Investment		Interest Income Recognized
With no related allowance recorded
1-4 Family Residential	$	1,820	$	1,734	$	-	$	86	$	1,758	$	-
Multifamily Residential		997		884		-		113		960		-
Commercial Real Estate		2,848		2,848		-		-		2,906		8
Construction and Land Development		-		-		-		-		-		-
Commercial and Industrial		560		560		-		-		578		-
Consumer and Other		-		-		-		-		-		-

With an allowance recorded
1-4 Family Residential	$	682	$	647	$	68	$	35	$	667	$	-
Multifamily Residential		-		-		-		-		-		-
Commercial Real Estate		-		-		-		-		-		-
Construction and Land Development		-		-		-		-		-		-
Commercial and Industrial		-		-		-		-		-		-
Consumer and Other		-		-		-		-		-		-

Total
1-4 Family Residential	$	2,502	$	2,381	$	68	$	121	$	2,425	$	-
Multifamily Residential		997		884		-		113		960		-
Commercial Real Estate		2,848		2,848		-		-		2,906		8
Construction and Land Development		-		-		-		-		-		-
Commercial and Industrial		560		560		-		-		578		-
Consumer and Other		-		-		-		-		-		-

Total	$	6,907	$	6,673	$	68	$	234	$	6,869	$	8

(1) Impaired balance; excludes accrued interest receivable and deferred fees and costs due to immateriality.

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 6 - Loans – (continued)

Impaired Loans

For the Three Months Ended September 30, 2015

(Dollars in thousands)

	Unpaid Principal Balance		Recorded Investment (1)		Related Allowance		Life to Date Charge offs		Average Recorded Investment		Interest Income Recognized

With no related allowance recorded
1-4 Family Residential	$	1,590	$	1,469	$	-	$	121	$	1,474	$	14
Multifamily Residential		-		-		-		-		-		-
Commercial Real Estate		1,473		1,473		-		-		1,509		-
Construction and Land Development		-		-		-		-		-		-
Commercial and Industrial		402		402		-		-		408		-
Consumer and Other		-		-		-		-		-		-

With an allowance recorded
1-4 Family Residential	$	495	$	495	$	42	$	-	$	498	$	-
Multifamily Residential		-		-		-		-		-		-
Commercial Real Estate		-		-		-		-		-		-
Construction and Land Development		-		-		-		-		-		-
Commercial and Industrial		-		-		-		-		-		-
Consumer and Other		-		-		-		-		-		-

Total
1-4 Family Residential	$	2,085	$	1,964	$	42	$	121	$	1,972	$	14
Multifamily Residential		-		-		-		-		-		-
Commercial Real Estate		1,473		1,473		-		-		1,509		-
Construction and Land Development		-		-		-		-		-		-
Commercial and Industrial		402		402		-		-		408		-
Consumer and Other		-		-		-		-		-		-

Total	$	3,960	$	3,839	$	42	$	121	$	3,889	$	14

(1) Impaired balance; excludes accrued interest receivable and deferred fees and costs due to immateriality.

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 6 - Loans – (continued)

(Dollars in thousands)

Impaired Loans
For the Three Months Ended September 30, 2014

	Unpaid Principal Balance		Recorded Investment (1)		Related Allowance		Life to Date Charge offs		Average Recorded Investment		Interest Income Recognized

With no related allowance recorded
1-4 Family Residential	$	1,820	$	1,734	$	-	$	86	$	1,743	$	-
Multifamily Residential		997		884		-		113		935		-
Commercial Real Estate		2,848		2,848		-		-		2,865		3
Construction and Land Development		-		-		-		-		-		-
Commercial and Industrial		560		560		-		-		565		-
Consumer and Other		-		-		-		-		-		-

With an allowance recorded
1-4 Family Residential	$	682	$	647	$	68	$	35	$	658	$	-
Multifamily Residential		-		-		-		-		-		-
Commercial Real Estate		-		-		-		-		-		-
Construction and Land Development		-		-		-		-		-		-
Commercial and Industrial		-		-		-		-		-		-
Consumer and Other		-		-		-		-		-		-

Total
1-4 Family Residential	$	2,502	$	2,381	$	68	$	121	$	2,401	$	-
Multifamily Residential		997		884		-		113		935		-
Commercial Real Estate		2,848		2,848		-		-		2,865		3
Construction and Land Development		-		-		-		-		-		-
Commercial and Industrial		560		560		-		-		565		-
Consumer and Other		-		-		-		-		-		-

Total	$	6,907	$	6,673	$	68	$	234	$	6,766	$	3

(1) Impaired balance; excludes accrued interest receivable and deferred fees and costs due to immateriality.

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 6 - Loans – (continued)

(Dollars in thousands)

Impaired Loans
For the Year Ended December 31, 2014

	Unpaid Principal Balance		Recorded Investment (1)		Related Allowance		Life to Date Charge offs		Average Recorded Investment		Interest Income Recognized

With no related allowance recorded
1-4 Family Residential	$	1,859	$	1,738	$	-	$	121	$	1,787	$	12
Multifamily Residential		-		-		-		-		-		-
Commercial Real Estate		1,096		1,096		-		-		1,127		-
Construction and Land Development		-		-		-		-		-		-
Commercial and Industrial		545		545		-		-		565		-
Consumer and Other		-		-		-		-		-		-

With an allowance recorded
1-4 Family Residential	$	513	$	513	$	63	$	-	$	517	$	-
Multifamily Residential		-		-		-		-		-		-
Commercial Real Estate		-		-		-		-		-		-
Construction and Land Development		-		-		-		-		-		-
Commercial and Industrial		-		-		-		-		-		-
Consumer and Other		-		-		-		-		-		-

Total
1-4 Family Residential	$	2,372	$	2,251	$	63	$	121	$	2,304	$	12
Multifamily Residential		-		-		-		-		-		-
Commercial Real Estate		1,096		1,096		-		-		1,127		-
Construction and Land Development		-		-		-		-		-		-
Commercial and Industrial		545		545		-		-		565		-
Consumer and Other		-		-		-		-		-		-

Total	$	4,013	$	3,892	$	63	$	121	$	3,996	$	12

(1) Impaired balance; excludes accrued interest receivable and deferred fees and costs due to immateriality.

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 7 – Repurchase Agreements

The Company utilizes retail repurchase agreements as a source of funding. Retail repurchase agreements are classified as short term debt obligations of the bank and will be deemed to mature every business day following the creation of the obligation. These obligations are contractually required to be fully collateralized by securities that are the direct obligation of, or which are fully guaranteed by, the United States or one of its agencies. The customers’ security interest in the securities pledged is perfected through the notification of the pledge to the securities’ safekeeping agent. The fair market values of the securities pledged are monitored on a daily basis to ensure that all borrowings are fully secured.

At September 30, 2015 retail repurchase agreements totaled $874,000 and were fully secured by a Freddie Mac mortgage backed security with a fair market value of $1.4 million.

Note 8 – Deferred Taxes

The Company maintains a valuation allowance of $271,000 related to its holding company net operating loss carryforward for state income taxes. Throughout the Company’s history, the holding company has consistently produced operating losses on a stand alone basis, and the realizability of this loss carryforward is considered unlikely. As of September 30, 2015, gross deferred tax assets totaled $4,548,000, while deferred tax assets net of the valuation allowance totaled $4,277,000.

During the nine months and three months ended September 30, 2015, the Company recognized $1,976,000 and $443,000, respectively, of income tax expense. Of these amounts, $1,781,000 and $394,000 were for Federal income taxes. During the nine months and three months ended September 30, 2014, the Company recognized $1,121,000 and $397,000, respectively, of income tax expense. Of these amounts, $1,012,000 and $355,000 were for Federal income taxes. Amounts related to Federal income taxes for 2015 and 2014 primarily represented direct reductions to the Company’s deferred tax asset related to its net operating loss carryforward. The deferred tax asset attributable to the Company’s net operating loss carryforward totaled approximately $1.9 million and $3.2 million at December 31, 2014 and December 31, 2013, respectively. Also during the nine months ended September 30, 2015 and September 30, 2014, the Company’s gross unrealized securities losses declined by approximately $819,000 and $1,097,000, respectively, which decreased the deferred tax asset related to unrealized available for sale securities losses by approximately $295,000 and $394,000, respectively.

Note 9 – Fair Value Measurements

Fair value is the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Generally accepted accounting principles also establish a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:

Level 1 - Quoted prices in active markets for identical assets or liabilities. Level 1 assets and liabilities include debt and equity securities and derivative contracts that are traded in an active exchange market, as well as U.S. Treasuries, and money market funds.

Level 2 - Observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Level 2 assets and liabilities include debt securities with quoted prices that are traded less frequently than exchange-traded instruments, mortgage backed securities, municipal bonds, corporate debt securities, and derivative contracts whose value is determined using a pricing model with inputs that are observable in the market or can be derived principally from or corroborated by observable market data.

Level 3 - Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, real estate appraisals, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation. For example, this category generally includes certain private equity investments, asset-backed securities in less liquid markets, retained residual interests in securitizations, residential mortgage servicing rights, and other real estate owned when adjusting for selling costs, and impaired loans.

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 9 – Fair Value Measurements – (continued)

The Company used the following methods and assumptions to estimate fair value:

Available for Sale Investment Securities

Investment securities available-for-sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available (Leve1 1). If quoted prices are not available, fair values are calculated based on market prices of similar securities (Level 2). For securities where quoted prices or market prices of similar securities are not available, fair values are calculated using discounted cash flows or other market indicators (Level 3). Securities classified as Level 3 include asset-backed securities in less liquid markets. The fair values of level 3 available for sale investment securities are determined by a third party pricing service and reviewed by the Company’s Chief Financial Officer for reasonableness. The fair value of the trust preferred securities is computed based upon discounted cash flows estimated using interest rates, principal balances of note classes and underlying issuers, the timing and amount of interest and principal payments of the underlying issuers, and the allocation to the note classes. Current estimates of expected cash flows are based on the most recent trustee reports and any other relevant market information, including announcements of interest payment deferrals or defaults of underlying issuers. The payment, default and recovery assumptions are believed to reflect the assumptions of market participants. Cash flows are discounted at appropriate market rates, including consideration of credit spreads and illiquidity discounts.

Loans Held for Sale

Mortgage loans held for sale are carried at the lower of cost or market value. The fair value of mortgage loans held for sale is based on what secondary markets are currently offering for portfolios with similar characteristics. As such, the Company categorizes loans subjected to nonrecurring fair value adjustments as Level 2. There were no fair value adjustments to mortgage loans held for sale as of September 30, 2015 and December 31, 2014.

Impaired Loans

Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Impaired loans are carried at the lesser of their principal balance or their fair value. The Company considers problem loans with principal balances of $250,000 or greater individually for impairment. The fair value of loans individually evaluated for impairment is estimated using one of several methods, including the present value of expected cash flows, market price of the loan, if available, or fair value of the underlying collateral less estimated costs to sell. At September 30, 2015, all impaired loans deemed collateral dependent were evaluated based on the fair value of the underlying collateral less estimated costs to sell, while those not deemed collateral dependent were evaluated based on the present value of expected cash flows. Those impaired loans not requiring a specific allowance for loan losses allocation represent loans with fair values exceeding their recorded investments. Impaired loans for which a specific allowance is established based on the fair value of collateral require classification in the fair value hierarchy. If the fair value of an impaired loan is based on an observable market price of the loan, the Company records the impaired loan as nonrecurring Level 2. When the fair value of an impaired loan is based on discounted cash flows or the fair value of the underlying collateral less estimated cost to sell, the Company records the impaired loan as nonrecurring Level 3.

Other real estate owned

Assets acquired through or instead of loan foreclosure are initially recorded at fair value less estimated costs to sell when acquired, establishing a new cost basis. These assets are subsequently accounted for at the lower of cost or fair value less estimated costs to sell. Fair value is commonly based on recent real estate appraisals.

For both collateral dependent impaired loans and other real estate owned the Company uses appraisals prepared by certified appraisal professionals whose qualifications and licenses have been reviewed and verified by the Company. These appraisals may utilize a single valuation approach or a combination of approaches, including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically lead to a Level 3 classification of the inputs for determining fair value. Once the Company receives an appraisal on an impaired loan, the Chief Credit Officer and Chief Financial Officer review the assumptions and approaches utilized in the appraisal as well as the overall resulting fair value in comparison with independent data sources such as recent market data or industry-wide statistics, as well as the Company’s own loss experience. For appraisals received on other real estate owned, the Chief Financial Officer and Chief Operating Officer use a similar approach. The Company may take additional discounts against the appraisals based on the circumstances surrounding individual properties.

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 9 – Fair Value Measurements – (continued)

Assets measured at fair value on a recurring basis are as follows as of September 30, 2015 and December 31, 2014 (dollars in thousands):

	September 30, 2015
	Quoted Market Price in Active Markets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total
Available-for-sale investment securities
Mortgage backed
Government sponsored enterprises	$	-	$	22,248	$	-	$	22,248
Municipals		-		3,674		-		3,674
Other		-		4,158		2,866		7,024

Total assets at fair value	$	-	$	30,080	$	2,866	$	32,946

	December 31, 2014
	Quoted Market Price in Active Markets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total
Available-for-sale investment securities
Mortgage backed
Government sponsored enterprises	$	-	$	24,938	$	-	$	24,938
Municipals		-		4,184		-		4,184
Other		-		4,139		2,008		6,147

Total assets at fair value	$	-	$	33,261	$	2,008	$	35,269

Investments in collateralized debt obligations and a single-issue trust preferred security comprise the Company’s Level 3 assets as shown above. Discounted cash flows are calculated using spread to swap and LIBOR curves that are updated to incorporate loss severities, volatility, credit spread and optionality. During times when trading is more liquid, broker quotes are used (if available) to validate the model. Rating agency and industry research reports as well as defaults and deferrals on individual securities are reviewed and incorporated into the calculations.

There were no transfers between Level 1 and Level 2 during 2015 or 2014.

The Company has no liabilities carried at fair value or measured at fair value on a recurring basis.

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 9 – Fair Value Measurements – (continued)

The following table reconciles the changes in recurring Level 3 financial instruments for the nine months ended September 30, 2015 and 2014 (dollars in thousands):

	September 30,		September 30,
	2015		2014

Beginning of Year Balance	$	2,008	$	1,836
Discount Accretion		6		7
Reduction in Unrealized Loss		852		200

Ending Balance	$	2,866	$	2,043

The following table presents quantitative information about Level 3 fair value measurements at September 30, 2015 (dollars in thousands):

Security Type	Fair Value		Valuation Technique	Unobservable Input	Rates
Collateralized Debt Obligations	$	2,366	Discounted cash flows and recent trade	Discount rate		Approximately 8%
				Weighted default probability for deferring issuers		Approximately 36%
				Recovery rate on deferring issuers	10%	-	15%
				Default probability for current issuers	0.33%	-	7.50%
Trust Preferred Security	$	500	Discounted cash flows	Discount rate		Approximately 4%

The significant unobservable inputs used in the fair value measurement of the Company’s collateralized debt obligations investments are prepayment rates, probability of default, and loss severity in the event of default. Significant increases/(decreases) in any of those inputs in isolation would result in a significantly lower/(higher) fair value measurement. Generally, a change in the assumption used for the probability of default is accompanied by a directionally similar change in the assumption used for the loss severity and a directionally opposite change in the assumption used for prepayment rates.

In addition to the collateralized debt obligations included in the table above, the Company owns a trust preferred security backed by a single issuer for which meaningful pricing data is not readily available. The security’s book value of $500,000 is assumed to equal its fair value. The discount rate shown for the security in the table above approximates the security’s yield at September 30, 2015.

No changes in unrealized gains and losses for Level 3 asssets were recorded in earnings for either of the nine month periods ended September 30, 2015 or September 30, 2014.

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 9 – Fair Value Measurements – (continued)

Assets measured at fair value on a nonrecurring basis are as follows as of September 30, 2015 and December 31, 2014 (dollars in thousands):

	September 30, 2015
	Quoted Market Price in Active Markets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total
Impaired Loans
1 - 4 Family Residential	$	-	$	-	$	1,841	$	1,841
Commercial Real Estate		-		-		1,517		1,517
Other Real Estate Owned
Construction and Land Development		-		-		54		54

Total assets at fair value	$	-	$	-	$	3,412	$	3,412

	December 31, 2014
	Quoted Market Price in Active Markets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total
Impaired Loans
1 - 4 Family Residential	$	-	$	-	$	2,124	$	2,124
Commercial Real Estate		-		-		1,105		1,105
Other Real Estate Owned
1 - 4 Family Residential		-		-		334		334
Construction and Land Development		-		-		54		54

Total assets at fair value	$	-	$	-	$	3,617	$	3,617

Impaired loans measured at fair value had a recorded investment of $3,164,000 with a valuation allowance of $42,000 at September 30, 2015. This valuation allowance included no provision for loan losses recorded during the nine months or three months ended September 30, 2015.

Impaired loans measured at fair value had a recorded investment of $3,065,000 with a valuation allowance of $63,000 at December 31, 2014, resulting in an additional provision for loan losses of $40,000 for the year ended December 31, 2014. This additional provision was assigned to 1 – 4 Family Residential loans.

Impaired loans measured at fair value had a recorded investment of $3,700,000 with a valuation allowance of $68,000 at September 30, 2014, resulting in an additional provision for loan losses of $113,000 for the nine months ended September 30, 2014. The additional provision included $21,000 for 1 – 4 Family Residential loans and $92,000 for Multifamily loans. During the three months ended September 30, 2014, the Company charged down its impaired Multifamily loans, thereby eliminating the related valuation allowance. The additional provision for loan losses for the three months ended September 30, 2014 totaled $21,000 and was attributable to 1- 4 Family Residential loans.

Other real estate owned measured at fair value less estimated costs to sell at September 30, 2015, had a net carrying amount of $50,000, which was comprised of the outstanding balance of $165,000, net of a valuation allowance of $115,000. No impairment provisions were made during the nine months or three months ended September 30, 2015. Other real estate owned measured at fair value less costs to sell at December 31, 2014, had a net carrying amount of $361,000, which was comprised of the outstanding balance of $482,000, net of a valuation allowance of $121,000. This valuation allowance included $6,000 of impairment provision made during the year ended December 31, 2014, which related entirely to 1-4 Family Residential real estate.

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 9 – Fair Value Measurements – (continued)

Other real estate owned measured at fair value less estimated costs to sell at September 30, 2014 had a net carrying amount of $361,000, which was comprised of the outstanding balance of $482,000, net of a valuation allowance of $121,000. This valuation allowance included an impairment provision of $6,000 made during the nine months ended September 30, 2014, all of which related to 1 – 4 Family Residential property. There was no impairment provision made for the three months ending September 30, 2014.

The Company has no liabilities carried at fair value or measured at fair value on a nonrecurring basis.

The following table presents quantitative information about Level 3 fair value measurements for financial instruments measured at fair value on a non-recurring basis at September 30, 2015 and December 31, 2014:

	Valuation Techniques	Unobservable Inputs	Range
Impaired Loans

1 - 4 Family Residential	Sales comparison approach	Bank Owned Discount		10%	-	20%
Multifamily Residential
Construction and Land Development

Commercial Real Estate	Sales comparison approach	Bank Owned Discount		10%	-	20%
	Income approach	Capitalization Rate		8%	-	12%
Other Real Estate Owned

Commercial Office Properties	Sales comparison approach	Bank Owned Discount		10%	-	20%
	Income approach	Capitalization Rate		8%	-	12%

Commercial Lots	Sales comparison approach	Bank Owned Discount		10%	-	20%
Residential 1 – 4 Family Lots
Residential 1 – 4 Family Homes
Residential 1 – 4 Family Under Construction
Multifamily Residential

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 9 – Fair Value Measurements – (continued)

The estimated fair values of the Company’s financial instruments are as follows (dollars in thousands):

	Fair Value Measurements at September 30, 2015 Using:
	Carrying
	Amount		Level 1		Level 2		Level 3		Total
Financial assets
Cash and cash equivalents	$	20,042	$	20,042	$	-	$	-	$	20,042
Available for sale investment securities		32,946		-		30,080		2,866		32,946
Federal Home Loan Bank Stock		3,059		N/A		N/A		N/A		N/A

Loans, net		382,756		-		-		383,132		383,132
Accrued interest receivable		1,220		-		85		1,135		1,220

Financial liabilities
Deposits		350,913		233,115		118,055		-		351,170
Short term borrowings		3,904		-		3,904		-		3,904
Advances from Federal Home Loan Bank		62,000		-		65,834		-		65,834
Junior subordinated debentures		10,310		-		-		5,182		5,182
Accrued interest payable		379		1		377		1		379

	Fair Value Measurements at December 31, 2014 Using:
	Carrying
	Amount		Level 1		Level 2		Level 3		Total
Financial assets
Cash and cash equivalents	$	33,572	$	33,572	$	-	$	-	$	33,572
Available for sale investment securities		35,269		-		33,261		2,008		35,269
Federal Home Loan Bank Stock		4,000		N/A		N/A		N/A		N/A
Loans, net		358,546		-		-		355,310		355,310
Accrued interest receivable		1,169		-		97		1,072		1,169

Financial liabilities
Deposits		331,034		210,391		120,950		-		331,341
Short term borrowings		3,802		-		3,802		-		3,802
Advances from Federal Home Loan Bank		80,000		-		83,488		-		83,488
Junior subordinated debentures		10,310		-		-		5,018		5,018
Accrued interest payable		777		-		776		1		777

Valuation Methodologies – Assets and Liabilities not recorded at Fair Value

The following is a description of the valuation methodologies used for assets and liabilities that are not recorded at fair value, but whose fair value must be estimated and disclosed:

Cash and Cash Equivalents

The carrying amounts of cash and short-term instruments approximate fair values and are classified Level 1.

FHLB Stock

It is not practical to determine the fair value of FHLB stock due to restrictions placed on its transferability.

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 9 – Fair Value Measurements – (continued)

Loans

Fair values of loans, excluding loans held for sale, are estimated as follows: For variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values, resulting in a Level 3 classification. Fair values for other loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality, resulting in a Level 3 classification. Impaired loans are valued at the lower of cost or fair value as described previously. The methods utilized to estimate the fair value of loans do not necessarily represent an exit price.

The fair value of loans held for sale is estimated based upon binding contracts and quotes from third party investors, resulting in a Level 2 classification.

Deposits

The fair values disclosed for demand deposits (e.g., interest and non-interest checking, passbook savings, and certain types of money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amount), resulting in a Level 1 classification. The carrying amounts of variable rate, fixed-term money market accounts and certificates of deposit approximate their fair values at the reporting date, resulting in a Level 1 classification. Fair values for fixed rate certificates of deposit are estimated using a discounted cash flows calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits, resulting in a Level 2 classification.

Short-term Borrowings

The carrying amounts of federal funds purchased, borrowings under repurchase agreements, and other short-term borrowings, generally maturing within ninety days, approximate their fair values, resulting in a Level 2 classification.

Other Borrowings

The fair values of the Company’s long-term borrowings are estimated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements, resulting in a Level 2 classification.

The fair values of the Company’s Subordinated Debentures are estimated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements, resulting in a Level 3 classification.

Accrued Interest Receivable/Payable

The carrying amounts of accrued interest are assigned Levels 1, 2, or 3 classifications commensurate with the assets or liabilities with which they are associated.

Off-balance Sheet Instruments

Fair values for off-balance sheet, credit-related financial instruments 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. The fair value of commitments is not material.

SOUTHCOAST FINANCIAL CORPORATION

Item 2. - Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis should be read in conjunction with the financial statements and related notes appearing herein and in the Company’s Annual Report on Form 10-K for the year ended December 31, 2014. Results of operations for the period ending September 30, 2015 are not necessarily indicative of the results to be attained for any other period.

This Report on Form 10-Q may contain forward-looking statements relating to such matters as anticipated financial performance, business prospects, technological developments, new products and similar matters. All statements that are not historical facts are "forward-looking statements." The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements. In order to comply with terms of the safe harbor, the Company notes that a variety of factors could cause the Company's actual results and experience to differ materially from the anticipated results or other expectations expressed in the Company's forward-looking statements. Forward-looking statements include statements with respect to management's beliefs, plans, objectives, goals, expectations, anticipations, assumptions, estimates, intentions, and future performance, and involve known and unknown risks, uncertainties and other factors, which may be beyond the Company's control, and which may cause actual results, performance or achievements to be materially different from future results, performance or achievements expressed or implied by such forward-looking statements. All statements other than statements of historical fact are statements that could be forward-looking statements. These forward-looking statements can be identified through use of words such as "may," "will," "anticipate," "assume," "should," "indicate," "would," "believe," "contemplate," "expect," "seek," "estimate," "continue," "plan," "point to," "project," “projection,” "predict," "could," "intend," "target," "potential," and other similar words and expressions of the future. These forward-looking statements may not be realized due to a variety of factors, including, without limitation:

the potential negative economic impacts of the recent historic flooding in our market area on the homes and businesses of our borrowers;

future economic and business conditions;

lack of sustained growth and disruptions in the economy of the Greater Charleston area, including, but not limited to, falling real estate values and increasing levels of unemployment;

government monetary and fiscal policies;

the effects of changes in interest rates on the levels, composition and costs of deposits, loan demand, and the values of loan collateral, securities, and interest sensitive assets and liabilities;

the effects of competition from a wide variety of local, regional, national and other providers of financial, investment, and insurance services, as well as competitors that offer banking products and services by mail, telephone, computer and/or the Internet;

the effects of credit rating downgrades on the value of investment securities issued or guaranteed by various governments and government agencies, including the United States of America;

credit risks;

higher than anticipated levels of defaults on loans;

perceptions by depositors about the safety of their deposits;

the failure of assumptions underlying the establishment of the allowance for loan losses and other estimates, including the value of collateral securing loans;

changes in assumptions underlying allowances on deferred tax assets;

changes in assumptions underlying, or accuracy of, analysis relating to other-than-temporary impairment of assets;

accuracy of fair value measurements and the methods and assumptions used to estimate fair value;

the risks of opening new offices, including, without limitation, the related costs and time of building customer relationships and integrating operations as part of these endeavors and the failure to achieve expected gains, revenue growth and/or expense savings from such endeavors;

changes in laws and regulations, including tax, banking and securities laws and regulations and deposit insurance assessments;

the effect of agreements with regulatory authorities, which restrict various activities and impose additional administrative requirements without commensurate benefits;

changes in the requirements of regulatory agencies;

changes in accounting policies, rules and practices;

changes in technology or products that may be more difficult or costly, or less effective than anticipated;

cybersecurity risk related to our dependence on internal security systems and the technology of outside service providers, as well as the potential impacts of third party security breaches;

the effects of war or other conflicts, acts of terrorism or other catastrophic events that may affect general economic conditions and economic confidence;

loss of consumer or investor confidence;

risks relating to the proposed merger between the Company and BNC Bancorp, including disruption of Southcoast’sbusiness operations and customer relationships and employee relationships, diversion of management’s time, as well asthe impact of such disruptions and the expenses incurred in connection with the merger if the merger is not completed;and

other factors and information described in any of the reports that we file with the Securities and Exchange Commission under the Securities Exchange Act of 1934.

SOUTHCOAST FINANCIAL CORPORATION

Item 2. - Management’s Discussion and Analysis of Financial Condition and Results of Operations - continued

All forward-looking statements are expressly qualified in their entirety by this cautionary notice. The Company has no obligation, and does not undertake, to update, revise or correct any of the forward-looking statements after the date of this report. The Company has expressed its expectations, beliefs, and projections in good faith and believes they have a reasonable basis. However, there is no assurance that these expectations, beliefs or projections will result or be achieved or accomplished.

Results of Operations

The Company’s net income for the nine months ended September 30, 2015 was $3,521,000 or $0.50 per basic share, compared to net income of $2,385,000, or $0.34 per basic share, for the nine months ended September 30, 2014. The average number of basic shares outstanding for the nine months ended September 30, 2015 was 7,102,498 compared to 7,089,630 for the nine months ended September 30, 2014.

The Company’s net income for the three months ended September 30, 2015 was $670,000 or $0.09 per basic share, compared to net income of $1,033,000, or $0.15 per basic share, for the three months ended September 30, 2014. The average number of basic shares outstanding for the three months ended September 30, 2015 was 7,103,751 compared to 7,093,132 for the three months ended September 30, 2014.

Net Interest Income

Net interest income is the difference between the interest earned on interest earning assets and the interest paid for funds acquired to support those assets, and is the principal source of the Company’s earnings. Net interest income was $12.0 million for the nine months ended September 30, 2015, compared to $10.9 million for the nine months ended September 30, 2014. Net interest income was $4.1 million for the three months ended September 30, 2015, compared to $3.7 million for the three months ended September 30, 2014.

Changes that affect net interest income include changes in the average rate earned on interest earning assets, changes in the average rate paid on interest bearing liabilities, and changes in the volumes of interest earning assets and interest bearing liabilities. The increase in the Company’s net interest income for the nine months and three months ended September 30, 2015 compared to the same periods of 2014 was due to increased interest income and decreased interest expense between the two periods. The increase in interest income related primarily to interest income on loans. The decrease in interest expense was primarily driven by lower interest expense on deposits, partially offset by a small increase in interest expense on other borrowings. Interest expense on deposits decreased between the two periods due primarily to changes in rate, as the Company was able to lower its cost of funds on both its time deposits and savings and interest bearing transaction accounts.

Average earning assets for the nine months ended September 30, 2015 increased 9.1 percent to $428.7 million from the $392.9 million reported for the nine months ended September 30, 2014. The increase was primarily attributable to an increase of $35.4 million in average loans. The increase in average loans between the two periods was primarily due to growth in the Company’s loan portfolio.

Average interest bearing liabilities for the nine months ended September 30, 2015 increased 4.6 percent to $365.5 million from the $349.4 million reported for the nine months ended September 30, 2014. The increase was attributable to an increase of $28.2 million in average savings and transacation accounts, partially offset by decreases of $11.4 million and $700,000 in average time deposits and other borrowings, respectively. The decrease in average time deposits was attributable to a decrease of $15.4 million in retail time deposits, partially offset by a $4.0 million increase in brokered and wholesale time deposits, respectively. The decrease in average other borrowings primarily related to repurchase agreements and federal funds purchased, partially offset by an increase in average Federal Home Loan Bank Borrowings.

SOUTHCOAST FINANCIAL CORPORATION

Item 2. - Management’s Discussion and Analysis of Financial Condition and Results of Operations - continued

Net Interest Income – (continued)

The following table compares the average balances, yields and rates for the interest sensitive segments of the Company’s balance sheets for the nine months ended September 30, 2015 and 2014.

	For the nine months ended							For the nine months ended
(Dollars in thousands)	September 30, 2015							September 30, 2014
	Average		Income/		Yield/			Average		Income/		Yield/
	Balance		Expense		Rate⁽¹⁾			Balance		Expense		Rate⁽¹⁾
Assets
Cash and Federal funds sold	$	18,878	$	33		0.23	%	$	13,046	$	24		0.24	%
Investments – taxable		35,362		611		2.31			40,652		725		2.38
Investments - nontaxable ⁽²⁾		3,693		171		6.19			3,920		176		6.04

Total investments and federal funds sold		57,933		815		1.88			57,618		925		2.15

Loans ⁽³⁾⁽⁴⁾		370,747		13,804		4.97			335,285		12,703		5.06

Total earning assets/interest income		428,680		14,619		4.55	%		392,903		13,628		4.63	%
Other assets		51,844							55,446

Total assets	$	480,524						$	448,349
Liabilities
Savings and transaction accounts	$	166,018		446		0.36	%	$	137,778		501		0.49	%
Time deposits		125,000		638		0.68			136,397		728		0.71
Other borrowings		64,169		1,355		2.82			64,903		1,343		2.77
Subordinated debt		10,310		135		1.74			10,310		134		1.73

Total interest bearing liabilities/interest expense		365,497		2,574		0.94	%		349,388		2,706		1.03	%

Non-interest bearing liabilities		65,674							54,846

Total liabilities		473,171		2,574		0.80	%		404,234		2,706		0.90	%

Equity		49,353							44,115

Total liabilities and equity	$	480,524						$	448,349

Net interest income/margin ⁽⁵⁾			$	12,045		3.73	%			$	10,922		3.69	%

Net interest spread ⁽⁶⁾						3.61	%						3.60	%

(1) Annualized

(2) Yield is calculated on a tax equivalent basis.

(3) Does not include nonaccruing loans.

(4) Income includes loan fees of $540,000 in 2015 and $529,000 in 2014.

(5) Net interest income divided by total earning assets.

(6) Total interest earning assets yield less interest bearing liabilities rate.

SOUTHCOAST FINANCIAL CORPORATION

Item 2. - Management’s Discussion and Analysis of Financial Condition and Results of Operations - continued

Net Interest Income – (continued)

As shown above, for the nine months ended September 30, 2015 the average yield on earning assets was 4.55 percent, while the average cost of interest bearing liabilities was 0.94 percent. For the nine months ended September 30, 2014 the average yield on earning assets was 4.63 percent and the average cost of interest-bearing liabilities was 1.03 percent. The moderate decrease in the overall asset yield reflects decreases in yields on loans and investments and federal funds sold, for which yields decreased by 0.09 percent and 0.27 percent, respectively. Due to a change in earning asset mix between the periods, overall asset yields only declined by 0.08 percent, as average loans accounted for nearly the entire growth in average earning assets between the periods. Because average loans carry a higher yield than average investments and federal funds sold, the overall asset yield decrease was reduced. The decrease in the cost of average interest bearing liabilities was primarily due to decreases in average rates paid on savings and transaction accounts. The net interest margin was 3.73 percent and 3.69 percent for the nine months ended September 30, 2015 and 2014, respectively. The increase in the net interest margin was attributable to an increase of $1,123,000 in net interest income, which was comprised of an increase in interest income of $991,000 and a decrease in interest expense of $132,000. The increase in interest income was primarily due to a $1,101,000 increase in interest income on loans. The interest expense reduction was primarily attributable to a $90,000 decrease in interest expense on time deposits.

The following tables present changes in the Company’s net interest income which are primarily a result of changes in the volume and rates of its interest-earning assets and interest-bearing liabilities.

	Analysis of Changes in Net Interest Income
(Dollars in thousands)	For the nine months ended September 30, 2015
	Versus nine months ended September 30, 2014 ⁽¹⁾
	Volume			Rate			Net Change
Interest income:

Cash and Federal funds sold	$	10		$	(1	)	$	9
Investments - taxable		(94	)		(20	)		(114	)
Investments - nontaxable ⁽²⁾		(10	)		5			(5	)

Total investments and federal funds sold		(94	)		(16	)		(110	)

Net loans ⁽³⁾⁽⁴⁾		1,347			(246	)		1,101

Total interest income		1,253			(262	)		991

Interest expense:

Savings and transaction accounts		104			(159	)		(55	)
Time deposits		(61	)		(29	)		(90	)
Other borrowings		(15	)		27			12
Subordinated debt		-			1			1

Total interest expense		28			(160	)		(132	)

Net interest income	$	1,225		$	(102	)	$	1,123


	(1)	Changes in rate/volume have been allocated to each category on a consistent basis between rate and volume.

(2)

Yield is calculated on a tax equivalent basis.

(3)

Income includes loan fees of $540,000 in 2015 and $529,000 in 2014.

(4)

Does not include nonaccruing loans.

SOUTHCOAST FINANCIAL CORPORATION

Item 2. - Management’s Discussion and Analysis of Financial Condition and Results of Operations - continued

Net Interest Income – (continued)

Average earning assets for the three months ended September 30, 2015 increased 10.2 percent to $439.0 million from the $398.3 million reported for the three months ended September 30, 2014. The increase was primarily attributable to an increase of $39.9 million in average loans. The increase in average loans between the two periods was primarily due to growth in the Company’s loan portfolio.

Average interest bearing liabilities for the three months ending September 30, 2015 increased 6.1 percent to $370.2 million from $349.0 million for the three months ending September 30, 2014. The increase was primarily attributable to an increase of $31.7 million in average savings and transacation accounts, partially offset by decreases of $9.0 million and $1.5 million in average time deposits and average other borrowings, respectively. The decrease in average time deposits was attributable to a decrease of $9.4 million in average retail time deposits, partially offset by an increase of $400,000 in brokered and wholesale time deposits.

SOUTHCOAST FINANCIAL CORPORATION

Item 2. - Management’s Discussion and Analysis of Financial Condition and Results of Operations - continued

Net Interest Income – (continued)

The following table compares the average balances, yields and rates for the interest sensitive segments of the Company’s balance sheets for the three months ended September 30, 2015 and 2014.

(Dollars in thousands)	For the three months ended							For the three months ended
	September 30, 2015							September 30, 2014
	Average		Income/		Yield/			Average		Income/		Yield/
	Balance		Expense		Rate⁽¹⁾			Balance		Expense		Rate⁽¹⁾
Assets
Cash and Federal funds sold	$	17,362	$	10		0.23	%	$	12,763	$	8		0.23	%
Investments – taxable		34,538		196		2.25			37,869		222		2.32
Investments - nontaxable ⁽²⁾		3,426		51		5.94			3,922		58		5.98

Total investments and federal funds sold		55,326		257		1.84			54,554		288		2.10

Loans ⁽³⁾⁽⁴⁾		383,661		4,729		4.89			343,722		4,286		4.95

Total earning assets/interest income		438,987		4,986		4.51	%		398,326		4,574		4.56	%
Other assets		54,752							54,039

Total assets	$	493,739						$	452,365
Liabilities
Savings and transaction accounts	$	171,331		148		0.34	%	$	139,677		162		0.46	%
Time deposits		125,584		218		0.69			134,556		239		0.70
Other borrowings		62,986		457		2.88			64,481		452		2.78
Subordinated debt		10,310		46		1.75			10,310		44		1.71

Total interest bearing liabilities/interest expense		370,211		869		0.93			349,024		897		1.02

Non-interest bearing liabilities		73,317							58,176

Total liabilities		443,528		869		0.78			407,200		897		0.87

Equity		50,211							45,165

Total liabilities and equity	$	493,739						$	452,365

Net interest income/margin ⁽⁵⁾
			$	4,117		3.72	%			$	3,677		3.66	%
Net interest spread ⁽⁶⁾						3.58	%						3.54	%

(1) Annualized

(2) Yield is calculated on a tax equivalent basis.

(3) Does not include nonaccruing loans.

(4) Income includes loan fees of $207,000 in 2015 and $188,000 in 2014.

(5) Net interest income divided by total earning assets.

(6) Total interest earning assets yield less interest bearing liabilities rate.

SOUTHCOAST FINANCIAL CORPORATION

Item 2. - Management’s Discussion and Analysis of Financial Condition and Results of Operations - continued

Net Interest Income – (continued)

As shown above, for the three months ended September 30, 2015 the average yield on earning assets was 4.51 percent, while the average cost of interest bearing liabilities was 0.93 percent. For the three months ended September 30, 2014 the average yield on earning assets was 4.56 percent and the average cost of interest-bearing liabilities was 1.02 percent. The moderate decrease in the overall asset yield is primarily due to loan yields, which decreased to 4.89% for the three months ended September 30, 2015 from 4.95% for the three months ended September 30, 2014. The decrease in the cost of average interest bearing liabilities was primarily due to decreases in average rates paid on savings and transaction accounts. The net interest margin was 3.72 percent and 3.66 percent for the three month periods ended September 30, 2015 and 2014, respectively.

	Analysis of Changes in Net Interest Income
(Dollars in thousands)	For the three months ended September 30, 2015
	Versus three months ended September 30, 2014 ⁽¹⁾
	Volume			Rate			Net Change
Interest income:

Cash and Federal funds sold	$	3		$	(1	)	$	2
Investments - taxable		(19	)		(7	)		(26	)
Investments - nontaxable⁽²⁾		(7	)		-			(7	)

Total investments and federal funds sold		(23	)		(8	)		(31	)

Net loans ⁽³⁾⁽⁴⁾		497			(54	)		443

Total interest income		474			(62	)		412

Interest expense:

Savings and transaction accounts		37			(51	)		(14	)
Time deposits		(16	)		(5	)		(21	)
Other borrowings		(10	)		15			5
Subordinated debt		-			2			2

Total interest expense		11			(39	)		(28	)

Net interest income	$	463		$	(23	)	$	440


	(1)	Changes in rate/volume have been allocated to each category on a consistent basis between rate and volume.
	(2)	Yield is calculated on a tax equivalent basis.

(3)

Income includes loan fees of $207,000 in 2015 and $188,000 in 2014.

(4)

Does not include nonaccruing loans.

SOUTHCOAST FINANCIAL CORPORATION

Item 2. - Management’s Discussion and Analysis of Financial Condition and Results of Operations - continued

Noninterest Income and Expenses

Noninterest income for the nine months ended September 30, 2015 was approximately $2,433,000, compared to approximately $1,630,000 for the nine months ended September 30, 2014, an increase of approximately $803,000. The increase was primarily due to a $750,000 gain recognized on the sale of premises and equipment during the nine months ended September 30, 2015. The premises disposed of was an unoccupied lot adjacent to the Company’s headquarters and main office. There were no such gains during the nine months ended September 30, 2014. Also contributing to the increase in noninterest income were increases of $94,000 and $41,000 in gains on the sale of mortgage loans and service fees on deposit accounts, respectively. These increases in noninterest income were partially offset by a decrease of $109,000 in gains on the sale of available for sale securities between the two periods. For the nine months ended September 30, 2014 there were gains on the sale of available for sale securities of $109,000. There were no such gains for the nine months ended September 30, 2015.

Noninterest income for the three months ended September 30, 2015 was approximately $598,000, compared to approximately $512,000 for the three months ended September 30, 2014, an increase of approximately $86,000. The increase was primarily due to an increase of approximately $54,000 in gains on sale of mortgage loans held for sale. Also contributing to the increase in noninterest income was a $17,000 increase in service fees on deposit accounts between the two periods.

Noninterest expenses for the nine months ended September 30, 2015 were $9,819,000, compared to $8,983,000 for the nine months ended September 30, 2014, an increase of $836,000. The largest contributing factor to the increase was a $615,000 increase in salaries and benefits expense. The increase in salaries and benefits was primarily attributable to the sale and benefit obligation settlement of a split dollar life insurance policy to the Company’s CEO in the third quarter of 2014. Proceeds received on this transaction represented a partial refund of insurance premiums, which was recorded as a $271,000 reduction to life insurance expense. Also contributing to the increase in salaries and benefits were $214,000 of salary increases, primarily due to raises, and a $71,000 increase in employee insurance premiums. Further contributing to the increase in noninterest expenses was a $394,000 increase in professional fees. The increase in professional fees was largely due to $317,000 in attorney and investment banker fees related to the Company’s proposed merger transaction with BNCN. Additionally, gains on the sale of other real estate owned decreased by $222,000 between the two periods. These gains are treated as reductions of noninterest expense. The increases in noninterest expense were partially offset by decreases of $96,000 in operating expenses and impairment provisions related to other real estate owned, net of rental income, $69,000 of occupancy expenses, and $69,000 of insurance expense. Also partially offsetting the increase in noninterest expenses was a $95,000 decrease in noninterest expenses related to the Allowance for Unfunded Commitments. The Allowance for Unfunded Commitments provides for future losses on contractual commitments to extend credit that have not yet been funded. The adequacy of the Allowance for Unfunded Commitments is analyzed on a quarterly basis.

Noninterest expenses for the three months ended September 30, 2015 were $3,584,000, compared to $2,738,000 for the three months ended September 30, 2014, an increase of $846,000. The increase was primarily due to increases of $411,000 and $344,000 in salaries and benefits and professional fees, respectively. As with the nine month period, the increase in salaries and benefits was primarily due to the $271,000 reduction of life insurance expense from the sale and benefit obligation settlement of the CEO’s split dollar life insurance policy. Also contributing to the increase in salaries and benefits were $60,000 of salary increases, primarily due to raises, and a $41,000 increase in employee insurance premiums. The increase in professional fees, as with the the nine month period, was mainly due to $317,000 of attorney and investment banker fees related to the aforementioned proposed merger transaction. Also contributing to the increase in noninterest expenses was a $184,000 decrease in gains on the sale of other real estate owned. The increases in noninterest expense were partially offset by decreases of $39,000 in operating expenses and impairment provisions related to other real estate owned, net of rental income, $29,000 of occupancy expenses, and $29,000 of insurance expense.

SOUTHCOAST FINANCIAL CORPORATION

Item 2. - Management’s Discussion and Analysis of Financial Condition and Results of Operations - continued

Income Taxes

The Company’s income tax expense for the nine months ended September 30, 2015 totaled $1,976,000, comprised of $1,781,000 for Federal income taxes and $195,000 for South Carolina income taxes. The Company’s income tax expense for the nine months ended September 30, 2014 totaled $1,121,000, comprised of $1,012,000 for Federal income taxes and $109,000 for South Carolina income taxes. The effective tax rates were 36.0% and 32.0% for the nine months ended September 30, 2015 and September 30, 2014, respectively. The Company’s income tax expense for the three months ended September 30, 2015 totaled $443,000, comprised of $394,000 for Federal income taxes and $49,000 for South Carolina income taxes. The effective tax rates were 39.8% and 27.8% for the three months ended September 30, 2015 and September 30, 2014, respectively. During the three months ended September 30, 2015, the Company incurred $171,000 of nondeductible professional fees associated with its proposed merger transaction with BNC. During the three months ended September 30, 2014, as previously discussed, the Company recorded a $271,000 reduction of life insurance expense through the sale and benefit obligation settlement of the CEO’s split dollar life insurance policy. As this represented a partial refund of previously nondeductible expenses, there was no income tax expense associated with the obligation settlement. These two extraordinary items contributed to the sizable disparity in effective tax rates between the three month periods, and to a lesser extent, the smaller disparity in effective tax rates between the nine month periods.

Liquidity

Liquidity is the ability to meet current and future obligations through liquidation or maturity of existing assets or the acquisition of additional liabilities. Adequate liquidity is necessary to meet the requirements of customers for loans and deposit withdrawals in the most timely and economical manner. Some liquidity is ensured by maintaining assets which may be immediately converted into cash at minimal cost (amounts due from banks and federal funds sold). However, the most manageable sources of liquidity are composed of liabilities, with the primary focus of liquidity management being on the ability to obtain deposits within the Bank’s service area. Core deposits (total deposits less certificates of deposit $250,000 or more, wholesale and brokered deposits) provide a relatively stable funding base, and were equal to 93.6% of total deposits as of September 30, 2015. Asset liquidity is provided from several sources, including amounts due from banks and federal funds sold and funds from maturing loans. The Bank is a member of the Federal Home Loan Bank of Atlanta (”FHLBA”) and, as such has the ability to borrow against pledges of its 1-4 family residential mortgage loans and its commercial real estate loans. Available borrowings under this line totaled $53.3 million at September 30, 2015. The Company also has federal funds accommodations of $10 million with Alostar Bank of Commerce, $10 million with Zions Bank, $5 million with Center State Bank, and $8 million with First Tennessee Bank. These accommodations may be withdrawn at any time at the sole discretion of these institutions. Additionally, the Company has a borrowing line with the Federal Reserve Bank of Richmond’s discount window. The Company has pledged its portfolios of construction and land development loans, and commercial and industrial loans against this borrowing line. Total available borrowings under this line were $24.4 million at September 30, 2015.

Loans

Gross loans totaled approximately $387,528,000 and $364,148,000 at September 30, 2015 and December 31, 2014, respectively. The largest contributing factor to the increase in gross loans was a $26.1 million increase in real estate secured loans, which was partially offset by a $3.4 million decrease in commercial and industrial loans. The increase in real estate loans was primarily due to a $21.9 million increase in residential 1-4 family real estate loans. At September 30, 2015, the Company had $4.5 million of nonaccrual loans and $45,000 of loans 90 days delinquent and still accruing interest. Of these, $4.0 million are secured by real estate. The primary risk of loss on these loans is a potential deterioration of real estate collateral values. At December 31, 2014, the Company had $5.0 million of nonaccrual loans and no loans 90 days past due and still accruing interest. At September 30, 2014, the Company had $8.0 million of nonaccrual loans and no loans 90 days past due and still accruing interest. The allowance for loan losses was 1.23 percent of loans as of September 30, 2015, compared to 1.54 percent as of December 31, 2014, and 1.67 percent as of September 30, 2014.

For the nine months ended September 30, 2015 the Company credited its loan loss provision $900,000. For the nine months ended September 30, 2014 the Company recorded no loan loss provision. Net recoveries for the nine months ended September 30, 2015 totaled $70,000. Net chargeoffs for the nine months ended September 30, 2014 totaled $103,000. The need for future loan loss provisions will be influenced by loan defaults, loan delinquency levels, loan chargeoffs beyond what has already been provided for on individual loans, the level of loans with credit grades of 6 through 9, and the need for additional specific reserves on loans individually evaluated for impairment, among other factors. In reviewing the adequacy of the allowance for loan losses at each quarter end, management takes into consideration the historical loan losses, current levels of past due loans by loan type, the historical severity of loan losses by loan type, loan to value exceptions in our loan portfolio, potential repayment risk for floating and adjustable rate loans due to the potential for rising interest rates, risks posed by unseasoned loans during periods of growth in the loan portfolio, and collateral values of impaired loans deemed to be collateral dependent. As referenced in Note 6, the Company’s general reserves portion of its allowance for loan losses decreased by $809,000 during the nine months ended September 30, 2015, from $5,539,000 at December 31, 2014 to $4,730,000 at September 30, 2015. The main factor leading to the loan loss provision credit of $900,000 for the nine months ended September 30, 2015 was a reduction in required general reserves related to loan default and loss severities risks totaling approximately $522,000. This reduction was the result of the inclusion of 2014 loan defaults and chargeoffs and recoveries data into the calculation of historical averages for these factors. Due to a comparatively low level of defaults, and net recoveries totaling $161,000 during 2014, the Company’s historical average defaults and loss severities were lessened significantly by the inclusion of 2014 data. Additionally, the Company’s required general reserves also decreased by approximately $308,000 between the two periods due to a $4.1 million reduction in grade 7 loans included in the general reserves calculation.

SOUTHCOAST FINANCIAL CORPORATION

Item 2. - Management’s Discussion and Analysis of Financial Condition and Results of Operations - continued

Loans – (continued)

For the nine months ended September 30, 2015, net recoveries to average loans outstanding totaled 0.02% on an annualized basis while the allowance for loan losses to gross loans totaled 1.23% at September 30, 2015. For the nine months ended September 30, 2014, net chargeoffs to average loans outstanding totaled 0.05% on an annualized basis while the allowance for loan losses to gross loans totaled 1.67% at September 30, 2014.

For the three months ended September 30, 2015 and 2014, net chargeoffs to average loans outstanding totaled 0.22% and 0.24%, respectively, on an annualized basis. There was no loan loss provision made for either of the three month periods ended September 30, 2015 or 2014.

Management identifies and maintains a list of potential problem loans. These are loans that are internally risk graded substandard or below but which 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. At September 30, 2015 potential problem loans totaled $7.6 million. The Company’s potential problem loans were comprised of $655,000 of construction and land development real estate loans, $3.1 million of nonfarm, nonresidential real estate loans, $3.5 million of 1-4 family real estate loans, and $390,000 of various loan types not secured by real estate, primarily commercial and industrial loans. At December 31, 2014 potential problem loans totaled $12.0 million. The Company’s potential problem loans at December 31, 2014 were comprised of $703,000 of construction and land development real estate loans, $7.0 million of nonfarm, nonresidential real estate loans, $3.5 million of 1-4 family real estate loans, $338,000 of multifamily real estate loans, and $513,000 of various loan types not secured by real estate, primarily commercial and industrial loans. As the majority of potential problem loans are real estate secured, management closely tracks the current values of real estate collateral when assessing the collectibility of these loans.

Other Real Estate Owned

Other real estate owned totaled approximately $2.6 million at September 30, 2015, $3.5 million at December 31, 2014, and $4.1 million at September 30, 2014, net of a valuation reserve. Sales of other real estate owned totaled approximately $1 million and $2.2 million for the nine months ended September 30, 2015, and 2014, respectively. The Company generated loans to facilitate the sales of other real estate owned totaling $675,000 and $1.0 million during the nine months ended September 30, 2015 and September 30, 2014, respectively. Impairment charges on other real estate owned totaled $0 and $6,000 for the nine months ended September 30, 2015, and 2014, respectively.

Deposits

Deposits increased $19.9 million during the first nine months of 2015 to $350.9 million at September 30, 2015. Included in this amount were increases of $11.8 million in noninterest bearing deposits, and $8.1 million in interest bearing deposits. The increase in interest bearing deposits was due to increases of $9.1 million and $1.9 million in savings and money market accounts and interest bearing transaction accounts, respectively. Partially offsetting the increase was a $2.9 million decrease in time deposits. The decrease in time deposits was primarily attributable to a $3.5 million decrease in brokered and wholesale time deposits, partially offset by a $618,000 increase in retail time deposits. Brokered and wholesale time deposits totaled $8.8 million and $12.3 million at September 30, 2015 and December 31, 2014, respectively.

SOUTHCOAST FINANCIAL CORPORATION

Item 2. - Management’s Discussion and Analysis of Financial Condition and Results of Operations – continued

Federal Home Loan Bank Borrowings

Other borrowings are primarily comprised of FHLBA advances. FHLBA advances are collateralized by pledged FHLBA stock and certain residential mortgage and commercial real estate loans. FHLBA advances outstanding at September 30, 2015 and December 31, 2014 are summarized as follows:

September 30, 2015
(Dollars in Thousands)
Maturity	Rate			Balance

March 2016		2.04	%	$	10,000
May 2016		0.75	%		2,000
March 2017		2.31	%		2,000
May 2017		1.07	%		2,000
March 2018		2.33	%		5,000
April 2018		3.03	%		5,000
May 2018		1.38	%		2,000
March 2019		3.56	%		5,000
March 2019		3.51	%		5,000
May 2019		1.69	%		2,000
May 2020		2.01	%		2,000
March 2021		3.71	%		5,000
March 2021		3.74	%		5,000
March 2021		3.80	%		5,000
March 2021		3.87	%		5,000

Balance				$	62,000

December 31, 2014
(Dollars in Thousands)
Maturity	Rate			Balance

February 2015		0.36	%	$	18,000
March 2016		2.04	%		10,000
May 2016		0.75	%		2,000
March 2017		2.31	%		2,000
May 2017		1.07	%		2,000
March 2018		2.33	%		5,000
April 2018		3.03	%		5,000
May 2018		1.38	%		2,000
March 2019		3.56	%		5,000
March 2019		3.51	%		5,000
May 2019		1.69	%		2,000
May 2020		2.01	%		2,000
March 2021		3.71	%		5,000
March 2021		3.74	%		5,000
March 2021		3.80	%		5,000
March 2021		3.87	%		5,000

Balance				$	80,000

SOUTHCOAST FINANCIAL CORPORATION

Item 2. - Management’s Discussion and Analysis of Financial Condition and Results of Operations – continued

Junior Subordinated Debentures

On August 5, 2005 Southcoast Capital Trust III (the "Capital Trust"), a non-consolidated subsidiary of the Company, issued and sold a total of 10,310 floating rate securities, with a $1,000 liquidation amount per security (the "Capital Securities"). Institutional buyers bought 10,000 of the Capital Securities denominated as preferred securities and the Company bought the other 310 Capital Securities which are denominated as common securities. The proceeds of those sales, $10.3 million, were used by the Capital Trust to buy $10.3 million of junior subordinated debentures from the Company which are reported on its consolidated balance sheets. The Capital Securities mature or are mandatorily redeemable upon maturity on September 30, 2035, or upon earlier optional redemption as provided in the indenture. Since September 30, 2010, the Company has had the right to redeem the Capital Securities in whole or in part. See Note 11 to the consolidated financial statements for the year ended December 31, 2014, and the information set forth in Exhibit 13 under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations- Junior Subordinated Debentures” filed with our Form 10-K for the year ended December 31, 2014, for more information about the terms of the junior subordinated debentures.

SOUTHCOAST FINANCIAL CORPORATION

Item 2. - Management’s Discussion and Analysis of Financial Condition and Results of Operations – continued

Capital Resources

The Company’s total shareholders’ equity increased by approximately $4.1 million during the first nine months of 2015, primarily due to net income of $3,521,000, other comprehensive income of $524,000, and proceeds from stock issuances pursuant to our Employee Stock Purchase Plan of approximately $51,000. The Company’s Tier 1 capital to average assets ratio was 12.61 percent as of September 30, 2015 compared to 11.98 percent as of December 31, 2014.

The Federal Reserve Board and other 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 150%. Under the risk-based standard, capital is classified into two tiers. The Company’s and the Bank’s Tier 1 capital consists of common shareholders’ equity minus a portion of deferred tax assets plus, in the case of the Company, junior subordinated debt subject to certain limitations. Tier 1 Capital includes Common Equity Tier 1 and Additional Tier 1, which consists of additions for certain items to Common Equity Tier 1. None of these additions apply to the Company or the Bank; therefore, for both entities Common Equity Tier 1 capital equals Tier 1 capital. The Company’s and the Bank’s Tier 2 capital consists of the allowance for loan losses subject to certain limitations and, in the case of the Company, its junior subordinated debt in excess of 25% of its Tier 1 capital. 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 illustrated in the chart below. The Company and the Bank are also required to maintain capital at a minimum level based on quarterly average assets, which is known as the leverage ratio. These requirements are set by regulation and are shown in the table below. These requirements are applicable to all but the most highly-rated institutions that are not anticipating or experiencing significant growth and have well-diversified risk, including no undue interest rate risk exposure, excellent asset quality, high liquidity and good earnings. The regulators may require individual bank holding companies and banks to maintain higher levels of capital depending on the regulators’ assessment of the risks faced by the bank holding company or the bank. As of September 30, 2015, the Company and the Bank exceeded each of the applicable capital requirements shown in the following table.

	Capital Ratios
						Minimum Basel III Phase In					Minimum Basel III Fully Phased In					Well Capitalized
	Actual					Requirement					Requirement					Requirement
(Dollars in thousands)	Amount		Ratio			Amount		Ratio			Amount		Ratio			Amount		Ratio
The Bank
Total capital (to risk-weighted assets)	$	58,033		16.51	%	$	28,118		8.00	%	$	36,905		10.50	%	$	35,140		10.00	%
Tier 1 capital (to risk-weighted assets)		53,609		15.25	%		21,088		6.00	%		29,875		8.50	%		28,112		8.00	%
Common equity Tier 1 capital (to risk-weighted assets)		53,609		15.25	%		15,816		4.50	%		24,603		7.00	%		22,841		6.50	%
Tier 1 capital (to average assets)		53,609		11.15	%		19,227		4.00	%		19,227		4.00	%		24,034		5.00	%
The Company
Total capital (to risk-weighted assets)	$	66,715		18.64	%	$	28,637		8.00	% (1)	$	37,585		10.50	% (1)		N/A		N/A
Tier 1 capital (to risk-weighted assets)		62,233		17.39	%		21,477		6.00	% (1)		30,426		8.50	% (1)		N/A		N/A
Common equity Tier 1 capital (to risk-weighted assets)		62,233		17.39	%		16,108		4.50	% (1)		25,057		7.00	% (1)		N/A		N/A
Tier 1 capital (to average assets)		62,233		12.61	%		19,748		4.00	% (1)		19,748		4.00	% (1)		N/A		N/A

(1)	Minimum requirements for bank holding companies with greater than $1 billion in consolidated total assets (the Company is not currently subject to these requirements)

SOUTHCOAST FINANCIAL CORPORATION

Item 2. - Management’s Discussion and Analysis of Financial Condition and Results of Operations - continued

Off Balance Sheet Risk

The Company makes contractual commitments to extend credit and issues standby letters of credit in the ordinary course of its business activities. These commitments are legally binding agreements to lend money to customers at predetermined interest rates for a specified period of time. In addition to commitments to extend credit, the Company also issues standby letters of credit which are assurances to a third party that it will not suffer a loss if the customer fails to meet a contractual obligation to the third party. At September 30, 2015, the Company had issued commitments to extend credit of approximately $27.8 million and letters of credit of approximately $471,000 through various types of commercial lending arrangements. Approximately $16.8 million of these commitments to extend credit had variable rates.

The following table sets forth the length of time until maturity for unused commitments to extend credit and standby letters of credit at September 30, 2015.

	Within One Month		After One Through Three Months		After Three Through Twelve Months		Within One Year		Greater Than One Year		Total

Unused commitments to extend credit	$	1,042	$	1,934	$	10,025	$	13,001	$	14,833	$	27,834
Standby letters of credit		30		-		335		365		106		471
Totals	$	1,072	$	1,934	$	10,360	$	13,366	$	14,939	$	28,305

Based on historical experience, many of the commitments and letters of credit will expire unfunded. Accordingly, the amounts shown in the table above do not necessarily reflect the Company’s need for funds in the periods shown. Further, through its various sources of liquidity, the Company believes it will be able to fund these obligations as they arise. The Company evaluates each customer’s credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary upon extension of credit, is based on the Company’s credit evaluation of the borrower. Collateral varies but may include accounts receivable, inventory, property, plant and equipment, and commercial and residential real estate.

Item 3. - Quantitative and Qualitative Disclosures About Market Risk.

Information about the Company’s exposure to market risk was disclosed in its Annual Report on Form 10-K for the year ended December 31, 2014, which was filed with the Securities and Exchange Commission on March 12, 2015. There have been no material quantitative or qualitative changes in market risk exposure since the date of that filing.

Item 4. - Controls and Procedures.

Based on the evaluation required by 17 C.F.R. Sections 240.13a-15(b) or 240.15d-15(b) of the Company’s disclosure controls and procedures (as defined in 17 C.F.R. Section 240.13a-15(e) and 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 quarterly report, were effective.

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.

SOUTHCOAST FINANCIAL CORPORATION

PART II - OTHER INFORMATION

Item 1. Legal Proceedings

On October 12, 2015, a purported shareholder of the Company filed a class action lawsuit in the Court of Common Pleas for the Ninth Judicial District, State of South Carolina, County of Charleston, captioned Matthew Sciabucuchi v. Southcoast Financial Corporation, Case No. 2015-CP10-5500. On October 26, 2015, the suit was removed to the United States District Court for the District of South Carolina and assigned Case No. 2:15-cv-04352-DCN. The Complaint names as defendants the Company, the current members of the Company's board of directors, whom we refer to as the director defendants, and BNC. The Complaint is brought on behalf of a putative class of shareholders of the Company’s common stock and seeks an order that it is properly maintainable as a class action. The Complaint alleges that the director defendants breached their fiduciary duties by failing to maximize shareholder value in connection with the proposed merger of the Company and BNC and also alleges that BNC aided and abetted those breaches of fiduciary duty. The Complaint further alleges that the director defendants breached their fiduciary duties to the Company’s shareholders by improperly securing for themselves certain benefits not shared equally by the Company’s shareholders and by approving certain terms and conditions in the merger agreement that may be adverse to potential alternate acquirors of the Company. The Complaint seeks injunctive relief to prevent the completion of the merger or rescission of the merger and recissory damages, an accounting to determine damages sustained by the putative class, and costs including plaintiffs' attorneys' and experts' fees. The Company believes that the claims asserted in the Complaint are without merit.

Item 6. Exhibits

31-1 Rule 13a-14(a) Certifications of CEO

31-2 Rule 13a-14(a) Certifications of CFO

32 Section 1350 Certification

101.INS**

XBRL Instance

101.SCH**

XBRL Taxonomy Extension Schema

101.CAL**

XBRL Taxonomy Extension Calculation

101.DEF**

XBRL Taxonomy Extension Definition

101.LAB**

XBRL Taxonomy Extension Labels

101.PRE**

XBRL Taxonomy Extension Presentation

SIGNATURES

Pursuant to the requirements 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.

Date: November 12, 2015	By:	/s/ L. Wayne Pearson
		L. Wayne Pearson
		Chief Executive Officer

Date: November 12, 2015	By:	/s/ William C. Heslop
		William C. Heslop
		Chief Financial Officer

SOUTHCOAST FINANCIAL CORPORATION

Exhibit Index

31.1	Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2	Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. This exhibit is not “filed” for purposes of Section 18 of the Securities Exchange Act of 1934 but is instead furnished as provided by applicable rules of the Securities and Exchange Commission.

101.INS**

XBRL Instance

101.SCH**

XBRL Taxonomy Extension Schema

101.CAL**

XBRL Taxonomy Extension Calculation

101.DEF**

XBRL Taxonomy Extension Definition

101.LAB**

XBRL Taxonomy Extension Labels

101.PRE**

XBRL Taxonomy Extension Presentation

** XBRL information is furnished and not filed or a part of a registration statement or prospectus for purposes of sections 11 or 12 of the Securities Act of 1933, as amended, is deemed not filed for purposes of section 18 of the Securities Exchange Act of 1934, as amended, and otherwise is not subject to liability under these sections.

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