10-K

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(MARK ONE)

[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2006

OR

[   ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM ___________ TO _____________

Commission file number 000-23877

Heritage Commerce Corp

(Exact name of Registrant as Specified in its Charter)

California	77-0469558
(State or Other Jurisdiction of Incorporation or Organization)	(I.R.S. Employer Identification Number)

150 Almaden Boulevard

San Jose, California    95113

(Address of Principal Executive Offices including Zip Code)

(408) 947-6900

(Registrant's Telephone Number, Including Area Code)

Securities registered pursuant to Section 12(b) of the Act: None

Title of Each Class	Name of Each Exchange on which Registered
Common Stock, no par value	The NASDAQ Stock Market

  

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 Securities registered pursuant to Section 12(g) of the Act: None

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

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

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

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

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

Large accelerated filer [ ]Accelerated filer [X]Non-accelerated filer [ ]

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

The aggregate market value of the stock held by non-affiliates of the Registrant, based upon the closing price of its common stock as of June 30, 2006 ($24.69 per share), as reported on the Nasdaq Global Select Market, was approximately $258 million.

      As of February 12, 2007, there were 11,658,109 shares of the Registrant’s common stock (no par value) outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

  DOCUMENTS INCORPORATED   Definitive proxy statement for the Company's 2007 Annual Meeting of Shareholders to be filed within 120 days of the end of the fiscal year ended December 31, 2006.   PARTS OF FORM 10-K INTO WHICH INCORPORATED   Part III

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HERITAGE COMMERCE CORP

INDEX TO

ANNUAL REPORT ON FORM 10-K

    FOR YEAR ENDED DECEMBER 31, 2006

Part I.		Page
Item 1.	Business	4
Item 1A	Risk Factors	15
Item 1B.	Unresolved Staff Comments	18
Item 2.	Properties	18
Item 3.	Legal Proceedings	20
Item 4.	Submission of Matters to a Vote of Security Holders	20
Part II.
Item 5.	Market for the Registrant's Commom Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities	20
Item 6.	Selected Financial Data	22
Item 7.	Management's Discussion and Analysis of Financial Condition and Results of Operations	24
Item 7A.	Quantiative and Qualitative Disclosures About Market Risk	47
Item 8.	Financial Statements and Supplementary Data	47
Item 9.	Changes in Disagreements with Accountants on Accounting and Financial Disclosures	47
Item 9A.	Controls and Procedures	47
Item 9B.	Other Information	44
Part III.
Item 10.	Directors and Executive Officers of the Registrant	48
Item 11.	Executive Compensation	48
Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	48
Item 13.	Certain Relationships and Related Transactions	48
Item 14.	Principal Accountant Fees and Services	48
Part IV.
Item 15.	Exhibits and Financial Statement Schedules	49
Signatures		49
Financial Statements		51
Exhibit Index		87

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PART I

ITEM 1 - BUSINESS

Discussions of certain matters in this Report on Form 10-K may constitute forward looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and as such, may involve risks and uncertainties. Forward-looking statements, which are based on certain assumptions and describe future plans, strategies, and expectations, are generally identifiable by the use of words such as “believe”, “expect”, “intend”, “anticipate”, “estimate”, “project”, “assume,”“plan,”“predict,”“forecast” or similar expressions. These forward-looking statements relate to, among other things, expectations of the business environment in which the Company operates, projections of future performance, potential future performance, potential future credit experience, perceived opportunities in the market, and statements regarding the Company’s mission and vision. The Company’s actual results, performance, and achievements may differ materially from the results, performance, and achievements expressed or implied in such forward-looking statements due to a wide range of factors. The factors include, but are not limited to changes in interest rates, reducing interest margins or increasing interest rate risk, general economic conditions nationally or in the State of California, legislative and regulatory changes adversely affecting the business in which the Company operates, monetary and fiscal policies of the US Government, real estate valuations, the availability of sources of liquidity at a reasonable cost, competition in the financial services industry, the occurrence of events such as the terrorist acts of September 11, 2001, and other risks. All of the Company’s operations and most of its customers are located in California. In addition, acts and threats of terrorism or the impact of military conflicts have increased the uncertainty related to the national and California economic outlook and could have an effect on the future operations of the Company or its customers, including borrowers. See Item 1A - Risk Factors for further discussion of factors that could cause actual results to differ from forward-looking statements. The Company does not undertake, and specifically disclaims any obligation, to update any forward-looking statements to reflect occurrences or unanticipated events or circumstances after the date of such statements.

GENERAL

Heritage Commerce Corp (the “Company”) is registered with the Board of Governors of the Federal Reserve System (“FRB”) as a Bank Holding Company under the Bank Holding Company Act (“BHCA”). The Company was organized in 1997 to be the holding company for Heritage Bank of Commerce (“HBC”). Subsequent to 1997, the Company became the holding company for Heritage Bank East Bay (“HBEB”), Heritage Bank South Valley (“HBSV”), and Bank of Los Altos (“BLA”). On January 1, 2003, HBEB, HBSV, and BLA were merged into Heritage Bank of Commerce. The former HBEB, HBSV, and BLA now operate as branch offices of HBC and continue to serve their local markets.

The Company’s only other direct subsidiaries are Heritage Capital Trust I (formed 2000), Heritage Statutory Trust I (formed 2000), Heritage Statutory Trust II (formed 2001) and Heritage Statutory Trust III (formed 2002) (collectively, “Subsidiary Trusts”), which were formed solely to facilitate the issuance of capital trust pass-through securities to enhance regulatory capital and liquidity. Pursuant to FASB Interpretation No. 46, Consolidation of Variable Interest Entities (FIN 46), the Subsidiary Trusts are not reflected on a consolidated basis in the financial statements of the Company.

The Company’s principal source of income is dividends from HBC. The expenditures of the Company, including (but not limited to) the payment of dividends to shareholders, if and when declared by the Board of Directors, the cost of servicing debt, legal fees, audit fees, and shareholder costs will generally be paid from dividends paid to the Company by HBC.

At December 31, 2006, the Company had consolidated assets of $1.04 billion, deposits of $847 million and shareholders’ equity of $123 million. The Company’s liabilities include $24 million in debt obligations due to the Subsidiary Trusts related to capital trust pass-through securities issued by those entities.

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The Internet address of the Company’s website is “http://www.heritagecommercecorp.com.” The Company makes available free of charge through the Company’s website, the Company’s annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to these reports. The Company makes these reports available on its website on the same day they appear on the SEC’s website.

Heritage Bank of Commerce

Heritage Bank of Commerce (“HBC”) is a California state-chartered bank headquartered in San Jose, California. It was incorporated in November 1993 and opened for business in January 1994. HBC is a multi-community independent bank that offers a full range of banking services to small to medium sized businesses and their owners, managers and employees residing in Santa Clara, Alameda and Contra Costa counties in California. We operate nine full service branch offices throughout this geographic footprint. The locations of HBC’s current offices are:

San Jose:	Administrative Office Main Branch 150 Almaden Boulevard
Los Gatos:	Branch Office 15575 Los Gatos Boulevard
Fremont:	Branch Office 3077 Stevenson Boulevard
Danville:	Branch Office 310 Hartz Avenue
Morgan Hill:	Branch Office 18625 Sutter Boulevard
Gilroy:	Branch Office 7598 Monterey Street
Los Altos:	Branch Office 369 S. San Antonio Road
Los Altos:	Branch Office 4546 El Camino Real
Mountain View:	Branch Office 175 E. El Camino Real

HBC’s gross loan balances at the end of 2006 totaled $726 million, excluding loans held for sale. HBC’s lending activities are diversified and include commercial, real estate, construction loans, and consumer loans. HBC’s commercial loans are made for working capital, financing the purchase of equipment or for other business purposes. Such loans include loans with maturities ranging from thirty days to one year and “term loans,” with maturities normally ranging from one to five years. Short-term business loans are generally intended to finance current transactions and typically provide for periodic principal payments, with interest payable monthly. Term loans normally provide for floating interest rates, with monthly payments of both principal and interest. HBC’s commercial loans are centered in locally-oriented commercial activities in markets where HBC has a physical presence through its branch offices and loan production offices.

HBC’s real estate term loans consist primarily of loans made based on the borrower’s cash flow and are secured by deeds of trust on commercial and residential property to provide a secondary source of repayment. HBC restricts real estate term loans to no more than 80% of the property’s appraised value or the purchase price of the property, depending on the type of property and its utilization. HBC offers both fixed and floating rate loans. Maturities on such loans are generally restricted to between five and ten years (with amortization ranging from fifteen to twenty-five years and a balloon payment due at maturity); however, SBA and certain other real estate loans that may be sold in the secondary market may be granted for longer maturities.

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HBC’s real estate land and construction loans are primarily short term interim loans to finance the construction of commercial and single family residential properties. HBC utilizes underwriting guidelines to assess the likelihood of repayment from sources such as sale of the property or permanent mortgage financing prior to making the construction loan.

HBC makes consumer loans for the purpose of financing automobiles, various types of consumer goods, and other personal purposes. Additionally, HBC makes home equity lines of credit available to its clientele. Consumer loans generally provide for the monthly payment of principal and interest. Most of HBC’s consumer loans are secured by the personal property being purchased or, in the instances of home equity loans or lines, real property.

We also actively engage in Small Business Administration (“SBA”) lending. We have been designated as an SBA preferred Lender since 1999 and HBC is a participant in the SBA’s innovative “Community Express” program. HBC regularly makes SBA-guaranteed loans; the guaranteed portion of these loans may be sold in the secondary market depending on market conditions. As of December 31, 2006, the percentage of our total loans guaranteed by the SBA was 5%.

As of December 31, 2006, the percentage of our total loans for each of the principal areas in which we directed our lending activities were as follows: (i) commercial 42%, (ii) real estate secured loans 33%, (iii) construction loans 20%, and (iv) consumer (including home equity) 5%. While no specific industry concentration is considered significant, our lending operations are located in market areas dependent on technology and real estate industries and their supporting companies.

In addition to loans, we offer a wide range of deposit products for retail and business banking markets including checking accounts, interest-bearing transaction accounts, savings accounts, time deposits and retirement accounts. We attract deposits from throughout our market area with a customer-oriented product mix, competitive pricing, and convenient locations. At December 31, 2006 we had 13,000 deposit accounts totaling approximately $847 million, compared to 14,000 deposit accounts totaling approximately $940 million as of December 31, 2005.

We offer a multitude of other products and services to complement our lending and deposit services. These include cashier’s checks, traveler’s checks, bank-by-mail, ATM, night depository, safe deposit boxes, direct deposit, automated payroll services, electronic funds transfers, on-line banking, and other customary banking services. We currently operate ATM’s at four different locations. In addition, we have established a convenient customer service group accessible by toll-free telephone to answer questions and promote a high level of customer service. HBC does not have a trust department.

Recent Developments

Merger Agreement with Diablo Valley Bank.

On February 8, 2007, the Company, HBC and Diablo Valley Bank (“Diablo”) entered into an Agreement and Plan of Merger (the “Merger Agreement”), pursuant to which, among other things, Diablo will merge with and into HBC, with HBC surviving the merger (the “Merger”) in a cash and stock transaction valued at approximately $70 million. The Merger Agreement has been unanimously approved by the Boards of Directors of the Company, HBC and Diablo. The Merger is subject to approval by the Diablo shareholders.

Under the terms of the Merger Agreement, the Company will pay a fixed number of 1,732,298 shares of the Company’s common stock and an aggregate of $15 million in cash for all of the issued and outstanding shares of Diablo common stock. Each Diablo common shareholder will be entitled to receive at the shareholder’s election (subject to certain prorating procedures) cash or the Company’s common stock. The per share consideration for each share of Diablo common stock will be calculated by reference to the Company’s average closing price over a 20 trading day period ending 5 days before the effective date of the Merger (“Average Closing Price”). Based on the closing price of the Company’s common stock of $27.25 on February 8, 2007, the per share consideration would be $24.87. The per share consideration will float within a band of $23.00 to $25.00 if the Average Closing Price is between $24.55 and $27.44. If the Average Closing Price is above $27.44, the per share consideration will be increased to reflect one-third of the increase in the Average Closing Price above $27.44. If the Average Closing Price is below $24.55, the aggregate amount of cash paid in the Merger will be increased to an amount necessary to maintain a minimum per share consideration of $23.00. If the Average Closing Price falls below $23.50, the Company has the right to terminate the Merger Agreement. All Diablo stock options will be terminated at the effective time of the Merger and option holders will receive cash in the amount of the per share consideration minus the exercise price of the option (in the aggregate approximately $8 million). Diablo’s issued and outstanding Series A Preferred Stock will be redeemed in full at $32 per share by Diablo prior to the effective time of the Merger (approximately $6.5 million).

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The Merger Agreement contains customary representations and warranties of the Company, HBC and Diablo. Consummation of the Merger is subject to certain conditions, including, among others, (i) approval by the Diablo common shareholders, (ii) receipt of certain regulatory approvals, (iii) the filing of a registration statement on Form S-4 to register the Company’s common stock to be issued in the Merger with the Securities and Exchange Commission and receipt of the SEC’s order that such registration statement is effective, (iv) listing of the Company’s common stock to be issued in the Merger with NASDAQ, (v) satisfaction of tangible net worth and customer deposit tests, (vi) redemption of Diablo’s Series A Preferred Stock, and (vii) the accuracy of representations and warranties of Diablo, the Company and HBC.

Certain shareholders of Diablo have entered into Shareholder Agreements with the Company pursuant to which they have agreed to vote their Diablo shares in favor of the Merger. The Diablo Board of Directors has agreed to recommend to its shareholders the approval of the Merger. The Merger Agreement provides for the payment of a Termination Fee in the amount of $3,380,000 if the Merger Agreement is terminated by the Company or Diablo under specified circumstances.

On the effective date of the Merger, two members of the Diablo Board of Directors, John J. Hounslow and Mark E. Lefanowicz will be added to the Company and HBC’s Board of Directors.

In connection with the Merger Agreement, the Company and/or HBC entered into the following agreements which will become effective upon the effective time of the Merger: (i) a three year employment agreement with James Mayer (the President of Diablo) for annual salaries of $220,000, $240,000 and $250,000 and the grant (subject to approval of the Company’s Compensation Committee and Board of Directors) of stock options for 20,000 shares of the Company’s common stock pursuant to its 2004 Stock Option Plan, (ii) a consulting agreement with John J. Hounslow (the Chairman of the Board of Diablo) pursuant to which Mr. Hounslow will receive $400,000, and (iii) non-compete agreements with Mr. Mayer and Mr. Hounslow (for which Mr. Hounslow will receive $200,000). Mr. Mayer and Mr. Hounslow have agreed to forego certain severance payments due to them as a result of the Merger in exchange for the Agreements with the Company and HBC.

The transaction is expected to close during the second or third quarter of 2007.

Personnel Changes

On May 5, 2006, Kenneth A. Corsello resigned as the Company’s Executive Vice President and Chief Credit Officer.

On May 12, 2006, Richard E. Hagarty was promoted to Executive Vice President and Chief Credit Officer of Heritage Bank of Commerce.

On July 27, 2006, the Company’s Board of Directors elected Jack W. Conner as Chairman of the Board, succeeding William Del Biaggio, Jr., who will remain on the Board of Directors as a director and Founding Chairman and will continue serving the Bank as an Executive Vice President.

Correspondent Banks

Correspondent bank deposit accounts are maintained to enable the Company to transact types of activity that it would otherwise be unable to perform or would not be cost effective due to the size of the Company or volume of activity. The Company has utilized several correspondent banks to process a variety of transactions.

COMPETITION

The banking and financial services business in California generally, and in the Company’s market areas specifically, is highly competitive. The increasingly competitive environment is a result primarily of changes in regulation, changes in technology and product delivery systems, and the consolidation among financial service providers. The Company competes for loans, deposits and customers for financial services with other commercial banks, savings and loan associations, securities and brokerage companies, mortgage companies, insurance companies, finance companies, money market funds, credit unions, and other non-bank financial service providers. Many of these competitors are much larger in total assets and capitalization, have greater access to capital markets and offer a broader array of financial services than the Company. In order to compete with the other financial service providers, the Company principally relies upon local promotional activities, personal relationships established by officers, directors, and employees with its customers, and specialized services tailored to meet its customers’ needs. In those instances where the Company is unable to accommodate a customer’s needs, the Company seeks to arrange for such loans on a participation basis with other financial institutions or to have those services provided in whole or in part by its correspondent banks. See Item 1 - “BUSINESS - Supervision and Regulation.”

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SUPERVISION AND REGULATION

Introduction

Banking is a complex, highly regulated industry. The primary goals of the regulatory scheme are to maintain a safe and sound banking system, protect depositors and the Federal Deposit Insurance Corporation’s insurance fund, and facilitate the conduct of sound monetary policy. In furtherance of these goals, Congress and the states have created several largely autonomous regulatory agencies and enacted numerous laws that govern banks, bank holding companies and the financial services industry. Consequently, the growth and earnings performance of the Company and HBC can be affected not only by management decisions and general economic conditions, but also by the requirements of applicable state and federal statues, regulations and the policies of various governmental regulatory authorities, including the Board of Governors of the Federal Reserve System, (“FRB”), and the California Department of Financial Institutions, (“DFI”).

The system of supervision and regulation applicable to financial services businesses governs most aspects of the business of the Company and HBC, including: (i) the scope of permissible business; (ii) investments; (iii) reserves that must be maintained against deposits; (iv) capital levels that must be maintained; (v) the nature and amount of collateral that may be taken to secure loans; (vi) the establishment of new branches; (vii) mergers and consolidations with other financial institutions; and (viii) the payment of dividends.

From time to time laws or regulations are enacted which have the effect of increasing the cost of doing business, limiting or expanding the scope of permissible activities, or changing the competitive balance between banks and other financial and non-financial institutions. Proposals to change the laws and regulations governing the operations of banks and bank holding companies are frequently made in Congress, in the California legislature and by various bank and other regulatory agencies. Future changes in the laws, regulations or polices that impact the Company and HBC cannot necessarily be predicted, but they may have a material effect on the business and earnings of the Company and HBC.

The Company

General. As a bank holding company, the Company is registered under the Bank Holding Company Act of 1956, as amended, or the BHCA, and is subject to regulation by the FRB. According to FRB policy, the Company is expected to act as a source of financial strength for HBC, to commit resources to support it in circumstances where the Company might not otherwise do so. Under the BHCA, the Company is subject to periodic examination by the FRB. The Company is also required to file periodic reports of its operations and any additional information regarding its activities and those of its subsidiaries, as may be required by the FRB.

The Company is also a bank holding company within the meaning of Section 3700 of the California Financial Code. Consequently, the Company and HBC are subject to examination by, and may be required to file reports with, the DFI. Regulations have not yet been proposed or adopted or steps otherwise taken to implement the DFI’s powers under this statute.

Bank Holding Company Liquidity. The Company is a legal entity, separate and distinct from HBC. The Company has the ability to raise capital on its own behalf or borrow from external sources. The Company may also obtain additional funds from dividends paid by, and fees charged for services provided to, HBC. However, regulatory constraints on HBC may restrict or totally preclude the payment of dividends by HBC to the Company.

The Company is entitled to receive dividends, when and as declared by HBC’s Board of Directors. Those dividends may come from funds legally available for those dividends, as specified and limited by the California Financial Code. Under the California Financial Code, funds available for cash dividends by a California-chartered bank are restricted to the lesser of: (i) the bank’s retained earnings; or (ii) the bank’s net income for its last three fiscal years (less any distributions to shareholders made during such period). With the prior approval of the DFI, cash dividends may also be paid out of the greater of: (a) the bank’s retained earnings; (b) net income for the bank’s last preceding fiscal year; or (c) net income of the bank’s current fiscal year.

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If the DFI determines that the shareholders’ equity of the bank paying the dividend is not adequate or that the payment of the dividend would be unsafe or unsound for the bank, the DFI may order the bank not to pay the dividend. Since HBC is an FDIC insured institution, it is also possible, depending upon its financial condition and other factors, that the FDIC could assert that the payment of dividends or other payments might, under some circumstances, constitute an unsafe or unsound practice and thereby prohibit such payments.

Transactions With Affiliates. The Company and any subsidiaries it may purchase or organize are deemed to be affiliates of HBC within the meaning of Sections 23A and 23B of the Federal Reserve Act and the FRB’s Regulation W. Under Sections 23A and 23B and Regulation W, loans by HBC to affiliates, investments by them in affiliates’ stock, and taking affiliates’ stock as collateral for loans to any borrower is limited to 10% of HBC’s capital, in the case of any one affiliate, and is limited to 20% of HBC’s capital, in the case of all affiliates. In addition, transactions between HBC and other affiliates must be on terms and conditions that are consistent with safe and sound banking practices; in particular, a bank and its subsidiaries generally may not purchase from an affiliate a low-quality asset, as defined in the Federal Reserve Act. These restrictions also prevent a bank holding company and its other affiliates from borrowing from a banking subsidiary of the bank holding company, unless the loans are secured by marketable collateral of designated amounts. The Company and HBC are also subject to certain restrictions with respect to engaging in the underwriting, public sale and distribution of securities.

Limitations on Business and Investment Activities.Under the BHCA, a bank holding company must obtain the FRB’s approval before: (i) directly or indirectly acquiring more than 5% ownership or control of any voting shares of another bank or bank holding company; (ii) acquiring all or substantially all of the assets of another bank; (iii) or merging or consolidating with another bank holding company.

The FRB may allow a bank holding company to acquire banks located in any state of the United States without regard to whether the acquisition is prohibited by the law of the state in which the target bank is located. In approving interstate acquisitions, however, the FRB must give effect to applicable state laws limiting the aggregate amount of deposits that may be held by the acquiring bank holding company and its insured depository institutions in the state in which the target bank is located, provided that those limits do not discriminate against out-of-state depository institutions or their holding companies, and state laws which require that the target bank have been in existence for a minimum period of time, not to exceed five years, before being acquired by an out-of-state bank holding company.

In addition to owning or managing banks, bank holding companies may own subsidiaries engaged in certain businesses that the FRB has determined to be “so closely related to banking as to be a proper incident thereto.” The Company, therefore, is permitted to engage in a variety of banking-related businesses. Some of the activities that the FRB has determined, pursuant to its Regulation Y, to be related to banking are: (i) making or acquiring loans or other extensions of credit for its own account or for the account of others; (ii) servicing loans and other extensions of credit; (iii) performing functions or activities that may be performed by a trust company in the manner authorized by federal or state law under certain circumstances; (iv) leasing personal and real property or acting as agent, broker, or adviser in leasing such property in accordance with various restrictions imposed by FRB regulations; (v) acting as investment or financial advisor; (vi) providing management consulting advice under certain circumstances; (vii) providing support services, including courier services and printing and selling MICR-encoded items; (viii) acting as a principal, agent, or broker for insurance under certain circumstances; (ix) making equity and debt investments in corporations or projects designed primarily to promote community welfare or jobs for residents; (x) providing financial, banking, or economic data processing and data transmission services; (xi) owning, controlling, or operating a savings association under certain circumstances; (xii) selling money orders, travelers’ checks and U.S. Savings Bonds; (xiii) providing securities brokerage services, related securities credit activities pursuant to Regulation T, and other incidental activities; and (xiv) underwriting dealing in obligations of the U.S., general obligations of states and their political subdivisions, and other obligations authorized for state member banks under federal law.

Additionally, under the Gramm-Leach-Bliley Act of 1999 qualifying bank holding companies making an appropriate election to the FRB may engage in a full range of financial activities, including insurance, securities and merchant banking. The Company has not elected to qualify for these financial activities.

Federal law prohibits a bank holding company and any subsidiary banks from engaging in certain tie-in arrangements in connection with the extension of credit. Thus, for example, HBC may not extend credit, lease or sell property, or furnish any services, or fix or vary the consideration for any of the foregoing on the condition that: (i) the customer must obtain or provide some additional credit, property or services from or to HBC other than a loan, discount, deposit or trust services; (ii) the customer must obtain or provide some additional credit, property or service from or to the Company or any subsidiaries; or (iii) the customer must not obtain some other credit, property or services from competitors, except reasonable requirements to assure soundness of credit extended.

The FRB also possesses enforcement powers over bank holding companies and their non-bank subsidiaries to prevent or remedy actions that represent unsafe or unsound practices or violations of applicable statutes and regulations.

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Capital Adequacy. Bank holding companies must maintain minimum levels of capital under the FRB’s risk-based capital adequacy guidelines. If capital falls below minimum guideline levels, a bank holding company, among other things, may be denied approval to acquire or establish additional banks or non-bank businesses.

The FRB’s risk-based capital adequacy guidelines, discussed in more detail below in the section entitled “SUPERVISION AND REGULATION — HBC — Regulatory Capital Guidelines,” assign various risk percentages to different categories of assets, and capital is measured as a percentage of risk assets. Under the terms of the guidelines, bank holding companies are expected to meet capital adequacy guidelines based both on total risk assets and on total assets, without regard to risk weights.

The risk-based guidelines are minimum requirements. Higher capital levels will be required if warranted by the particular circumstances or risk profiles of individual organizations. For example, the FRB’s capital guidelines contemplate that additional capital may be required to take adequate account of, among other things, interest rate risk, or the risks posed by concentrations of credit, nontraditional activities or securities trading activities. Moreover, any banking organization experiencing or anticipating significant growth or expansion into new activities, particularly under the expanded powers under the Gramm-Leach-Bliley Act, would be expected to maintain capital ratios, including tangible capital positions, well above the minimum levels.

Limitations on Dividend Payments. The California General Corporation Law prohibits the Company from paying dividends on the Common Stock unless: (i) its retained earnings, immediately prior to the dividend payment, equals or exceeds the amount of the dividend or (ii) immediately after giving effect to the dividend the sum of the Company’s assets (exclusive of goodwill and deferred charges) would be at least equal to 125% of its liabilities (not including deferred taxes, deferred income and other deferred liabilities) and the current assets of the Company would be at least equal to its current liabilities, or, if the average of its earnings before taxes on income and before interest expense for the two preceding fiscal years was less than the average of its interest expense for the two preceding fiscal years, at least equal to 125% of its current liabilities. Additionally, the FRB’s policy regarding dividends provides that a bank holding company should not pay cash dividends exceeding its net income or which can only be funded in ways that weaken the bank holding company’s financial health, such as by borrowing.

The Gramm-Leach-Bliley Act of1999. On November 12, 1999, the Gramm-Leach-Bliley Act of 1999 (the “Financial Services Modernization Act”) was signed into law. The Financial Services Modernization Act is intended to modernize the banking industry by removing barriers to affiliation among banks, insurance companies, the securities industry and other financial service providers. It provides financial organizations with the flexibility to structure such affiliations through a holding company structure or through a financial subsidiary of a bank, subject to certain limitations. The Financial Services Modernization Act establishes a new type of bank holding company, known as a financial holding company, that may engage in an expanded list of activities that are “financial in nature,” which include securities and insurance brokerage, securities underwriting, insurance underwriting and merchant banking.

The Company currently meets all the requirements for financial holding company status. However, the Company does not expect to elect financial holding company status unless and until it intends to engage in any of the expanded activities under the Financial Services Modernization Act which require such status. Unless and until it elects such status, the Company will only be permitted to engage in non-banking activities that were permissible for bank holding companies as of the date of the enactment of the Financial Services Modernization Act.

The Financial Services Modernization Act also sets forth a system of functional regulation that makes the FRB the “umbrella supervisor” for holding companies, while providing for the supervision of the holding company’s subsidiaries by other federal and state agencies. A bank holding company may not become a financial holding company if any of its subsidiary financial institutions are not well-capitalized or well-managed. Further, each bank subsidiary of the holding company must have received at least a satisfactory Community Reinvestment Financial Services Modernization Act (CRA) rating. The Financial Services Modernization Act also expands the types of financial activities a national bank may conduct through a financial subsidiary, addresses state regulation of insurance, generally prohibits unitary thrift holding companies organized after May 4, 1999 from participating in new financial activities, provides privacy protection for nonpublic customer information of financial institutions, modernizes the Federal Home Loan Bank system and makes miscellaneous regulatory improvements. The FRB and the Secretary of the Treasury must coordinate their supervision regarding approval of new financial activities to be conducted through a financial holding company or through a financial subsidiary of a bank. While the provisions of the Financial Services Modernization Act regarding activities that may be conducted through a financial subsidiary directly apply only to national banks, those provisions indirectly apply to state-chartered banks.

In addition, HBC is subject to other provisions of the Financial Services Modernization Act, including those relating to CRA, privacy and safe-guarding confidential customer information, regardless of whether the Company elects to become a financial holding company or to conduct activities through a financial subsidiary of HBC.

The Company and HBC do not believe that the Financial Services Modernization Act has had thus far, or will have in the near term, a material adverse effect on their operations. However, to the extent that it permits banks, securities firms, and insurance companies to affiliate, the financial services industry may experience further consolidation. The Financial Services Modernization Act is intended to grant to community banks certain powers as a matter of right that larger institutions have accumulated on an ad hoc basis. Nevertheless, this act may have the result of increasing the amount of competition that the Company and HBC face from larger institutions and other types of companies offering financial products, many of which may have substantially more financial resources than the Company and HBC.

The Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act of 2002 (“SOX”), became effective on July 30, 2002, and represents the most far reaching corporate and accounting reform legislation since the enactment of the Securities Act of 1933 and the Exchange Act of 1934. SOX is intended to provide a permanent framework that improves the quality of independent audits and accounting services, improves the quality of financial reporting, strengthens the independence of accounting firms and increases the responsibility of management for corporate disclosures and financial statements.

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Sox’s provisions are significant to all companies that have a class of securities registered under Section 12 of the Exchange Act, or are otherwise reporting to the SEC (or the appropriate federal banking agency) pursuant to Section 15(d) of the Exchange Act, including the Company (collectively, “public companies”). In addition to SEC rulemaking to implement SOX, The Nasdaq National Market has adopted corporate governance rules intended to allow shareholders to more easily and effectively monitor the performance of companies and directors. The principal provisions of SOX, many of which have been interpreted through regulations released in 2003, provide for and include, among other things: (i) the creation of an independent accounting oversight board; (ii) auditor independence provisions that restrict non-audit services that accountants may provide to their audit clients; (iii) additional corporate governance and responsibility measures, including the requirement that the chief executive officer and chief financial officer of a public company certify financial statements; (iv) the forfeiture of bonuses or other incentive-based compensation and profits from the sale of an issuer’s securities by directors and senior officers in the twelve month period following initial publication of any financial statements that later require restatement; (v) an increase in the oversight of, and enhancement of certain requirements relating to, audit committees of public companies and how they interact with the Company’s independent auditors; (vi) requirements that audit committee members must be independent and are barred from accepting consulting, advisory or other compensatory fees from the issuer; (vii) requirements that companies disclose whether at least one member of the audit committee is a “financial expert’ (as such term is defined by the SEC) and if not discuss, why the audit committee does not have a financial expert; (viii) expanded disclosure requirements for corporate insiders, including accelerated reporting of stock transactions by insiders and a prohibition on insider trading during pension blackout periods; (ix) a prohibition on personal loans to directors and officers, except certain loans made by insured financial institutions on non-preferential terms and in compliance with other bank regulatory requirements; (x) disclosure of a code of ethics and filing a Form 8-K for a change or waiver of such code; (xi) a range of enhanced penalties for fraud and other violations; and (xii) expanded disclosure and certification relating to an issuer’s disclosure controls and procedures and internal controls over financial reporting.

As a result of SOX and its implementing regulations, the Company continues to incur substantial cost to interpret and ensure compliance with the law and its regulations. The Company cannot be certain of the effect, if any, of the foregoing legislation on the business of the Company. Future changes in the laws, regulation, or policies that impact the Company cannot necessarily be predicted and may have a material effect on the business and earnings of the Company.

Heritage Bank of Commerce

General. HBC, as a California-chartered bank which is a member of the Federal Reserve System, is subject to regulation, supervision, and regular examination by the DFI and the FRB. HBC’s deposits are insured by the FDIC up to the maximum extent provided by law. The regulations of these agencies govern most aspects of HBC’s business and establish a comprehensive framework governing its operations. California law exempts all banks from usury limitations on interest rates.

Regulatory Capital Guidelines. The federal banking agencies have established minimum capital standards known as risk-based capital guidelines. These guidelines are intended to provide a measure of capital that reflects the degree of risk associated with a bank’s operations. The risk-based capital guidelines include both a definition of capital and a framework for calculating the amount of capital that must be maintained against a bank’s assets and off-balance sheet items. The amount of capital required to be maintained is based upon the credit risks associated with the various types of a bank’s assets and off-balance sheet items. A bank’s assets and off-balance sheet items are classified under several risk categories, with each category assigned a particular risk weighting from 0% to 100%. The following table sets forth the regulatory capital guidelines and the actual capitalization levels for HBC and the Company as of December 31, 2006:

		Adequately Capitalized		Well Capitalized		HBC		Company (consolidated)
	(greater than or equal to)
Total risked-based capital		8.00	%	10.00	%	18.12	%		18.39	%
Tier 1 risk-based capital ratio		4.00	%	6.00	%	16.98	%		17.25	%
Tier 1 leverage capital ratio		4.00	%	5.00	%	13.35	%		13.57	%

As of December 31, 2006, management believes that the Company’s capital levels met all minimum regulatory requirements and that HBC was considered “well capitalized” under the regulatory framework for prompt corrective action.

To enhance regulatory capital and to provide liquidity, the Company, through unconsolidated subsidiary grantor trusts, issued $23.7 million of trust preferred securities. These securities are currently included in our Tier I capital for purposes of determining the Company’s Tier I and total risk-based capital ratios. The FRB has promulgated a modification of the capital regulations affecting trust preferred securities. Under this modification, effective March 31, 2009, the Company will be required to use a more restrictive formula to determine the amount of trust preferred securities that can be included in regulatory Tier I capital. At that time, the Company will be allowed to include in Tier I capital an amount of trust preferred securities equal to no more than 25% of the sum of all core capital elements, which is generally defined as shareholders’ equity, less goodwill and any related deferred income tax liability. The regulations currently in effect through December 31, 2008, limit the amount of trust preferred securities that can be included in Tier I capital to 25% of the sum of core capital elements without a deduction for goodwill. Management has determined that the Company’s Tier I capital ratios would remain above the “well-capitalized” level had the modification of the capital regulations been in effect at December 31, 2006. Management expects that the Company’s Tier I capital ratios will be at or above the existing well capitalized levels on March 31, 2009, the first date on which the modified capital regulations must be applied.

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Prompt Corrective Action. The federal banking agencies possess broad powers to take prompt corrective action to resolve the problems of insured banks. Each federal banking agency has issued regulations defining five capital categories: “well capitalized,”“adequately capitalized,”“undercapitalized,”“significantly undercapitalized,” and “critically undercapitalized.” Under the regulations, a bank shall be deemed to be:

·   “well capitalized” if it has a total risk-based capital ratio of 10.0% or more, has a Tier 1 risk-based capital ratio of 6.0% or more, has a leverage capital ratio of 5.0% or more, and is not subject to specified requirements to meet and maintain a specific capital level for any capital measure;

·   “adequately capitalized” if it has a total risk-based capital ratio of 8.0% or more, a Tier 1 risk-based capital ratio of 4.0% or more, and a leverage capital ratio of 4.0% or more (3.0% under certain circumstances) and does not meet the definition of “well capitalized”;

·   “undercapitalized” if it has a total risk-based capital ratio that is less than 8.0%, a Tier 1 risk-based capital ratio that is less than 4.0%, or a leverage capital ratio that is less than 4.0% (3.0% under certain circumstances);

·   “significantly undercapitalized” if it has a total risk-based capital ratio that is less than 6.0%, a Tier 1 risk-based capital ratio that is less than 3.0% or a leverage capital ratio that is less than 3.0%; and

·   “critically undercapitalized” if it has a ratio of tangible equity to total assets that is equal to or less than 2.0%.

Banks are prohibited from paying dividends or management fees to controlling persons or entities if, after making the payment the bank would be “undercapitalized,” that is, the bank fails to meet the required minimum level for any relevant capital measure. Asset growth and branching restrictions apply to “undercapitalized” banks. Banks classified as “undercapitalized” are required to submit acceptable capital plans guaranteed by its holding company, if any. Broad regulatory authority was granted with respect to “significantly undercapitalized” banks, including forced mergers, growth restrictions, ordering new elections for directors, forcing divestiture by its holding company, if any, requiring management changes, and prohibiting the payment of bonuses to senior management. Even more severe restrictions are applicable to “critically undercapitalized” banks, those with capital at or less than 2%. Restrictions for these banks include the appointment of a receiver or conservator. All of the federal banking agencies have promulgated substantially similar regulations to implement this system of prompt corrective action.

A bank, based upon its capital levels, that is classified as “well capitalized,”“adequately capitalized” or “undercapitalized” may be treated as though it were in the next lower capital category if the appropriate federal banking agency, after notice and opportunity for a hearing, determines that an unsafe or unsound condition, or an unsafe or unsound practice, warrants such treatment. At each successive lower capital category, an insured bank is subject to more restrictions. The federal banking agencies, however, may not treat an institution as “critically undercapitalized” unless its capital ratios actually warrant such treatment.

In addition to measures taken under the prompt corrective action provisions, insured banks may be subject to potential enforcement actions by the federal banking agencies for unsafe or unsound practices in conducting their businesses or for violations of any law, rule, regulation or any condition imposed in writing by the agency or any written agreement with the agency. Enforcement actions may include the imposition of a conservator or receiver, the issuance of a cease-and-desist order that can be judicially enforced, the termination of insurance of deposits (in the case of a depository institution), the imposition of civil money penalties, the issuance of directives to increase capital, the issuance of formal and informal agreements, the issuance of removal and prohibition orders against institution-affiliated parties. The enforcement of such actions through injunctions or restraining orders may be based upon a judicial determination that the agency would be harmed if such equitable relief was not granted.

The DFI, as the primary regulator for state-chartered banks, also has a broad range of enforcement measures, from cease and desist powers and the imposition of monetary penalties to the ability to take possession of a bank, including causing its liquidation.

FDIC Insurance and Insurance Assessments. Banks and thrifts have historically paid varying amounts of premiums for federal deposit insurance depending upon a risk-based system which evaluated the institution’s regulatory and capital adequacy ratings. The FDIC operated two separate insurance funds, the Bank Insurance Fund (“BIF”) and the Savings Association Insurance Fund (“SAIF”).

As a result of the Federal Deposit Insurance Reform Act of 2005 (the “FDI Reform Act”) and regulations adopted by the FDIC effective as of November 2, 2006: (i) the BIF and the SAIF have been merged into the Deposit Insurance Fund (the “DIF”); (ii) the $100,000 insurance level has been indexed to reflect inflation (the first adjustment for inflation will be effective January 1, 2011 and thereafter adjustments will occur every 5 years); (iii) deposit insurance coverage for retirement accounts has been increased to $250,000, and will also be subject to adjustment every five years; (iv) banks that historically have capitalized the BIF are entitled to a one-time credit which can be used to off-set premiums otherwise due (this addresses the fact that institutions that have grown rapidly have not had to pay deposit premiums); (v) a cap on the level of the DIF has been imposed and dividends will be paid when the DIF grows beyond a specified threshold; and (vi) the previous risk-based system for assessing premiums has been revised.

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Prior to January 1, 2007, the FDIC utilized a risk-based assessment system to set semi-annual insurance premium assessments which categorized banks into risk categories based on two criteria, (1) three capital levels and (2) three supervisory ratings, creating a nine-cell matrix for risk-based assessments. The new assessment system consolidates the previous nine risk categories into four and names them Risk Categories I, II, III and IV. The four new categories will continue to be defined based upon supervisory and capital evaluations. In practice, the subgroup evaluations will generally be based on an institution’s composite CAMELS rating assigned to it by the institution’s federal supervisor at the end of its examination. The CAMELS rating system is based upon an evaluation of the five critical elements of an institution’s operations: Capital adequacy, Asset quality, Management, Earnings, Liquidity, and Sensitivity to risk. This rating system is designed to take into account and reflect all significant financial and operational factors financial institution examiners assess in their evaluation of an institution’s performance. The consolidation creates four new Risk Categories as shown in following table:

	Supervisory Subgroup
Captial Group	A	B	C
1. Well Capitalized	I		III
2. Adequately Capitalized	II
3. Undercapitalized	III		IV

Within Risk Category I, the new assessment system combines supervisory ratings with other risk measures to differentiate risk. For most institutions, the new assessment system combines CAMELS component ratings with financial ratios to determine an institution’s assessment rate. For large institutions that have long-term debt issuer ratings, the new assessment system differentiates risk by combining CAMELS component ratings with those ratings. For large institutions within Risk Category I, initial assessment rate determinations may be modified within limits upon review of additional relevant information. The new assessment system assesses those within Risk Category I that pose the least risk a minimum assessment rate and those that pose the greatest risk a maximum assessment rate that is two basis points higher. An institution that poses an intermediate risk within Risk Category I will be charged a rate between the minimum and maximum that will vary incrementally by institution.

Effective January 1, 2007, the actual assessment rates under this new assessment system are summarized below, expressed in terms of cents per $100 in insured deposits:

Risk Category
I*		II	III	IV
Minimum	Maximum
5	7	10	28	43

* Rates for institutions that do no pay the minimum or maximum rate vary between these rates.

The FDIC may terminate its insurance of deposits if it finds that HBC has engaged in unsafe and unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC.

Money Laundering and Currency Controls. Various federal statutory and regulatory provisions are designed to enhance record-keeping and reporting of currency and foreign transactions. Pursuant to the Bank Secrecy Act, financial institutions must report high levels of currency transactions or face the imposition of civil monetary penalties for reporting violations. The Money Laundering Control Act imposes sanctions, including revocation of federal deposit insurance, for institutions convicted of money laundering.

The International Money Laundering Abatement and Financial Anti-Terrorism Act of 2001 (“IMLAFATA”), a part of the Patriot Act, authorizes the Secretary of the Treasury, in consultation with the heads of other government agencies, to adopt special measures applicable to banks and other financial institutions to enhance record-keeping and reporting requirements for certain financial transactions that are of primary money laundering concern. Among its other provisions, IMLAFATA requires each financial institution to: (i) establish an anti-money laundering program; (ii) establish due diligence policies, procedures and controls with respect to its private banking accounts and correspondent banking accounts involving individuals and certain foreign banks; and (iii) avoid establishing, maintaining, administering, or managing correspondent accounts in the Untied States for, or on behalf of, a foreign bank that does not have a physical presence in any country. In addition, IMLAFATA contains a provision encouraging cooperation among financial institutions, regulatory authorities and law enforcement authorities with respect to individuals, entities and organizations engaged in, or reasonably suspected of engaging in, terrorist acts or money laundering activities.

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The Treasury Department’s regulations implementing IMLAFATA mandate that federally-insured banks and other financial institutions establish customer identification programs designed to verify the identity of persons opening new accounts, maintain the records used for verification, and determine whether the person appears on any list of known or suspected terrorists or terrorist organizations.

Community Reinvestment Act (“CRA”). The CRA is intended to encourage insured depository institutions, while operating safely and soundly, to help meet the credit needs of their communities. The CRA specifically directs the federal bank regulatory agencies, in examining insured depository institutions, to assess their record of helping to meet the credit needs of their entire community, including low-and moderate-income neighborhoods, consistent with safe and sound banking practices. The CRA further requires the agencies to take a financial institution’s record of meeting its community credit needs into account when evaluating applications for, among other things, domestic branches, consummating mergers or acquisitions, or holding company formations.

The federal banking agencies have adopted regulations which measure a bank’s compliance with its CRA obligations on a performance-based evaluation system. This system bases CRA ratings on an institution’s actual lending service and investment performance rather than the extent to which the institution conducts needs assessments, documents community outreach or complies with other procedural requirements. The ratings range from “outstanding” to a low of “substantial noncompliance.” HBC had a CRA rating of “Satisfactory” as of its most recent regulatory examination.

Environmental Regulation. Federal, state and local laws and regulations regarding the discharge of harmful materials into the environment may have an impact on HBC. Since HBC is not involved in any business that manufactures, uses or transports chemicals, waste, pollutants or toxins that might have a material adverse effect on the environment, HBC’s primary exposure to environmental laws is through its lending activities and through properties or businesses HBC may own, lease or acquire. Based on a general survey of HBC’s loan portfolio, conversations with local appraisers and the type of lending currently and historically done by HBC, management is not aware of any potential liability for hazardous waste contamination that would be reasonably likely to have a material adverse effect on the Company as of December 31, 2006.

Safeguarding of Customer Information and Privacy. The FRB and other bank regulatory agencies have adopted guidelines for safeguarding confidential, personal customer information. These guidelines require financial institutions to create, implement and maintain a comprehensive written information security program designed to ensure the security and confidentiality of customer information, protect against any anticipated threats or hazards to the security or integrity of such information and protect against unauthorized access to or use of such information that could result in substantial harm or inconvenience to any customer. HBC has adopted a customer information security program to comply with such requirements.

Financial institutions are also required to implement policies and procedures regarding the disclosure of nonpublic personal information about consumers to non-affiliated third parties. In general, financial institutions must provide explanations to consumers on policies and procedures regarding the disclosure of such nonpublic personal information, and, except as otherwise required by law, prohibits disclosing such information except as provided in HBC’s policies and procedures. HBC has implemented privacy policies addressing these restrictions which are distributed regularly to all existing and new customers of HBC.

USA Patriot Act of 2001. On October 26, 2001, President Bush signed the USA Patriot Act of 2001 (the “Patriot Act”). Enacted in response to the terrorist attacks in New York, Pennsylvania and Washington, D.C. on September 11, 2001, the Patriot Act is intended to strengthen the ability of U.S. law enforcement agencies and intelligence communities to work cohesively to combat terrorism on a variety of fronts. The impact of the Patriot Act on financial institutions of all kinds has been significant and wide ranging. The Patriot Act substantially enhanced existing anti-money laundering and financial transparency laws, and required appropriate regulatory authorities to adopt rules to promote cooperation among financial institutions, regulators, and law enforcement entities in identifying parties that may be involved in terrorism or money laundering. Under the Patriot Act, financial institutions are subject to prohibitions regarding specified financial transactions and account relationships, as well as enhanced due diligence and “know your customer” standards in their dealings with foreign financial institutions and foreign customers. For example, the enhanced due diligence policies, procedures, and controls generally require financial institutions to take reasonable steps:

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·   to conduct enhanced scrutiny of account relationships to guard against money laundering and report any suspicious transactions;

·   to ascertain the identity of the nominal and beneficial owners of, and the source of funds deposited into, each account as needed to guard against money laundering and report any suspicious transactions;

·   to ascertain for any foreign bank, the shares of which are not publicly traded, the identity of the owners of the foreign bank, and the nature and extent of the ownership interest of each such owner; and

·   to ascertain whether any foreign bank provides correspondent accounts to other foreign banks and, if so, the identity of those foreign banks and related due diligence information.

The Patriot Act also requires all financial institutions to establish anti money laundering programs, which must include, at minimum:

·   the development of internal policies, procedures, and controls;

·   the designation of a compliance officer;

·   an ongoing employee training program; and

·   an independent audit function to test the programs.

HBC has incorporated the requirements of the Patriot Act into its operating procedures, and while these requirements have resulted in an additional time burden the financial impact on HBC is difficult to quantify.

Other Aspects of Banking Law. HBC is also subject to federal statutory and regulatory provisions covering, among other things, security procedures, insider and affiliated party transactions, management interlocks, electronic funds transfers, funds availability, and truth-in-savings. There are also a variety of federal statutes which regulate acquisitions of control and the formation of bank holding companies.

EMPLOYEES

At December 31, 2006, the Company had 196 full-time equivalent employees. The Company’s employees are not represented by any union or collective bargaining agreement and the Company believes its employee relations are satisfactory.

ITEM 1A - RISK FACTORS

In addition to the other information in this Annual Report on Form 10-K, shareholders or prospective investors should carefully consider the following risk factors:

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Our profitability is dependent upon the economic conditions of the markets in which we operate. We operate primarily in Santa Clara County, Contra Costa County and Alameda County and, as a result, our financial condition, results of operations and cash flows are subject to changes in the economic conditions in those areas. Our success depends upon the business activity, population, income levels, deposits and real estate activity in these markets. Although our customers’ business and financial interests may extend well beyond these market areas, adverse economic conditions that affect these market areas could reduce our growth rate, affect the ability of our customers to repay their loans to us and generally affect our financial condition and results of operations. While no specific industry concentration is considered significant, our lending operations are located in market areas dependent on technology and real estate industries and their supporting companies. Thus, the Company’s borrowers could be adversely impacted by a downturn in these sectors of the economy which could reduce the demand for loans and adversely impact the borrower’s ability to repay their loans. Because of our geographic concentration, we are less able than other regional or national financial institutions to diversify our credit risks across multiple markets.

Our growth must be effectively managed and our growth strategy involves risks that may impact our net income.As part of our general growth strategy, we may expand into additional communities or attempt to strengthen our position in our current markets to take advantage of expanding market share by opening new offices. To the extent that we undertake additional office openings, we are likely to experience the effects of higher operating expenses relative to operating income from the new operations for a period of time, which may have an adverse effect on our levels of reported net income, return on average equity and return on average assets. Our current growth strategies involve internal growth from our current offices and the addition of new branch offices over time, so that the additional overhead expenses associated with these openings is absorbed prior to opening other new offices.

We must compete with other banks and financial institutions in all lines of business.The banking and financial services business in our market is highly competitive. Our competitors include large regional banks, local community banks, savings institutions, securities and brokerage companies, mortgage companies, insurance companies, finance companies, money market mutual funds, credit unions and other non-bank financial service providers. Many of these competitors are not subject to the same regulatory restrictions we are and are able to provide customers with an alternative to traditional banking services. In addition, there is an increased importance on remaining current on technological changes because such technological advances may diminish the importance of depository institutions and financial intermediaries in the transfer of funds between parties. Increased competition in our market and market changes, such as interest rate changes, force management to better control costs in order to absorb any resultant narrowing of our net interest margin, i.e., the spread between the interest rates earned on investments and loans and the interest rates paid on deposits and other interest-bearing liabilities. Without effective management and cost controls, net income may be adversely impacted by changing conditions and competition.

Interest rates and other conditions impact our results of operations.The earnings of most financial institutions depend largely on the relationship between the cost of funds, primarily deposits and borrowings, and the yield on earning assets such as loans and investment securities. This relationship, known as the interest rate spread, is subject to fluctuation and is affected by economic, regulatory and competitive factors that influence interest rates, the volume and mix of interest-earning assets and interest-bearing liabilities, and the level of non-performing assets. Many of these factors are beyond our control. Fluctuations in interest rates affect the demand of customers for our products and services, and we are subject to interest rate risk to the degree that our interest-bearing liabilities re-price or mature more slowly or more rapidly or on a different basis than our interest-earning assets. Given the current volume, mix, and re-pricing characteristics of our interest-bearing liabilities and interest-earning assets, our interest rate spread is expected to increase slightly in a rising rate environment, and decrease slightly in a declining interest rate scenario. However, there are scenarios where fluctuations in interest rates in either direction could have a negative effect on net income. For example, if funding rates rise faster than asset yields in a rising rate environment (i.e., if basis compression occurs), or if we do not actively manage certain loan index rates in a declining rate environment, we would be negatively impacted.

We must effectively manage our credit risk. There are risks inherent in making any loan, including risks inherent in dealing with individual borrowers, risks of nonpayment, risks resulting from uncertainties as to the future value of collateral and risks resulting from changes in economic and industry conditions. We attempt to minimize our credit risk through prudent loan application approval procedures, careful monitoring of the concentration of our loans within specific industries and periodic independent reviews of outstanding loans by external parties as well as external auditors. However, we cannot assure such approval and monitoring procedures will eliminate these credit risks.

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Our allowance for loan losses must be managed to provide a sufficient amount to absorb potential losses in our loan portfolio. We maintain our allowance for loan losses at a level considered adequate by management to absorb potential loan losses. The amount of future loan losses is susceptible to changes in economic, operating and other conditions within our market, which may be beyond our control, and such losses may exceed current estimates. At December 31, 2006, our allowance for loan losses as a percentage of total loans was 1.28%. Although management believes that the allowance for loan losses is adequate to absorb losses on any existing loans that may become uncollectible, we cannot predict loan losses with certainty, and we cannot assure that our allowance for loan losses will prove sufficient to cover actual loan losses in the future. Loan losses in excess of our allowance may adversely affect our business, financial condition and results of operations. Additional information regarding our allowance for loan losses and the methodology we use to determine an appropriate level of the allowance are located in the “Management’s Discussion and Analysis” section included under Item 7 of Part II of this Form 10-K.

Government regulation can result in limitations on our operations. We operate in a highly regulated environment and are subject to supervision and regulation by a number of governmental regulatory agencies, including the Board of Governors of the Federal Reserve System, the California Department of Financial Institutions and the Federal Deposit Insurance Corporation. Regulations adopted by these agencies, which are generally intended to provide protection for depositors and customers rather than for the benefit of shareholders, govern a comprehensive range of matters relating to ownership and control of our shares, our acquisition of other companies and businesses, permissible activities for us to engage in, maintenance of adequate capital levels and other aspects of our operations. These bank regulators possess broad authority to prevent or remedy unsafe or unsound practices or violations of law. The laws and regulations applicable to the banking industry could change at any time and we cannot predict the effects of these changes on our business and profitability. Increased regulation could increase our cost of compliance and adversely affect profitability.

Technology is continually changing and we must effectively implement new technologies. The financial services industry is undergoing rapid technological changes with frequent introductions of new technology-driven products and services. In addition to better serving customers, the effective use of technology increases efficiency and enables us to reduce costs. Our future success will depend in part upon our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands for convenience as well as to create additional efficiencies in our operations as we continue to grow and expand our market areas. In order to anticipate and develop new technology, we employ a qualified staff of internal information system specialists and consider this area a core part of our business. We do not develop our own software products, but have been able to respond to technological changes in a timely manner through association with leading technology vendors. We must continue to make substantial investments in technology which may affect our net income.

System failure or breaches of our network security could subject us to increased operating costs as well as litigation and other liabilities. The computer systems and network infrastructure we use could be vulnerable to unforeseen problems. Our operations are dependent upon our ability to protect our computer equipment against damage from physical theft, fire, power loss, telecommunications failure or a similar catastrophic event, as well as from security breaches, denial of service attacks, viruses, worms and other disruptive problems caused by hackers. Any damage or failure that causes an interruption in our operations could have a material adverse effect on our financial condition and results of operations. Computer break-ins, phishing and other disruptions could also jeopardize the security of information stored in and transmitted through our computer systems and network infrastructure, which may result in significant liability to us and may cause existing and potential customers to refrain from doing business with us. We employ external auditors to conduct extensive auditing and testing for any weaknesses in our systems, controls, firewalls and encryption to reduce the likelihood of any security failures or breaches. Although we, with the help of third-party service providers and auditors, intend to continue to implement security technology and establish operational procedures to prevent such damage, there can be no assurance that these security measures will be successful. In addition, advances in computer capabilities, new discoveries in the field of cryptography or other developments could result in a compromise or breach of the algorithms we and our third-party service providers use to encrypt and protect customer transaction data. A failure of such security measures could have a material adverse affect on our financial condition and results of operations.

Our loan portfolio has a large concentration of real estate loans, which involve risks specific to real estate value. Real estate lending (including commercial and construction) is a large portion of our loan portfolio; however, it is within recently established regulatory guidelines based on a percentage of Tier 2 Capital. These categories constitute $382.9 million, or approximately 53% of our total loan portfolio as of December 31, 2006. The market value of real estate can fluctuate significantly in a short period of time as a result of market conditions in the geographic area in which the real estate is located. Although a significant portion of such loans is secured by real estate as a secondary form of collateral, adverse developments affecting real estate values in one or more of our markets could increase the credit risk associated with our loan portfolio. Additionally, commercial real estate lending typically involves larger loan principal amounts and the repayment of the loans generally is dependent, in large part, on sufficient income from the properties securing the loans to cover operating expenses and debt service. Economic events or governmental regulations outside of the control of the borrower or lender could negatively impact the future cash flow and market values of the affected properties. If the loans that are collateralized by real estate become troubled during a time when market conditions are declining or have declined, we may not be able to realize the amount of security that we anticipated at the time of originating the loan, which could cause us to increase our provision for loan losses and adversely affect our operating results and financial condition.

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Our construction and development loans are based upon estimates of costs and value associated with the complete project. These estimates may be inaccurate and we may be exposed to more losses on these projects than on other loans. At December 31, 2006, residential construction loans, including land acquisition and development, totaled $143.8 million or 20%, of our total loan portfolio. This was comprised of 13% owner-occupied and 87% speculative construction and land loans. Construction, land acquisition and development lending involve additional risks because funds are advanced upon the security of the project, which is of uncertain value prior to its completion. Because of the uncertainties inherent in estimating construction costs, as well as the market value of the completed project and the effects of governmental regulation on real property, it is relatively difficult to evaluate accurately the total funds required to complete a project and the related loan-to-value ratio. As a result, speculative construction loans often involve the disbursement of substantial funds with repayment dependent, in part, on the completion of the project and the ability of the borrower to sell the property, rather than the ability of the borrower or guarantor to repay principal and interest. If our appraisal of the value of the completed project proves to be overstated, we may have inadequate security for the repayment of the loan upon completion of construction of the project. If we are forced to foreclose on a project prior to or at completion due to a default, there can be no assurance that we will be able to recover all of the unpaid balance of, and accrued interest on, the loan as well as related foreclosure and holding costs. In addition, we may be required to fund additional amounts to complete the project and may have to hold the property for an unspecified period of time.

ITEM 1B - UNRESOLVED STAFF COMMENTS

None

ITEM 2 - PROPERTIES

The main and executive offices of the Company and HBC are located at 150 Almaden Boulevard in San Jose, California 95113, with branch offices located at 15575 Los Gatos Boulevard in Los Gatos, California 95032, at 3077 Stevenson Boulevard in Fremont, California 94538, at 310 Hartz Avenue in Danville, California 94526, at 18625 Sutter Boulevard in Morgan Hill, California 95037, at 7598 Monterey Street in Gilroy, California 95020, at 4546 El Camino Real in Los Altos, California 94022, at 369 S. San Antonio Road in Los Altos, California 94022, and at 175 E. El Camino Real in Mountain View, California 94040.

Main Office

The main offices of Heritage Bank of Commerce are located at 150 Almaden Boulevard in San Jose, California on the first three floors in a fifteen-story Class-A type office building. The first two floors, which consist of approximately 22,417 square feet of office space, were subleased from a non-affiliated third party under a non-cancelable operating lease dated February 12, 1996, as amended. The third floor, which consists of approximately 12,824 square feet of office space, was acquired directly under an office lease dated April 13, 2000, as amended. The current monthly rent payment for the third floor is $27,828 and is subject to annual increases of no more than 3% until August 1, 2009, when it will become fixed at $53,861 until the lease expires on May 31, 2015. The current monthly rent payment for the first two floors is $42,592 until the sublease expires on February 28, 2010; however, after the sublease expires, the first two floors will become part of the direct lease for the third floor, subject to all of the terms and conditions therein, except that the monthly rent will be based on the then prevailing market rate to be determined no later than January 15, 2010. The Company has reserved the right to extend the term of the direct lease for two additional periods of five years each.

In January of 1997, the Company leased approximately 1,255 square feet of office space (referred to as the “Kiosk”) located next to the primary operating area at 150 Almaden Boulevard in San Jose, California to be used for meetings, staff training and marketing events. The current monthly rent payment for this space is $2,723 and is subject to annual increases of no more than 3% until August 1, 2009, when the monthly rent payment will then become fixed at $5,271 until the lease expires on May 31, 2015. The Company has reserved the right to extend the term of the lease for two additional periods of five years each.

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Branch Offices

In November of 1997, the Company leased approximately 6,590 square feet of space for a branch office in a stand alone office building located at 3077 Stevenson Boulevard in Fremont, California. The current monthly rent payment for this space is $18,715 and is subject to annual increases of approximately 4% until the lease expires on February 29, 2008. The Company has reserved the right to extend the term of the lease for two additional periods of five years each.

In March of 1999, the Company leased approximately 7,260 square feet of space for a branch office in a one-story multi-tenant office building located at 18625 Sutter Boulevard in Morgan Hill, California. The current monthly rent payment for this space is $11,944 and is subject to adjustment every 36 months, based on the Consumer Price Index of the Labor of Statistics as defined in the lease agreement, until the lease expires on October 31, 2014.

In September of 1999, the Company subleased approximately 2,700 square feet of space for a branch office in a one-story multi-tenant retail center located at 310 Hartz Avenue in Danville, California. The current monthly rent payment for this space is $9,245, and is subject to annual increases of 4% until the lease expires on December 31, 2007.

In December of 2003, the Company leased approximately 1,920 square feet of office space in a one-story stand-alone building located in an office complex at 15575 Los Gatos Boulevard in Los Gatos, California. The current monthly rent payment for this space is $4,930 and is subject to annual increases of 3%, until the lease expires on November 30, 2008. The Company has reserve the right to extend the term of the lease for two additional periods of years each.

In May of 2006, the Company leased approximately 2,505 square feet of space for a branch office on the first floor in a three-story multi-tenant multi-use building located at 7598 Monterey Street in Gilroy, California. The current monthly rent payment for this space is $4,509, and is subject to annual increases of 2% until the lease expires on September 30, 2016. However, as provided for in the lease, the monthly rent payment has been waived until January of 2009 in exchange for a tenant improvement allowance equal to the amount that would have been paid during the free rent period. The Company has reserved the right to extend the term of the lease for two additional periods of five years each.

In February of 1995, the Company leased approximately 7,889 square feet of space for a branch office in a two-story multi-tenant shopping center located at 4546 El Camino Real in Los Altos, California. In October of 2001, the lease was amended to return 795 square feet to the Landlord, leaving 7,094 square feet remaining under the lease. The current monthly rent payment for this space is $16,068 and is subject to annual increases, based on the Consumer Price Index of the Bureau of Labor Statistics as defined in the lease agreement, until the lease expires on September 30, 2008.

In January of 1998, the Company leased approximately 4,840 square feet of space for a branch office in a multi-tenant shopping center located at 175 E. El Camino Real in Mountain View, California. The current monthly rent payment for this space is $13,553 and is subject to annual increases based on the Consumer Price Index of the Bureau of Labor Statistics, as defined in the lease agreement. The lease expires on May 30, 2008; however, the Company has reserved the right to extend the term of the lease for two additional periods of five years each.

In September of 1998, the Company leased approximately 3,471 square feet of space for a branch office in a one-story stand-alone office building located at 369 S. San Antonio Road in Los Altos, California. The current monthly rent payment for this space is $16,626 and is subject to annual increases of 4% until the lease expires on September 30, 2008. The Company has reserved the right to extend the term of the lease for two additional periods of five years each.

Loan Production Offices

In August of 2005, the Company renewed its lease for a loan production office located at 740 Front Street in Santa Cruz, California 95060. The lease covers approximately 1,022 square feet of office space and expires on July 31, 2010. The current monthly rent payment for this space is $1,947 and is subject to annual increases of 3% until the lease expires.

In March of 2006, the Company renewed its lease for a loan production office located at 23 E. Beach Street in Watsonville, California 95076. The lease covers approximately 287 square feet of office space and expires on March 31, 2007. The current monthly rent payment for this space is $330.

In March of 2006, the Company renewed its lease for a loan production office located at 264 Clovis Avenue in Clovis, California 93612. The lease covers approximately 140 square feet of office space and expires on March 31, 2007. The current monthly rent payment for this space is $500.

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In January of 2007, the Company leased approximately 225 square feet of office space for a loan production office located at 8788 Elk Grove Boulevard in Elk Grove, California 95624. The current monthly rent payment for this space is $675 until the lease expires on January 31, 2008. The Company has reserved the right to extend the term of the lease for three additional periods of one year each.

In January of 2007, the Company leased approximately 333 square feet of office space for a loan production office located at 2619 Forest Avenue in Chico, California 95928. The current monthly rent payment for this space is $416 until the lease expires on January 31, 2008. The Company has reserved the right to extend the term of the lease for one additional period of one year.

For additional information on operating leases and rent expense, refer to Footnote 9 to the Consolidated Financial Statements following “Item 15 - Exhibits and Financial Statement Schedules.”

ITEM 3 - LEGAL PROCEEDINGS

The Company is involved in certain legal actions arising from normal business activities. Management, based upon the advice of legal counsel, believes the ultimate resolution of all pending legal actions will not have a material effect on the financial statements of the Company.

ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

There was no submission of matters to a vote of security holders during the fourth quarter of the year ended December 31, 2006.

PART II

ITEM 5 - MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

Market Information

The Company’s Common Stock is listed on the NASDAQ General Select Market under the symbol “HTBK.” Management is aware of the following securities dealers which make a market in the Company’s Common Stock. Citigroup Global Markets Holdings Inc., FTN Midwest Research Securities Corp., Keefe, Brunette & Woods, Inc., Knight Equity Markets, L.P., Merrill Lynch, Morgan Stanley & Company, Inc., RBC Dain Rauscher Inc., UBS Capital Markets, Goldman Sachs & Co., Citadel Derivatives Markets, Howe Barnes Hoefer & Arnett, and E-Trade Capital Markets. These market makers have committed to make a market for the Company’s Common Stock, although they may discontinue making a market at any time. No assurance can be given that an active trading market will be sustained for the Common Stock at any time in the future.

The information in the following table for 2006 and 2005 indicates the high and low closing prices for the Common Stock, based upon information provided by the NASDAQ General Select Market.

					Dividends Paid
Quarter	High		Low		Per Share
Year ended December 31, 2006:
Fourth quarter	$	27.25	$	22.61	$	0.05
Third quarter	$	24.95	$	22.55	$	0.05
Second quarter	$	25.16	$	22.30	$	0.05
First quarter	$	25.00	$	21.08	$	0.05
Year ended December 31, 2005:
Fourth quarter	$	22.89	$	19.45	$	-
Third quarter	$	21.94	$	18.38	$	-
Second quarter	$	19.24	$	17.55	$	-
First quarter	$	19.39	$	17.65	$	-

As of February 12, 2007, there were approximately 2,500 holders of record of Common Stock. There are no other classes of common equity outstanding.

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Dividends

As a bank holding company that currently has no significant assets other than its equity interest in HBC, the Company’s ability to declare dividends depends primarily upon dividends it receives from HBC. HBC’s dividend practices in turn depend upon legal restrictions, HBC’s earnings, financial position, current and anticipated capital requirements, and other factors deemed relevant by HBC’s Board of Directors at that time.

The Company declared a $0.06 per share quarterly cash dividend on February 6, 2007. The dividend will be paid on March 15, 2007, to shareholders of record on February 22, 2007.

The Company paid cash dividends totaling $2.36 million, or $0.20 per share in 2006 representing 14% of 2006 earnings. The Company’s general dividend policy is to pay cash dividends within the range of typical peer payout ratios, provided that such payments do not adversely affect the Company’s financial condition and are not overly restrictive to our growth capacity. However, no assurance can be given that earnings and/or growth expectations in any given year will justify the payment of such a dividend.

During any period in which the Company has deferred payment of interest otherwise due and payable on its subordinated debt securities, it may not make any dividends or distributions with respect to its capital stock (see “Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations - Capital Resources”). The ability of HBC’s Board of Directors to declare cash dividends is also subject to statutory and regulatory restrictions which limit the amount available for cash dividends depending upon the earnings, financial condition and cash needs of HBC, as well as general business conditions. Under California banking law, HBC may declare dividends in an amount not exceeding the lesser of its retained earnings or its net income for the last three years (reduced by dividends paid during such period) or, with the prior approval of the California Commissioner of Financial Institutions, in an amount not exceeding the greatest of (i) the retained earnings of HBC, (ii) the net income of HBC for its last fiscal year, or (iii) the net income of HBC for its current fiscal year. The payment of any cash dividends by HBC will depend not only upon HBC’s earnings during a specified period, but also on HBC meeting certain regulatory capital requirements.

The Company’s ability to pay dividends is also limited by state corporation law. The California General Corporation Law prohibits the Company from paying dividends on the Common Stock unless: (i) its retained earnings, immediately prior to the dividend payment, equals or exceeds the amount of the dividend or (ii) immediately after giving effect to the dividend the sum of the Company’s assets (exclusive of goodwill and deferred charges) would be at least equal to 125% of its liabilities (not including deferred taxes, deferred income and other deferred liabilities) and the current assets of the Company would be at least equal to its current liabilities, or, if the average of its earnings before taxes on income and before interest expense for the two preceding fiscal years was less than the average of its interest expense for the two preceding fiscal years, at least equal to 125% of its current liabilities.

Additionally, the FRB’s policy regarding dividends provides that a bank holding company should not pay cash dividends exceeding its net income or which can only be funded in ways that weaken the bank holding company’s financial health, such as by borrowing.

The FDIC and the DFI have authority to prohibit a bank from engaging in business practices that are considered to be unsafe or unsound. Depending upon the financial condition of a bank and upon other factors, the FDIC or DFI could assert that payments of dividends or other payments by a bank might be such an unsafe or unsound practice. The FRB has similar authority with respect to a bank holding company.

For regulatory restrictions on payment of dividends by the Company, see Item 1- “BUSINESS - Regulation and Supervision - Limitations on Dividends Payments.”

Stock Repurchase Program

In February 2006, the Company’s Board of Directors authorized the purchase of up to $10 million of its common stock, which represents approximately 455,000 shares, or 4%, of its outstanding shares at current market price. The share repurchase authorization is valid through June 30, 2007. The Company intends to continue to finance the repurchase of shares using its available cash. Shares may be repurchased by the Company in open market purchases or in privately negotiated transactions as permitted under applicable rules and regulations. The repurchase program may be modified, suspended or terminated by the Board of Directors at any time without notice. The extent to which the Company repurchases its shares and the timing of such repurchases will depend upon market conditions and other corporate considerations (including compliance with the Company’s “black out” trading policies).

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The following table provides information concerning the Company’s repurchase of its common stock in 2006.

	As of December 31, 2006
Total Shares Purchased	330,300
Average Per Share Price	$	23.88
Number of Shares as Part of Announced Plan or Program		330,300
Maximum Amount Remaining for Purchase Under Plan or Program	$	2,092,000

ITEM 6 - SELECTED FINANCIAL DATA

The following table presents a summary of selected financial information that should be read in conjunction with the Company’s consolidated financial statements and notes thereto included under Item 8 - “FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.”

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SELECTED FINANCIAL DATA

	AT AND FOR YEAR ENDED DECEMBER 31,
(Dollars in thousands, except per share amounts and ratios)	2006			2005			2004			2003			2002
INCOME STATEMENT DATA:
Interest income	$	72,957		$	63,756		$	50,685		$	46,447		$	51,015
Interest expense		22,525			15,907			9,648			10,003			15,237
Net interest income before provision for loan losses		50,432			47,849			41,037			36,444			35,778
Provision for loan losses		(503	)		313			666			2,900			2,663
Net interest income after provision for loan losses		50,935			47,536			40,371			33,544			33,115
Noninterest income		9,840			9,423			10,544			10,812			9,684
Noninterest expense		34,268			35,233			39,238			33,084			32,161
Income before income taxes		26,507			21,726			11,677			11,272			10,638
Income tax expense		9,237			7,280			3,199			3,496			3,484
Net income	$	17,270		$	14,446		$	8,478		$	7,776		$	7,154
PER SHARE DATA:
Basic net income (1)	$	1.47		$	1.22		$	0.73		$	0.69		$	0.65
Diluted net income (2)	$	1.44		$	1.19		$	0.71		$	0.67		$	0.63
Book value (3)	$	10.54		$	9.45		$	8.45		$	7.86		$	7.30
Weighted average number of shares outstanding - basic		11,725,671			11,795,635			11,559,155			11,221,232			11,063,965
Weighted average number of shares outstanding - diluted		11,956,433			12,107,230			11,986,856			11,572,588			11,324,650
Shares outstanding at period end		11,656,943			11,807,649			11,669,837			11,381,037			11,214,414
BALANCE SHEET DATA:
Securities	$	172,298		$	198,495		$	232,809		$	153,473		$	126,443
Net loans	$	716,475		$	678,554		$	713,033		$	648,706		$	660,680
Allowance for loan losses	$	9,279		$	10,224		$	12,497		$	13,451		$	13,227
Total assets	$	1,037,138		$	1,130,509		$	1,108,173		$	1,005,982		$	960,066
Total deposits	$	846,593		$	939,759		$	918,535		$	835,410		$	841,936
Other borrowed funds	$	21,800		$	32,700		$	47,800		$	43,600		$	0
Notes payable to subsidiary grantor trusts	$	23,702		$	23,702		$	23,702		$	23,702		$	23,000
Total shareholders' equity	$	122,820		$	111,617		$	98,579		$	89,485		$	81,862
SELECTED PERFORMANCE RATIOS:
Return on average assets (4)		1.57	%		1.27	%		0.80	%		0.81	%		0.77	%
Return on average equity		14.62	%		13.73	%		9.04	%		9.04	%		9.15	%
Net interest margin		5.06	%		4.58	%		4.22	%		4.15	%		4.19	%
Efficiency ratio		56.86	%		61.52	%		76.07	%		70.01	%		70.74	%
Average net loans as a percentage of average deposits		77.61	%		73.55	%		77.11	%		77.21	%		76.49	%
Average total shareholders' equity as a
percentage of average total assets		10.75	%		9.25	%		8.80	%		8.95	%		8.41	%
SELECTED ASSET QUALITY RATIOS:
Net loan charge-offs to average loans		0.06	%		0.28	%		0.19	%		0.41	%		0.09	%
Allowance for loan losses to total loans		1.28	%		1.48	%		1.72	%		2.03	%		1.96	%
CAPITAL RATIOS:
Tier 1 risk-based		17.3	%		14.2	%		13.0	%		13.3	%		12.1	%
Total risk-based		18.4	%		15.3	%		14.3	%		14.5	%		13.3	%
Leverage		13.6	%		11.6	%		10.9	%		11.1	%		10.7	%

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Notes:

1) Represents net income divided by the average number of shares of common stock outstanding for the respective period.

2) Represents net income divided by the average number of shares of common stock and common stock-equivalents outstanding for the respective period.

3) Represents shareholders’ equity divided by the number of shares of common stock outstanding at the end of the period indicated.

4) Average balances used in this table and throughout this Annual Report are based on daily averages.

ITEM 7 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Executive Summary

This summary is intended to identify the most important matters on which management focuses when it evaluates the financial condition and performance of the Company. When evaluating financial condition and performance, management looks at certain key metrics and measures. The Company’s evaluation includes an analysis including comparisons with peer group financial institutions and with its own performance objectives established in the internal planning process.

The primary activity of the Company is commercial banking. The Company’s operations are located entirely in the southern and eastern regions of the general San Francisco Bay area of California in the counties of Santa Clara, Alameda and Contra Costa. The largest city in this area is San Jose and the Company’s market includes the headquarters of a number of technology based companies in the region known commonly as Silicon Valley. The Company’s customers are primarily closely held businesses and professionals.

Performance Overview

Net income in 2006 was $17.3 million, an increase of $2.9 million, or 20%, over the $14.4 million in net earnings achieved in 2005. Net income in 2005 was $5.9 million higher than 2004 net earnings of $8.5 million. Net income per diluted share was $1.44 for 2006, as compared to $1.19 during 2005 and $0.71 in 2004. The Company’s Return on Average Assets was 1.57% and Return on Average Equity was 14.62% in 2006, as compared to 1.27% and 13.73%, respectively for 2005, and 0.80% and 9.04%, respectively in 2004.

The following are major factors impacting the Company’s results of operations in recent years:

·   Net interest income grew by $2.6 million, or 5%, in 2006, and by $6.8 million, or 17%, in 2005. The growth in both periods was largely driven by an increased rate on earning assets.

·   Noninterest income increased by 4% in 2006 but decreased 11% in 2005 from 2004.

·   The efficiency ratio was reduced to 56.86% in 2006 from 61.52% in 2005 due to the continued efforts on cost savings.

·   The loan loss provision was $0.9 million lower in 2006 than in 2005, and $0.4 million lower in 2005 than in 2004. This is the result of a general improvement in credit quality.

The following are important factors in understanding our current financial condition and liquidity position:

·   Total assets declined by $93.4 million, or 8%, to $1.04 billion at the end of 2006 from $1.13 billion at the end of 2005.

·   Gross loan balances (including loans held for sale) decreased by $15.9 million, or 2%, in 2006, primarily due to the Company selling its Capital Group loan portfolio in the first quarter of 2006 of approximately $30 million, which consisted primarily of “factoring” type loans.

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Deposits

Growth in deposits is an important metric management uses to measure market share. The Company’s depositors are primarily located in its primary market area. Depending on loan demand and other funding requirements, the Company will occasionally obtain deposits from wholesale sources including deposit brokers. The Company had $32 million in brokered deposits at December 31, 2006. The Company also seeks deposits from title insurance companies and real estate exchange facilitators. The Company has a policy to monitor all deposits that may be sensitive to interest rate changes to help assure that liquidity risk does not become excessive due to concentrations.

Lending

Our lending business originates primarily through our branch offices located in our primary market. The economy in our primary service area continued to stabilize in 2006. Commercial loans increased from December 31, 2005 primarily from increased loan demand reflecting the improving economy in our primary service area. Commercial real estate mortgage loans increased from December 31, 2005 primary due to general improvements in commercial income property markets. We will continue to use and improve existing products to expand market share at current locations.

Net Interest Income

The management of interest income and interest expense is fundamental to the performance of the Company. Net interest income, the difference between interest income and interest expense, is the largest component of the Company’s total revenue. Management closely monitors both total net interest income and the net interest margin (net interest income divided by average earning assets).

Increases in short-term interest rates contributed to growth in net interest income since the interest rate earned on a majority of the Company’s loan portfolio adjusts with the prime rate. Approximately 77% of the Company’s loan portfolio is indexed to the prime rate. As the Federal Open Market Committee (“FOMC”) reduced short term interest rates from 2000 to 2003, the prime rate dropped sharply from 9.50% at December 31, 2000 to 4.00% in June 2003. The FOMC began to increase short term rates in July 2004 and the prime rate at December 31, 2006 was 8.25%. The improvement in net interest margin in 2006 and 2005 is largely attributable to the FOMC action. Because of its focus on commercial lending to closely held businesses, the Company will continue to have a high percentage of floating rate loans and other assets. Given the current volume, mix and repricing characteristics of our interest-bearing liabilities and interest-earning assets, we believe our interest rate spread is expected to increase slightly in a rising rate environment, and decrease slightly in a declining interest rate scenario.

The Company, through its asset and liability policies and practices, seeks to maximize net interest income without exposing the Company to an excessive level of interest rate risk. Interest rate risk is managed by monitoring the pricing, maturity and repricing options of all classes of interest bearing assets and liabilities. This is discussed in more detail in Items 7- Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Asset/Liability Management.

Management of Credit Risk

Because of its focus on business banking, loans to single borrowing entities are often larger than would be found in a more consumer oriented bank with many smaller, more homogenous loans. The average size of its relationships makes the Company more susceptible to larger losses. As a result of this concentration of larger risks, the Company has maintained an allowance for loan losses which is substantially higher than would be indicated by its actual historic loss experience. The Company’s provision for loan losses has decreased each of the last two years because of a reduction in classified loans from $35.6 million in 2004 to $16.3 million in 2005, and a reduction of impaired loans from $15.6 million in 2005 to $9.0 million in 2006. A complete discussion of the management of credit risk appears in Item 7- Management’s Discussion and Analysis of Financial Condition and Results of Operations - Provision for Loan Losses and Allowance for Loan Losses.

Noninterest Income

While net interest income remains the largest single component of total revenues, noninterest income has become a growing component. A significant percentage of the Company’s noninterest income is associated with its SBA lending activity, either as gains on the sale of loans sold in the secondary market or servicing income from loans sold in the secondary market with  retained servicing rights.

Noninterest income associated with SBA activity has increased each year from 2003 through 2006. Risks associated with the continuation of this level of noninterest income from SBA lending include the possibility that the federal government will eliminate or change SBA programs in a manner that becomes less attractive to the Company or to SBA borrowers. Further, change in the secondary market for SBA loans could reduce gains on sale. Higher than expected prepayments of SBA loans on which the Company has retained servicing could reduce the carrying value of the associated servicing asset and interest only strip. Loan servicing is discussed in Item 7- Management’s Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies and in the Notes to Consolidated Financial Statements.

25

Noninterest Expense

Management considers the control of operating expenses to be a critical element of the Company’s performance. Over the last three years the Company has undertaken several initiatives to reduce its noninterest expense and improve its efficiency. These initiatives included a reduction in staff and the consolidation of operations under the common Heritage Bank brand and restructuring each department. Management monitors progress in reducing nonexpense through review of the Company’s efficiency ratio. The Company’s efficiency was 56.86% in 2006 compared with 61.52% in 2005.

In the fourth quarter of 2005 the Company recognized additional expenses of $1.05 million, representing the present value of term insurance for participants in the Company’s Supplemental Executive Retirement Plan, substantially all of whom have split dollar life insurance agreements with the Company. Typically, under the split dollar life insurance agreements, the insureds’ beneficiary receives 80% of the excess of the death benefit over the cash surrender value of the policy. This accounting adjustment was undertaken after the Company’s review of split dollar life insurance agreements and recognition that the Company has contractually agreed with each participant to provide life insurance on an ongoing basis without interruption. In order to replace this coverage, the Company would have to obtain term insurance for the remainder of the insureds’ expected lives, if the Company ever terminated its company owned life insurance. This charge reflected the term insurance cost for all insureds.

In September 2006, the FASB Emerging Issues Task Force finalized Issue No. 06-4, Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements. This issue requires that a liability be recorded during the service period when a split-dollar life insurance agreement continues after participants’ employment or retirement. The required accrued liability will be based on either the post-employment benefit cost for the continuing life insurance or on the future death benefit depending on the contractual terms of the underlying agreement. This issue is effective for fiscal years beginning after December 15, 2007.

Adoption of Statement 158 did not affect the Company’s financial statements since the Company’s supplemental retirement plan has no assets and the liability for benefits is measured as of December 31 and recorded on the Company’s balance sheet.

Capital Management and Share Repurchases

Heritage Commerce Corp and Heritage Bank of Commerce meet the regulatory definition of “well capitalized” at December 31, 2006. As part of its asset and liability process, the Company continually assesses its capital position to take into consideration growth, expected earnings, risk profile and potential corporate activities that it may choose to pursue. As a part of this process, the Company determined in the second quarter of 2004 that its capital levels were higher than necessary. To adjust capital to levels consistent with its view of current market conditions, the Company commenced a stock repurchase plan in June 2004. The repurchase program was completed at the end of third quarter 2005. On February 7, 2006, the Board of Directors authorized the repurchase of up to an additional $10 million of common stock through June 30, 2007.

In 2006, the Company initiated the payment of quarterly cash dividends. The Company paid cash dividends totaling $2.36 million, or $0.20 per share in 2006, representing 14% of 2006 earnings. The Company’s general policy is to pay cash dividends within the range of typical peer payout ratios, provided that such payments do not adversely affect our financial condition and are not overly restrictive to our growth capacity. On February 6, 2007, the Company declared a $0.06 per share quarterly cash dividend. The dividend will be paid on March 15, 2007, to shareholders of record on February 22, 2007.

Results of Operations

The Company earns income from two primary sources. The first is net interest income, which is interest income generated by earnings assets less interest expense on interest-bearing liabilities. The second is non-interest income, which primarily consists of gains from the sale of loans, loan servicing fees, and customer service charges and fees but also includes non-customer sources such as Company-owned life insurance. The majority of the Company’s non-interest expenses are operating costs that relate to providing a full range of banking services to our customers.

Net Interest Income and Net Interest Margin

In 2006, net interest income was $50.4 million, an increase of 5% compared to $47.8 million in 2005. The level of net interest income depends on several factors in combination, including growth in earning assets, yields on earning assets, the cost of interest-bearing liabilities, the relative volumes of earning assets and interest-bearing liabilities, and the mix of products which comprise the Company’s earning assets, deposits, and other interest-bearing liabilities. To maintain its net interest margin, the Company must manage the relationship between interest earned and paid.

26

The following Distribution, Rate and Yield table presents for each of the past three years, the average amounts outstanding for the major categories of the Company’s balance sheet, the average interest rates earned or paid thereon, and the resulting net interest margin on average interest earning assets for the periods indicated. Average balances are based on daily averages.

Distribution, Rate and Yield

	Year Ended December 31,
	2006						2005						2004
			Interest		Average				Interest		Average				Interest		Average
	Average		Income /		Yield /		Average		Income /		Yield /		Average		Income /		Yield /
(Dollars in thousands)	Balance		Expense		Rate		Balance		Expense		Rate		Balance		Expense		Rate
Assets:
Loans, gross	$	738,297	$	61,859		8.38%	$	762,328	$	54,643		7.17%	$	725,921	$	43,593		6.01	%
Securities		191,220		7,796		4.08%		226,043		7,247		3.21%		216,012		6,715		3.11	%
Interest bearing deposits in other financial institutions		2,826		132		4.67%		3,234		97		3.00%		1,336		14		1.05	%
Federal funds sold		63,739		3,170		4.97%		52,438		1,769		3.37%		28,964		363		1.25	%
Total interest earning assets		996,082		72,957		7.32%		1,044,043		63,756		6.11%		972,233		50,685		5.21	%
Cash and due from banks		34,810						38,670						47,911
Premises and equipment, net		2,482						2,879						3,728
Other assets		64,904						51,593						41,923
Total assets	$	1,098,278					$	1,137,185					$	1,065,795
Liabilities and shareholders' equity:
Deposits:
Demand, interest bearing	$	145,471	$	3,220		2.21%	$	134,412	$	1,749		1.30%	$	112,439	$	536		0.48	%
Savings and money market		358,846		10,274		2.86%		363,570		6,058		1.67%		350,922		3,658		1.04	%
Time deposits, under $100		31,967		1,037		3.24%		37,260		862		2.31%		38,717		575		1.49	%
Time deposits, $100 and over		107,387		3,762		3.50%		115,104		2,867		2.49%		100,309		1,556		1.55	%
Brokered time deposits, $100 and over		34,234		1,295		3.78%		35,764		1,313		3.67%		11,460		473		4.13	%
Notes payable to subsidiary grantor trusts		23,702		2,310		9.75%		23,702		2,136		9.01%		23,702		1,958		8.26	%
Securities sold under agreement to repurchase		25,429		627		2.47%		40,748		922		2.26%		43,140		892		2.07	%
Total interest bearing liabilities		727,036	$	22,525		3.10%		750,560	$	15,907		2.12%		680,689	$	9,648		1.42	%
Demand, noninterest bearing		229,190						259,881						275,192
Other liabilities		23,957						21,536						16,139
Total liabilities		980,183						1,031,977						972,020
Shareholders' equity		118,095						105,208						93,775
Total liabilities and shareholders' equity	$	1,098,278					$	1,137,185					$	1,065,795
Net interest income / margin			$	50,432		5.06%			$	47,849		4.58%			$	41,037		4.22	%

(1) Yields and amounts earned on loans include loan fees of $0.6 million, $1.3 million, $1.5 million, for the years ended December 31, 2006, 2005, and 2004. Nonaccrual loans are included in the average balance calculations above.

(2) Interest income is reflected on an actual basis, not a fully taxable equivalent basis and does not include a fair value adjustment.

27

The Volume and Rate Variances table below sets forth the dollar difference in interest earned and paid for each major category of interest-earning assets and interest-bearing liabilities for the noted periods, and the amount of such change attributable to changes in average balances (volume) or changes in average interest rates. Volume variances are equal to the increase or decrease in the average balance times the prior period rate, and rate variances are equal to the increase or decrease in the average rate times the prior period average balance. Variances attributable to both rate and volume changes are equal to the change in rate times the change in average balance and are included below in the average volume column.

Volume and Rate Variances

	2006 vs. 2005							2005 vs. 2004
	Increase (Decrease) Due to Change in:							Increase (Decrease) Due to Change in:
	Average			Average		Net		Average			Average		Net
(Dollars in thousands)	Volume			Rate		Change		Volume			Rate		Change
Income from the interest earning assets:
Loans, gross	$	(2,024)		$	9,240	$	7,216	$	2,594		$	8,456	$	11,050
Securities		(1,427)			1,976		549		313			219		532
Interest bearing deposits in other financial institutions		(19)	)		54		35		57			26		83
Federal funds sold		564			837		1,401		793			613		1,406
Total interest income on interest earning assets	$	(2,906)		$	12,107	$	9,201	$	3,757		$	9,314	$	13,071
Expense from the interest liabilities:
Demand, interest bearing	$	249		$	1,222	$	1,471	$	287		$	926	$	1,213
Savings and money market		(124)			4,340		4,216		198			2,202		2,400
Time deposits, under $100		(170)			345		175		(94	)		381		287
Time deposits, $100 and over		(267)			1,162		895		420			891		1,311
Brokered time deposits, $100 and over		(57)			39		(18)		892			(52)		840
Notes payable to subsidiary grantor trusts		-			174		174		-			178		178
Securities sold under agreement to repurchase		(379)			84		(295)		(53)			83		30
Total interest expense on interest bearing liabilities	$	(748)		$	7,366	$	6,618	$	1,650		$	4,609	$	6,259
Net interest income	$	(2,158)		$	4,741	$	2,583	$	2,107		$	4,705	$	6,812

Net interest income for 2006 increased $2.58 million or 5% from 2005. The increase in 2006 was primarily due to increasing short-term interest rates. The Company’s net interest margin expressed as a percentage of average earning assets, was 5.06% in 2006 relative to 4.58% in 2005, an increase of 48 basis points. A substantial portion of the Company’s earning assets are variable-rate loans that re-price shortly when the Company’s prime lending rate is changed, versus a large base of core deposits that are generally slower to re-price. This causes the Company’s balance sheet to be slightly asset-sensitive, which means that all else being equal, the Company’s net interest margin will be lower during periods when short-term interest rates are falling and higher when rates are rising. This effect was visible in 2006, when the Company’s net interest margin rose in correlation to increases in short-term market interest rates. Management anticipates that the Company’s net interest margin could experience some compression if short-term interest rates do not continue to rise, nevertheless we feel that net interest income will continue to increase if loans and core deposits grow as planned. However, no assurance can be given that this will, in fact, occur.

Net interest income for 2005 increased 17% from 2004. The increase in 2005 was due to the increase in average earning assets and increases in key market interest rates in 2005. Average interest earning assets increased 7% in 2005 from 2004. This increase was primarily attributable to growth in average loans and Federal funds sold. Average loans outstanding, including loans held for sale, increased $36.4 million during 2005, over the average during 2004. Average Federal funds sold in 2005 increased $23.5 million from 2004. The increase in average interest bearing assets is partially offset by the increase in average interest bearing liabilities. Average interest bearing liabilities increased 10% in 2005 from 2004. This increase was primarily attributable to growth in interest bearing demand deposits, savings and money-market accounts and time deposits. The Company’s average rate paid on interest bearing liabilities increased to 2.12% in 2005 from 1.42% in 2004. Overall, the net interest margin increased 36 basis points to 4.58% in 2005 from 4.22% in 2004. Net interest income increased $6.8 million or 17%, for 2005 to $47.8 million from $41.0 million for 2004, primarily due to the increase in interest rates.

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Provision for Loan Losses

Credit risk is inherent in the business of making loans. The Company sets aside an allowance or reserve for loan losses through charges to earnings, which are shown in the income statement as the provision for loan losses. Specifically identifiable and quantifiable losses are immediately charged off against the allowance. The loan loss provision is determined by conducting a monthly evaluation of the adequacy of the Company’s allowance for loan losses, and charging the shortfall, if any, to the current month’s expense. This has the effect of creating variability in the amount and frequency of charges to the Company’s earnings. The loan loss provision and level of allowance for each period is dependent upon many factors, including loan growth, net charge-offs, changes in the composition of the loan portfolio, delinquencies, management’s assessment of the quality of the loan portfolio, the valuation of problem loans and the general economic conditions in the Company’s market area.

For 2006, the Company had a credit provision for loan losses of $0.5 million, compared to provision for loan losses of $0.3 million for 2005 and $0.7 million for 2004. The allowance for loan losses represented 1.28%, 1.48% and 1.72% of total loans at December 31, 2006, 2005 and 2004, respectively. See “Allowance for Loan Losses” on page 37 for additional information.

Noninterest Income

While net interest income remains the largest single component of consolidated net income, noninterest income has become a growing component. A significant percentage of the Company’s noninterest income is associated with its SBA lending activity, either as gains on the sale of loans sold in the secondary market or servicing income from loans sold in the secondary market with retained servicing rights. SBA loan activity includes the origination, sale, and servicing of loans guaranteed by the U.S. Department of Agriculture.

Noninterest income associated with SBA activity has increased each year from 2003 through 2006. Risks associated with the continuation of this level of noninterest income from SBA lending include the possibility that the federal government will eliminate or change SBA programs in a manner that becomes less attractive to the Company or to SBA borrowers. Further, change in the secondary market for SBA loans could reduce gains on sale. Higher than expected prepayments of SBA loans on which the Company has retained servicing could reduce the carrying value of the associated servicing asset and interest only strip. Loan servicing is discussed in Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies and in the Notes to Consolidated Financial Statements.

The following table sets forth the various components of the Company’s noninterest income:

Noninterest Income

							Increase (decrease)				Increase (decrease)
	Year Ended December 31,						2006 versus 2005				2005 versus 2004
(Dollars in thousands)	2006		2005		2004		Amount		Percent		Amount		Percent
Gain on sale of loans	$	4,008	$	2,871	$	3,052	$	1,137		40%	$	(181)		-6%
Servicing income		1,860		1,838		1,498		22		1%		340		23%
Increase in cash surrender value of life insurance		1,439		1,236		1,031		203		16%		205		20%
Service charges and fees on deposit accounts		1,335		1,468		1,799		(133)		-9%		(331)		-18%
Gain on sale of leased equipment		-		299		-		(299)		N/A		299		N/A
Equipment leasing		-		131		871		(131)		-100%		(740)		-85%
Gain on sales of securities available-for-sale		-		-		476		-		N/A		(476)		-100%
Mortgage brokerage fees		-		-		168		-		N/A		(168)		-100%
Other		1,198		1,580		1,649		(382)		-24%		(69)		-4%
Total	$	9,840	$	9,423	$	10,544	$	417		4%	$	(1,121)		-11%

The increase in noninterest income in 2006 as compared to 2005 was primarily attributable to a $1.14 million increase in gain on sale of loans. The Company, subject to market conditions, sells the guaranteed portion of its SBA loans and retains the servicing rights. The increase gain on sale of loans included a one time gain on sale of certain specialty loans that occurred during the first quarter of 2006, which resulted in a one time gain of $0.7 million.

29

Gains or losses on SBA loans held for sale are recognized upon completion of the sale, and are based on the difference between the net sales proceeds and the relative fair value of the guaranteed portion of the loan sold compared to the relative fair value of the unguaranteed portion. The servicing assets that result from the sale of SBA loans, with servicing rights retained, are amortized over the lives of the loans using a method approximating the interest method.

Also contributing to the improvements in noninterest income in 2006 was an increase in the cash surrender value of life insurance and a slight increase in servicing income which offset a slight decline in deposit service charges and fees. The increases in 2006 offset the $0.4 million generated last year from leasing activities, a business the Company exited in 2005.

In 2005, the increase in the cash surrender value of life insurance was primarily the result of additional policies purchased in 2005. The reduction in gain on sale of loans was related to the market conditions. The decrease in deposit service charges and fees on deposit accounts was primarily because higher interest rates applied to collected balances created a waiver of (or credit against) service charges for many business customers. The Company sold all leased equipment during the second quarter of 2005 and closed the residential mortgage department in June 2004.

Noninterest Expense

Management considers the control of operating expenses to be a critical element of the Company’s performance. The Company undertook several initiatives to reduce its noninterest expense and improve its efficiency. These initiatives included a reduction in staff and the consolidation of its operations under the common Heritage Bank brand and restructuring each department.

The following table sets forth the various components of the Company’s noninterest expense:

Noninterest Expense

							Increase (decrease)				Increase (decrease)
	Year Ended December 31,						2006 versus 2005				2005 versus 2004
(Dollars in thousands)	2006		2005		2004		Amount		Percent		Amount			Percent
Salaries and employee benefits	$	19,414	$	19,845	$	20,189	$	(431)		-2%	$	(344)			-2%
Occupancy		3,110		3,254		3,670		(144)		-4%		(416)			-11%
Professional fees		1,688		1,617		2,656		71		4%		(1,039)	)		-39%
Client services		1,000		1,404		1,044		(404)		-29%		360			34%
Advertising and promotion		1,064		985		1,090		79		8%		(105)			-10%
Low income housing investment losses and writedowns		995		957		878		38		4%		79			9%
Furniture and equipment		517		734		921		(217)		-30%		(187)			-20%
Data processing expense		806		661		722		145		22%		(61)			-8%
Retirement plan expense		352		619		306		(267)		-43%		313			102%
Amortization of leased equpiment		-		334		1,016		(334)		-100%		(682)			-67%
Operational losses		9		37		2,219		(28)		-76%		(2,182)			-98%
Other		5,313		4,786		4,527		527		11%		259			6%
Total	$	34,268	$	35,233	$	39,238	$	(965)		-3%		(4,005)			-10%

30

The following table indicates the percentage of noninterest expense in each category:

Noninterest Expense by Category

	2006					2005					2004
			Percent					Percent					Percent
(Dollars in thousands)	Amount		of Total			Amount		of Total			Amount		of Total
Salaries and employee benefits	$	19,414		57	%	$	19,845		56	%	$	20,189		51	%
Occupancy		3,110		9	%		3,254		9	%		3,670		9	%
Professional fees		1,688		5	%		1,617		4	%		2,656		7	%
Client services		1,000		3	%		1,404		4	%		1,044		3	%
Advertising and promotion		1,064		3	%		985		3	%		1,090		3	%
Low income housing investment losses and writedowns		995		3	%		957		3	%		878		2	%
Furniture and equipment		517		1	%		734		2	%		921		2	%
Data processing expense		806		2	%		661		2	%		722		2	%
Retirement plan expense		352		1	%		619		2	%		306		1	%
Amortization of leased equpiment		-		0	%		334		1	%		1,016		2	%
Operational losses		9		0	%		37		0	%		2,219		6	%
Other		5,313		16	%		4,786		14	%		4,527		12	%
Total	$	34,268		100	%	$	35,233		100	%	$	39,238		100	%

Noninterest expense decreased $1.0 million, or 3% in 2006 as compared with 2005. Non-interest expense for 2005 decreased $4.0 million, or 10%, from 2004. Management monitors progress in its management of noninterest expense by improvements in the Company’s efficiency ratio. The efficiency ratio represents operating expense divided by the sum of net interest and non-interest income, with the provision for loan losses and security gains and losses excluded from the equation. The Company’s efficiency ratio was 56.86% in 2006 as compared to 61.52% in 2005.

Salaries and employee benefits, the single largest component of noninterest expense, decreased $0.4 million in 2006 from 2005. In 2005, salaries and employee benefits decreased $0.3 million from 2004. The decrease in 2006 from 2005 was primarily attributable to a decrease in loan officer commissions, executive severance and term life insurance expense, partially offset by an increase in stock option expense. The Company adopted Statement 123R in 2006, which has resulted in an increase of stock option expense in noninterest expense of $780,000 in 2006. In 2005, stock option expense was not included in the salaries and employee benefits but rather disclosed in a footnote in the Company’s financial statements on a pro forma basis. The decrease in 2005 from 2004 was primarily attributable to a decrease in the number of employees.

Occupancy expense decreased $0.1 million in 2006 from 2005. In 2005, occupancy expense decreased $0.4 million from 2004. The decrease in 2006 from 2005 was primarily a result of lower depreciation on leasehold improvements and reduction in repairs at bank branches. The decrease in 2005 from 2004 was also a result of lower depreciation on leasehold improvements. Occupancy expense in 2006 and partially in 2005 were reduced because, during the third quarter of 2005, the Company amended two of its existing lease contracts to reduce monthly rent and extend the terms of the leases. These costs were 9% of total operating expenses in 2006 and remained fairly constant compared to 2005 and 2004.

Professional fees increased $0.1 million in 2006 from 2005. In 2005, professional fees decreased $1.0 million from 2004. The increase in 2006 was primarily attributable to increased legal and audit expenses, partially offset by a decrease in consultant expenses. The decrease in 2005 from 2004 was primarily attributable to decreased legal, audit and consulting expenses. Professional fees in 2004 included audit and consulting expenses related to compliance with Sarbanes-Oxley and legal expenses related to the proxy solicitation for the 2004 annual meeting and other corporate governance matters.

Client services decreased $0.4 million in 2006 from 2005 primarily due to the decrease in service fees charged to the Company from the third party vendors, such as for armored car services. In 2005, client services increased $0.4 million from 2004. The increase in 2005 from 2004 was primarily attributable to the increase in service fees charged to the Company from third party vendors who have certain deposit accounts.

Advertising and promotion costs increased $0.1 million in 2006 from 2005. The increase in 2006 from 2005 was due to an increase in business promotion. In 2005, advertising and promotion costs decreased $0.1 million from 2004. The decrease in 2005 from 2004 was primarily attributable to the discontinuation of certain sponsorships.

31

Low income housing investment losses and writedowns increased $0.04 million in 2006 from 2005. In 2005, low income housing investment losses and writedowns increased $0.1 million from 2004. The increase in 2006 was primarily attributable to the increased losses from three fully active limited partnerships. The Company obtains tax credits from these investments which reduce income tax expense. These investments are written down to zero over the period that tax credits are recognized, since no residual value is assumed.

Furniture and equipment expense decreased $0.2 million in 2006 from 2005. In 2005, furniture and equipment expense decreased $0.2 million from 2004. The decrease in 2006 was primarily due to lower depreciation on furniture and equipment. The decrease in 2005 was primarily due to fewer equipment repairs and lower depreciation on furniture and equipment.

Data processing expense increased $0.1 million in 2006 from 2005. In 2005, data processing expense decreased $0.1 million from 2004. The increase in 2006 from 2005 was primarily due to a higher volume of data processing. The decrease in 2005 was a result of cost saving by outsourcing the core data and item processing.

Retirement plan expense for directors decreased $0.3 million in 2006 from 2005. In 2005, retirement plan expense increased $0.3 million from 2004. The increase in 2005 was primarily due to more participants in 2005.

Amortization of leased equipment decreased $0.7 million in 2005 from 2004. All of the leased equipment was sold in the second half of 2005.

Operational losses in 2004 were primarily due to the write-off of electronic test equipment subject to an operating lease. The Company sold all leased equipment during the second quarter of 2005.

Other noninterest expenses remained fairly constant for 2006, 2005 and 2004.

Income Tax Expense

The Company computes its provision for income taxes on a monthly basis. As indicated in Note 7 in the Notes to the Consolidated Financial Statements, the amount of such provision is determined by applying the Company’s statutory income tax rates to pre-tax book income as adjusted for permanent differences between pre-tax book income and actual taxable income. These permanent differences include but are not limited to tax-exempt interest income, increases in the cash surrender value of life insurance policies, California Enterprise Zone deductions, certain expenses that are not allowed as tax deductions, and tax credits.

The Company’s federal and state income tax expense was $9.2 million in 2006, compared to $7.3 million and $3.2 million for 2005 and 2004 respectively. This represents 34.8% of income before taxes in 2006, 33.5% in 2005, and 27.4% in 2004. The effective tax rate is higher in 2006 than in 2005 and 2004 because pre-tax income increased at a greater rate than savings from tax advantaged investments.

Tax-exempt interest income is generated primarily by the Company’s investments in state, county and municipal bonds, which provided $0.2 million in federal tax-exempt income in 2006 and 2005, and $0.3 million in 2004. Although not reflected in the investment portfolio, the Company also has total investments of $11.7 million in low-income housing limited partnerships as of December 31, 2006. These investments have generated tax credits for the past few years, with about $1.0 million in credits available for the 2006 tax year and $1.0 million in tax credits realized in 2005. The investments are expected to generate an additional $7.2 million in aggregate tax credits from 2007 through 2016; however, the credits are dependent upon the occupancy level of the housing projects and income of the tenants and cannot be projected with certainty.

Some items of income and expense are recognized in different years for tax purposes than when applying generally accepted accounting principles, leading to timing differences between the Company’s actual tax liability and the amount accrued for this liability based on book income. These temporary differences comprise the “deferred” portion of the Company’s tax expense, which is accumulated on the Company’s books as a deferred tax asset or deferred tax liability until such time as it reverses. At the end of 2006, the Company had a net deferred tax asset of $11.2 million.

Financial Condition

As of December 31, 2006, total assets were $1.04 billion, a decrease of 8% from $1.13 billion at year-end 2005. Total securities available-for-sale (at fair value) were $172.3 million, a decrease of 13% from $198.5 million at year-end 2005. The total loan portfolio (excluding loans held for sale) was $725.8 million, an increase of 5% from $688.8 million at year-end 2005. Total deposits were $846.6 million, a decrease of 10% from $939.8 million at year-end 2005. Securities sold under agreement to repurchase decreased $10.9 million, or 33%, to $21.8 million at December 31, 2006, from $32.7 million at year-end 2005.

32

Securities Portfolio

The following table reflects the amortized cost and fair market values for the total portfolio for each category of securities for the past three years.

Investment Portfolio

	December 31,
(Dollars in thousands)	2006		2005		2004
Securities available-for-sale (at fair value)
U.S. Treasury	$	5,963	$	6,920	$	5,942
U.S. Government Agencies		59,396		82,041		90,308
Mortgage-Backed Securities		90,186		91,868		107,735
Municipals - Tax Exempt		8,142		8,268		9,206
Collateralized Mortgage Obligations		8,611		9,398		19,618
Total	$	172,298	$	198,495	$	232,809

The following table summarizes the amounts and distribution of the Company’s securities and the weighted average yields as of December 31, 2006:

	Maturity
					After One and				After Five and
	Within One Year				Within Five Years				Within TenYears				After Ten Years				Total
(Dollars in thousands)	Amount		Yield		Amount		Yield		Amount		Yield		Amount		Yield		Amount		Yield
Securities available-for-sale (at fair value):
U.S. Treasury	$	5,963		3.50%	$	-		-	$	-		-	$	-		-	$	5,963		3.50	%
U.S. Government Agencies		27,385		4.96%		32,011		4.79%		-		-		-		-		59,396		4.87	%
Mortgage Backed Securities		-		-		2,028		3.46%		7,256		4.41%		80,902		4.44%		90,186		4.41	%
Municipals - non-taxable		4,086		2.76%		4,056		3.14%		-		-		-		-		8,142		2.95	%
Collateralized Mortgage Obligations		-		-		-		-		5,353		5.64%		3,258		2.82%		8,611		4.57	%
Total	$	37,434		4.49%	$	38,095		4.54	$	12,609		4.93%	$	84,160		4.38%	$	172,298		4.48	%

The investment securities portfolio is the second largest component of the Company’s interest earning assets, and the structure and composition of this portfolio is important to any analysis of the financial condition of the Company. The investment portfolio serves the following purposes:  (i) it can be readily reduced in size to provide liquidity for loan balance increases or deposit balance decreases; (ii) it provides a source of pledged assets for securing certain deposits and borrowed funds, as may be required by law or by specific agreement with a depositor or lender; (iii) it can be used as an interest rate risk management tool, since it provides a large base of assets, the maturity and interest rate characteristics of which can be changed more readily than the loan portfolio to better match changes in the deposit base and other funding sources of the Company; (iv) it is an alternative interest-earning use of funds when loan demand is weak or when deposits grow more rapidly than loans; and (v) it can enhance the Company’s tax position by providing partially tax exempt income.

The Company uses two portfolio classifications for its securities: “Held-to-maturity”, and “Available-for-sale”. Accounting rules also allow for a trading portfolio classification, but the Company has no securities that would be classified as such. The held-to-maturity portfolio can consist only of securities that the Company has both the intent and ability to hold until maturity, to be sold only in the event of concerns with an issuer’s credit worthiness, a change in tax law that eliminates their tax exempt status, or other infrequent situations as permitted by generally accepted accounting principles. Since the Company does not have a trading portfolio, the available-for-sale portfolio is comprised of all securities not included as “held-to-maturity”. Even though management currently has the intent and the ability to hold the Company’s securities for the foreseeable future, they are all currently classified as available-for-sale to allow flexibility with regard to the active management of the Company’s investment portfolio. FASB Statement 115 requires available-for-sale securities to be marked to market with an offset to accumulated other comprehensive income, a component of shareholders’ equity. Monthly adjustments are made to reflect changes in the market value of the Company’s available-for-sale securities.

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The Company’s investment portfolio is currently composed primarily of: (i) U.S. Treasury and Agency issues for liquidity and pledging; (ii) mortgage-backed securities, which in many instances can also be used for pledging, and which generally enhance the yield of the portfolio; (iii) state, county and municipal obligations, which provide tax free income and limited pledging potential; and (iv) collateralized mortgage obligations, which generally enhance the yield of the portfolio. The amortized cost of securities pledged as collateral for repurchase agreements, public deposits and for other purposes as required or permitted by law was $53.7 million and $64.4 million at December 31, 2006 and 2005, respectively.

Except for obligations of the U.S. government or U.S. government agencies, no securities of a single issuer exceeded 10% of shareholders’ equity at December 31, 2006. The Company has not used interest rate swaps or other derivative instruments to hedge fixed rate loans or to otherwise mitigate interest rate risk.

In 2006, the investment portfolio declined by $26.2 million, or 13%, and decreased to 16.6% of total assets at the end of 2006 from 17.6% at the end of 2005. While the overall change is not significant, certain components of the investment portfolio changed. U.S. Treasury and U.S. Agency securities decreased to 38% of the portfolio at the end of 2006 from 45% at the end of 2005. The decrease was primarily due to maturities of U.S. Agency securities during 2006. Municipal securities, mortgage-backed securities and collateralized mortgage obligations remained fairly constant in the portfolio in 2006 compared to 2005.

U.S. Treasury and U.S. Agency securities increased to 45% of the portfolio at the end of 2005 from 41% at the end of 2004. Municipal securities and mortgage backed securities remained fairly constant in the portfolio at the end of 2005 and 2004. Collateralized mortgage obligations decreased to 5% of the portfolio in 2005 from 8% in 2004, primarily due to maturity. Higher interest rates at December 31, 2005 resulted in lower fair values for the period.

Loans

The Company’s loans represent the largest portion of invested assets, substantially greater than the securities portfolio or any other asset category, and the quality and diversification of the loan portfolio is an important consideration when reviewing the Company’s financial condition.

Gross loans (including loans held for sale) represented 72% of total assets at December 31, 2006, as compared to 67% of at December 31, 2005. The ratio of net loans to deposits increased to 85% at the end of 2006 from 72% at the end of 2005. Demand for loans remains relatively strong in many areas within the Company’s markets and competition continues to intensify. To help ensure that we remain competitive, we make every effort to be flexible and creative in our approach to structuring loans.

The Selected Financial Data table in Item 6 above reflects the amount of loans outstanding at December 31st for each year from 2002 through 2006, net of deferred fees and origination costs and the allowance for loan losses. The Loan Distribution table that follows sets forth the Company’s gross loans outstanding and the percentage distribution in each category at the dates indicated. The amounts shown in the table do not reflect any deferred loan fees or deferred origination costs, nor is the allowance deducted.

Loan Distribution

	December 31,
(Dollars in thousands)	2006		% to Total		2005		% to Total		2004		% to Total		2003		% to Total		2002		% to Total
Commercial	$	300,611		42%	$	256,713		37%	$	300,452		41%	$	281,561		43%	$	263,144		39	%
Real estate - mortgage		239,041		33%		237,566		35%		250,984		35%		227,474		35%		210,121		31	%
Real estate - land and construction		143,834		20%		149,851		22%		118,290		16%		101,082		15%		147,822		22	%
Home equity		38,976		5%		41,772		6%		52,170		7%		49,434		7%		49,853		7	%
Consumer		2,422		0%		1,721		0%		2,908		1%		1,743		0%		2,850		1	%
Total loans		724,884		100%		687,623		100%		724,804		100%		661,294		100%		673,790		100	%
Deferred loan costs, net		870				1,155				726				863				117
Allowance for loan losses		(9,279)				(10,224)				(12,497)				(13,451)				(13,227)
Loans, net	$	716,475			$	678,554			$	713,033			$	648,706			$	660,680

Total loans (excluding of loans held for sale) were $725.8 million at December 31, 2006, an increase of 5% from $688.8 million at December 31, 2005, and a decrease of 5% from $725.5 million at December 31, 2004. The Company’s allowance for loan losses was $9.3 million, or 1.28% of total loans, for 2006 as compared to $10.2 million, or 1.48% of total loans, for 2005, $12.5 million, or 1.72% of total loans, for 2004. As of December 31, 2006, 2005, and 2004, the Company had $4.3 million, $3.7 million, and $1.3 million, respectively, in nonperforming assets.

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Total loan balances (including deferred loan cost, net) increased by $51.8 million, or 8%, from the end of 2002 to the end of 2006. The Company’s loan portfolio concentrated in commercial, primarily manufacturing, wholesale, and services and real estate, with the balance in land development and construction and home equity and consumer loans. The loan portfolio mix over the past five years has remained relatively the same.

The change in the Company’s loan portfolio in 2006 from 2005 is primarily due to the increase in the commercial loan portfolio and commercial real estate mortgage loan portfolio, partially offset by a decrease in the real estate land and construction loan portfolio. The Company does not have any concentrations by industry or group of industries in its loan portfolio, however, 58% and 63% of its net loans were secured by real property as of December 31, 2006 and 2005. While no specific industry concentration is considered significant, the Company’s lending operations are located in areas that are dependent on the technology and real estate industries and their supporting companies. In the fourth quarter of 2005, the Company entered into negotiations for the sale of its Capital Group loan portfolio consisting primarily of “factoring” type loans. In contemplation of the sale, $32 million, net of the respective allowance loan loss, was moved from commercial loans into loans held-for-sale. Primarily as a result of this reclassification, gross loans decreased 5% to $688.8 million at December 31, 2005, compared to $725.5 million at December 31, 2004. The sale of the Capital Group loan portfolio was completed in 2006, resulting in a gain of $0.7 million. In 2005, commercial real estate mortgages decreased as mortgage loans matured or were paid off. The increase in real estate land and construction loans is due to increased market demand for this type of financing.

The Company’s commercial loans are made for working capital, financing the purchase of equipment or for other business purposes. Such loans include loans with maturities ranging from thirty days to one year and “term loans,” with maturities normally ranging from one to five years. Short-term business loans are generally intended to finance current transactions and typically provide for periodic principal payments, with interest payable monthly. Term loans normally provide for floating interest rates, with monthly payments of both principal and interest. The Company’s commercial loans are centered in locally-oriented commercial activities in markets where the Company has a physical presence, and this segment of the portfolio has struggled for growth as these markets have become more competitive and business activity has moderated.

The Company is an active participant in the Small Business Administration (“SBA”) and U.S. Department of Agriculture guaranteed lending programs, and has been approved by the SBA as a lender under the Preferred Lender Program. The Company regularly makes SBA-guaranteed loans; however, the guaranteed portion of these loans may be sold in the secondary market depending on market conditions. Once it is determined that they will be sold, these loans are classified as held for sale and carried at the lower of cost or market. In the event of the sale of the guaranteed portion of an SBA loan, the Company retains the servicing rights for the sold portion. As of December 31, 2006, 2005, and 2004, $188.8 million, $179.8 million and $166.8 million, respectively, in SBA and U.S. Department of Agriculture loans were serviced by the Company for others.

As of December 31, 2006, real estate mortgage loans of $238.1 million consist of adjustable and fixed rate loans secured by commercial property, and loans secured by first mortgages on 1-4 family residential properties of $0.9 million. Home equity lines of credit are secured by junior deeds of trust on 1-4 family residential properties totaling $39.0 million. Properties securing the real estate mortgage loans are primarily located in the Company’s market area. While no specific industry concentration is considered significant, the Company’s lending operations are located in market areas that are dependent on the technology and real estate industries and their supporting companies. Real estate values in portions of Santa Clara County and neighboring San Mateo County are among the highest in the country at present. The Company’s borrowers could be adversely impacted by a downturn in these sectors of the economy, which could reduce the demand for loans and adversely impact the borrowers’ ability to repay their loans.

The Company’s real estate term loans consist primarily of loans made based on the borrower’s cash flow and are secured by deeds of trust on commercial and residential property to provide a secondary source of repayment. The Company restricts real estate term loans to no more than 80% of the property’s appraised value or the purchase price of the property, depending on the type of property and its utilization. The Company offers both fixed and floating rate loans. Maturities on such loans are generally restricted between five and ten years (with amortization ranging from fifteen to twenty-five years and a balloon payment due at maturity); however, SBA and certain other real estate loans that are easily sold in the secondary market may be granted for longer maturities.

The Company’s real estate land and construction loans are primarily short term interim loans to finance the construction of commercial and single family residential properties. The Company utilizes underwriting guidelines to assess the likelihood of repayment from sources such as sale of the property or permanent mortgage financing prior to making the construction loan.

The Company makes consumer loans for the purpose of financing automobiles, various types of consumer goods, and other personal purposes. Additionally, the Company makes home equity lines of credit available to its clientele. Consumer loans generally provide for the monthly payment of principal and interest. Most of the Company’s consumer loans are secured by the personal property being purchased or, in the instances of home equity loans or lines, real property.

With certain exceptions, state chartered banks are permitted to make extensions of credit to any one borrowing entity up to 15% of the bank’s capital and reserves for unsecured loans and up to 25% of the bank’s capital and reserves for secured loans. For HBC, these lending limits were $22.9 million and $38.1 million at December 31, 2006.

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Loan Maturities

The following table presents the maturity distribution of the Company’s loans as of December 31, 2006. The table shows the distribution of such loans between those loans with predetermined (fixed) interest rates and those with variable (floating) interest rates. Floating rates generally fluctuate with changes in the prime rate as reflected in the western edition of The Wall Street Journal. As of December 31, 2006, approximately 77% of the Company’s loan portfolio consisted of floating interest rate loans.

Loan Maturities

			Over One
	Due in		Year But
	One Year		Less than		Over
(Dollars in thousands)	or Less		Five Years		Five Years		Total
Commercial	$	283,469	$	13,567	$	3,575	$	300,611
Real estate - mortgage		97,935		81,260		59,846		239,041
Real estate - land and construction		143,763		71		-		143,834
Home equity		30,163		-		8,813		38,976
Consumer		2,306		116		-		2,422
Total loans	$	557,636	$	95,014	$	72,234	$	724,884
Loans with variable interest rates	$	526,642	$	23,108	$	8,890	$	558,640
Loans with fixed interest rates		30,994		71,906		63,344		166,244
Total loans	$	557,636	$	95,014	$	72,234	$	724,884

Nonperforming Assets

Financial institutions generally have a certain level of exposure to asset quality risk, and could potentially receive less than a full return of principal and interest if a debtor becomes unable or unwilling to repay. Since loans are the most significant assets of the Company and generate the largest portion of its revenues, the Company’s management of asset quality risk is focused primarily on loan quality. Banks have generally suffered their most severe earnings declines as a result of customers’ inability to generate sufficient cash flow to service their debts, or as a result of the downturns in national and regional economies which have brought about declines in overall property values. In addition, certain debt securities that the Company may purchase have the potential of declining in value if the obligor’s financial capacity to repay deteriorates.

To help minimize credit quality concerns, we have established a sound approach to credit that includes well-defined goals and objectives and well-documented credit policies and procedures. The policies and procedures identify market segments, set goals for portfolio growth or contraction, and establish limits on industry and geographic credit concentrations. In addition, these policies establish the Company’s underwriting standards and the methods of monitoring ongoing credit quality. The Company’s internal credit risk controls are centered in underwriting practices, credit granting procedures, training, risk management techniques, and familiarity with loan and lease customers as well as the relative diversity and geographic concentration of our loan portfolio.

The Company’s credit risk may also be affected by external factors such as the level of interest rates, employment, general economic conditions, real estate values, and trends in particular industries or geographic markets. As a multi-community independent bank serving a specific geographic area, the Company must contend with the unpredictable changes of both the general California and, particularly, primary local markets. The Company’s asset quality has suffered in the past from the impact of national and regional economic recessions, consumer bankruptcies, and depressed real estate values.

Non-performing assets are comprised of the following: Loans for which the Company is no longer accruing interest; loans 90 days or more past due and still accruing interest (although they are generally placed on non-accrual when they become 90 days past due unless they are both well secured and in the process of collcetion); loans restructured where the terms of repayment have been renegotiated, resulting in a deferral of interest or principal; and other real estate owned (“OREO”). Management’s classification of a loan as “non-accrual” is an indication that there is reasonable doubt as to the full recovery of principal or interest on the loan. At that point, the Company stops accruing interest income, reverses any uncollected interest that had been accrued as income, and begins recognizing interest income only as cash interest payments are received as long as the collection of all outstanding principal is not in doubt. The loans may or may not be collateralized, and collection efforts are continuously pursued. Loans may be restructured by management when a borrower has experienced some change in financial status causing an inability to meet the original repayment terms and where the Company believes the borrower will eventually overcome those circumstances and make full restitution. OREO consists of properties acquired by foreclosure or similar means that management is offering or will offer for sale.

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The following table provides information with respect to components of the Company’s non-performing assets at the dates indicated.

Non-performing Assets

	December 31,
(Dollars in thousands)	2006			2005			2004			2003			2002
Nonaccrual loans	$	3,866		$	3,672		$	1,028		$	3,972		$	4,571
Loans 90 days past due and still accruing		451			-			302			608			-
Total nonperforming loans		4,317			3,672			1,330			4,580			4,571
Other real estate owned		-			-			-			-			-
Total nonperforming assets	$	4,317		$	3,672		$	1,330		$	4,580		$	4,571
Nonperforming assets as a percentage of
loans plus other real estate owned		0.60	%		0.53	%		0.18	%		0.69	%		0.68	%

The balance of nonperforming assets at the end of 2006 represents an increase of $0.6 million, or 18%, from year-end 2005 levels. Nonperforming assets increased by $2.3 million, or 176%, in 2005 as compared to 2004. The ratio of nonperforming assets to total gross loans plus OREO also increased to 0.60% at the end of 2006 from 0.53% at the end of 2005. The main changes during 2006 were in Land and Construction loans.

In 2005, the nonperforming loan changes were primarily in commercial and industrial loans which increased by $1.6 million.

While the current level of non-performing assets is relatively low, we recognize that an increase in the dollar amount of non-accrual loans is possible in the normal course of business as we expand our lending activities. We also expect occasional foreclosures as a last resort in the resolution of some problem loans.

Allowance for Loan Losses

The allowance for loan losses is an estimate of the losses in our loan portfolio. The allowance is based on two basic principles of accounting: (1) Statement of Financial Accounting Standards (“Statement”) No. 5 “Accounting for Contingencies,” which requires that losses be accrued when they are probable of occurring and estimable and (2) Statement No. 114, “Accounting by Creditors for Impairment of a Loan,” which requires that losses be accrued based on the differences between the impaired loan balance and value of collateral, if the loan is collateral dependent, or present value of future cash flows or values that are observable in the secondary market.

Management conducts a critical evaluation of the loan portfolio monthly. This evaluation includes periodic loan by loan review for certain loans to evaluate the level of impairment, as well as detailed reviews of other loans (either individually or in pools) based on an assessment of the following factors: past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay, collateral values, loan volumes and concentrations, size and complexity of the loans, recent loss experience in particular segments of the portfolio, bank regulatory examination and independent loan review results, and current economic conditions in the Company’s marketplace, in particular the state of the technology industry and the real estate market. This process attempts to assess the risk of loss inherent in the portfolio by segregating loans into two categories for purposes of determining an appropriate level of the allowance: Loans graded “Pass through Special Mention” and “Substandard.”

Loans are charged against the allowance when management believes that the uncollectibility of the loan balance is confirmed. The Company’s methodology for assessing the appropriateness of the allowance consists of several key elements, which include the formula allowance and specific allowances.

Specific allowances are established for impaired loans. Management considers a loan to be impaired when it is probable that the Company will be unable to collect all amounts due according to the original contractual terms of the note agreement. When a loan is considered to be impaired, the amount of impairment is measured based on the fair value of the collateral if the loan is collateral dependent or on the present value of expected future cash flow.

The formula portion of the allowance is calculated by applying loss factors to pools of outstanding loans. Loss factors are based on the Company's historical loss experience, adjusted for significant factors that, in management's judgment, affect the collectibility of the portfolio as of the evaluation date. The adjustment factors for the formula allowance may include existing general economic and business conditions affecting the key lending areas of the Company, in particular the real estate market, credit quality trends, collateral values, loan volumes and concentrations, the technology industry and specific industry conditions within portfolio segments, recent loss experience in particular segments of the portfolio, duration of the current business cycle, and bank regulatory examination results. The evaluation of the inherent loss with respect to these conditions is subject to a higher degree of uncertainty.

Loans that demonstrate a weakness, for which there is a possibility of loss if the weakness is not corrected, are categorized as “classified.” Classified loans include all loans considered as substandard, doubtful, and loss and may result from problems specific to a borrower’s business or from economic downturns that affect the borrower’s ability to repay or that cause a decline in the value of the underlying collateral (particularly real estate). The principal balance of classified loans, which include all loans internally graded as substandard, doubtful, and loss, was $24.5 million, $16.3 million, and $35.6 million, respectively, at December 31, 2006, 2005, and 2004. At December 31, 2006 and 2005, all of the Company’s classified loans were graded as substandard.

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In adjusting the historical loss factors applied to the respective segments of the loan portfolio, management considered the following factors:

·   Levels and trends in delinquencies, non-accruals, charge offs and recoveries

·   Trends in volume and loan terms

·   Lending policy or procedural changes

·   Experience, ability, and depth of lending management and staff

·   National and local economic trends and conditions

·   Concentrations of Credit

There can be no assurance that the adverse impact of any of these conditions on HBC will not be in excess of the current level of estimated losses.

It is the policy of management to maintain the allowance for loan losses at a level adequate for risks inherent in the loan portfolio. On an ongoing basis, we have engaged outside firms to independently assess our methodology and perform independent credit reviews of our loan portfolio. The Company’s credit review consultants, the FRB and the DFI also review the allowance for loan losses as an integral part of the examination process. Based on information currently available to analyze loan loss delinquency and a history of actual charge-offs, management believes that the loan loss allowance is adequate. However, the loan portfolio can be adversely affected if California economic conditions and the real estate market in the Company’s market area were to weaken. Also, any weakness of a prolonged nature in the technology industry would have a negative impact on the local market. The effect of such events, although uncertain at this time, could result in an increase in the level of nonperforming loans and increased loan losses, which could adversely affect the Company’s future growth and profitability. No assurance of the ultimate level of credit losses can be given with any certainty.

The following table summarizes the Company’s loan loss experience, as well as provisions and charges to the allowance for loan losses and certain pertinent ratios for the periods indicated:

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Allowance for Loan Losses

(Dollars in thousands)	2006		2005			2004			2003		2002
Balance, beginning of year	$	10,224	$	12,497		$	13,451		$	13,227	$	11,154
Charge-offs:
Commercial		(291)		(3,273)			(2,901)			(2,906)		(936)
Real estate - mortgage		-		-			-			-		-
Real estate - land and construction		-		-			-			-		-
Home equity		(540)		-			-			-		-
Consumer		-		-			-			-		-
Total charge-offs		(831)		(3,273)			(2,901)			(2,906)		(936)
Recoveries:
Commercial		389		1,358			1,562			230		346
Real estate - mortgage		-		-			-			-		-
Real estate - land and construction		-		-			-			-		-
Home equity		-		-			-			-		-
Consumer		-		-			-			-		-
Total recoveries		389		1,358			1,562			230		346
Net charge-offs		(442)		(1,915)			(1,339)			(2,676)		(590)
Provision for loan losses		(503)		313			666			2,900		2,663
Reclassification of allowance for loan losses		-		(671)	(1)		-			-		-
Reclassification to other liabilities		-		-			(281)	(2)		-		-
Balance, end of year	$	9,279	$	10,224		$	12,497		$	13,451	$	13,227
RATIOS:
Net charge-offs to average loans *		0.06%		0.28%			0.19%			0.41		0.09%
Allowance for loan losses to average loans *		1.32%		1.47%			1.80%			2.07%		2.07%
Allowance for loan losses to total loans *		1.28%		1.48%			1.72%			2.03%		1.96%
Allowance for loan losses to nonperforming loans		215%		278%			940%			294%		289%

* Average loans and total loans exclude loans held for sale

(1) The Company reclassified $0.7 million of the allowance allocated to $32 million of commercial asset based loans that were reclassified to loans held-for-sale as of December 31, 2005. Thus, the carrying value of these loans held-for-sale includes an allowance for loan losses of $0.7 million.

(2) The Company reclassified estimated losses on unused commitments of $0.3 million to other liabilities as of December 31, 2004.

The Company’s allowance for loan losses has steadily decreased from 2003 through 2006. This trend has been attributable primarily to decreases in classified loan balances. The Company’s allowance for loan losses decreased $0.9 million in 2006 as compared to 2005. The Company had a credit provision of $0.5 million in 2006, compared to a loss provision of $0.3 million in 2005.

Net loans charged-off reflect the realization of losses in the portfolio that were recognized previously though provisions for loan losses. Net charge-offs were $0.4 million, $1.9 million, and $1.3 million in 2006, 2005, and 2004, respectively. The decrease in net loan charge-offs in 2006 was primarily due to continued improvement in credit quality. The increase in net loan charge-offs in 2005 was primarily due to a $2.0 million charge-off from one commercial loan, partially offset by recoveries. Historical net loan charge-offs are not necessarily indicative of the amount of net charge-offs that the Company will realize in the future.

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As of December 31, 2006, the Company’s unallocated allowance was $1.4 million, compared to $1.1 million as of December 31, 2005. The unallocated component of the allowance is maintained to cover uncertainties that could affect management's estimate of probable losses and also reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating losses on specific problem loans and pools of other loans. The unallocated allowance increased from 2004 to 2005, as the Company updated its allowance methodology. If the same methodology used at year end 2005 was applied as of December 31, 2004, the unallocated allowance would be more comparable. The unallocated amount is reviewed periodically based on trends in credit losses, the results of credit reviews and overall economic trends.

The following table provides a summary of the allocation of the allowance for loan and lease losses for specific categories at the dates indicated. The allocation presented should not be interpreted as an indication that charges to the allowance for loan and lease losses will be incurred in these amounts or proportions, or that the portion of the allowance allocated to each category represents the total amounts available for charge-offs that may occur within these categories.

Allocation of Loan Loss Allowance

	December 31,
	2006				2005				2004				2003				2002
			Percent				Percent				Percent				Percent				Percent
			of Loans				of Loans				of Loans				of Loans				of Loans
			in each				in each				in each				in each				in each
			category				category				category				category				category
			to total				to total				to total				to total				to total
(Dollars in thousands)	Allowance		loans		Allowance		loans		Allowance		loans		Allowance		loans		Allowance		loans
Commercial	$	4,872		42%	$	4,199		37%	$	8,691		41%	$	9,667		43%	$	6,349		39	%
Real estate - mortgage		1,507		33%		2,631		35%		1,498		35%		1,846		35%		2,041		31	%
Real estate - land and construction		1,243		20%		1,914		22%		1,711		16%		1,714		15%		3,574		22	%
Home equity		244		5%		300		6%		173		7%		157		7%		370		7	%
Consumer		24		0%		33		0%		38		1%		37		0%		47		1	%
Unallocated		1,389		0%		1,147		0%		386		0%		30		0%		846		0	%
Total	$	9,279		100%	$	10,224		100%	$	12,497		100%	$	13,451		100%	$	13,227		100	%

Deposits

The composition and cost of the Company’s deposit base are important components in analyzing the Company’s net interest margin and balance sheet liquidity characteristics, both of which are discussed in greater detail in other sections herein. Our net interest margin is improved to the extent that growth in deposits can be concentrated in historically lower-cost deposits such as non-interest-bearing demand, NOW accounts, savings accounts and money market deposit accounts. The Company’s liquidity is impacted by the volatility of deposits or other funding instruments, or in other words by the propensity of that money to leave the institution for rate-related or other reasons. Potentially, the most volatile deposits in a financial institution are jumbo certificates of deposit, meaning time deposits with balances that equal or exceed $100,000, as customers with balances of that magnitude are typically more rate-sensitive than customers with smaller balances.

The following table summarizes the distribution of deposits and the percentage of distribution in each category of deposits for the periods indicated:

Deposits

	Years Ended December 31,
	2006				2005				2004
(Dollars in thousands)	Balance		% to Total		Balance		% to Total		Balance		% to Total
Demand, noninterest bearing	$	231,841		27%	$	248,009		26%	$	277,451		30	%
Demand, interest bearing		133,413		16%		157,330		17%		120,890		13	%
Savings and money market		307,266		36%		353,798		38%		357,318		39	%
Time deposits, under $100		31,097		4%		35,209		4%		38,295		4	%
Time deposits, $100 and over		111,017		13%		109,373		12%		104,719		12	%
Brokered deposits, $100 and over		31,959		4%		36,040		4%		19,862		2	%
Total deposits	$	846,593		100%	$	939,759		100%	$	918,535		100	%

40

Total deposits were $846.6 million at December 31, 2006, a decrease of $93.2 million, or 10%, compared to $939.8 million at December 31, 2005. At December 31, 2006, noninterest bearing demand deposits decreased $16.2 million, or 7%, from December 31, 2005 primarily due to decreases in title and escrow companies’ accounts. Interest bearing demand deposits decreased $23.9 million, or 15%, primarily because the Company reduced certain high yield accounts; savings and money market deposits decreased $46.5 million, or 13%; time deposits decreased $2.5 million, or 2%; and brokered deposits decreased $4.1 million, or 11%.

As of December 31, 2006, the Company had a deposit mix of 36% in savings and money market accounts, 21% in time deposits, 16% in interest bearing demand accounts, and 27% in noninterest bearing demand deposits. On December 31, 2006, approximately $2.4 million, or less than 1%, of deposits were from public sources, and approximately $108.2 million, or 13%, of deposits were from real estate exchange company and title company accounts. As of December 31, 2005, the Company had a deposit mix of 38% in savings and money market accounts, 19% in time deposits, 17% in interest bearing demand accounts, and 26% in noninterest bearing demand deposits. On December 31, 2005, approximately $2.4 million, or less than 1%, of deposits were from public sources, and approximately $129.5 million, or 14%, of deposits were from real estate exchange company and title company accounts.

The Company obtains deposits from a cross-section of the communities it serves. The Company’s business is not seasonal in nature. The Company had brokered deposits totaling approximately $32.0 million, and $36.0 million at December 31, 2006 and 2005, respectively. These brokered deposits generally mature within one to three years. Brokered deposits are generally less desirable because of higher interest rates. The Company is not dependent upon funds from sources outside the United States.

The following table indicates the maturity schedule of the Company’s time deposits of $100,000 or more as of December 31, 2006:

Deposit Maturity Distribution

(Dollars in thousands)	Balance		% of Total
Three months or less	$	56,886		40	%
Over three months through six months		33,809		23	%
Over six months through twelve months		28,258		20	%
Over twelve months		24,023		17	%
Total	$	142,976		100	%

The Company focuses primarily on providing and servicing business deposit accounts that are frequently over $100,000 in average balance per account. As a result, certain types of business clients that the Company serves typically carry average deposits in excess of $100,000. The account activity for some account types and client types necessitates appropriate liquidity management practices by the Company to ensure its ability to fund deposit withdrawals.

Return on Equity and Assets

The following table indicates the ratios for return on average assets and average equity, dividend payout, and average equity to average assets for 2006, 2005, and 2004:

	2006			2005			2004
Return on average assets		1.57	%		1.27	%		0.80	%
Return on average equity		14.62	%		13.73	%		9.04	%
Dividend payout ratio		13.65	%		-			-
Average equity to average assets ratio		10.75	%		9.25	%		8.80	%

Off-Balance Sheet Arrangements

In the normal course of business, the Company makes commitments to extend credit to its customers as long as there are no violations of any conditions established in contractual arrangements. These commitments are obligations that represent a potential credit risk to the Company, yet are not reflected in any form within the Company’s consolidated balance sheets. Total unused commitments to extend credit were $322.2 million at December 31, 2006, as compared to $334.1 million at December 31, 2005. Unused commitments represented 45% and 49% of outstanding gross loans at December 31, 2006 and 2005, respectively.

The effect on the Company’s revenues, expenses, cash flows and liquidity from the unused portion of the commitments to provide credit cannot be reasonably predicted, because there is no certainty that the lines of credit will ever be fully utilized. For more information regarding the Company’s off-balance sheet arrangements, see Note 12 to the financial statements located elsewhere herein.

41

The following table presents the Company’s commitments to fund as of December 31, 2006, 2005, and 2004:

	December 31,
(Dollars in thousands)	2006		2005		2004
Commitments to extend credit	$	310,200	$	328,031	$	313,036
Standby letters of credit		12,020		6,104		5,256
	$	322,220	$	334,135	$	318,292

Allowance for Off-Balance Sheet Credit Losses

The allowance for unfunded commitments is based on management’s estimate of the amount required to reflect the probable inherent losses on outstanding letters of credit and unused loan credit commitments. Adequacy of the allowance is determined using a systematic methodology similar to the one that analyzes the allowance for loan losses. Management must also estimate the likelihood that these commitments would be funded and become loans. This is done by evaluating the historical utilization of each type of unfunded commitment and estimating the likelihood that the current utilization rates on lines available at the balance sheet date could change in the future. The allowance for unfunded commitments is included in other liabilities on the balance sheet. See table below for activity in 2006 and 2005.

	For the Year Ended December 31,
(Dollars in thousands)	2006		2005
Balance at beginning of period	$	203	$	281
Provision for credit losses		274		(78)
Balance at end of period	$	477	$	203

Contractual Obligations

The contractual obligations of the Company, summarized by type of obligation and contractual maturity, at December 31, 2006, are as follows:

	Less Than		One to		Three to		After
(Dollars in thousands)	One Year		Three Years		Five Years		Five Years		Total
Securities sold under agreement to repurchase	$	10,900	$	10,900	$	-	$	-	$	21,800
Notes payable to subsidiary grantor trusts		-		-		-		23,702		23,702
Operating leases		2,027		2,832		2,922		4,978		12,759
Time deposits		147,741		26,267		65		-		174,073
Total debt and operating leases	$	160,668	$	39,999	$	2,987	$	28,680	$	232,334

In addition to those obligations listed above, in the normal course of business, the Company will make cash distributions for the payment of interest on interest bearing deposit accounts and debt obligations, payments for quarterly income tax estimates and contributions to certain employee benefit plans.

Liquidity and Asset/Liability Management

Liquidity refers to the Company’s ability to maintain cash flows sufficient to fund operations, and to meet obligations and other commitments in a timely and cost-effective fashion. At various times the Company requires funds to meet short-term cash requirements brought about by loan growth or deposit outflows, the purchase of assets, or liability repayments. To manage liquidity needs properly, cash inflows must be timed to coincide with anticipated outflows or sufficient liquidity resources must be available to meet varying demands. The Company manages liquidity in such a fashion as to be able to meet unexpected sudden changes in levels of its assets or deposit liabilities without maintaining excessive amounts of on-balance sheet liquidity. Excess balance sheet liquidity can negatively impact the interest margin.

An integral part of the Company’s ability to manage its liquidity position appropriately is the Company’s large base of core deposits, which are generated by offering traditional banking services in its service area and which have, historically, been a stable source of funds. In addition to core deposits, the Company has the ability to raise deposits through various deposit brokers if required for liquidity purposes. The Company’s net loan to deposit ratio increased to 86% at end of 2006 from 73% at the end of 2005, due to a decrease in deposits during 2006.

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To meet liquidity needs, the Company maintains a portion of its funds in cash deposits at other banks, in Federal funds sold and in securities available for sale. The primary liquidity ratio is composed of net cash, non-pledged securities, and other marketable assets, divided by total deposits and short-term liabilities minus liabilities secured by investments or other marketable assets. As of December 31, 2006, the Company’s primary liquidity ratio was 13.64%, comprised of $75.5 million in securities available for sale of maturities of up to five years, less $10.9 million of securities that were pledged to secure public and certain other deposits as required by law and contract, Federal funds sold of $15.1 million, and $34.3 million cash and due from banks, as a percentage of total unsecured deposits of $835.7 million.

As of December 31, 2005, the Company’s primary liquidity ratio was 20.16%, comprised of $99.7 million in securities available for sale of maturities of up to five years, less $10.8 million of securities that were pledged to secure public and certain other deposits as required by law and contract, Federal funds sold of $62.9 million and $35.6 million in cash and due from banks, as a percentage of total unsecured deposits of $929.0 million.

The following table summarizes the Company’s borrowings under its Federal funds purchased, security repurchase arrangements and lines of credit for the periods indicated:

	December 31,
(Dollars in thousands)	2006		2005		2004
Average balance during the year	$	25,429	$	40,748	$	43,109
Average interest rate during the year		2.46%		2.26%		2.07%
Maximum month-end balance	$	32,700	$	57,800	$	48,600
Average rate at December 31,		2.56%		2.34%		2.21%

Capital Resources

At December 31, 2006, the Company had total shareholders’ equity of $122.8 million, which included $62.4 million in common stock and $62.5 million in retained earnings.

The Company paid cash dividends totaling $2.4 million, or $0.20 per share in 2006. In the first quarter of 2007, the Company increased its quarterly dividend from $0.05 per share to $0.06 per share. The Company anticipates paying future dividends within the range of typical peer payout ratios provided, however, that no assurance can be given that earnings and/or growth expectations in any given year will justify the payment of such a dividend.

On February 7, 2006, the Board of Directors authorized the repurchase of up to $10 million of common stock through June 30, 2007. Shares may be repurchased in open market purchases or in privately negotiated transactions as permitted under applicable rules and regulations. The repurchase program may be modified, suspended or terminated by the Board of Directors at any time without notice. The extent to which the Company repurchases its shares and the timing of such repurchases will depend upon market conditions and other corporate considerations.

The Company uses a variety of measures to evaluate capital adequacy. Management reviews various capital measurements on a regular basis and takes appropriate action to ensure that such measurements are within established internal and external guidelines. The external guidelines, which are issued by the Federal Reserve Board and the FDIC, establish a risk-adjusted ratio relating capital to different categories of assets and off-balance sheet exposures. There are two categories of capital under the Federal Reserve Board and FDIC guidelines: Tier 1 and Tier 2 Capital. Our Tier 1 Capital currently includes common shareholders’ equity and the proceeds from the issuance of trust preferred securities (trust preferred securities are counted only up to a maximum of 25% of Tier 1 capital), less intangible assets, and add the unrealized net losses (after tax adjustments) on securities available for sale and accumulated net losses on cash flow hedges, which are carried at fair market value. Our Tier 2 Capital includes the amount of trust preferred securities not includible in Tier 1 Capital, and the allowances for loan losses and off balance sheet credit losses.

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The following table summarizes risk-based capital, risk-weighted assets, and risk-based capital ratios of the Company:

	December 31,
(Dollars in thousands)	2006			2005			2004
Capital components:
Tier 1 Capital	$	147,600		$	133,715		$	121,096
Tier 2 Capital		9,756			10,427			11,623
Total risk-based capital	$	157,356		$	144,142		$	132,719
Risk-weighted assets	$	855,715		$	941,567		$	929,241
Average assets (regulatory purposes)	$	1,087,502		$	1,157,704		$	1,112,526
										Minimum
										Regulatory
Capital ratios:										Requirements
Total risk-based capital		18.4	%		15.3	%		14.3	%	8.00	%
Tier 1 risk-based capital		17.3	%		14.2	%		13.0	%	4.00	%
Leverage (1)		13.6	%		11.6	%		10.9	%	4.00	%

(1) Tier 1 capital divided by average assets (excluding goodwill).

The table above presents the capital ratios of the Company computed in accordance with applicable regulatory guidelines and compared to the standards for minimum capital adequacy requirements under the FDIC’s prompt corrective action authority as of December 31, 2006. The risk-based and leverage capital ratios are defined in Item 1 - “Business - Supervision and Regulation - HBC” on page 8.

At December 31, 2006, 2005 and 2004, the Company’s capital met all minimum regulatory requirements. As of December 31, 2006, 2005 and 2004, management believes that HBC was considered “well capitalized” under the regulatory framework for prompt corrective action.

Mandatory Redeemable Cumulative Trust Preferred Securities.

To enhance regulatory capital and to provide liquidity, the Company, through unconsolidated subsidiary grantor trusts, issued the following mandatorily redeemable cumulative trust preferred securities of subsidiary grantor trusts: In the first quarter of 2000, the Company issued $7 million aggregate principal amount of 10.875% subordinated debentures due on March 8, 2030 to a subsidiary trust, which in turn issued a similar amount of trust preferred securities. In the third quarter of 2000, the Company issued $7 million aggregate principal amount of 10.60% subordinated debentures due on September 7, 2030 to a subsidiary trust, which in turn issued a similar amount of trust preferred securities. In the third quarter of 2001, the Company issued $5 million aggregate principal amount of Floating Rate Junior Subordinated Deferrable Interest Debentures due on July 31, 2031 to a subsidiary trust, which in turn issued a similar amount of trust preferred securities. In the third quarter of 2002, the Company issued $4 million aggregate principal amount of Floating Rate Junior Subordinated Deferrable Interest Debentures due on September 26, 2032 to a subsidiary trust, which in turn issued a similar amount of trust preferred securities. Under applicable regulatory guidelines, the trust preferred securities currently qualify as Tier I capital. The subsidiary trusts are not consolidated in the Company’s consolidated financial statements and the subordinated debt payable to the subsidiary grantor trusts is recorded as debt of the Company to the related trusts. See Footnote 6 the Consolidated Financial Statements.

Market Risk

Market risk is the risk of loss to future earnings, to fair values, or to future cash flows that may result from changes in the price of a financial instrument. The value of a financial instrument may change as a result of changes in interest rates, foreign currency exchange rates, commodity prices, equity prices and other market changes that affect market risk sensitive instruments. Market risk is attributed to all market risk sensitive financial instruments, including securities, loans, deposits and borrowings, as well as the Company’s role as a financial intermediary in customer-related transactions. The objective of market risk management is to avoid excessive exposure of the Company’s earnings and equity to loss and to reduce the volatility inherent in certain financial instruments.

44

Interest Rate Management

Market risk arises from changes in interest rates, exchange rates, commodity prices and equity prices. The Company’s market risk exposure is primarily that of interest rate risk, and it has established policies and procedures to monitor and limit earnings and balance sheet exposure to changes in interest rates. The Company does not engage in the trading of financial instruments, nor does the Company have exposure to currency exchange rates.

The principal objective of interest rate risk management (often referred to as “asset/liability management”) is to manage the financial components of the Company in a manner that will optimize the risk/reward equation for earnings and capital in relation to changing interest rates. The Company’s exposure to market risk is reviewed on a regular basis by the Asset/Liability Committee (“ALCO”). Interest rate risk is the potential of economic losses due to future interest rate changes. These economic losses can be reflected as a loss of future net interest income and/or a loss of current fair market values. The objective is to measure the effect on net interest income and to adjust the balance sheet to minimize the inherent risk while at the same time maximizing income. Management realizes certain risks are inherent, and that the goal is to identify and accept the risks. Management uses two methodologies to manage interest rate risk: (i) a standard GAP analysis; and (ii) an interest rate shock simulation model.

The planning of asset and liability maturities is an integral part of the management of an institution’s net interest margin. To the extent maturities of assets and liabilities do not match in a changing interest rate environment, net interest margin may change over time. Even with perfectly matched repricing of assets and liabilities, risks remain in the form of prepayment of loans or securities or in the form of delays in the adjustment of rates of interest applying to either earning assets with floating rates or to interest bearing liabilities. The Company has generally been able to control its exposure to changing interest rates by maintaining primarily floating interest rate loans and a majority of its time certificates with relatively short maturities.

Interest rate changes do not affect all categories of assets and liabilities equally or at the same time. Varying interest rate environments can create unexpected changes in prepayment levels of assets and liabilities, which may have a significant effect on the net interest margin and are not reflected in the interest sensitivity analysis table. Because of these factors, an interest sensitivity gap report may not provide a complete assessment of the exposure to changes in interest rates.

The Company uses modeling software for asset/liability management in order to simulate the effects of potential interest rate changes on the Company’s net interest margin, and to calculate the estimated fair values of the Company’s financial instruments under different interest rate scenarios. The program imports current balances, interest rates, maturity dates and repricing information for individual financial instruments, and incorporates assumptions on the characteristics of embedded options along with pricing and duration for new volumes to project the effects of a given interest rate change on the Company’s interest income and interest expense. Rate scenarios consisting of key rate and yield curve projections are run against the Company’s investment, loan, deposit and borrowed funds portfolios. These rate projections can be shocked (an immediate and parallel change in all base rates, up or down), ramped (an incremental increase or decrease in rates over a specified time period), based on current trends and econometric models or economic conditions stable (unchanged from current actual levels).

The Company applies a market value (“MV”) methodology to gauge its interest rate risk exposure as derived from its simulation model. Generally, MV is the discounted present value of the difference between incoming cash flows on interest earning assets and other investments and outgoing cash flows on interest bearing liabilities and other liabilities. The application of the methodology attempts to quantify interest rate risk as the change in the MV which would result from a theoretical 200 basis point (1 basis point equals 0.01%) change in market interest rates. Both a 200 basis point increase and a 200 basis point decrease in market rates are considered.

At December 31, 2006, it was estimated that the Company’s MV would increase 17.16% in the event of a 200 basis point increase in market interest rates. The Company’s MV at the same date would decrease 24.76% in the event of a 200 basis point decrease in market interest rates.

Presented below, as of December 31, 2006 and 2005, is an analysis of the Company’s interest rate risk as measured by changes in MV for instantaneous and sustained parallel shifts of 200 basis points in market interest rates:

	2006										2005
	$ Change		% Change			Market Value as a % of					$ Change		% Change			Market Value as a % of
	in Market		in Market			Present Value of Assets					in Market		in Market			Present Value of Assets
(Dollars in thousands)	Value		Value			MV Ratio			Change (bp)		Value		Value			MV Ratio			Change (bp)
Change in rates
+ 200 bp	$	31,607		17.16	%		21.1	%		309	$	41,217		23.41	%		19.6	%		371
0 bp	$	-		0.00	%		18.0	%		0	$	-		0.00	%		15.9	%		0
- 200 bp	$	(45,606)		-24.76	%		13.6	%		(446)	$	(61,175)		-34.74	%		10.4	%		(551)

Management believes that the MV methodology overcomes three shortcomings of the typical maturity gap methodology. First, it does not use arbitrary repricing intervals and accounts for all expected future cash flows. Second, because the MV method projects cash flows of each financial instrument under different interest rate environments, it can incorporate the effect of embedded options on an institution’s interest rate risk exposure. Third, it allows interest rates on different instruments to change by varying amounts in response to a change in market interest rates, resulting in more accurate estimates of cash flows.

45

However, as with any method of gauging interest rate risk, there are certain shortcomings inherent to the MV methodology. The model assumes interest rate changes are instantaneous parallel shifts in the yield curve. In reality, rate changes are rarely instantaneous. The use of the simplifying assumption that short-term and long-term rates change by the same degree may also misstate historic rate patterns, which rarely show parallel yield curve shifts. Further, the model assumes that certain assets and liabilities of similar maturity or period to repricing will react in the same way to changes in rates. In reality, certain types of financial instruments may react in advance of changes in market rates, while the reaction of other types of financial instruments may lag behind the change in general market rates. Additionally, the MV methodology does not reflect the full impact of annual and lifetime restrictions on changes in rates for certain assets, such as adjustable rate loans. When interest rates change, actual loan prepayments and actual early withdrawals from certificates may deviate significantly from the assumptions used in the model. Finally, this methodology does not measure or reflect the impact that higher rates may have on adjustable-rate loan clients’ ability to service their debt. All of these factors are considered in monitoring the Company’s exposure to interest rate risk.

CRITICAL ACCOUNTING POLICIES

General

The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). The financial information contained within our consolidated financial statements is, to a significant extent, based on approximate measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. In certain instances, we use a discount factor and prepayment assumptions to determine the present value of assets and liabilities. A change in the discount factor or prepayment speeds could increase or decrease the values of those assets and liabilities which would result in either a beneficial or adverse impact to our financial results. We use historical loss factors as one factor in determining the inherent loss that may be present in our loan portfolio. Actual losses could differ significantly from the historical factors that we use. The Company adopted Statement 123R on January 1, 2006, and elected the modified prospective method, under which prior periods are not revised for comparative purposes. Other estimates that we use are related to the expected useful lives of our depreciable assets. In addition, GAAP itself may change from one previously acceptable method to another method, although the economics of our transactions would be the same.

Allowance for Loan Losses

The allowance for loan losses is an estimate of the losses in our loan portfolio. Our accounting for estimated loan losses is discussed under the heading “Allowance for Loan Losses” beginning on page 37.

Loan Sales and Servicing

The amounts of gains recorded on sales of loans and the initial recording of servicing assets and I/O strips are based on the estimated fair values of the respective components. In recording the initial value of the servicing assets and the fair value of the I/O strips receivable, the Company uses estimates which are made on management’s expectations of future prepayment and discount rates as discussed in Note 3 to the consolidated financial statements.

Stock Based Compensation

We grant stock options to purchase our common stock to our employees and directors under the 2004 Plan. We also granted our chief executive officer restricted stock when he joined the Company. Additionally, we have outstanding options that were granted under an option plan from which we no longer make grants. The benefits provided under all of these plans are subject to the provisions of FASB Statement 123(Revised), “Share-Based Payments,” which we adopted effective January 1, 2006. We elected to use the modified prospective application in adopting Statement 123R and therefore have not restated results for prior periods. The valuation provisions of Statement 123R apply to new awards and to awards that are outstanding on the adoption date and subsequently modified or cancelled. Our results of operations for fiscal 2006 were impacted by the recognition of non cash expense related to the fair value of our share-based compensation awards as discussed in Note 1 to the consolidated financial statements.

The determination of fair value of stock-based payment awards on the date of grant using the Black-Scholes model is affected by our stock price, as well as the input of other subjective assumptions. These assumptions include, but are not limited to, the expected term of stock options and our expected stock price volatility over the term of the awards. Our stock options have characteristics significantly different from those of traded options, and changes in the assumptions can materially affect the fair value estimates.

Statement 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. If actual forfeitures vary from our estimates, we will recognize the difference in compensation expense in the period the actual forfeitures occur of when options vest.

Our accounting for stock options is disclosed primarily in Notes 1 and 8 to the consolidated financial statements.

46

ITEM 7A - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

As a financial institution, the Company’s primary component of market risk is interest rate volatility. Fluctuations in interest rates will ultimately impact both the level of income and expense recorded on most of the Company’s assets and liabilities, and the market value of all interest-earning assets, other than those which have a short term to maturity. Based upon the nature of the Company’s operations, the Company is not subject to foreign exchange or commodity price risk. The Company has no market risk sensitive instruments held for trading purposes. As of December 31, 2006, the Company does not use interest rate derivatives to hedge its interest rate risk.

The information concerning quantitative and qualitative disclosure or market risk called for by Item 305 of Regulation S-K is included as part of Item above. See page 44.

ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The financial statements and reports of Independent Registered Public Accounting Firms are set forth on pages 52 through 86.

ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES

None

ITEM 9A - CONTROLS AND PROCEDURES

Disclosure Control and Procedures

The Company has carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of December 31, 2006. As defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), disclosure controls and procedures are controls and procedures designed to reasonably assure that information required to be disclosed in our reports filed or submitted under the Exchange Act are recorded, processed, summarized and reported on a timely basis. Disclosure controls are also designed to reasonably assure that such information is accumulated and communicated to our management, including the Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. Based upon their evaluation, our Chief Executive Officer and Chief Financial Officer concluded the Company’s disclosure controls were effective as of December 31, 2006, the period covered by this report on Form 10K.

Management’s Annual Report on Internal Control over Financial Reporting

Management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting. As defined in Rule 13a-15(f) under the Exchange Act, internal control over financial reporting is a process designed by, or under the supervision of, a company’s principal executive and principal financial officers and effected by a company’s board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. It includes those policies and procedures that:

·   Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of a company;

·   Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of a company are being made only in accordance with authorizations of management and the board of directors of the company; and

·   Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of a company’s assets that could have a material effect on its financial statements.

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

The Company’s management has used the criteria established in “Internal Control-Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) to evaluate the effectiveness of the Company’s internal control over financial reporting. Management has selected the COSO framework for its evaluation as it is a control framework recognized by the SEC and the Public Company Accounting Oversight Board, that is free from bias, permits reasonably consistent qualitative and quantitative measurement of the Company’s internal controls, is sufficiently complete so that relevant controls are not omitted and is relevant to an evaluation of internal controls over financial reporting.

Based on our assessment, management has concluded that our internal control over financial reporting, based on criteria established in “Internal Control-Integrated Framework” issued by COSO was effective as of December 31, 2006.

47

The Company’s independent registered public accounting firm has issued an attestation report on the management’s assessment of the Company’s internal controls over financial reporting.

Inherent Limitations on Effectiveness of Controls

The Company’s management, including the CEO and CFO, does not expect that our disclosure controls or our internal control over financial reporting will prevent or detect all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. The design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Further, because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, within the company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Projections of any evaluation of controls effectiveness to future periods are subject to risks. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures.

ITEM 9B - OTHER INFORMATION

None

PART III

ITEM 10 - DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNACE

Information required by this item will be contained in our Definitive Proxy Statement for our 2007 Annual Meeting of Shareholders, to be filed pursuant to Regulation 14A with the Securities and Exchange Commission within 120 days of December 31, 2006. Such Information is incorporated herein by reference.

We have adopted a code of ethics that applies to our Chief Executive Officer, Chief Financial Officer, and to all of our other officers, directors, employees and agents. The code of ethics is available at the Corporate Governance section of the Investor Relations page on our website at www.heritagecommercecorp.com. We intend to disclose future amendments to, or waivers from, certain provisions of our code of ethics on the above website within four business days following the date of such amendment or waiver.

ITEM 11 - EXECUTIVE COMPENSATION

Information required by this item will be contained in our Definitive Proxy Statement forour 2007 Annual Meeting of Shareholders, to be filed pursuant to Regulation 14A with the Securities and Exchange Commission within 120 days of December 31, 2006. Such information is incorporated herein by reference.

ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

Information required by this item will be contained in our Definitive Proxy Statement for our 2007 Annual Meeting of Shareholders, to be filed pursuant to Regulation 14A with the Securities and Exchange Commission within 120 days of December 31, 2006. Such information is incorporated herein by reference.

ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

Information required by this item will be contained in our Definitive Proxy Statement for our 2007 Annual Meeting of Shareholders, to be filed pursuant to Regulation 14A, with the Securities and Exchange Commission within 120 days of December 31, 2006. Such information is incorporated herein by reference.

ITEM 14 - PRINCIPAL ACCOUNTANT FEES AND SERVICES

Information required by this item will be contained in our Definitive Proxy Statement forour 2007 Annual Meeting of Shareholders, to be filed pursuant to Regulation 14A, with the Securities and Exchange Commission within 120 days of December 31, 2006. Such information is incorporated herein by reference.

48

PART IV

ITEM 15 - EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

(a)(1) FINANCIAL STATEMENTS

The Financial Statements of the Company and the independent auditors’ reports are set forth on pages 52 through 86.

(a)(2) FINANCIAL STATEMENT SCHEDULES

All schedules to the Financial Statements are omitted because of the absence of the conditions under which they are required or because the required information is included in the Financial Statements or accompanying notes.

(a)(3) EXHIBITS

The exhibit list required by this Item is incorporated by reference to the Exhibit Index included in this report.

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report on Form 10-K to be signed on its behalf by the undersigned thereunto duly authorized.

	Heritage Commerce Corp
DATE: March 16, 2007	BY: /s/ Walter T. Kaczmarek Walter T. Kaczmarek Chief Executive Officer

49

Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated:

Signature	Title	Date
/s/ FRANK BISCEGLIA         Frank Bisceglia	Director	March 16, 2007
/s/ JAMES BLAIR        James Blair	Director	March 16, 2007
/s/ JACK CONNER         Jack Conner	Director and Chairman of the Board	March 16, 2007
/s/ WILLIAM DEL BIAGGIO, JR.         William Del Biaggio, Jr.	Director	March 16, 2007
/s/ WALTER T. KACZMAREK         Walter T. Kaczmarek	Director and Chief Executive Officer and President (Principle Executive Officer)	March 16, 2007
/s/ LAWRENCE D. MCGOVERN        Lawrence D. McGovern	Executive Vice President and Chief Financial Officer (Principal Financial and Accounting Officer)	March 16, 2007
/s/ ROBERT MOLES         Robert Moles	Director	March 16, 2007
/s/ LON NORMANDIN         Lon Normandin	Director	March 16, 2007
/s/ JACK PECKHAM        Jack Peckham	Director	March 16, 2007
/s/ HUMPHREY POLANEN         Humphrey Polanen	Director	March 16, 2007
/s/ CHARLES TOENISKOETTER         Charles Toeniskoetter	Director	March 16, 2007
/s/ RANSON WEBSTER         Ranson Webster	Director	March 16, 2007

50

HERITAGE COMMERCE CORP

INDEX TO FINANCIAL STATEMENTS

DECEMBER 31, 2006

	Page
Report of Independent Registered Public Accounting Firm for 2006 and 2005	52
Report of Independent Registered Public Accounting Firm for 2004	53
Consolidated Balance Sheets as of December 31, 2006 and 2005	54
Consolidated Income Statements for the years ended December 31, 2006, 2005 and 2004	55
Consolidated Statements of Changes in Shareholders’ Equity for the years ended December 31, 2006, 2005 and 2004	56
Consolidated Statements of Cash Flows for the years ended December 31, 2006, 2005 and 2004	57
Notes to Consolidated Financial Statements	58

51

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Board of Directors

Heritage Commerce Corp

San Jose, California

We have audited the accompanying consolidated balance sheets of Heritage Commerce Corp as of December 31, 2006 and 2005, and the related consolidated income statements, statements of changes in shareholders’ equity and statements of cash flows for the years then ended. We also have audited management’s assessment, included in Management’s Annual Report on Internal Control over Financial Reporting in Item 9A of Form 10-K, that Heritage Commerce Corp maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the TreadwayCommission (COSO). Heritage Commerce Corp’s management is responsible for thesefinancial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on these financial statements, an opinion on management’s assessment, and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audit of financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

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

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Heritage Commerce Corp as of December 31, 2006 and 2005, and the results of its operations and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, management’s assessment that Heritage Commerce Corp maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on criteria established in Internal Control—IntegratedFramework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Furthermore, in our opinion, Heritage Commerce Corp maintained, in allmaterial respects, effective internal control over financial reporting as of December 31, 2006, based on criteria established in InternalControl—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

/s/ Crowe Chizek and Company LLP

Oak Brook, Illinois

March 15, 2007

52

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Shareholders of

Heritage Commerce Corp:

We have audited the accompanying consolidated statements of income, changes in shareholders’ equity, and cash flows of Heritage Commerce Corp and subsidiary (the “Company”) for the year ended December 31, 2004. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit.

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

In our opinion, such consolidated financial statements present fairly, in all material respects, the results of operations and cash flows of Heritage Commerce Corp and subsidiary for the year ended December 31, 2004, in conformity with accounting principles generally accepted in the United States of America.

/s/ Deloitte & Touche LLP

San Francisco, California

March 30, 2005

53

HERITAGE COMMERCE CORP
CONSOLIDATED BALANCE SHEETS
	December 31,			December 31,
(Dollars in thousands)	2006			2005
Assets
Cash and due from banks	$	34,285		$	35,560
Federal funds sold		15,100			62,900
Total cash and cash equivalents		49,385			98,460
Securities available for sale, at fair value		172,298			198,495
Loans held for sale, at lower of cost or market		17,234			70,147
Loans, net of deferred costs		725,754			688,778
Allowance for loan losses		(9,279	)		(10,224)
Loans, net		716,475			678,554
Federal Home Loan Bank and Federal Reserve Bank stock, at cost		6,113			5,859
Company owned life insurance		36,174			34,735
Premises and equipment, net		2,539			2,541
Accrued interest receivable and other assets		36,920			41,718
Total assets	$	1,037,138		$	1,130,509
Liabilities and Shareholders' Equity
Liabilities:
Deposits
Demand, noninterest bearing	$	231,841		$	248,009
Demand, interest bearing		133,413			157,330
Savings and money market		307,266			353,798
Time deposits, under $100		31,097			35,209
Time deposits, $100 and over		111,017			109,373
Brokered deposits, $100 and over		31,959			36,040
Total deposits		846,593			939,759
Notes payable to subsidiary grantor trusts		23,702			23,702
Securities sold under agreement to repurchase		21,800			32,700
Accrued interest payable and other liabilities		22,223			22,731
Total liabilities		914,318			1,018,892
Shareholders' equity:
Preferred stock, no par value; 10,000,000
shares authorized; none outstanding		-			-
Common Stock, no par value; 30,000,000 shares authorized;
shares outstanding: 11,656,943 in 2006 and 11,807,649 in 2005		62,363			67,602
Retained earnings		62,452			47,539
Unearned restricted stock award		-			(803)
Accumulated other comprehensive loss		(1,995	)		(2,721)
Total shareholders' equity		122,820			111,617
Total liabilities and shareholders' equity	$	1,037,138		$	1,130,509
See notes to consolidated financial statements

54

HERITAGE COMMERCE CORP
CONSOLIDATED INCOME STATEMENTS
	Years Ended December 31,
(Dollars in thousands, except per share data)	2006		2005		2004
Interest income:
Loans, including fees	$	61,859	$	54,643	$	43,593
Securities, taxable		7,614		7,042		6,418
Securities, non-taxable		182		205		297
Interest bearing deposits in other financial institutions		132		97		14
Federal funds sold		3,170		1,769		363
Total interest income		72,957		63,756		50,685
Interest expense:
Deposits		19,588		12,849		6,798
Notes payable to subsidiary grantor trusts		2,310		2,136		1,958
Repurchase agreements and other		627		922		892
Total interest expense		22,525		15,907		9,648
Net interest income before provison for loan losses		50,432		47,849		41,037
Provision for loan losses		(503)		313		666
Net interest income after provision for loan losses		50,935		47,536		40,371
Noninterest income:
Gain on sale of loans		4,008		2,871		3,052
Servicing income		1,860		1,838		1,498
Increase in cash surrender value of life insurance		1,439		1,236		1,031
Service charges and fees on deposit accounts		1,335		1,468		1,799
Gain on sale of leased equipment		0		299		0
Equipment leasing		0		131		871
Gain on sales of securities available-for-sale		0		0		476
Mortgage brokerage fees		0		0		168
Other		1,198		1,580		1,649
Total noninterest income		9,840		9,423		10,544
Noninterest expense:
Salaries and employee benefits		19,414		19,845		20,189
Occupancy		3,110		3,254		3,670
Professional fees		1,688		1,617		2,656
Advertising and promotion		1,064		985		1,090
Client services		1,000		1,404		1,044
Low income housing investment losses and writedowns		995		957		878
Data processing		806		661		722
Furniture and equipment		517		734		921
Retirement plan expense		352		619		306
Operational losses		9		37		2,219
Amortization of leased equipment		0		334		1,016
Other		5,313		4,786		4,527
Total noninterest expense		34,268		35,233		39,238
Income before income taxes		26,507		21,726		11,677
Income tax expense		9,237		7,280		3,199
Net income	$	17,270	$	14,446	$	8,478
Earnings per share:
Basic	$	1.47	$	1.22	$	0.73
Diluted	$	1.44	$	1.19	$	0.71
See notes to consolidated financial statements

55

HERITAGE COMMERCE CORP
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
YEARS ENDED DECEMBER 31, 2006, 2005, AND 2004
	Common Stock						Unearned Restricted			Unallocated ESOP			Accumlated Other Comprehensive			Retained			Total Shareholders'			Comprehensive
(Dollars in thousands, except shares)	Shares			Amount			Stock Award			Shares			Income (Loss)			Earnings			Equity			Income
Balance, January 1, 2004		11,381,037		$	65,234		$	-		$	(443	)	$	79		$	24,615		$	89,485
Net Income		-			-			-			-			-			8,478			8,478		$	8,478
Net change in unrealized gain/loss on securities
available-for-sale and Interest-Only strips, net
of reclassification adjustment and deferred income taxes		-			-			-			-			(684	)		-			(684	)		(684	)
Increase in pension liability, net of deferred income taxes		-			-			-			-			(1,125	)		-			(1,125	)		(1,125	)
Total comprehensive income																						$	6,669
ESOP shares released		-			296			-			250			-			-			546
Common stock repurchased		(263,728	)		(4,214	)		-			-			-			-			(4,214	)
Stock options exercised, including related tax benefits		552,528			6,093			-			-			-			-			6,093
Balance, December 31, 2004		11,669,837			67,409			-			(193	)		(1,730	)		33,093			98,579
Net Income		-			-			-			-			-			14,446			14,446		$	14,446
Net change in unrealized gain/loss on securities
available-for-sale and Interest-Only strips, net
of reclassification adjustment and deferred income taxes		-			-			-			-			(664	)		-			(664	)		(664	)
Increase in pension liability, net of deferred income taxes		-			-			-			-			(327	)		-			(327	)		(327	)
Total comprehensive income																						$	13,455
ESOP shares released		-			284			-			193			-			-			477
Restricted stock award		51,000			926			(926	)		-			-			-			-
Amortization of restricted stock award		-			-			123			-			-			-			123
Redemption payment on commom stock		-			(12	)		-			-			-			-			(12	)
Common stock repurchased		(300,160	)		(5,732	)		-			-			-			-			(5,732	)
Stock options exercised, including related tax benefits		386,972			4,727			-			-			-			-			4,727
Balance, December 31, 2005		11,807,649			67,602			(803	)		-			(2,721	)		47,539			111,617
Net Income		-			-			-			-			-			17,270			17,270		$	17,270
Net change in unrealized gain/loss on securities
available-for-sale and Interest-Only strips, net
of reclassification adjustment and deferred income taxes		-			-			-			-			377			-			377			377
Decrease in pension liability, net of deferred income taxes		-			-			-			-			349			-			349			349
Total comprehensive income																						$	17,996
Reclassification of unearned restricted stock award upon adoption
of Statement 123 (revised 2004)		-			(803	)		803			-			-			-			-
Amortization of restricted stock award		-			154			-			-			-			-			154
Cash dividend declared on common stock, $0.20 per share		-			-			-			-			-			(2,357	)		(2,357	)
Common stock repurchased		(330,300	)		(7,888	)		-			-			-			-			(7,888	)
Stock option expense		-			780			-			-			-			-			780
Stock options exercised, including related tax benefits		179,594			2,518			-			-			-			-			2,518
Balance, December 31, 2006		11,656,943		$	62,363		$	-		$	-		$	(1,995	)	$	62,452		$	122,820
See notes to consolidated financial statements

56

HERITAGE COMMERCE CORP
CONSOLIDATED STATEMENTS OF CASH FLOWS
	Years ended December 31,
(Dollars in thousands)	2006			2005			2004
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	17,270		$	14,446		$	8,478
Adjustments to reconcile net income to net cash provided by
operating activities:
Net gain/loss on disposals of property and equipment		0			0			(17)
Depreciation and amortization		662			988			1,366
Provision for loan losses		(503	)		313			666
Gain on sale of leased equipment		0			(299	)		0
Gain on sales of securities available-for-sale		0			0			(476)
Deferred income tax benefit		(319	)		(360	)		(1,163)
Non-cash compensation expense related to ESOP plan		0			477			546
Stock option expense		780			0			0
Amortization of restricted stock award		154			123			0
Amortization (accretion) of discounts and premiums on securities		(1,087	)		928			1,090
Gain on sale of loans		(4,008	)		(2,871	)		(3,052)
Proceeds from sales of loans held for sale		96,749			51,176			57,647
Originations of loans held for sale		(65,839	)		(78,227	)		(74,898)
Maturities of loans held for sale		26,011			26,510			13,763
Increase in cash surrender value of life insurance		(1,439	)		(1,236	)		(1,031)
Effect of changes in:
Accrued interest receivable and other assets		4,270			(7,181	)		(3,948)
Accrued interest payable and other liabilities		1,562			4,909			4,540
Net cash provided by operating activities		74,263			9,696			3,511
CASH FLOWS FROM INVESTING ACTIVITIES:
Net change in loans (including purchase of $10,306 in 2006)		(37,418	)		4,609			(64,712)
Purchases of securities available-for-sale		(64,018	)		(26,087	)		(127,662)
Maturities/Paydowns/Calls of securities available-for-sale		92,274			57,707			23,270
Proceeds from sales of securities available-for-sale		0			0			22,641
Sale of leased equipment		0			687			0
Purchases of company owned life insurance		0			(7,196	)		0
Purchase of premises and equipment		(660	)		(346	)		(532)
Purchase of restricted stock and other investments		(254	)		(1,164	)		(2,191)
Net cash provided by (used in) investing activities		(10,076	)		28,210			(149,186)
CASH FLOWS FROM FINANCING ACTIVITIES:
Net change in deposits		(93,166	)		21,224			83,125
Payment of other liability		(1,469	)		(2,299	)		0
Exercise of stock options		2,518			4,727			6,093
Common stock repurchased		(7,888	)		(5,744	)		(4,214)
Payment of cash dividend		(2,357	)		0			0
Net change in other borrowings		(10,900	)		(15,100	)		4,200
Net cash provided by (used in) financing activities		(113,262	)		2,808			89,204
Net increase (decrease) in cash and cash equivalents		(49,075	)		40,714			(56,471)
Cash and cash equivalents, beginning of year		98,460			57,746			114,217
Cash and cash equivalents, end of year	$	49,385		$	98,460		$	57,746
Supplemental disclosures of cash flow information:
Cash paid during the year for:
Interest	$	22,285		$	15,291		$	9,493
Income taxes	$	4,781		$	13,828		$	3,080
Supplemental schedule of non-cash investing activity:
Transfer of commerical loans to loans held-for-sale	$	0		$	32,057		$	0
Transfer of commercial loan held for sale to commercial loans	$	0		$	2,500		$	0
See notes to consolidated financial statements

57

HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(1) Summary of Significant Accounting Policies

Description of Business and Basis of Presentation

Heritage Commerce Corp (the “Company”) operates as a bank holding company. Effective January 1, 2003, Heritage Bank East Bay (“HBEB”), Heritage Bank South Valley (“HBSV”), and Bank of Los Altos (“BLA”) were merged into Heritage Bank of Commerce (“HBC” or “the Bank”). HBC is a California state chartered bank which offers a full range of commercial and personal banking services to residents and the business/professional community in Santa Clara and Alameda counties, California. HBC was incorporated on November 23, 1993 and commenced operations on June 8, 1994.

The consolidated financial statements include the accounts of the Company and its subsidiary bank. All inter- company accounts and transactions have been eliminated.

The Company also has four other subsidiaries, Heritage Capital Trust I and Heritage Statutory Trust I, formed in 2000, Heritage Statutory Trust II, formed in 2001, and Heritage Statutory Trust III, formed in 2002, which are Delaware statutory business trusts formed for the exclusive purpose of issuing trust preferred securities. These subsidiary trusts are not consolidated in the Company’s consolidated financial statements and the subordinated debt payable to subsidiary grantor trusts is recorded as debt of the Company to the related trusts.

Use of Estimates

The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The allowance for loan losses, loan servicing rights, defined benefit pension obligation, interest-only strip receivables and the fair values of financial instruments are particularly subject to change.

Cash and Cash Equivalents

Cash and cash equivalents include cash on hand, amounts due from banks, and Federal funds sold. Generally, Federal funds are sold and purchased for one-day periods.

Cash Flows

Net cash flows are reported for customer loan and deposit transactions, and Federal funds purchased and repurchase agreements.

Securities

The Company classifies its securities as either available-for-sale or held-to-maturity at the time of purchase. Securities available-for-sale are recorded at fair value with a corresponding recognition of the net unrealized holding gain or loss, net of deferred income taxes, as a net amount within accumulated other comprehensive income (loss), which is a separate component of shareholders’ equity. Securities held-to-maturity are recorded at amortized cost and are based on the Company’s positive intent and ability to hold the securities to maturity. As of December 31, 2006 and 2005, all the Company’s securities were classified as available-for-sale securities.

A decline in the market value of any available-for-sale or held-to-maturity security below amortized cost that is deemed other than temporary results in a charge to earnings and the corresponding establishment of a new cost basis for the security. In estimating other-than-temporary losses, management considers (1) the length of time and extent that fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the Company’s ability and intent to hold the security for a period sufficient to allow for any anticipated recovery in fair value.

Interest income includes amortization of purchase premiums or discount. Premiums and discounts are amortized, or accreted, over the life of the related security as an adjustment to income using a method that approximates the interest method. Realized gains and losses are recorded on the trade date and determined using the specific identification method for determining the cost of securities sold.

Federal Home Loan Bank (“FHLB”) and Federal Reserve Bank (“FRB”) Stock

The Bank is a member of the FHLB system. Members are required to own a certain amount of stock based on the level of borrowings and other factors, and may invest in additional amounts. The FHLB stock is carried at cost, classified as a restricted security, and periodically evaluated for impairment. Because this stock is viewed as a long term investment, impairment is based on ultimate recovery of par value. Both cash and stock dividends are reported as income. The Bank is also member of the FRB. FRB stock is classified as a restricted security, and cash dividends are reported as income.

58

Loans Held for Sale

The Company holds for sale the guaranteed portion of certain loans guaranteed by the Small Business Administration or the U.S. Department of Agriculture (collectively referred to as “SBA loans”). These loans are carried at the lower of cost or market, based on the aggregate value of the portfolio. Net unrealized losses, if any, are recorded as a valuation allowance and charged to earnings.

Gains or losses on SBA loans held for sale are recognized upon completion of the sale, and are based on the difference between the net sales proceeds and the relative fair value of the guaranteed portion of the loan sold compared to the relative fair value of the unguaranteed portion.

SBA loans are sold with servicing retained. The servicing assets that result from the sale of SBA loans consist of servicing rights and interest-only strip receivables.

The Company accounts for the sale and servicing of SBA loans based on the financial and servicing assets it controls and liabilities it has incurred, derecognizing financial assets when control has been surrendered, and derecognizing liabilities when extinguished. Servicing rights are measured at their fair value and are amortized in proportion to and over the period of net servicing income and are assessed for impairment on an ongoing basis. Impairment is determined by stratifying the servicing rights based on interest rates and terms. Any servicing assets in excess of the contractually specified servicing fees are reclassified at fair value as an interest-only (I/O) strip receivable and treated like an available for sale security. Fair value is determined using prices for similar assets with similar characteristics, when available, or based upon discounted cash flows using market-based assumptions. Impairment is recognized through a valuation allowance. The servicing rights, net of any required valuation allowance, and I/O strip receivable are included in other assets.

Loans

Loans that management has the intent and ability to hold for the foreseeable future or maturity or payoff are stated at the principal amount outstanding net of deferred loan origination fees and costs. The majority of the Company’s loans are at variable interest rates. Interest on loans is accrued on the unpaid principal balance and is credited to income using the effective yield interest method.

Generally, if a loan is classified as non-accrual, the accrual of interest is discontinued, any accrued and unpaid interest is reversed, and the amortization of deferred loan fees and costs is discontinued. Loans are classified as non-accrual when the payment of principal or interest is 90 days past due, unless the amount is well secured and in the process of collection. Any interest or principal payments received on nonaccrual loans are applied toward reduction of principal. Nonaccrual loans generally are not returned to performing status until the obligation is brought current, the loan has performed in accordance with the contract terms for a reasonable period of time, and the ultimate collectibility of the total contractual principal and interest is no longer in doubt.

Non-refundable loan fees and direct origination costs are deferred and recognized over the expected lives of the related loans using the effective yield interest method.

Allowance for Loan Losses

The Company maintains an allowance for loan losses to absorb probable losses incurred in the loan portfolio. The allowance is based on ongoing, quarterly assessments of the probable estimated losses. Loans are charged against the allowance when management believes that the uncollectibility of a loan balance is confirmed. The allowance is increased by the provision for loan losses, which is charged against current period operating results, and decreased by loan charge-offs, net of recoveries. The Company’s methodology for assessing the appropriateness of the allowance consists of several key elements, which include the formula allowance and specific allowances.

The formula allowance is calculated by applying loss factors to pools of outstanding loans. Loss factors are based on the Company’s historical loss experience, adjusted for significant factors that, in management’s judgment, affect the collectibility of the portfolio as of the evaluation date. The adjustment factors for the formula allowance may include existing general economic and business conditions affecting the key lending areas of the Company, in particular the technology industry and the real estate market, credit quality trends, collateral values, loan volumes and concentrations, specific industry conditions within portfolio segments, recent loss experience in particular segments of the portfolio, duration of the current business cycle, and bank regulatory examination results. The evaluation of the inherent loss with respect to these conditions is subject to a higher degree of uncertainty.

Specific allowances are established for impaired loans, but the entire allowance is available for any loan, that in management’s judgment, should be charged off. Management considers a loan to be impaired when it is probable that the Company will be unable to collect all amounts due according to the original contractual terms of the note agreement. When a loan is considered to be impaired, the amount of impairment is measured based on the present value of expected future cash flows discounted at the note’s effective interest rate, or the fair value of the collateral if the loan is collateral dependent. Commercial, land and construction and commercial real estate loans are individually evaluated for impairment. Large groups of smaller balance homogeneous loans, such as consumer and residential real estate loans, are collectively evaluated for impairment and, accordingly, they are not separately identified for impairment disclosures.

Loss Contingencies

Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated. Management does not believe there now are such matters that will have a material effect on the financial statements.

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Company Owned Life Insurance

The Company has purchased life insurance policies on certain directors and officers. Company owned life insurance is recorded at its cash surrender value or the amount that can be realized.

Premises and Equipment

Premises and equipment are stated at cost. Depreciation and amortization are computed on a straight-line basis over the lesser of the respective lease terms or estimated useful lives of five to fifteen years. The Company evaluates the recoverability of long-lived assets on an on-going basis.

Equipment under Operating Leases to Others

Equipment under operating leases where the Company was the lessor were carried at cost less accumulated depreciation based on the terms of the leases. This equipment represented a pool of electronic testing equipment available for short-term rentals purchased in 2002 from a third party, who serviced the leases. At December 31, 2004, the Company had $2,807,000 in equipment and $2,085,000 in accumulated depreciation related to these leases. Depreciation expense was $1,016,000 and rental revenue on the leases was $871,000 in 2004. The Company regularly evaluates this equipment for impairment. In 2004, the Company recorded a write-off on the electronic test equipment of $2,193,000 due to an impairment. In 2005, the Company sold all the electronic test equipment and recognized a gain on sale of $299,000.

Termination Benefits

In 2004, the Company recorded certain termination benefits related to the elimination of certain full time positions and the resignation of the former CEO. The Company recorded severance expense of $1,283,000 and special termination benefit expense of $765,000 recognized in salaries and employee benefits.

Income Taxes

The Company files consolidated Federal and combined state income tax returns. Income tax expense is the total of the current year income tax payable or refundable and the change in deferred tax assets and liabilities. Deferred tax assets and liabilities are the expected future tax amounts for the temporary differences between carrying amounts and tax basis of assets and liabilities, computed using enacted tax rates. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized.

Earnings per Share

Basic earnings per share is computed by dividing net income by the weighted average common shares outstanding. Diluted earnings per share reflects potential dilution from outstanding stock options, using the treasury stock method. There were 167,763, 25,225 and 14,336 stock options for 2006, 2005, and 2004 that were considered to be antidilutive and excluded from the computation of diluted earnings per share. For each of the years presented, net income is the same for basic and diluted earnings per share. Reconciliation of weighted average shares used in computing basic and diluted earnings per share is as follows:

	Year ended December 31,
		2006	2005	2004
Weighted average common shares outstanding - used  in computing basic earnings per share		11,725,671	11,795,635	11,559,155
Dilutive effect of stock options outstanding,using the treasury stock method		230,762	311,595	427,701
Shares used in computing diluted earnings per share		11,956,433	12,107,230	11,986,856

Stock-Based Compensation

Prior to 2006, the Company accounted for stock-based awards to employees using the intrinsic value method in accordance with Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees.” No compensation expense was recognized in the financial statements for stock option arrangements, as the Company’s stock option plan provides for the issuance of options at a price of no less than the fair market value at the date of the grant.

Statement of Financial Accounting Standards (“Statement”) No. 123, “Accounting for Stock-Based Compensation,” required the disclosure of pro forma net income and earnings per share had the Company adopted the fair value method at the grant date of all stock options. Under Statement 123, the fair value of stock-based awards to employees is calculated through the use of option pricing models, even though such models were developed to estimate the fair value of freely tradable, fully transferable options without vesting restrictions, which differ significantly from the Company’s stock option awards. Those models also require subjective assumptions, which affect the calculated values.

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In December 2004, the FASB issued Statement 123 (revised 2004), “Share-Based Payment”. This Statement requires that compensation costs related to share-based payment transactions be recognized in the financial statements. Measurement of the cost of employee service is based on the grant-date fair value of the equity or liability instruments issued. That cost is recognized over the period during which an employee is required to provide service in exchange for the award. Additionally, liability awards will be remeasured each reporting period. Statement 123R replaces Statement 123, and supersedes APB Opinion 25. On April 14, 2005, the SEC issued rule 2005-57, which allowed companies to delay implementation of Statement 123R to the beginning of 2006.

The Company adopted Statement 123R on January 1, 2006, which has resulted in an increase in noninterest expense of $780,000 in 2006. The income tax benefit recognized in the income statement for stock option expense was $108,000 in 2006. Adoption of Statement 123R reduced net income by $672,000 in 2006, and decreased basic and diluted earnings per share by approximately $0.05 each. Operating and financing cash flows were not significantly affected by the adoption of Statement 123R. The Company elected the modified prospective method, under which prior periods are not revised for comparative purposes. The following table presents the Company’s pro forma net income and earnings per common share for 2005 and 2004 as if the Company had applied the requirements of Statement 123:

	Year ended December 31,
(Dollars in thousands, except per share data)	2005			2004
Net income as reported	$	14,446		$	8,478
Less: Compensation expense for stock options determined
under fair value method		(438	)		(445)
Pro forma net income	$	14,008		$	8,033
Net income per common share - basic
As reported	$	1.22		$	0.73
Pro forma	$	1.19		$	0.69
Net income per common share - diluted
As reported	$	1.19		$	0.71
Pro forma	$	1.16		$	0.67

Comprehensive Income

Comprehensive income includes net income and other comprehensive income, which represents the changes in net assets during the period from non-owner sources. The Company’s sources of other comprehensive income are unrealized gains and losses on securities available-for-sale and I/O strips, which are treated like available-for-sale securities, and the liability related to the Company’s supplemental retirement plan. The items in other comprehensive income are presented net of deferred income tax effects. Reclassification adjustments result from gains or losses on securities that were realized and included in net income of the current period that also had been included in other comprehensive income as unrealized holding gains and losses.

The following is a summary of the components of other comprehensive income (loss):

	Year ended December 31,
(Dollars in thousands)	2006		2005		2004
Net unrealized gains (losses) on available-for-sale of securities and I/O strips
during the year, including reclassification adjustment of the net realized security
gain of $346, net of tax of $130, in 2004 that was recognized in income	$	650	$	(1,212)	$	(929)
Less: Deferred income tax on unrealized gains (losses) on
available-for-sale of securities and I/O strips		(273)		548		245
Net unrealized gains (losses) on available-for-sale
securities and I/O strips, net of deferred income tax		377		(664)		(684)
Pension liability adjustment during the year		601		(563)		(1,940)
Less: Deferred income tax on pension liability adjustment		(252)		236		815
Pension liability adjustment, net of deferred income tax		349		(327)		(1,125)
Other comprehensive income (loss)	$	726	$	(991)	$	(1,809)

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Accumulated other comprehensive income (loss) consisted of the following items, net of deferred tax, at year-end.

(Dollars in thousands)	2006		2005
Unrealized net losses on securities available-for-sale and I/O strips	$	(892)	$	(1,269)
Pension liability		(1,103)		(1,452)
Accumulated other comprehensive income (loss)	$	(1,995)	$	(2,721)

Segment Reporting

HBC is an independent community business bank with nine branch offices, which offer similar products to customers located in Santa Clara, Alameda, and Contra Costa counties of California. No customer accounts for more than 10 percent of revenue for HBC or the Company. Management evaluates the Company’s performance as a whole and does not allocate resources based on the performance of different lending or transaction activities. Accordingly, the Company and its subsidiary bank all operate as one business segment.

Reclassifications

Certain amounts in the 2005 and 2004 financial statements have been reclassified to conform to the 2006 presentation.

Adoption of Other New Accounting Standards

In September 2006, FASB issued Statement 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans - an amendment of FASB Statements No. 87, 88, 106 and 132(R). This Statement requires an employer to recognize the overfunded or underfunded status of a defined benefit postretirement plan (other than a multiemployer plan) as an asset or liability in its balance sheet, beginning with year end 2006, and to recognize changes in the funded status in the year in which the changes occur through comprehensive income beginning in 2007. Additionally, defined benefit plan assets and obligations are to be measured as of the date of the employer’s fiscal year-end. Adoption of Statement 158 did not significantly change the method the Company used to account for its benefit plan since the Company’s supplemental retirement plan has no assets and the liability for benefits was previously measured as of each December 31 and recorded on the Company’s balance sheet.

In September 2006, the Securities and Exchange Commission (SEC) released Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (SAB 108), which is effective for fiscal years ending on or after November 15, 2006. SAB 108 provides guidance on how the effects of prior-year uncorrected financial statement misstatements should be considered in quantifying a current year misstatement. SAB 108 requires public companies to quantify misstatements using both an income statement (rollover) and balance sheet (iron curtain) approach and evaluate whether either approach results in a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. If prior year errors that had been previously considered immaterial now are considered material based on either approach, no restatement is required so long as management properly applied its previous approach and all relevant facts and circumstances were considered. Adjustments considered immaterial in prior years under the method previously used, but now considered material under the dual approach required by SAB 108, are to be recorded upon initial adoption of SAB 108. The adoption of SAB 108 had no effect on the Company’s financial statements for the year ended December 31, 2006.

Newly Issued but not yet Effective Accounting Standards

In February, 2006, FASB issued Statement 155, Accounting for Certain Hybrid Instruments. This standard amended the guidance in Statement 133, Accounting for Derivative Instruments and Hedging Activities, and Statement 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. Statement 155 permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation and clarifies which interest-only and principal-only strips are not subject to the requirements of Statement 133. Statement 155 is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. The adoption of this standard is not expected to have a material impact on the Company’s financial statements.

In March, 2006, FASB issued Statement 156, Accounting for Servicing of Financial Assets - An Amendment of FASB Statement No. 140. This standard amends the guidance in Statement 140, with respect to the accounting for separately recognized servicing assets and servicing liabilities. Among other requirements, Statement 156 requires an entity to recognize a servicing asset or servicing liability each time it undertakes an obligation to service a financial asset by entering into a servicing contract in certain situations, including a transfer of loans with servicing retained that meets the requirements for sale accounting. Statement 156 is effective as of the beginning of an entity’s first fiscal year that begins after September 15, 2006. The adoption of this standard is not expected to have a material impact on the Company’s financial statements.

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In June 2006, FASB issued FASB Interpretation (“FIN”) 48, Accounting for Uncertainty in Income Taxes. This Interpretation clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with Statement 109, Accounting for Income Taxes. This Interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This Interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. This Interpretation is effective for fiscal years beginning after December 15, 2006. The adoption of this standard is not expected to have a material impact on the Company’s financial statements.

In September 2006, the FASB Emerging Issues Task Force finalized Issue No. 06-4, Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements. This issue requires that a liability be recorded during the service period when a split-dollar life insurance agreement continues after participants’ employment or retirement. The required accrued liability will be based on either the post-employment benefit cost for the continuing life insurance or based on the future death benefit depending on the contractual terms of the underlying agreement. This issue is effective for fiscal years beginning after December 15, 2007. Adoption of EITF Issue 06-4 is not expected to have a material effect on the Company’s financial statements. In 2005, the Company began recognizing the cost of continuing life insurance coverage under split-dollar arrangements. The recorded liability for split-dollar life insurance coverage was $1,221,000 and 1,050,000 at December 31, 2006 and 2005, respectively.

In September 2006, the FASB Emerging Issues Task Force finalized Issue No. 06-5, Accounting for Purchases of Life Insurance - Determining the Amount That Could Be Realized in Accordance with FASB Technical Bulletin No. 85-4 (Accounting for Purchases of Life Insurance). This issue requires that a policyholder consider contractual terms of a life insurance policy in determining the amount that could be realized under the insurance contract. It also requires that if the contract provides for a greater surrender value if all individual policies in a group are surrendered at the same time, that the surrender value be determined based on the assumption that policies will be surrendered on an individual basis. Lastly, the issue discusses whether the cash surrender value should be discounted when the policyholder is contractually limited in its ability to surrender a policy. This issue is effective for fiscal years beginning after December 15, 2006. The adoption of this issue is not expected to have a material impact on the financial statements.

In September 2006, FASB issued Statement 157, Fair Value Measurements. This Statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (“GAAP”), and expands disclosures about fair value measurements. This Statement applies under other accounting pronouncements that require or permit fair value measurements, FASB having previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. This Statement is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The adoption of this standard is not expected to have a material impact on the Company’s financial statements.

In February 2007, FASB issued Statement 159, The Fair Value Option for Financial Assets and Financial Liabilities. This statement provides companies with an option to report selected financial assets and liabilities at fair value.  The Standard’s objective is to reduce both complexity in accounting for financial instruments and the volatility in earnings caused by measuring related assets and liabilities differently. The standard requires companies to provide additional information that will help investors and other users of financial statements to more easily understand the effect of the company’s choice to use fair value on its earnings. It also requires entities to display the fair value of those assets and liabilities for which the company has chosen to use fair value on the face of the balance sheet.  The new Statement does not eliminate disclosure requirements included in other accounting standards, including requirements for disclosures about fair value measurements included in Statements 157, Fair Value Measurements, and 107, Disclosures about Fair Value of Financial Instruments. This Statement is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. The Company has not completed its evaluation of Statement 159’s effects on its financial statements.

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(2) Securities

The amortized cost and estimated fair value of securities at year-end were as follows:

			Gross		Gross		Estimated
2006	Amortized		Unrealized		Unrealized		Fair
(Dollars in thousands)	Cost		Gains		Losses		Value
Securities available-for-sale:
U.S. Treasury	$	6,000	$	-	$	(37)	$	5,963
U.S. Government Agencies		59,610		27		(241)		59,396
Municipals - Tax Exempt		8,299		-		(157)		8,142
Mortgage-Backed Securities		93,150		74		(3,038)		90,186
Collateralized Mortgage Obligations		8,683		76		(148)		8,611
Total securities available-for-sale	$	175,742	$	177	$	(3,621)	$	172,298

			Gross		Gross		Estimated
2005	Amortized		Unrealized		Unrealized		Fair
(Dollars in thousands)	Cost		Gains		Losses		Value
Securities available-for-sale:
U.S. Treasury	$	7,000	$	-	$	(80)	$	6,920
U.S. Government Agencies		82,759		6		(724)		82,041
Municipals - Tax Exempt		8,480		-		(212)		8,268
Mortgage-Backed Securities		95,009		78		(3,219)		91,868
Collateralized Mortgage Obligations		9,663		-		(265)		9,398
Total securities available-for-sale	$	202,911	$	84	$	(4,500)	$	198,495

Securities classified as U.S. Government Agencies as of December 31, 2006 were issued by the Federal National Mortgage Association, Federal Home Loan Mortgage Corporation, and the Federal Home Loan Bank.

At year end 2006 and 2005, there were no holdings of securities of any one issuer, other than the U.S. Government and its agencies, in an amount greater than 10% of shareholders’ equity.

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Securities with unrealized losses at year end, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, are as follows:

	Less Than 12 Months					12 Months or More				Total
2006	Fair		Unrealized			Fair		Unrealized		Fair		Unrealized
(Dollars in thousands)	Value		Losses			Value		Losses		Value		Losses
U.S. Treasury	$	-	$	-		$	5,963	$	(37)	$	5,963	$	(37)
U.S. Government Agencies		35,078		(87	)		11,456		(154)		46,534		(241)
Mortgage-Backed Securities		11,691		(65	)		68,421		(2,973)		80,112		(3,038)
Municipals - Tax Exempt		-		-			8,142		(157)		8,142		(157)
Collateralized Mortgage Obligations		-		-			3,257		(148)		3,257		(148)
Total	$	46,769	$	(152	)	$	97,239	$	(3,469)	$	144,008	$	(3,621)

	Less Than 12 Months					12 Months or More				Total
2005	Fair		Unrealized			Fair		Unrealized		Fair		Unrealized
(Dollars in thousands)	Value		Losses			Value		Losses		Value		Losses
U.S. Treasury	$	5,924	$	(76)		$	996	$	(4)	$	6,920	$	(80)
U.S. Government Agencies		8,094		(2)			69,990		(722)		78,084		(724)
Mortgage-Backed Securities		25,354		(584)			57,362		(2,635)		82,716		(3,219)
Municipals - Tax Exempt		1,891		(37)			6,227		(175)		8,118		(212)
Collateralized Mortgage Obligations		-		-			9,398		(265)		9,398		(265)
Total	$	41,263	$	(699	)	$	143,973	$	(3,801)	$	185,236	$	(4,500)

At December 31, 2006, the Company held 99 securities, of which 73 had fair values below amortized cost. Fifty-two securities have been carried with an unrealized loss for over 12 months. Unrealized losses were primarily due to higher interest rates. No security sustained a downgrade in credit rating. The issuers are of high credit quality and all principal amounts are expected to be paid when securities mature. The fair value is expected to recover as the securities approach their maturity date and/or market rates decline. Because the Company has the ability and intent to hold these securities until a recovery of fair value, which may be maturity, the Company does not consider these securities to be other-than-temporarily impaired at December 31, 2006 or 2005.

The amortized cost and estimated fair values of securities as of December 31, 2006, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or pre-pay obligations with or without call or pre-payment penalties.

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	Available-for-sale
(Dollars in thousands)	Amortized Cost		Estimated Fair Value
Due within one year	$	37,549	$	37,434
Due after one through five years		38,498		38,095
Due after five through ten years		12,754		12,609
Due after ten years		86,941		84,160
Total	$	175,742	$	172,298

Sales of securities available-for-sale resulted in gross realized gains of $0, $0, and $477,000 in 2006, 2005, and 2004, respectively.

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Securities with amortized cost of $53,708,000 and $64,445,000 as of December 31, 2006 and 2005 were pledged to secure public and certain other deposits as required by law or contract.

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(3) Loans and Loan Servicing

Loans at year-end were as follows:

(Dollars in thousands)	2006		2005
Loans held for sale	$	17,234	$	70,147
Loans held for investment:
Commercial		300,611		256,713
Real estate - mortgage		239,041		237,566
Real estate - land and construction		143,834		149,851
Home equity		38,976		41,772
Consumer		2,422		1,721
Total loans		724,884		687,623
Deferred loan origination costs and fees, net		870		1,155
Allowance for loan losses		(9,279)		(10,224)
Loans, net	$	716,475	$	678,554

Real estate mortgage loans are primarily secured by mortgages on commercial property.

During 2006, HBC purchased $10,306,000 of home equity loans from another bank. The premium that HBC paid over the face value of the loans was insignificant. The purchased loans are considered to be of satisfactory credit quality.

Changes in the allowance for loan losses were as follows:

	Year ended December 31,
(Dollars in thousands)	2006		2005			2004
Balance, beginning of year	$	10,224	$	12,497		$	13,451
Loans charged-off		(831)		(3,273)			(2,901)
Recoveries		389		1,358			1,562
Net loans charged-off		(442)		(1,915)			(1,339)
Provision for loan losses		(503)		313			666
Reclassification of allowance for loan losses		-		(671)	(1)		-
Reclassification to other liabilities		-		-			(281)	(2)
Balance, end of year	$	9,279	$	10,224		$	12,497

(1) The Company reclassified $671,000 of the allowance allocated to $32 million of commercial asset based loans that were reclassified to loans held-for-sale as of December 31, 2005. Thus, the carrying value of these loans held-for-sale includes an allowance for loan losses of $671,000.

(2) The Company reclassified the allowance for loan losses on unused commitments of $281,000 to other liabilities as of December 31, 2004.

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Impaired loans were as follows:

(Dollars in thousands)	2006		2005
Year-end loans with no allocated allowance for loan losses	$	1,020	$	1,150
Year-end loans with allocated allowance for loan losses		8,011		14,493
Total	$	9,031	$	15,643

(Dollars in thousands)	2006		2005		2004
Amount of the allowance for loan losses allocated at year-end	$	1,226	$	2,656	$	250
Average of impaired loans during the year	$	13,551	$	16,823	$	1,111
Cash basis interest income recognized during impairment	$	28	$	110	$	36
Interest income during impairment	$	1,012	$	885	$	36

Nonperforming loans include both smaller dollar balance homogenous loans that are collectively evaluated for impairment and individually classified loans. Nonperforming loans were as follows at year-end:

(Dollars in thousands)	2006		2005
Loans past due over 90 days still on accrual	$	451	$	-
Nonaccrual loans	$	3,866	$	3,672

Concentrations of credit risk arise when a number of clients are engaged in similar business activities, or activities in the same geographic region, or have similar features that would cause their ability to meet contractual obligations to be similarly affected by changes in economic conditions. The Company’s loan portfolio is concentrated in commercial (primarily manufacturing, wholesale, and service) and real estate lending, with the balance in consumer loans. While no specific industry concentration is considered significant, the Company’s lending operations are located in the Company’s market areas that are dependent on the technology and real estate industries and their supporting companies. Thus, the Company’s borrowers could be adversely impacted by a downturn in these sectors of the economy which could reduce the demand for loans and adversely impact the borrowers’ ability to repay their loans.

HBC makes loans to executive officers, directors, and their affiliates. The following table presents the loans outstanding to these related parties:

(Dollars in thousands)	2006
Balance, beginning of year	$	3,012
Advances on loans during the year		-
Repayment on loans during the year		(3,010)
Balance, end of year	$	2

At December 31, 2006 and 2005, the Company serviced Small Business Administration and other guaranteed loans which it had sold to the secondary market of approximately $188,844,000 and $179,756,000.

Activity for loan servicing rights follows:

(Dollars in thousands)	2006		2005
Beginning of year balance	$	2,171	$	2,213
Additions		1,195		1,001
Amortization		(1,212)		(1,043)
End of year balance	$	2,154	$	2,171

Loan servicing income is reported net of amortization. There was no valuation allowance as of December 31, 2006 and 2005, as the fair market value of the assets was greater than the carrying value. The estimated fair value of loan servicing rights was $3,562,000 and $3,810,000 at December 31, 2006 and 2005.

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Servicing assets represent the servicing spread generated from the sold guaranteed portions of SBA and other guaranteed loans. In recording the initial value of the servicing rights and the fair value of the I/O strip receivable, the Company uses estimates which are based on management’s expectations of future prepayment and discount rates. Management’s estimate of constant prepayment rate (“CPR”) was 17.7% and 15.0% for the years ended December 31, 2006 and 2005, respectively. The weighted average discount rate assumption was 9.8% and 9.0% at December 31, 2006 and 2005, respectively. These prepayment and discount rates were based on current market conditions and historical performance of the various loan pools. If actual prepayments with respect to sold loans occur more quickly than projected, the carrying value of the servicing rights may have to be adjusted through a charge to earnings. A corresponding decrease in the value of the I/O strip receivable would also be expected.

Management reviews key economic assumptions used in the FASB Statement 140 accounting model to establish the value of the I/O strip on a quarterly basis. The bank has completed a sensitivity analysis to determine the impact on the value of the asset in the event of a 10% and 20% adverse change, independently from any change in another key assumption. This test involved the CPR assumption and the discount rate assumptions. The value of the I/O strip can be adversely impacted by a significant increase in either the prepayment speed of the portfolio or a significant increase in the discount rate.

At December 31, 2006, key economic assumptions and the sensitivity of the current fair value of residual cash flows on the I/O strip to immediate 10 percent and 20 percent adverse changes in those assumptions are as follows:

(Dollars in thousands)
Carrying amount/fair value of Interest-Only (I/O) strip	$	4,537
Weighted average life (in years)		4.5
Prepayment speed assumption (annual rate)		17.7	%
Impact on fair value of 10% adverse change in prepayment speed (CPR 19.5%)	$	(280	)
Impact on fair value of 20% adverse change in prepayment speed (CPR 21.2%)	$	(534	)
Residual cash flow discount rate assumption (annual)		9.8	%
Impact on fair value of 10% adverse change in discount rate (10.8% discount rate)	$	(133	)
Impact on fair value of 20% adverse change in discount rate (11.8% discount rate)	$	(259	)

Activity for I/O strip receivables in 2006 and 2005 follows:

(Dollars in thousands)	2006		2005
Beginning of year balance	$	4,679	$	3,954
Additions		1,272		1,398
Amortization		(1,229)		(1,226)
Unrealized (loss) gain		(185)		553
End of year balance	$	4,537	$	4,679

(4) Premises and Equipment

Premises and equipment at year end were as follows:

(Dollars in thousands)	2006		2005
Furniture and equipment	$	4,704	$	4,326
Leasehold improvements		4,420		4,553
		9,124		8,879
Accumulated depreciation and amortization		(6,585)		(6,338)
Premises and equipment, net	$	2,539	$	2,541

Depreciation expense was $662,000, $988,000, and $1,366,000 in 2006, 2005, and 2004, respectively.

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(5) Deposits

The following table presents the scheduled maturities of time deposits, including brokered deposits, for the next five years:

(Dollars in thousands)	December 31, 2006
2007	$	147,741
2008		17,536
2009		8,731
2010		65
2011		-
Total	$	174,073

Deposits from executive officers, directors, and their affiliates were $3,582,000 at December 31, 2006.

(6) Borrowing Arrangements

FHLB Borrowings & Available Lines of Credit

The Company maintains a collateralized line of credit with the Federal Home Loan Bank (“the FHLB”) of San Francisco. Under this line, the Company can borrow from the FHLB on a short-term (typically overnight) or long-term (over one year) basis. As of December 31, 2006, the Company had no borrowings from the FHLB.

At December 31, 2006, the Company has Federal funds purchase arrangements and lines of credit available of $72,000,000.

Information about securities sold under repurchase agreements and short-term borrowings is summarized as follows:

	December 31,
(Dollars in thousands)	2006		2005
Average balance during the year	$	25,429	$	40,748
Average interest rate during the year		2.46%		2.26%
Maximum month-end balance during the year	$	32,700	$	57,800
Average rate at December 31,		2.56%		2.34%

Securities sold under agreements to repurchase are secured by mortgage-backed securities carried at $27,694,000 and $36,451,000, respectively, at December 31, 2006 and 2005.

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The maturity of the Company’s securities sold under agreement to repurchase at December 31, 2006 is as follows:

(Dollars in thousands)	2007		2008		2009		Total
Repurchase agreements	$	10,900	$	10,900	$	-	$	21,800

Notes Payable to Subsidiary Grantor Trusts

The following is a summary of the notes payable to the Company’s subsidiary grantor trusts at December 31:

(Dollars in thousands)	2006		2005
Subordinated debentures due to Heritage Capital Trust I with
interest payable semi-anually at 10.875%, redeemable with a
premium beginning March 8, 2010 and with no premium beginning
March 8, 2020 and due March 8, 2030	$	7,217	$	7,217
Subordinated debentures due to Heritage Statutory Trust I with
interest payable semi-anually at 10.6%, redeemable with a
premium beginning September 7, 2010 and with no premium beginning
September 7, 2020 and due September 7, 2030		7,206		7,206
Subordinated debentures due to Heritage Statutory Trust II with
interest payable semi-anually based on 3-month Libor plus 3.58%
(8.96% at December 31, 2006), redeemable with a premium beginning
July 31, 2006 and with no premium beginning July 31, 2011 and
due July 31, 2031		5,155		5,155
Subordinated debentures due to Heritage Statutory Trust III with
interest payable semi-anually based on 3-month Libor plus 3.40%
(8.77% at December 31, 2006), redeemable with no premium beginning
September 26, 2007 and due September 26, 2032		4,124		4,124
Total	$	23,702	$	23,702

The Company has guaranteed, on a subordinated basis, distributions and other payments due on the trust preferred securities issued by the subsidiary grantor trusts.

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(7) Income Taxes

Income tax expense consisted of the following:

	December 31,
(Dollars in thousands)	2006			2005		2004
Currently payable tax:
Federal	$	7,472		$	5,921	$	3,439
State		2,084			1,719		923
Total currently payable		9,556			7,640		4,362
Deferred tax (benefit)
Federal		(258	)		(292)		(844)
State		(61	)		(68)		(319)
Total deferred tax (benefit)		(319	)		(360)		(1,163)
Income tax expense	$	9,237		$	7,280	$	3,199

The effective tax rate differs from the federal statutory rate for the years ended December 31, as follows:

	2006			2005			2004
Statutory Federal income tax rate		35.0	%		35.0	%		35.0	%
State income taxes, net of federal tax benefit		5.6	%		4.9	%		7.9	%
Low income housing credits		-3.9	%		-4.3	%		-5.3	%
Non-taxable interest income		-0.2	%		-0.3	%		-2.6	%
Increase in cash surrender value of life insurance		-1.9	%		-2.0	%		-8.8	%
Other		0.2	%		0.2	%		1.2	%
Effective tax rate		34.8	%		33.5	%		27.4	%

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Net deferred tax assets at year-end consist of the following:

(Dollars in thousands)	2006		2005
Deferred tax assets:
Allowance for loan losses	$	3,901	$	4,299
Deferred compensation		4,183		3,564
Securities available-for-sale and I/O strips		646		1,057
Postretirement benefit obligation		799		1,051
Loans held for sale		389		951
Fixed Assets		924		934
Accrued expenses		524		650
State income taxes		729		539
Other		322		2
Total deferred tax assets		12,417		13,047
Deferred tax liabilities:
FHLB Stock		(150)		(63)
Loan fees		(606)		(924)
Prepaid expenses		(277)		(240)
Other		(215)		(307)
Total deferred tax liabilities		(1,248)		(1,534)
Net deferred tax assets	$	11,169	$	11,513

The Company believes that it is more likely than not, that it will realize the above deferred tax assets in future periods; therefore, no valuation allowance has been provided against its deferred tax assets.

(8) Stock option plan

The Company has a stock option plan (the Plan) for directors, officers, and key employees. The Plan provides for the grant of incentive and non-qualified stock options. The Plan provides that the option price for both incentive and non-qualified stock options will be determined by the Board of Directors at no less than the fair value at the date of grant. Options granted vest on a schedule determined by the Board of Directors at the time of grant. Generally, options vest over four years. All options expire no later than ten years from the date of grant. On May 25, 2006, the Company’s shareholders approved an amendment to the Heritage Commerce Corp 2004 Stock Option Plan by authorizing 550,000 additional shares available for option grants. As of December 31, 2006, there are 418,912 shares available for future grants under the Plan.

Option activity under the Plan is as follows:

			Weighted		Weighted Average		Aggregate
	Number		Average		Remaining Contractual		Intrinsic
Total Stock Options	of Shares		Exercise Price		Life (Years)		Value
Outstanding at January 1, 2006		753,978	$	12.92
Granted		222,400	$	23.67
Exercised		(179,594)	$	10.09
Forfeited or expired		(43,801)	$	16.52
Outstanding at December 31, 2006		752,983	$	16.56		7.1	$	7,587,000
Exercisable at December 31, 2006		406,960	$	12.76		5.5	$	5,648,000

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Information related to the stock option plan during each year follows:

	2006		2005		2004
Intrinsic value of options exercised	$	2,435,000	$	3,791,000	$	3,793,000
Cash received from option exercise	$	1,812,000	$	3,641,000	$	4,316,000
Tax benefit realized from option exercises	$	706,000	$	1,086,000	$	1,777,000
Weighted average fair value of options granted	$	7.57	$	5.93	$	5.03

As of December 31, 2006, there was $2,407,000 of total unrecognized compensation cost related to nonvested share-based compensation arrangements granted under the Company’s stock option plan. That cost is expected to be recognized over a weighted-average period of aproximately 2.2 years. The total fair value of options vested during 2006 is approximately $780,000.

The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model that uses the assumptions noted in the following table.

	2006			2005			2004
Expected life in months (1)		84			84			84
Volatility (1)		21	%		21	%		22	%
Weighted average risk-free interest rate (2)		4.85	%		4.14	%		4.10	%
Expected dividends (3)		0.85	%		0	%		0	%

(1)   The expected life of employee stock options represents the weighted average period the stock options are expected to remain outstanding. It is estimated based on historical experience. Volatility is based on the historical volatility of the stock price over the same period of the expected life of the option.

(2)   Based on the U.S. Treasury constant maturity interest rate with a term consistent with the expected life of the option granted.

(3)   The Company began paying cash dividends on the common stock in 2006. Each grant’s dividend yield is calculated by annualizing the most recent quarterly cash dividend and dividing that amount by the market price of the Company’s common stock as of the grant date.

Forfeitures for options granted prior to 2006 were recognized as they occurred. Beginning in 2006, the Company estimates the impact of forfeitures based on historical experience, and has concluded that forfeitures have no significant effect on stock option expense. The Company issues new shares of common stock to satisfy stock option exercises.

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The Company granted 51,000 restricted shares of its common stock to an executive officer pursuant to the terms of a restricted stock agreement, dated March 17, 2005. The grant price was $18.15. Under the terms of the agreement, the restricted shares will vest 25% per year at the end of years three, four, five and six, provided the executive officer is still with the Company, subject to accelerated vesting upon a change of control, termination without cause, termination by the executive officer for good reason (as defined by the executive employment agreement), death or disability. The fair value of stock award at the grant date was $926,000, which is being amortized to expense over the six-year vesting period on the straight-line method. Amortization expense was $154,000 in 2006 and $123,000 in 2005.

(9) Leases

Operating Leases

The Company leases its premises under non-cancelable operating leases with terms, including renewal options, ranging from five to fifteen years. Future minimum payments under the agreements are as follows:

(Dollars in thousands)
Year ending December 31,
2007	$	2,027
2008		1,527
2009		1,305
2010		1,465
2011		1,457
Thereafter		4,978
Total	$	12,759

Rent expense under operating leases was $2,375,000, $2,402,000, and $2,610,000, respectively, in 2006, 2005, and 2004.

(10) Benefit Plans

The Company offers a 401(k) savings plan that allows employees to contribute up to a maximum percentage of their compensation, as established by the Internal Revenue Code. The Company has made a discretionary matching contribution of up to $1,500 for each employee’s contributions in 2006, 2005 and 2004. Contribution expense was $279,000, $271,000, and $292,000 in 2006, 2005 and 2004.

The Company sponsors an employee stock ownership plan. The plan allows the Company to purchase shares on the open market and award those shares to employees. To be eligible to receive an award of shares under this plan, an employee must have worked at least 1,000 hours during the year and must be employed by the Company, or its subsidiary, on December 31. Awards under this plan generally vest over four years. During 2006, 2005 and 2004, the Company made contributions of $400,000, $177,000, and $450,000 into the Plan. At December 31, 2006, the ESOP owned approximately 169,000 shares of the Company’s stock.

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On September 7, 2001, the ESOP borrowed $1,000,000 from an unaffiliated third party lender to fund the purchase of common stock of the Company. This loan was paid off in June 2005. The loan was collateralized by the shares of the Company’s common stock held by the ESOP.

The Company has a nonqualified deferred compensation plan for its directors (“Deferral Plan”). Under the Deferral Plan, a participating director may defer up to 100% of his monthly board fees into the Deferral Plan for up to ten years. Amounts deferred earn interest. The director may elect a distribution schedule of up to ten years. The Company’s deferred compensation obligation of $484,000 and $417,000 as of December 31, 2006 and 2005 is included in “Accrued interest payable and other liabilities.”

The Company has purchased life insurance policies on the lives of directors who have agreed to participate in the Deferral Plan. It is expected that the earnings on these policies will offset the cost of the program. In addition, the Company will receive death benefit payments upon the death of the director. The proceeds will permit the Company to “complete” the deferral program as the director originally intended if he dies prior to the completion of the deferral program. The disbursement of deferred fees is accelerated at death and commences one month after the director dies.

In the event of the director’s disability prior to attainment of his benefit eligibility date, the director may request that the Board permit him to receive an immediate disability benefit equal to the annualized value of the director’s deferral account.

The Company has a supplemental retirement plan covering key executives and directors (“Plan”). The Plan is a nonqualified defined benefit plan and is unsecured and unfunded and there are no Plan assets. The combined number of active and retired/terminated participants in the Plan was 51 at December 31, 2006. The defined benefit represents a stated amount for key executives and directors that generally vests over nine years and is reduced for early retirement. The Company has purchased insurance on the lives of the directors and executive officers in the plan. If the life insurance contract is terminated by the Company, the Company will have the obligation to pay the retirement and death benefits. The accrued pension obligation was $8,576,000 and $7,279,000 as of December 31, 2006 and 2005, respectively, and is included in “Accrued interest payable and other liabilities”. The Plan had accumulated other comprehensive expense before taxes of $1,902,000 and $2,503,000, respectively, as of December 31, 2006 and 2005. The measurement date of the plan is December 31.

The following table sets forth the nonqualified supplemental retirement defined benefit plan’s status at December 31:

(Dollars in thousands)	2006		2005		2004
Change in projected benefit obligation
Projected benefit obligation at beginning of year	$	9,782	$	7,745	$	3,962
Service cost		799		826		473
Interest cost		552		464		386
Actuarial (gain)/loss		(422)		842		2,223
Special termination benefits		-		-		765
Benefits paid		(233)		(95)		(64)
Projected benefit obligation at end of year	$	10,478	$	9,782	$	7,745

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(Dollars in thousands)	2006			2005			2004
Unfunded Status	$	(10,478	)	$	(9,782	)	$	(7,745	)
Unrecognized net actuarial (gain)/loss		1,902			2,503			1,940
Net amount recognized	$	(8,576	)	$	(7,279	)	$	(5,805	)
Accrued benefit liability	$	(10,478	)	$	(9,782	)	$	(7,745	)
Accumulated other comprehensive expense		1,902			2,503			1,940
Net amount recognized	$	(8,576	)	$	(7,279	)	$	(5,805	)
Weighted-average assumptions as of December 31
Discount rate		5.98	%		5.68	%		5.60	%
Rate of compensation increase		N/A			N/A			N/A
Expected return on Plan assets		N/A			N/A			N/A

The following benefit payments, which reflect anticipated future events, as appropriate, are expected to be paid over the following years:

Year (Dollars in thousands)	Benefit Payments
2007	$	239
2008		338
2009		412
2010		441
2011		553
2012 to 2016		5,226

The elements of pension costs for the nonqualified supplemental retirement defined benefit plan were as follows:

(Dollars in thousands)	2006		2005		2004
Components of net periodic benefits cost
Service cost	$	799	$	825	$	473
Interest cost		552		464		386
Amortization of (gain)/loss		180		280		116
Net periodic benefit cost		1,531		1,569		975
Expense due to special termination benefits		-		-		765
Total expense	$	1,531	$	1,569	$	1,740

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The net periodic pension cost was determined using the following assumptions:

	2006			2005			2004
Discount rate in determining expense		5.68	%		5.60	%		6.25	%
Discount rate in determining benefit obligations at year end		5.98	%		5.68	%		5.60	%
Rate of increase in future compensation levels for determining expense		N/A			N/A			N/A
Rate of increase in future compensation levels for determining
benefit obligations at year end		N/A			N/A			N/A
Expected return on Plan assets		N/A			N/A			N/A

(11) Disclosures of Fair Value of Financial Instruments

The estimated fair value amounts have been determined by using available market information and appropriate valuation methodologies. However, considerable judgment is required to interpret market data to develop the estimates of fair value. Accordingly, the estimates presented are not necessarily indicative of the amounts that could be realized in a current market exchange. The use of different market assumptions and/or estimation techniques may have a material effect on the estimated fair value amounts.

The carrying amounts and estimated fair values of the Company’s financial instruments at year-end were as follows:

	2006				2005
			Estimated				Estimated
	Carrying		Fair		Carrying		Fair
(Dollars in thousands)	Amounts		Value		Amounts		Value
Assets
Cash and cash equivalents	$	49,385	$	49,385	$	98,460	$	98,460
Securities		172,298		172,298		198,495		198,495
Loans, including loans held for sale, net		733,709		723,302		748,701		733,217
FHLB and FRB Stock		6,113		6,113		5,859		5,859
Accrued interest receivable		4,876		4,876		4,383		4,383
Liabilities
Time deposits	$	174,073	$	173,953	$	180,622	$	180,884
Other deposits		672,520		672,520		759,137		759,137
Securities sold under agreement to repurchase		21,800		21,421		32,700		31,931
Notes payable subsidiary grantor trusts		23,702		25,820		23,702		26,050
Accrued interest payable		2,048		2,048		1,808		1,808

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The following methods and assumptions were used to estimate the fair value in the table, above:

Cash and Cash Equivalents and Accrued Interest Receivable and Payable

The carrying amount approximates fair value because of the short maturities of these instruments.

Securities

Security fair values are based on market prices or dealer quotes and, if no such information is available, on the rate and term of the security and information about the issuer. The carrying amount is the estimated fair value for Federal Home Loan Bank and Federal Reserve Bank stock.

Loans

Loans with similar financial characteristics are grouped together for purposes of estimating their fair value. Loans are segregated by type such as commercial, term real estate, residential construction, and consumer. Each loan category is further segmented into fixed and adjustable rate interest terms.

The fair value of performing, fixed rate loans is calculated by discounting scheduled future cash flows using estimated market discount rates that reflect the credit and interest rate risk inherent in the loan. The fair value of variable rate loans approximates the carrying amount as these loans generally reprice within 90 days. The fair value of loans held for sale is based on estimated market values.

Deposits

The fair value of deposits with no stated maturity, such as non-interest bearing demand deposits, savings, and money market accounts, approximates the amount payable on demand. The carrying amount approximates the fair value of time deposits with a remaining maturity of less than 90 days. The fair value of all other time deposits is calculated based on discounting the future cash flows using rates currently offered by the Bank for time deposits with similar remaining maturities.

Notes Payable to Subsidiary Grantor Trusts and Securities Sold Under Agreement to Repurchase

The fair values of notes payable to subsidiary grantor trusts and securities sold under agreement to repurchase were determined based on the current market value for like kind instruments of a similar maturity and structure.

Commitments to Fund Loans/Standby Letters of Credit

The fair values of commitments are estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. The amounts of and differences between the carrying value of commitments to fund loans or stand by letters of credit and their fair value is not significant and therefore is not included in the table above.

Limitations

Fair value estimates are made at a specific point in time, based on relevant market information about the financial instruments. These estimates do not reflect any premium or discount that could result from offering for sale at one time the entire holdings of a particular financial instrument. Fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates.

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(12) Commitments and Contingencies

Financial Instruments with Off-Balance Sheet Risk

HBC is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its clients. These financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amounts recognized in the balance sheets.

HBC’s exposure to credit loss in the event of non-performance of the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments. HBC uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. Credit risk is the possibility that a loss may occur because a party to a transaction failed to perform according to the terms of the contract. HBC controls the credit risk of these transactions through credit approvals, limits, and monitoring procedures. Management does not anticipate any significant losses as a result of these transactions.

Commitments to extend credit as of December 31, 2006 and 2005 were as follows:

(Dollars in thousands)	2006		2005
Commitments to extend credit	$	310,200	$	328,031
Standby letters of credit		12,020		6,104
	$	322,220	$	334,135

Generally, commitments to extend credit as of December 31, 2006 are at variable rates, typically based on the prime rate (with a margin). Commitments generally expire within one year.

Commitments to extend credit are agreements to lend to a client as long as there is no violation of conditions established in the contract. Commitments generally have fixed expiration dates or other termination clauses. Since some of the commitments are expected to expire without being drawn upon, the total commitment amount does not necessarily represent future cash requirements. HBC evaluates each client’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by HBC upon the extension of credit, is based on management’s credit evaluation of the borrower. Collateral held varies but may include cash, marketable securities, accounts receivable, inventory, property, plant and equipment, income-producing commercial properties, and/or residential properties. Fair value of these instruments is not material.

Standby letters of credit are written with conditional commitments issued by HBC to guaranty the performance of a client to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to clients.

The Company is required to maintain noninterest bearing reserves. Reserve requirements are based on a percentage of certain deposits. As of December 31, 2006, the Company maintained reserves of $5,246,000 in the form of vault cash and balances at the Federal Reserve Bank of San Francisco, which satisfied the regulatory requirements.

Claims

The Company is involved in certain legal actions arising from normal business activities. Management, based upon the advice of legal counsel, believes the ultimate resolution of all pending legal actions will not have a material effect on the financial statements of the Company.

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(13) Capital Requirements

The Company and its subsidiary bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory - and possibly additional discretionary - actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial statements and operations. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and HBC must meet specific capital guidelines that involve quantitative measures of assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.

Quantitative measures established by regulation to ensure capital adequacy require the Company and HBC to maintain minimum amounts and ratios (set forth in the table below) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital to average assets (as defined). Management believes that, as of December 31, 2006 and 2005, the Company and HBC meet all capital adequacy guidelines to which they are subject.

The most recent notification from the FDIC as of December 31, 2006 categorized HBC as “well capitalized” under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the Bank’s category.

The Company’s actual and required consolidated capital amounts and ratios are presented in the following table:

	Actual				For Capital Adequacy Purposes
(Dollars in thousands)	Amount		Ratio		Amount		Ratio
As of December 31, 2006
Total Capital	$	157,356		18.4%	$	68,416		8.0	%
(to risk-weighted assets)
Tier 1 Capital	$	147,600		17.3%	$	34,127		4.0	%
(to risk-weighted assets)
Tier 1 Capital	$	147,600		13.6%	$	43,412		4.0	%
(to average assets)
As of December 31, 2005
Total Capital	$	144,142		15.3%	$	75,528		8.0	%
(to risk-weighted assets)
Tier 1 Capital	$	133,715		14.2%	$	37,764		4.0	%
(to risk-weighted assets)
Tier 1 Capital	$	133,715		11.6%	$	46,308		4.0	%
(to average assets)

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HBC’s actual capital and required amounts and ratios are presented in the following table.

									To Be Well-Capitalized Under Prompt
	Actual				For Capital Adequacy Purposes				Corrective Action Provisions
(Dollars in thousands)	Amount		Ratio		Amount		Ratio		Amount		Ratio
As of December 31, 2006
Total Capital	$	154,711		18.1%	$	68,381		8.0%	$	85,476		10.0	%
(to risk-weighted assets)
Tier 1 Capital	$	144,955		17.0%	$	34,107		4.0%	$	51,161		6.0	%
(to risk-weighted assets)
Tier 1 Capital	$	144,955		13.4%	$	43,270		4.0%	$	54,088		5.0	%
(to average assets)
As of December 31, 2005
Total Capital	$	142,776		15.2%	$	75,180		8.0%	$	93,975		10.0	%
(to risk-weighted assets)
Tier 1 Capital	$	132,349		14.1%	$	37,590		4.0%	$	56,385		6.0	%
(to risk-weighted assets)
Tier 1 Capital	$	132,349		11.3%	$	46,896		4.0%	$	58,620		5.0	%

Under California law, the holders of common stock are entitled to receive dividends when and as declared by the Board of Directors, out of funds legally available therefore. The California Banking Law provides that a state-licensed bank may not make a cash distribution to its shareholders in excess of the lesser of the following: (i) the bank’s retained earnings, or (ii) the bank’s net income for its last three fiscal years, less the amount of any distributions made by the bank to its shareholders during such period. However, a bank, with the prior approval of the Commissioner, may make a distribution to its shareholders of an amount not to exceed the greater of (i) a bank’s retained earnings, (ii) its net income for its last fiscal year, or (iii) its net income for the current fiscal year. In the event that the Commissioner determines that the shareholders’ equity of a bank is inadequate or that the making of a distribution by a bank would be unsafe or unsound, the Commissioner may order a bank to refrain from making such a proposed distribution. At December 31, 2006, the amount available for such dividends without prior regulatory approval was approximately $36,918,000 for HBC. Similar restrictions apply to the amounts and sum of loan advances and other transfers of funds from HBC to the parent Company.

83

(14) Parent Company only Condensed Financial Information

The condensed financial statements of Heritage Commerce Corp (parent company only) are as follows:

Condensed Balance Sheets
	December 31,
(Dollars in thousands)	2006		2005
Assets
Cash and cash equivalents	$	2,104	$	2,776
Investment in subsidiary bank		143,175		131,297
Investment in subsidiary trusts		702		702
Other assets		1,131		1,117
Total assets	$	147,112	$	135,892
Liabilities and Shareholders' Equity
Notes payable to subsidiary trusts	$	23,702	$	23,702
Other liabilities		590		573
Shareholders' equity		122,820		111,617
Total liabilities and shareholders' equity	$	147,112	$	135,892

Condensed Statements of Income and Comprehensive Income
	For the Year Ended December 31,
(Dollars in thousands)	2006			2005			2004
Interest income	$	27		$	63		$	97
Dividend from subsidiary bank		10,000			-			-
Interest expense		(2,310	)		(2,136	)		(1,958)
Other expenses		(1,431	)		(1,130	)		(1,166)
Income (loss) before equity in undistributed net income of subsidiary bank		6,286			(3,203	)		(3,027)
Equity in undistributed net income of subsidiary bank		9,666			16,576			10,676
Income tax benefit		1,318			1,073			829
Net income		17,270			14,446			8,478
Other comprehensive income (loss)		726			(991	)		(1,809)
Comprehensive income	$	17,996		$	13,455		$	6,669

84

Condensed Statements of Cash Flows
	For the Year Ended December 31,
(Dollars in thousands)	2006		2005			2004
Cash flows from operating activities:
Net Income	$	17,270	$	14,446		$	8,478
Adjustments to reconcile net income to net cash provided by (used in) operations:
Amortization of restricted stock award		154		123			-
Equity in undistributed net income of subsidiary bank		(9,666)		(16,576)			(10,676)
Net change in other assets and liabilities		3		(944)			796
Net cash provided by (used in) operating activities		7,761		(2,951)			(1,402)
Cash flows from financing activities:
Exercise of stock options		1,812		3,641			4,316
Common stock repurchased		(7,888)		(5,732	)		(4,214)
Dividends paid		(2,357)		-			-
Other, net		-		(12)			250
Net cash provided by (used in) financing activities		(8,433)		(2,103)			352
Net decrease in cash and cash equivalents		(672)		(5,054)			(1,050)
Cash and cash equivalents, beginning of year		2,776		7,830			8,880
Cash and cash equivalents, end of year	$	2,104	$	2,776		$	7,830

(15) Quarterly Financial Data (Unaudited)

The following table discloses the Company’s selected unaudited quarterly financial data:

	For the Quarters Ended
(Dollars in thousands, except per share amounts)	12/31/06		09/30/06		06/30/06			03/31/06
Interest income	$	18,737	$	18,568	$	18,392		$	17,260
Interest expense		5,936		5,754		5,766			5,069
Net interest income		12,801		12,814		12,626			12,191
Provision for loan losses		100		0		(114	)		(489	)
Net interest income after provision for loan losses		12,701		12,814		12,740			12,680
Noninterest income		2,390		2,299		2,257			2,894
Noninterest expense		8,703		8,312		8,492			8,761
Income before income taxes		6,388		6,801		6,505			6,813
Income tax expense		2,036		2,448		2,316			2,437
Net income	$	4,352	$	4,353	$	4,189		$	4,376
Earnings per share
Basic	$	0.37	$	0.37	$	0.35		$	0.37
Diluted	$	0.37	$	0.36	$	0.35		$	0.36

85

	For the Quarters Ended
(Dollars in thousands, except per share amounts)	12/31/05		09/30/05			06/30/05		03/31/05
Interest income	$	17,588	$	16,469		$	15,299	$	14,400
Interest expense		4,773		4,269			3,668		3,197
Net interest income		12,815		12,200			11,631		11,203
Provision for loan losses		0		(494	)		394		413
Net interest income after provision for loan losses		12,815		12,694			11,237		10,790
Noninterest income		2,204		2,224			2,638		2,357
Noninterest expense		8,567		8,478			8,878		9,310
Income before income taxes		6,452		6,440			4,997		3,837
Income tax expense		2,194		2,245			1,657		1,184
Net income	$	4,258	$	4,195		$	3,340	$	2,653
Earnings per share
Basic	$	0.36	$	0.36		$	0.28	$	0.23
Diluted	$	0.35	$	0.35		$	0.27	$	0.22

(16) Subsequent Event (Unaudited)

On February 8, 2007, the Company, HBC and Diablo Valley Bank (“Diablo”) entered into an Agreement and Plan of Merger (the “Merger Agreement”), pursuant to which, among other things, Diablo will merge with and into HBC, with HBC surviving the merger (the “Merger”) in a cash and stock transaction valued at approximately $70 million. The Merger Agreement has been unanimously approved by the Boards of Directors of the Company, HBC and Diablo. The Merger is subject to regulatory approval and approval by the Diablo shareholders. The transaction is expected to close during the second or third quarter of 2007.

86

EXHIBIT INDEX

			Incorporated by Reference to Form
		Filed Herewith		Form S-8	8-K or 8-A Dated	10-Q Dated	10-K Dated	Exhibit No.
2.1	Agreement and Plan of Merger, dated February 8, 2007, by and between Heritage Commerce Corp, Heritage Bank of Commerce and Diablo Valley Bank	X
3.1	Heritage Commerce Corp Restated Articles of Incorporation as Amended effective May 26, 2005				6/2/05			3.1
3.2	Heritage Commerce Corp Bylaws as amended to May 26, 2005				6/2/05			3.2
4.1	The indenture, dated as of March 23, 2000, between Heritage Commerce Corp, as Issuer, and the Bank of New York, as Trustee						4-6-01 (10-K/A Amendment No. 1)	4.1
4.2	Amended and restated Declaration of Trust, Heritage Capital Trust I, dated as of March 23, 2000						4-6-01 (10-K/A Amendment No. 1)	4.2
4.3	The indenture, dated as of September 7, 2000, between Heritage Commerce Corp, as Issuer, and State Street Bank and Trust Company, of Connecticut, National Association, as Trustee						4-6-01 (10-K/A Amendment No. 1)	4.3
4.4	Amended and restated Declaration of Trust, Heritage Commerce Corp Statutory Trust I, dated as of September 7, 2000						4-6-01 (10-K/A Amendment No. 1)	4.4
4.5	The indenture, dated as of July 31, 2001, between Heritage Commerce Corp, as Issuer, and State Street Bank and Trust Company, of Connecticut, National Association, as Trustee						3/28/02	4.5
4.6	Amended and restated Declaration of Trust, Heritage Statutory Trust II, dated as of July 31, 2001	87					3/28/02	4.6
4.7	The indenture, dated as of September 26, 2002, between Heritage Commerce Corp, as Issuer, and State Street Bank and Trust Company, of Connecticut, National Association, as Trustee						3/28/03	4.7
4.8	Amended and restated Declaration of Trust, Heritage Commerce Corp Statutory Trust III, dated as of September 26, 2002						3/28/03	4.8
10.1	Real Property Leases for properties located at 150 Almaden Blvd., San Jose.				6/21/05			10.1
10.2	Heritage Commerce Corp Management Incentive Plan				5/3/05			10.2
10.3	Employment agreement with Mr. McGovern dated July 16, 1998 *						3-31-99	10.3
10.4	Agreement between Fiserv Solutions, Inc. and Heritage Commerce Corp dated October 20, 2003						3-12-04	10.4
10.5	Employment agreement with Mr. Corsello dated May 11, 2001, with an amendment dated May 11, 2004 *						03/31/05	10.5
10.6	1994 Stock Option Plan and Form of Agreement			07/17/98				10.6
10.7	2004 Stock Option Plan and Form of Agreement			7/16/04				10.7
10.8	Employment agreement with Mr. Kaczmarek dated March 17, 2005 *				03/22/05			10.8
10.9	Restricted stock agreement with Mr. Kaczmarek dated March 17, 2005				03/22/05			10.9
10.10	2004 stock option agreement with Mr. Kaczmarek dated March 17, 2005				03/22/05			10.10
10.11	Non-qualified Deferred Compensation Plan						03/31/05	10.11
10.12	Director Deferred Fee Agreement with James R. Blair dated June 30, 1997	88					03/31/05	10.12
10.13	Director Deferred Fee Agreement with Jack Peckham dated June 30, 1997						03/31/05	10.13
10.14	Purchase Agreement dated January 31, 2006 between Heritage Commerce Corp and County Bank						3/28/06
10.15	Employment agreement with Raymond Parker dated May 16, 2005 *				5/18/05
10.16	Third Amendment to Lease for Registrant’s Principle Office				8/17/05
10.17	Fourth Amendment to Lease for Registrant’s Principle Office				8/17/05
10.18	Fourth Amendment to Sublease for Registrant’s Principle Office				6/21/05
10.19	Employment agreement with Richard Hagarty dated July 27, 2006*				8/1/06
21.1	Subsidiaries of the registrant	X
23.1	Consent of Deloitte & Touche LLP	X
23.2	Consent of Crowe Chizek and Company LLP	X
31.1	Certification of Registrant’s Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002	X
31.2	Certification of Registrant’s Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002	X
32.1	Certification of Registrant’s Chief Executive Officer Pursuant to 18 U.S.C. Section 1350	X
32.2	Certification of Registrant’s Chief Financial Officer Pursuant to 18 U.S.C. Section 1350	X

* Management contract or compensatory plan or arrangement.

89

EX-2.1

Exhibit 2.1

AGREEMENT AND PLAN OF MERGER

BY AND BETWEEN

HERITAGE COMMERCE CORP

HERITAGE BANK OF COMMERCE

AND

DiABLO VALLEY BANK

dated as of February 8, 2007

TABLE OF CONTENTS

		Page
ARTICLE  I	THE MERGER AND RELATED TRANSACTIONS	2
Section 1.1	Structure and Effect of the Merger	2
Section 1.2	Effective Date and Effective Time; Closing	3
Section 1.3	Alternative Structure	3
ARTICLE  II	EFFECT OF THE MERGER ON THE CAPITAL STOCK OF THE CONSTITUENT CORPORATIONS	4
Section 2.1	Effect on Capital Stock	4
Section 2.2	Conversion of Diablo Common Stock	4
Section 2.3	Proration	5
Section 2.4	Stock Options	6
Section 2.5	Conversion of Dissenting Common Stock	7
ARTICLE  III	EXCHANGE OF SHARES	7
Section 3.1	Election Procedures	7
Section 3.2	Deposit of Merger Consideration	9
Section 3.3	Delivery of Merger Consideration	9
Section 3.4	Withholding Rights	11
Section 3.5	No Liability	12
ARTICLE IV	CONDUCT PENDING THE MERGER	12
Section 4.1	Conduct of Diablo’s Business Prior to the Effective Time	12
Section 4.2	Forbearance By Diablo	12
Section 4.3	Conduct by Heritage and HBC Prior to the Effective Time	16
ARTICLE V	REPRESENTATIONS AND WARRANTIES	17
Section 5.1	Representations and Warranties of Diablo	17
Section 5.2	Representations and Warranties of Heritage	33
ARTICLE VI	COVENANTS OF HERITAGE AND HBC	39
Section 6.1	Material Adverse Changes; Reports; Financial Statements; Filings	39
Section 6.2	Rule 144 Compliance	40
Section 6.3	Access	40
Section 6.4	Listing of Heritage Stock	40
Section 6.5	Appointment of Heritage Directors	40
Section 6.6	Participation in Subsequent Transactions	40
Section 6.7	Benefit Plans	41
Section 6.8	Compliance with Anti-Money Laundering Laws	42
ARTICLE VII	COVENANTS OF DIABLO	42
Section 7.1	Access	42
Section 7.2	Material Adverse Changes; Reports; Financial Statements; Filings Notifications	43
Section 7.3	Certain Loans and Other Extensions of Diablo	44
Section 7.4	Delivery Of Supplements To Disclosure Schedule	44
Section 7.5	Shareholder Approval	44
Section 7.6	Certain Transactions	45
Section 7.7	Shareholder Agreements	45
Section 7.8	Affiliates	45
Section 7.9	Access to Operations	45
Section 7.10	Access to Employees	45
Section 7.11	Transition	47
Section 7.12	Stock Options	47
Section 7.13	Third Party Consents; Estoppel; Title	47
i
ARTICLE VIII	FURTHER COVENANTS OF HERITAGE AND DIABLO	48
Section 8.1	Form S-4 and Proxy Statement	48
Section 8.2	Appropriate Actions; Consents; Filings	48
Section 8.3	Cooperation	49
Section 8.4	Establishment of Accruals	49
Section 8.5	[Intentionally deleted]	50
Section 8.6	Publicity	50
Section 8.7	Notices and Communications	50
Section 8.8	Insurance Policies Assignment	50
Section 8.9	Indemnification of Directors and Officers	50
Section 8.10	Confidentiality	51
ARTICLE IX	CONDITIONS TO THE PARTIES’ OBLIGATIONS TO CLOSE	51
Section 9.1	Conditions to Each Party’s Obligations to Close	51
Section 9.2	Additional Conditions to Obligations of Heritage and HBC to Close	52
Section 9.3	Additional Conditions to Obligations of Diablo to Close	56
ARTICLE X	TERMINATION	58
Section 10.1	Termination	58
Section 10.2	Effect of Termination	61
ARTICLE XI	OTHER MATTERS	62
Section 11.1	Certain Definitions; Interpretations	62
Section 11.2	Non-Survival of Representations, Warranties and Covenants	69
Section 11.3	Waiver and Modification	69
Section 11.4	Counterparts	70
Section 11.5	Governing Law, Jurisdiction and Venue	70
Section 11.6	Notices	70
Section 11.7	Entire Agreement	71
Section 11.8	Binding Effect; Assignment	71
Section 11.9	Severability	71
Section 11.10	No Third party Beneficiaries	71
Section 11.11	Specific Performance	72
Section 11.12	Expenses	72

ii

EXHIBITS

A-MERGER AGREEMENT

B-SHAREHOLDERS AGREEMENT

C-AFFILIATES LETTER

iii

AGREEMENT AND PLAN OF MERGER

This AGREEMENT AND PLAN OF MERGER (this “Agreement”) is made and entered into as of the 8^th day of February, 2007, by and among HERITAGE COMMERCE CORP, a California corporation and bank holding company under the Bank Holding Company Act of 1956, as amended, with its principal offices in San Jose, California (“Heritage”), HERITAGE BANK OF COMMERCE, a California banking corporation with its principal offices in San Jose, California (“HBC”) and DIABLO VALLEY BANK, a California banking corporation with its principal offices in Danville, California (“Diablo”).

RECITALS

A.HBC is a California state-chartered bank and a wholly-owned subsidiary of Heritage.

B.Diablo is a California state-chartered bank.

C.Heritage, HBC and Diablo believe it would be in their respective best interest and in the best interests of their respective shareholders for Diablo to merge with and into HBC (the “Merger”) with HBC as the surviving corporation in the Merger.

D.Heritage, HBC and Diablo desire to set forth certain representations, warranties and covenants made by each to the other as an inducement to the execution and delivery of this Agreement and certain additional agreements related to the transactions contemplated hereby.

E.As a condition to, and simultaneously with the execution of this Agreement, certain shareholders of Diablo are entering into an agreement pursuant to which such shareholder has agreed, upon the terms and conditions set forth therein, among other things, to vote his or her shares in favor of the Merger and transactions contemplated by this Agreement.

F.The Merger is intended to qualify as a tax-free reorganization within the meaning of the provisions of Section 368 of the Internal Revenue Code of 1986, as amended (the “Code”).

G.The respective boards of directors of Heritage, HBC and Diablo have approved this Agreement and the proposed transactions substantially on the terms and conditions set forth in this Agreement and the schedules and exhibits hereto and have authorized the execution thereof.

NOW, THEREFORE, for and in consideration of the foregoing and of the mutual representations, warranties, covenants and agreements contained in this Agreement, and other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, and subject to the conditions set forth below, the parties hereto undertake, promise, covenant and agree with each other as follows:

1

ARTICLE I

THE MERGER AND RELATED TRANSACTIONS

Section 1.1STRUCTURE AND EFFECT OF THE MERGER.

(a)SUBJECT TO THE terms and conditions of this Agreement and the Merger Agreement substantially in the form of Exhibit A hereto (the “Merger Agreement”), Diablo shall be merged with and into HBC at the Effective Time (as such term is defined in Section 1.2) in accordance with the provisions of the California General Corporation Law (the “CGCL”) and California Financial Code (the “Financial Code”). HBC shall be the surviving corporation in the Merger and shall continue its corporate existence under the laws of the State of California. HBC as the surviving corporation after the Merger, is hereinafter sometimes referred to as the “surviving corporation”.

(b)At the Effective Time, (i) the separate corporate existence of Diablo shall cease, (ii) the Articles of Incorporation and Bylaws of HBC as in effect immediately prior to the Effective Time shall be the Articles of Incorporation and Bylaws of the surviving corporation, (iii) HBC shall continue operation as a California state-chartered bank and its corporate existence under the laws of the State of California, and (iv) the name of the surviving corporation shall be “Heritage Bank of Commerce.”

(c)The directors of the surviving corporation immediately after the Merger shall be the directors of HBC immediately prior to the Merger, provided, however, that HBC shall have taken prior to the Effective Time all the necessary steps so that at the Effective Time (i) the number of directors of HBC shall be increased by two and (ii) John J. Hounslow and Mark E. Lefanowicz shall be added to the HBC board of directors and serve until their successors are duly elected and qualified. The executive officers of the surviving corporation immediately after the Merger shall be the executive officers of HBC immediately prior to the Merger, provided, however, that HBC shall have taken prior to the Effective Time all the necessary steps so that at the Effective Time James A. Mayer shall be elected as an Executive Vice President of HBC.

(d)At the Effective Time, the effect of the Merger shall be as provided in accordance with the CGCL and Financial Code as established by the California Commissioner of Financial Institutions (the "Commissioner"). Without limiting the generality of the foregoing, and subject thereto, at the Effective Time, all the property, rights, privileges, powers and franchises of Diablo shall vest in the surviving corporation, and all debts, liabilities, obligations, restrictions, disabilities and duties of Diablo shall become the debts, liabilities, obligations, restrictions, disabilities and duties of the surviving corporation.

(e)If, at any time after the Effective Time, the surviving corporation shall consider that any further assignments or assurances in law or any other acts are necessary or desirable to (i) vest, perfect or confirm, of record or otherwise, in the surviving corporation its right, title or interest in, to or under any of the rights, properties or assets of Diablo acquired or to be acquired by the surviving corporation as a result of, or in connection with, the Merger, or (ii) otherwise carry out the purposes of this Agreement, Diablo, and its proper officers and directors, shall be deemed to have granted to the surviving corporation an irrevocable power of attorney to execute and deliver all such proper deeds, assignments and assurances in law and to do all acts necessary or proper to vest, perfect or confirm title to and possession of such rights, properties or assets in the surviving corporation and otherwise to carry out the purposes of this Agreement, and the proper officers and directors of the surviving corporation are fully authorized in the name of the surviving corporation or otherwise to take any and all such action.

2

Section 1.2EFFECTIVE DATE AND EFFECTIVE TIME; Closing.

(a)AS SOON AS PRACTICABLE on a date mutually agreeable to Heritage and Diablo after each of the conditions set forth in Article IX hereof have been satisfied or waived and receipt of all required corporate, regulatory, shareholder and other approvals and the expiration of any mandatory waiting or notice periods, the parties will file, or cause to be filed, with the California Secretary of State and the Commissioner, the Merger Agreement and such certificates and other documents as Heritage or HBC may deem necessary or appropriate for the Merger, which Merger Agreement and certificates and other documents shall in each case be in the form required by and executed in accordance with the applicable provisions of the CGCL and the Financial Code. The Merger shall become effective at the time the Merger Agreement and certificate of merger for such merger is filed with the California Secretary of State and the Commissioner (“Effective Time”). The date of such filings or such later effective date is herein called the “Effective Date.” The “Effective Time” of the Merger shall be the time established by the Commissioner.

(b)On a date mutually agreeable to Heritage and Diablo which is not more than five (5) Business Days after the receipt of all necessary regulatory, corporate, shareholder and other approvals and the expiration of any mandatory waiting periods, or on such other date mutually agreeable to Heritage and Diablo (herein called the “Closing Date”), a meeting (the “Closing”) will take place at the offices of Heritage in San Jose, California on the Closing Date (or at such other place to which the parties may mutually agree) at which the parties to this Agreement will exchange certificates, opinions, letters and other documents in order to determine whether all of the conditions set forth in Article IX of this Agreement have been satisfied or waived or whether any condition exists that would permit a party to this Agreement to terminate this Agreement. If no such condition then exists, or if no party elects to exercise any right it may have to terminate this Agreement, then and thereupon the appropriate parties shall execute such documents and instruments as may be necessary or appropriate in order to effect the transactions contemplated by this Agreement.

Section 1.3ALTERNATIVE STRUCTURE. After consultation with Diablo, Heritage shall have the right, exercisable at any time prior to the Effective Time to change the method of effecting the acquisition of Diablo, if and to the extent Heritage deems such changes to be necessary, appropriate or desirable and Diablo shall take all necessary corporate and other reasonable actions to give effect to such change and shall execute, deliver and file any and all agreements and other documents necessary to effect the consummation of the transactions contemplated by such change; provided, however, that in no event shall Diablo be required to take any action set forth above or agree to any such change if such action or change could reasonably be expected to or would (x) alter or change the amount or kind of the merger consideration or the rights of or obligations to Diablo hereunder, or (y) diminish the benefits to be received by the directors, officers or employees of Diablo as set forth in this Agreement or substantially delay the delivery of the Merger Consideration, including, without limitation, any adverse effect upon the tax free treatment thereof, or (z) materially impede or delay the consummation of the Merger otherwise be materially prejudicial to the interests of the Diablo shareholders.

3

ARTICLE II

EFFECT OF THE MERGER ON THE CAPITAL

STOCK OF THE CONSTITUENT CORPORATIONS

Section 2.1EFFECT ON CAPITAL STOCK. Subject to the other provisions of this Article II, at the Effective Time, by virtue of the Merger and without any additional action on the part of the holders of shares of stock of Heritage, HBC and Diablo:

(a)COMMON STOCK OF Heritage. Each share of common stock, no par value per share, of Heritage (“Heritage Common Stock”), issued and outstanding immediately prior to the Effective Time shall remain an issued and outstanding share of common stock of Heritage, and shall not be affected by the Merger;

(b)Common Stock of HBC. Each share of common stock, no par value per share, of HBC (“HBC Common Stock”), issued and outstanding immediately prior to the Effective Time shall remain an issued and outstanding share of common stock of the surviving corporation, and shall not be affected by the Merger;

(c)Common Stock of Diablo. Each share of common stock, no par value per share, of Diablo (“Diablo Common Stock”) issued and outstanding immediately prior to the Effective Time (other than shares of Dissenting Common Stock (as defined in Section 2.1(d)) and Treasury Shares (as defined in Section 2.1(e)) shall be automatically cancelled and cease to be an issued and outstanding share of Diablo Common Stock and shall be converted into the right to receive Heritage Common Stock or cash as provided in Section 2.2(a);

(d)Dissenting Common Stock. Each share of Diablo Common Stock that is a “dissenting share” within the meaning of Chapter 13 of the CGCL (“Dissenting Common Stock”) shall not be converted into or represent a right to receive Heritage Common Stock or cash hereunder unless and until such shares have lost their status as dissenting shares under Chapter 13 of the CGCL, at which time such shares shall be converted into Heritage Common Stock and cash pursuant to Section 2.5; and

(e)Cancellation of Certain Shares. Any shares of Diablo Common Stock held by Heritage or HBC or by Diablo, other than those held in a fiduciary capacity (“Treasury Shares”), shall be canceled and retired at the Effective Time and no consideration shall be issued in exchange therefor.

Section 2.2CONVERSION OF Diablo Common Stock.

(a)SUBJECT TO THE OTHER PROVISIONS OF THIS ARTICLE II, each share of Diablo Common Stock issued and outstanding immediately prior to the Effective Time (other than Dissenting Common Stock and Treasury Shares) shall at the election of the holder thereof, by virtue of the Merger, be converted into the right to receive the following without interest:

4

(i)FOR EACH SHARE OF DIABLO COMMON STOCK WITH RESPECT TO WHICH AN ELECTION TO RECEIVE CASH HAS BEEN EFFECTIVELY MADE AND NOT REVOKED OR DEEMED REVOKED (A “Cash Election”), the right to receive in cash an amount (the “Cash Consideration”) equal to the Per Share Consideration (the “Cash Per Share Amount”) (collectively, the “Cash Election Shares”);

(ii)for each share of Diablo Common Stock with respect to which an election to receive stock has been effectively made and not revoked or deemed revoked (a “Stock Election”), the right to receive the fraction of a share of Heritage Common Stock (the “Stock Consideration”) equal to the Exchange Ratio; provided, however, that if the Average Closing Price is less than $23.50, Heritage may terminate this Agreement pursuant to Section 10.1(h) (collectively, the “Stock Election Shares”); and,

(iii)for each share of Diablo Common Stock other than shares to which a Cash Election or a Stock Election has been effectively made and not revoked (collectively, the “Non-Election Shares”), the right to receive such Stock Consideration and/or Cash Consideration as is determined in accordance with Section 2.3.

The Cash Consideration and Stock Consideration are sometimes referred to herein collectively on the “Merger Consideration.”

(b)IF, BETWEEN THE DATE HEREOF AND THE EFFECTIVE TIME, THE OUTSTANDING SHARES OF HERITAGE COMMON STOCK SHALL HAVE BEEN INCREASED, DECREASED, CHANGED INTO OR EXCHANGED FOR A DIFFERENT NUMBER OR KIND OF SHARES OR SECURITIES AS A RESULT OF A REORGANIZATION, RECAPITALIZATION, RECLASSIFICATION, STOCK DIVIDEND, STOCK SPLIT, REVERSE STOCK SPLIT, OR OTHER SIMILAR CHANGE IN CAPITALIZATION (A “Share Adjustment”), then the shares of Heritage Common Stock into which a share of Diablo Common Stock shall be converted pursuant to this Sections 2.2 shall be appropriately and proportionately adjusted so that each shareholder of Diablo shall be entitled to receive the Exchange Ratio such shareholder would have received pursuant to such Share Adjustment had the record date therefor been immediately following the Effective Time.

Section 2.3PRORATION.

(a)NOTWITHSTANDING ANY OTHER PROVISION CONTAINED IN THIS AGREEMENT, THE NUMBER OF SHARES OF DIABLO COMMON STOCK THAT WILL BE CONVERTED INTO CASH CONSIDERATION PURSUANT TO SECTION 2.2 SHALL BE EQUAL TO THE QUOTIENT OBTAINED BY DIVIDING (X) THE TOTAL CASH CONSIDERATION, BY (Y) THE PER SHARE CONSIDERATION (WHICH, FOR THIS PURPOSE, SHALL BE DEEMED TO INCLUDE THE DISSENTING COMMON STOCK DETERMINED AS OF THE EFFECTIVE TIME) (THE “Cash Conversion Number”). All other shares of Diablo Common Stock shall be converted into Stock Consideration.

(b)Within five (5) Business Days after the Effective Time, Heritage shall cause the Exchange Agent (as defined below) to effect the allocation among holders of Diablo Common Stock of rights to receive the Cash Consideration and the Stock Consideration as follows:

(i)IF THE AGGREGATE NUMBER OF SHARES OF Diablo Common Stock with respect to which Cash Elections shall have been made (which, for this purpose, shall be deemed to include the Dissenting Common Stock determined as of the Effective Time) (the “Cash Election Number”) exceeds the Cash Conversion Number, then all Stock Election Shares and all Non-Election Shares shall be converted into the right to receive the Stock Consideration, and Cash Election Shares of each holder thereof will be converted into the right to receive the Cash Consideration in respect of that number of Cash Election Shares equal to the product obtained by multiplying (x) the number of Cash Election Shares held by such holder by (y) a fraction, the numerator of which is the Cash Conversion Number and the denominator of which is the Cash Election Number (with the Exchange Agent to determine, consistent with Section 2.3(a), whether fractions of Cash Election Shares shall be rounded up or down), with the remaining number of such holder’s Cash Election Shares being converted into the right to receive the Stock Consideration; and

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(ii)If the Cash Election Number is less than the Cash Conversion Number (the amount by which the Cash Conversion Number exceeds the Cash Election Number being referred to herein as the “Shortfall Number”), then all Cash Election Shares shall be converted into the right to receive the Cash Consideration and the Non-Election Shares and Stock Election Shares shall be treated in the following manner:

(A)IF THE SHORTFALL NUMBER IS LESS THAN OR EQUAL TO THE NUMBER OF NON-ELECTION SHARES, THEN ALL STOCK ELECTION SHARES SHALL BE CONVERTED INTO THE RIGHT TO RECEIVE THE STOCK CONSIDERATION, AND THE NON-ELECTION SHARES OF EACH HOLDER THEREOF SHALL CONVERT INTO THE RIGHT TO RECEIVE THE CASH CONSIDERATION IN RESPECT OF THAT NUMBER OF NON-ELECTION SHARES EQUAL TO THE PRODUCT OBTAINED BY MULTIPLYING (X) THE NUMBER OF NON-ELECTION SHARES HELD BY SUCH HOLDER BY (Y) A FRACTION, THE NUMERATOR OF WHICH IS THE SHORTFALL NUMBER AND THE DENOMINATOR OF WHICH IS THE TOTAL NUMBER OF NON-ELECTION SHARES (WITH THE EXCHANGE AGENT TO DETERMINE, CONSISTENT WITH SECTION 2.3(A), WHETHER FRACTIONS OF NON-ELECTION SHARES SHALL BE ROUNDED UP OR DOWN), WITH THE REMAINING NUMBER OF SUCH HOLDER’S NON-ELECTION SHARES BEING CONVERTED INTO THE RIGHT TO RECEIVE THE STOCK CONSIDERATION; OR

(B)IF THE SHORTFALL NUMBER EXCEEDS THE NUMBER OF NON-ELECTION SHARES, THEN ALL NON-ELECTION SHARES SHALL BE CONVERTED INTO THE RIGHT TO RECEIVE THE CASH CONSIDERATION, AND STOCK ELECTION SHARES OF EACH HOLDER THEREOF SHALL CONVERT INTO THE RIGHT TO RECEIVE THE CASH CONSIDERATION IN RESPECT OF THAT NUMBER OF STOCK ELECTION SHARES EQUAL TO THE PRODUCT OBTAINED BY MULTIPLYING (X) THE NUMBER OF STOCK ELECTION SHARES HELD BY SUCH HOLDER BY (Y) A FRACTION, THE NUMERATOR OF WHICH IS THE AMOUNT BY WHICH (1) THE SHORTFALL NUMBER EXCEEDS (2) THE TOTAL NUMBER OF NON-ELECTION SHARES, AND THE DENOMINATOR OF WHICH IS THE TOTAL NUMBER OF STOCK ELECTION SHARES (WITH THE EXCHANGE AGENT TO DETERMINE, CONSISTENT WITH SECTION 2.3(A), WHETHER FRACTIONS OF STOCK ELECTION SHARES SHALL BE ROUNDED UP OR DOWN), WITH THE REMAINING NUMBER OF SUCH HOLDER’S STOCK ELECTION SHARES BEING CONVERTED INTO THE RIGHT TO RECEIVE THE STOCK CONSIDERATION.

Section 2.4STOCK OPTIONS. Prior to the Effective Time, in addition to the amount of cash equal to the Total Cash Consideration, Heritage will deposit with the Exchange Agent an amount in cash sufficient to pay the aggregate amount of all cash payments required by this Section 2.4. Each such cash payment will be paid by the Exchange Agent on behalf of Heritage to each holder of an outstanding Diablo option at the Effective Time and reduced by any required withholding Taxes. Prior to the Effective Time, Diablo shall take appropriate action such that each option to purchase shares of the Diablo Common Stock that is outstanding and unexercised immediately prior to the Effective Time including all options granted by Diablo pursuant to The Diablo Valley Bank 2003 Stock Option Plan (the “Stock Option Plan”), shall be canceled by Diablo in consideration of the payment by the Exchange Agent to each holder of such option of an aggregate amount in cash equal to the positive difference, if any, between (a) the Per Share Consideration times the number of shares of Diablo Common Stock as to which such holder has options, and (b) the aggregate exercise price of such options. At the Effective Time, each option to purchase a share of Diablo Common Stock pursuant to the Stock Option Plan shall terminate and be of no further force or effect, and any rights thereunder to purchase shares of Diablo Common Stock shall also terminate and be of no further force or effect.

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Section 2.5Conversion of Dissenting Common Stock.

(a)NO SHARES OF DISSENTING COMMON STOCK THAT ARE ISSUED AND OUTSTANDING AT THE EFFECTIVE TIME AND ARE HELD BY A SHAREHOLDER WHO PROPERLY EXERCISED SUCH SHAREHOLDERS RIGHT UNDER CHAPTER 13 OF THE CGCL SHALL BE CONVERTED INTO THE RIGHT TO RECEIVE THE MERGER CONSIDERATION AND INSTEAD SHALL BE ENTITLED TO SUCH RIGHTS (BUT ONLY SUCH RIGHTS) AS ARE GRANTED BY CHAPTER 13 OF THE CGCL AND TO RECEIVE THE CONSIDERATION AS MAY BE DETERMINED TO BE DUE WITH RESPECT TO SUCH SHARES OF DISSENTING COMMON STOCK PURSUANT TO AND SUBJECT TO THE REQUIREMENTS OF THE CGCL. DIABLO shall give Heritage prompt notice upon receipt by Diablo of any written demands for appraisal rights, withdrawal of such demands, and any other documents received or instruments served pursuant to Chapter 13 of the CGCL and shall give Heritage the opportunity to direct all negotiations and proceedings with respect to such demands. Diablo shall not voluntarily make any payment with respect to any demands for appraisal rights and shall not except with the prior written consent of Heritage, settle or offer to settle such demands.

(b)If any such holder shall have failed to perfect or shall have effectively withdrawn or lost such right prior to the Election Deadline, each of such holder’s shares of Diablo Common Stock shall thereupon be deemed to be Non-Election Shares for all purposes of this Agreement, unless such holder shall thereafter otherwise make a timely Election under this Agreement. If any holder of Dissenting Common Stock shall have so failed to perfect or has effectively withdrawn or lost such holder’s right to dissent from the Merger after the Election Deadline, each of such holder’s shares of Diablo Common Stock shall thereupon be deemed to have been converted into and to have become, as of the Effective Time, the right to receive the Stock Consideration or the Cash Consideration, or a combination thereof, as determined by Heritage in its sole discretion.

ARTICLE III

EXCHANGE OF SHARES

Section 3.1Election Procedures. Each holder of record of shares of Diablo Common Stock (“Holder”) shall have the right, subject to the limitations set forth in this Article III, to submit an election in accordance with the following procedures:

(a)EACH HOLDER MAY SPECIFY IN A REQUEST MADE IN ACCORDANCE WITH THE PROVISIONS OF THIS SECTION 3.1 (HEREIN CALLED AN “Election”) (i) the number of shares of Diablo Common Stock owned by such Holder with respect to which such Holder desires to make a Stock Election and (ii) the number of shares of Diablo Common Stock owned by such Holder with respect to which such Holder desires to make a Cash Election.

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(b)Heritage shall prepare a form reasonably acceptable to Diablo (the “Form of Election”) which shall be mailed to record holders of Diablo Common Stock by the Exchange Agent so as to permit those holders to exercise their right to make an Election prior to the Election Deadline.

(c)The Exchange Agent shall make the Form of Election initially available to Holders not less than twenty (20) Business Days prior to the anticipated Election Deadline and shall use all reasonable efforts to make available as promptly as possible a Form of Election to any shareholder of Diablo who requests such Form of Election following the initial mailing of the Forms of Election and prior to the Election Deadline.

(d)Any Election shall have been made properly only if the person authorized to receive Elections and to act as exchange agent under this Agreement, which person shall be a bank or trust company selected by Heritage (the “Exchange Agent”), pursuant to an agreement (the “Exchange Agent Agreement”) entered into prior to the mailing of the Form of Election to Diablo shareholders, shall have received, by the Election Deadline, a Form of Election properly completed and signed and accompanied by Certificates to which such Form of Election relates or by an appropriate customary guarantee of delivery of such certificates, as set forth in such Form of Election, from a member of any registered national securities exchange or a commercial bank or trust company in the United States; provided, that such Certificates are in fact delivered to the Exchange Agent by the time required in such guarantee of delivery. Failure to deliver shares of Diablo Common Stock covered by such a guarantee of delivery within the time set forth on such guarantee shall be deemed to invalidate any otherwise properly made Election, unless otherwise determined by Heritage, in its sole discretion. As used herein, unless otherwise agreed in advance by the parties, “Election Deadline” means 5:00 p.m. local time (in the city in which the principal office of the Exchange Agent is located) on the day that is the Business Day immediately preceding the date of the Diablo Shareholders Meeting to approve the transactions anticipated by this Agreement. Diablo and Heritage shall cooperate to issue a press release reasonably satisfactory to each of them announcing the date of the Election Deadline not more than 15 Business Days before, and at least 5 Business Days prior to, the Election Deadline.

(e)Any Holder may, at any time prior to the Election Deadline, change or revoke his or her Election by written notice received by the Exchange Agent prior to the Election Deadline accompanied by a properly completed and signed revised Form of Election. Subject to the terms of the Exchange Agent Agreement, if Heritage shall determine in its reasonable discretion that any Election is not properly made with respect to any shares of Diablo Common Stock (neither Heritage nor Diablo nor the Exchange Agent being under any duty to notify any shareholder of any such defect), such Election shall be deemed to be not in effect, and the shares of Diablo Common Stock covered by such Election shall, for purposes hereof, be deemed to be Non-Election Shares, unless a proper Election is thereafter timely made.

(f)Any Diablo shareholder may, at any time prior to the Election Deadline, revoke his or her Election by written notice received by the Exchange Agent prior to the Election Deadline or by withdrawal prior to the Election Deadline of his or her Certificates, or of the guarantee of delivery of such Certificates, previously deposited with the Exchange Agent. All Elections shall be automatically deemed revoked upon receipt by the Exchange Agent of written notification from Heritage or Diablo that this Agreement has been terminated in accordance with Article X.

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(g)Subject to the terms of the Exchange Agent Agreement, Heritage, in the exercise of its reasonable discretion, shall have the right to make all determinations, not inconsistent with the terms of this Agreement, governing (i) the validity of the Forms of Election and compliance by any Holder with the Election procedures set forth herein, (ii) the manner and extent to which Elections are to be taken into account in making the determinations prescribed by Section 2.3, (iii) the issuance and delivery of certificates representing the whole number of shares of Heritage Common Stock into which shares of Diablo Common Stock are converted in the Merger and (iv) the method of payment of cash for shares of Diablo Common Stock converted into the right to receive the Cash Consideration and cash in lieu of fractional shares of Heritage Common Stock.

Section 3.2DEPOSIT OF MERGER CONSIDERATION. At or prior to the Effective Time, Heritage shall deposit, or shall cause to be deposited, with the Exchange Agent, (i) certificates representing the number of shares of Heritage Common Stock sufficient to deliver, and Heritage shall instruct the Exchange Agent to timely deliver, the aggregate Stock Consideration, and (ii) immediately available funds equal to the Total Cash Consideration (together with, to the extent then determinable, any cash payable in lieu of fractional shares pursuant to Section 3.3(f)) (collectively, the “Exchange Fund”) and Heritage shall instruct the Exchange Agent to timely pay the Cash Consideration, and such cash in lieu of fractional shares, in accordance with this Agreement.

Section 3.3Delivery of Merger Consideration.

(a)AS SOON AS REASONABLY PRACTICABLE AFTER THE EFFECTIVE TIME, BUT IN ANY EVENT PRIOR TO THE FIFTH (5^th) Business Day following the Effective Time, the Exchange Agent shall mail to each holder of record of Certificate(s) which immediately prior to the Effective Time represented outstanding shares of Diablo Common Stock whose shares were converted into the right to receive the Merger Consideration pursuant to Section 2.2 and any cash in lieu of fractional shares of Heritage Common Stock to be issued or paid in consideration therefor who did not properly complete and submit an Election Form, (i) a letter of transmittal (which shall specify that delivery shall be effected, and risk of loss and title to Certificate(s) shall pass, only upon delivery of Certificate(s) (or affidavits of loss in lieu of such Certificate(s))) (the “Letter of Transmittal”) to the Exchange Agent and shall be substantially in such form and have such other provisions as shall be prescribed by the Exchange Agent Agreement and (ii) instructions for use in surrendering Certificate(s) in exchange for the Merger Consideration and any cash in lieu of fractional shares of Heritage Common Stock to be issued or paid in consideration therefor in accordance with Section 3.3(f) upon surrender of such Certificate and any dividends or distributions to which such holder is entitled pursuant to Section 3.3(c).

(b)Upon surrender to the Exchange Agent of its Certificate(s), accompanied by a properly completed Form of Election or a properly completed Letter of Transmittal, a holder of Diablo Common Stock will be entitled to receive, as promptly as practicable after the Effective Time, the Merger Consideration (elected or deemed elected by it, subject to, and in accordance with Sections 2.2 and 2.3) and any cash in lieu of fractional shares of Heritage Common Stock to be issued or paid in consideration therefor in respect of the shares of Diablo Common Stock represented by its Certificate(s). Until so surrendered, each such Certificate shall represent after the Effective Time, for all purposes, only the right to receive, without interest, the Merger Consideration and any cash in lieu of fractional shares of Heritage Common Stock to be issued or paid in consideration therefor upon surrender of such Certificate in accordance with, and any dividends or distributions to which such holder is entitled pursuant to, this Article III.

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(c)No dividends or other distributions with respect to Heritage Common Stock shall be paid to the holder of any unsurrendered Certificate with respect to the shares of Heritage Common Stock represented thereby, in each case unless and until the surrender of such Certificate in accordance with this Article III. Subject to the effect of applicable abandoned property, escheat or similar laws, following surrender of any such Certificate in accordance with this Article III the record holder thereof shall be entitled to receive, without interest, (i) the amount of dividends or other distributions with a record date after the Effective Time theretofore payable with respect to the whole shares of Heritage Common Stock represented by such Certificate and not paid and/or (ii) at the appropriate payment date, the amount of dividends or other distributions payable with respect to shares of Heritage Common Stock represented by such Certificate with a record date after the Effective Time (but before such surrender date) and with a payment date subsequent to the issuance of the Heritage Common Stock issuable with respect to such Certificate.

(d)In the event of a transfer of ownership of a Certificate representing Diablo Common Stock that is not registered in the stock transfer records of Diablo, the proper amount of cash and/or shares of Heritage Common Stock shall be paid or issued in exchange therefor to a person other than the person in whose name the Certificate so surrendered is registered if the Certificate formerly representing such Diablo Common Stock shall be properly endorsed or otherwise be in proper form for transfer and the person requesting such payment or issuance shall pay any transfer or other similar Taxes required by reason of the payment or issuance to a Person other than the registered holder of the Certificate or establish to the satisfaction of Heritage that the Tax has been paid or is not applicable.

(e)After the Effective Time, there shall be no transfers on the stock transfer books of Diablo of any shares of Diablo Common Stock that were issued and outstanding immediately prior to the Effective Time other than to settle transfers of Diablo Common Stock that occurred prior to the Effective Time. If, after the Effective Time, Certificates representing such shares are presented for transfer to the Exchange Agent, they shall be cancelled and exchanged for the Merger Consideration and any cash in lieu of fractional shares of Heritage Common Stock to be issued or paid in consideration therefor in accordance with Section 2.3 and the procedures set forth in this Article III.

(f)Notwithstanding anything to the contrary contained in this Agreement, no certificates or scrip representing fractional shares of Heritage Common Stock shall be issued upon the surrender of Certificates for exchange, no dividend or distribution with respect to Heritage Common Stock shall be payable on or with respect to any fractional share, and such fractional share interests shall not entitle the owner thereof to vote or to any other rights of a shareholder of Heritage. In lieu of the issuance of any such fractional share, Heritage shall pay to each former shareholder of Diablo who otherwise would be entitled to receive such fractional share, an amount in cash (rounded to the nearest whole cent) determined by multiplying (i) the Cash Per Share Amount by (ii) the fraction of a share (after taking into account all shares of Diablo Common Stock held by such holder at the Effective Time and rounded to the nearest one thousandth when expressed in decimal form) of Heritage Common Stock to which such holder would otherwise be entitled to receive pursuant to Section 2.2.

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(g)Any portion of the Exchange Fund that remains unclaimed by the shareholders of Diablo as of six months of the Effective Time shall be paid to Heritage. Any former shareholders of Diablo who have not theretofore complied with this Article III shall thereafter look only to Heritage with respect to the Merger Consideration, any cash in lieu of any fractional shares and any unpaid dividends and distributions on the Heritage Common Stock deliverable in respect of each share of Diablo Common Stock such shareholder holds as determined pursuant to this Agreement, in each case, without any interest thereon. Notwithstanding the foregoing, none of Heritage, Diablo, the Exchange Agent or any other person shall be liable to any former holder of shares of Diablo Common Stock for any amount delivered in good faith to a public official pursuant to applicable abandoned property, escheat or similar laws.

(h)In the event any Certificate shall have been lost, stolen or destroyed, upon the making of an affidavit of that fact by the person claiming such Certificate to be lost, stolen or destroyed and, if reasonably required by Heritage or the Exchange Agent, the posting by such person of a bond in such amount as Heritage may determine is reasonably necessary as indemnity against any claim that may be made against it with respect to such Certificate, the Exchange Agent will issue in exchange for such lost, stolen or destroyed Certificate the Merger Consideration deliverable in respect thereof pursuant to this Agreement.

(i)Notwithstanding anything to the contrary contained herein, no certificates representing shares of Heritage Common Stock shall be delivered to a Diablo Shareholder who is an “affiliate” of Diablo for purposes of Rule 145 under the Securities Act of 1933, as amended (the “Securities Act”) unless such “affiliate” shall have theretofore executed and delivered to a written agreement from such person referred to in Section 7.8.

(j)Holders of Certificates representing shares of Diablo Common Stock shall not be entitled to vote as holders of shares of Heritage Common Stock until such Certificates representing Diablo Common Stock have been exchanged for shares of Heritage Common Stock as provided in this Article III.

Section 3.4WITHHOLDING RIGHTS. The Exchange Agent (or, subsequent to six months from the Effective Time, Heritage) shall be entitled to deduct and withhold from any cash portion of the Merger Consideration, any cash in lieu of fractional shares of Heritage Common Stock, cash dividends or distributions payable pursuant to Section 3.3(c) hereof and any other cash amounts otherwise payable pursuant to this Agreement to any holder of Diablo Common Stock or Diablo stock options (pursuant to Section 2.4) such amounts as the Exchange Agent or Heritage, as the case may be, is required to deduct and withhold under the Code, or any provision of state, local or foreign Tax law, with respect to the making of such payment. To the extent the amounts are so withheld by the Exchange Agent or Heritage, as the case may be, such withheld amounts shall be treated for all purposes of this Agreement as having been paid to the holder of shares of Diablo Common Stock in respect of whom such deduction and withholding was made by the Exchange Agent or Heritage, as the case may be.

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Section 3.5No Liability. Neither Heritage, HBC, Diablo nor the Exchange Agent shall be liable to any holder of shares of Diablo Common Stock for any shares of Heritage Common Stock (or dividends or distributions with respect thereto) or cash delivered to a public official pursuant to any applicable abandoned property, escheat or similar law.

ARTICLE IV

CONDUCT PENDING THE MERGER

Section 4.1CONDUCT OF Diablo’s Business Prior to the Effective Time. Except as expressly provided in this Agreement, or with the prior written consent of Heritage, which consent shall not be unreasonably withheld, during the period from the date of this Agreement to the Effective Time, Diablo shall, (a) conduct its business in the usual, regular and ordinary course, consistent with past practices and consistent with prudent banking practices; (b) use its commercially reasonable efforts to maintain and preserve intact its business organization, employees and advantageous customer relationships and to continue to develop such customer relationships and retain the services of its officers and key employees; (c) maintain and keep its properties in as good repair and condition as at present except for obsolete properties and for deterioration due to ordinary wear and tear; (d) maintain in full force and effect insurance comparable in amount and scope of coverage to that now maintained by it; (e) perform in all material respects all of its obligations under contracts, leases and obligations relating to and affecting its assets, properties and businesses except such obligations as it may in good faith reasonably dispute; (f) charge off all loans, leases and other assets, or portions thereof, deemed uncollectible in accordance with GAAP or applicable law or regulation, classified as “loss” or as directed by its regulators; (g) maintain the ALLL in accordance with past practices and methodology and GAAP; and (h) give notice to and consult with Heritage prior to hiring any employees or independent contractors; (i) give notice to and consult with Heritage before acquiring any security or investment for the Diablo investment portfolio; and (j) substantially comply with and perform all material obligations and duties imposed upon it by all federal and state laws, statutes and rules, regulations and orders imposed by any Governmental Authority applicable to its business.

Section 4.2Forbearance By Diablo. Except as expressly provided in this Agreement, during the period from the date of this Agreement to the Effective Time, Diablo shall not without the prior written consent of Heritage which consent shall not be unreasonably withheld:

(a)TAKE or fail to take any action which would reasonably be expected to have a Material Adverse Effect on Diablo or adversely delay the ability of Heritage, HBC or Diablo to obtain any necessary approvals, consents or waivers of any Governmental Authority or other parties required for the Merger or to perform its covenants or agreements under this Agreement on a timely basis;

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(b)take or fail to take any action that would cause or permit the representations and warranties made in Section 5.1 to be materially inaccurate at the time of Closing or preclude Diablo from making such representations and warranties at the time of Closing;

(c)incur any indebtedness for borrowed money or issue any debt securities or trust preferred (other than deposits, federal funds purchased, cash management accounts, Federal Home Loan Bank borrowings that mature within one year and securities sold under agreements to repurchase that mature within 90 days, in each case in the ordinary course of business consistent with past practice) or assume, guarantee, endorse or otherwise as an accommodation become responsible for the obligations of any other Person, other than in the ordinary course of business consistent with past practice;

(d)issue any shares of capital stock; adjust, split, combine or reclassify any capital stock; grant options under the Stock Option Plan, make, declare or pay any dividend or make any other distribution on any capital stock (including payment of any stock dividends); except for the redemption for the Diablo Preferred Stock, directly or indirectly, redeem, purchase or otherwise acquire any shares of its capital stock or any securities or obligations convertible into or exchangeable for any shares of its capital stock; grant any stock appreciation rights; grant any person any right to acquire any shares of its capital stock (whether pursuant to an option, warrant, right or otherwise including the grant of options under the Stock Option Plan); or provided, however, that Diablo may make cash payments on account of stock options outstanding under the Option Plan on the date of this Agreement in the manner provided in Section 2.4;

(e)enter into or amend or renew any employment, consulting, severance or similar agreements or arrangements with any director, officer or employee of Diablo or grant any salary or wage increase or increase any employee benefit (including incentive or bonus payments), or grant any severance or termination payment except (i) for normal individual increases in compensation to employees in the ordinary course of business consistent with past practice, provided that no such increase shall result in an annual adjustment of more than 5%, (ii) for other changes that are required by applicable law, (iii) to satisfy contractual obligations existing as of the date hereof, (iv) for payment of bonuses approved in 2006 and accrued on the financial statements for the year ended December 31, 2006 previously delivered to Heritage, or (v) for accrual of bonuses to option holders to compensate such holders for an adjustment to option exercise prices made in order to satisfy Section 9.2(p).

(f)hire any person as an employee of Diablo or promote any employee, except (i) to satisfy contractual obligations existing as of the date hereof and (ii) persons hired to fill any vacancies arising after the date hereof and whose employment is terminable at the will of Diablo before or after consummation of the Merger, other than any person to be hired to fill a newly created position who would have a base salary, including any guaranteed bonus or any similar bonus, considered on an annual basis equal to or greater than $50,000;

(g)enter into, establish, adopt or amend, or make any contributions to (except (i) as may be required by applicable law, (ii) to satisfy contractual obligations existing as of the date hereto, or (iii) as permitted by Section 4.2(e)), any pension, retirement, stock option, stock purchase, savings, profit sharing, deferred compensation, consulting, bonus, group insurance or other employee benefit, incentive or welfare contract, plan or arrangement, or any trust agreement (or similar arrangement) related thereto, in respect of any director, officer or employee of Diablo or take any action to accelerate the vesting or exercisability of stock options, restricted stock or other compensation or benefits payable thereunder;

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(h)sell, transfer, pledge mortgage, encumber license, guarantee or otherwise dispose of or discontinue any of its assets, deposits, business or properties except upon prior notice to Heritage and pursuant to existing contracts or commitments or in the case of a pledge in the ordinary course of business consistent with past practice;

(i)acquire by merger, consolidation with, by purchase of an equity interest, or asset purchase, or by any other manner acquire (other than by way of foreclosures or acquisitions of control in a bona fide fiduciary capacity or in satisfaction of debts previously contracted in good faith, in each case in the ordinary and usual course of business consistent with past practice) all or any portion of the assets, business, deposits or properties of any other Person;

(j)make any capital expenditures other than those related to the establishment and completion of the new branch currently under construction in Danville and other than capital expenditures in the ordinary course of business consistent with past practice in amounts not in excess of $25,000;

(k)amend the Diablo Articles of Incorporation or the Diablo Bylaws;

(l)implement or adopt any change in its accounting principles, practices or methods, other than as may be required by changes in laws or regulations or GAAP;

(m)except in the ordinary course of business consistent with past practice or as otherwise permitted under this Agreement, enter into any contract in excess of $50,000, or terminate any material contract or amend or modify in any material respect any of its existing material contracts, provided however, that Diablo will give prior notice to Heritage before entering into any contract in excess of $15,000;

(n)enter into any settlement or similar agreement with respect to any action, suit, proceeding, order or investigation to which Diablo is or becomes a party after the date of this Agreement, which settlement, agreement or action involves payment by Diablo of an amount which exceeds $50,000 and/or would impose any material restriction on the business of Diablo or create precedent for claims that are reasonably likely to be material to Diablo;

(o)except as required by applicable law or a Governmental Authority, (i) implement or adopt any material change in its interest rate and other risk management policies, procedures or practices, (ii) fail to follow in any material respect its existing policies or practices with respect to managing its exposure to interest rate an other risk, (iii) fail to use commercially reasonable means to avoid any material increase in its aggregate exposure to interest rate risk, (iv) enter into a new material line of business, or (v) change its investment, underwriting, or asset liability management or other material banking policy.

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(p)change its investment securities portfolio policy or the manner in which the portfolio is classified or reported; or invest in any mortgage-backed or mortgage-related securities which would be considered “high-risk” securities under applicable regulatory pronouncements;

(q)take any action or omit to take any action that may result, individually or in the aggregate with any other actions or omissions, in a material violation of the Bank Secrecy Act, the anti-money laundering laws and regulations or the policies and procedures of Diablo with respect to the foregoing;

(r)enter into any derivatives contract;

(s)acquire (other than by way of foreclosures or acquisitions in a bona fide fiduciary capacity or in satisfaction of debts previously contracted in good faith, in each case in the ordinary course of business consistent with past practice) any debt security or equity investment other than federal funds or United States Government securities or United States Government agency securities, in each case with a term of one (1) year or less;

(t)make, renew or otherwise modify any loan, loan commitment, letter of credit or other extension of credit (collectively, “Loans”) other than in the ordinary course of business consistent with past practice, provided that Diablo shall not make, renew or otherwise modify any Loan with a principal balance in excess of $1,500,000 without Heritage’s written consent, which consent shall be deemed to have been received to the extent Diablo has provided written notice hereunder, which Heritage has not objected to within two (2) Business Days of receipt of such written notice;

(u)make any investment or commitment to invest in real estate or in any real estate development project (other than by way of foreclosure or acquisitions in a bona fide fiduciary capacity or in satisfaction of a debt previously contracted in good faith, in each case in the ordinary course of business consistent with past practice);

(v)forgive any loans to directors, officers or employees of Diablo;

(w)adopt or enter into a plan of complete or partial liquidation, dissolution, merger, consolidation, restructuring, recapitulation or other reorganization of Diablo (other than the Merger) or any agreement relating to an Acquisition Proposal, except as expressly permitted in Section 7.6;

(x)file or cause to be filed any amended Returns or claims for refund of Taxes; or (A) prepare any Return in a manner which is materially inconsistent with the past practices of Diablo, as the case may be, with respect to the treatment of items on such Returns, (B) incur any material liability for Taxes other than in the ordinary course of business, or (C) enter into any settlement or closing agreement with a taxing authority that materially affects or may materially affect the Tax liability of Diablo, as the case may be, for any period ending after the Closing Date;

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(y)fail to maintain with financially responsible insurance companies insurance on its tangible assets and its business in such amounts and against such risks and losses as are consistent in all material respects with past practice;

(z)(i) take any action that would, or is reasonably likely to, prevent or impede the Merger from qualifying as a reorganization within the meaning of Section 368(a) of the Code or (ii) take any action that is intended or is reasonably likely to result in (y) any of the conditions to the Merger set forth in Article VII not being satisfied or (z) a material violation of any provision of this Agreement, except as may be required by applicable law or regulation; or

(aa)enter into any transaction with any director of officer, except as permitted by this Agreement or pursuant to any contract or obligations existing on the date hereof, copies of which contract or obligation have been previously provided to Heritage.

(bb)make, acquire a participation in, reacquire an interest in a participation sold or sell any loan or lease that is not in compliance with its normal credit underwriting standards, policies and procedures as in effect on date of this Agreement, as modified, if necessary, to become or remain in accordance with GAAP or RAP or in conformity with the recommendations of Diablo’s regulators; or renew, extend the maturity of, or alter any of the material terms of any such loan or lease for a period of greater than six months;

(cc)except as required by GAAP, reduce any material accrual or reserve, including, without limitation, any contingency reserve, litigation reserve, tax reserve, or the ALLL, by reversal or booking a negative provision, or change the methodology by which such accounts generally have been handled in past periods, unless required to do so by GAAP or RAP;

(dd)enter into any contract with respect to, or otherwise agree or commit to do, any of the foregoing.

Section 4.3CONDUCT BY Heritage and HBC Prior to the Effective Time. Except as expressly provided in this Agreement, or with the prior written consent of Diablo, which consent shall not be unreasonably withheld, during the period from the date of this Agreement to the Effective Time, Heritage shall, and shall cause HBC to (a) take no action which would reasonably be expected to have a Material Adverse Effect on or adversely delay the ability of Heritage, Diablo or HBC to obtain any necessary approvals, consents or waivers of any Governmental Authority or other parties required for the Merger, or to perform its covenants or agreements under this Agreement on a timely basis, (b) not amend its Articles of Incorporation in any respect that materially and adversely affects the rights and privileges attendant to the Heritage Common Stock, (c) not take or agree to take, or make any commitment to take or adopt any resolutions of its board of directors in support of, any of the actions prohibited by this Agreement, (d) not take any action or cause to be taken any action that would prevent or impede the Merger from qualifying as a reorganization within the meaning of Section 368(a) of the Code, and (e) substantially comply with and perform all material obligations and duties imposed upon it by all federal and state laws, and rules, regulations and orders imposed by federal, state and local Governmental Authorities.

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ARTICLE V

REPRESENTATIONS AND WARRANTIES

Section 5.1REPRESENTATIONS AND WARRANTIES OF Diablo. Diablo represents and warrants that, except as specifically set forth in the Disclosure Schedule (and as identified in the Disclosure Schedule by appropriate section of this Agreement to which the disclosure relates) delivered to Heritage as of the date of this Agreement (the “Disclosure Schedule”):

(a)ORGANIZATION.

(i)DIABLO is a California banking a corporation duly organized, validly existing and in good standing under the laws of the State of California and has all requisite power and authority, corporate and otherwise, to own, operate and lease its assets and properties and to carry on its business substantially as it has been and is now being conducted. Diablo is duly qualified to do business and is in good standing in each jurisdiction where the character of the assets or properties owned or leased by it or the nature of the business transacted by it requires that it be so qualified, except where the failure to so qualify would not have a Material Adverse Effect on Diablo.

(ii)Diablo has all requisite corporate power and authority to enter into this Agreement and, subject to the approval of this Agreement by its shareholders and the receipt of all requisite regulatory approvals and the expiration of any applicable waiting periods, to consummate the transactions contemplated hereby.

(iii)Diablo is authorized by the California Department of Financial Institutions (“DFI”) in accordance with the California Financial Code to conduct a commercial banking business. The deposits of Diablo are insured by the Federal Deposit Insurance Corporation (“FDIC”) in the manner and fullest extent provided by applicable law and all premiums and assessments required to be paid in connection therewith have been paid when due.

(iv)True and complete copies of the Articles of Incorporation and Bylaws of Diablo, as amended to date, have been delivered to Heritage. The corporate record books, transfer books and stock ledgers of Diablo are complete and accurate in all material respects and reflect all meetings, consents and other material actions of the shareholders, Boards of Directors and committees of the Boards of Directors of Diablo, and all transactions in its capital stock, since its inception.

(b)AUTHORIZATION. The execution, delivery and performance of this Agreement and the consummation of the transactions contemplated hereby and thereby have been duly approved and authorized by the board of directors of Diablo, and all necessary corporate action on the part of Diablo has been taken, subject to the approval of this Agreement and the Merger by the affirmative vote of a majority of the outstanding shares of Diablo Common Stock. This Agreement has been duly executed and delivered by Diablo and, subject to shareholder approval, constitutes the valid and binding obligation of it and is enforceable against it, except to the extent that enforceability thereof may be limited by applicable bankruptcy, insolvency, reorganization, moratorium, receivership, conservatorship or similar laws or equitable principles or doctrines.

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(c)Conflictsand Approvals. Subject to the second sentence of this Section 5.1(c), the execution and delivery of this Agreement does not, and the consummation of the transactions contemplated hereby and thereby will not, conflict with or result in any violation, breach or termination of, or default or loss of a material benefit under, permit the acceleration of any obligation under, require the giving of notice or obtaining consent under, or result in the creation of any material lien, charge or encumbrance on any property or assets under, any provision of the Articles of Incorporation or Bylaws of Diablo, or any mortgage, indenture, lease, agreement or other instrument, permit, concession, grant, franchise, license, judgment, order, decree, statute, law, ordinance, rule or regulation applicable to Diablo or its properties, other than any such conflicts, violations or defaults which (i) will be cured or waived prior to the Effective Time or (ii) are disclosed in the Disclosure Schedule. No consent, approval, order or authorization of, or registration, declaration or filing with, any Governmental Authority is required by or with respect to Diablo in connection with the execution and delivery of this Agreement or the consummation by Diablo of the transactions contemplated hereby or thereby except for: (a) the filing and approval of all required regulatory applications or notifications by Heritage, Diablo and/or HBC for approval of the transactions contemplated by this Agreement; (b) the filing by Heritage of the Form S-4, which shall include the Proxy Statement for use in connection with Diablo’s Shareholders’ Meeting and the SEC’s order declaring the Form S-4 effective; (c) the filing of the Merger Agreement and certificates of merger with respect to the Merger with the California Secretary of State and the Commissioner; (d) filings and approval with and from the DFI, and (f) any filings, approvals or no-action letters with or from any other regulatory agency or state securities authorities.

(d)Subsidiary. Diablo does not own or control any subsidiary. Diablo does not have any equity interest, direct or indirect, in any other bank or corporation or in any partnership, joint venture or other business enterprise or entity, except as acquired through settlement of indebtedness, foreclosure, the exercise of creditors’ remedies or in a fiduciary capacity, and the business carried on by Diablo has not been conducted through any other direct or indirect subsidiary or Affiliate of Diablo. Diablo is not a Subsidiary of any Person.

(e)Capitalization. The entire authorized capital stock of Diablo consists of (i) 20,000,000 shares of Diablo Common Stock, of which 2,502,146 are issued and outstanding (subject to the exercise of Diablo stock options from and after the date hereof), and 715,350 additional shares of which have been reserved for issuance to holders of outstanding Diablo stock options under the Stock Option Plan (subject to the exercise of Diablo stock options from and after the date hereof), and (ii) 10,000,000 shares of preferred stock, no par value per share, of which 207,061 shares of Series A Preferred Stock are issued and outstanding (“Diablo Preferred Stock”). The Disclosure Schedule contains a list of (i) the number of outstanding options with respect to the Stock Option Plan, (ii) the exercise price per share with respect to each Diablo stock option, (iii) a list of all option holders with respect to the Stock Option Plan, and (iv) the number of vested and unvested Diablo stock options with respect to each such option holder in the Stock Option Plan. Subject to the actions required to be taken in accordance with Section 9.2(p), all Diablo stock options were issued and, upon issuance in accordance with the terms of the outstanding option agreements, the shares of Diablo Common Stock have been issued in compliance with all applicable law. Except as set forth on the Diablo Disclosure Schedule, the exercise price of each stock option issued pursuant to the Stock Option Plan was the price on the date of grant in accordance with GAAP and applicable law. Except for options issued under the Stock Option Plan, there are no (i) other outstanding equity securities of any kind or character, (ii) outstanding subscriptions, options, convertible securities, rights, warrants, calls or other agreements or commitments of any kind issued or granted by, or binding upon, Diablo to purchase or otherwise acquire any security of or equity interest in Diablo or (iii) outstanding subscriptions, options, rights, warrants, calls, convertible securities, irrevocable proxies or other agreements or commitments obligating Diablo to issue any shares of, restricting the transfer of or otherwise relating to shares of its capital stock of any class. All of the issued and outstanding shares of Diablo Common Stock and Diablo Preferred Stock have been duly authorized, validly issued and are fully paid and non-assessable, and have not been issued in violation of the preemptive rights of any person. Such shares of Diablo Common Stock and Diablo Preferred Stock have been issued in full compliance with applicable law.

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(f)Financial Statements and Accounting Records. Diablo has furnished to Heritage true and complete copies of (i) the audited balance sheets of Diablo as of December 31, 2003, 2004 and 2005, and the related audited statements of income, stockholders’ equity and cash flows for the years ended December 31, 2003, 2004 and 2005, (ii) an unaudited balance sheet of Diablo as of September 30, 2006, and the related unaudited statement of income for the nine-month period ended September 30, 2006 (such balance sheets and the related statements of income, stockholders’ equity and cash flows are collectively referred to herein as the “Diablo Financial Statements”). The Diablo Financial Statements fairly present, in all material respects, the financial position of Diablo as of the respective dates thereof and the results of operations and changes in financial position of Diablo for the periods then ended, in conformity with GAAP, applied on a basis consistent with prior periods (subject, in the case of the unaudited interim financial statements, to normal year-end adjustments and the fact that they do not contain all of the footnote disclosures required by GAAP). Diablo makes and keeps accurate books and records and maintains a system of internal accounting controls over financial reporting that are sufficient to provide reasonable assurance that transactions are properly recorded and records are kept which accurately and fairly reflect, in all material respects, financial activities of Diablo, so as to permit the preparation of Diablo’s financial statements in conformity with GAAP. Since December 31, 2005, Diablo has not been advised of (i) any significant deficiencies in the design or operation of internal controls that could adversely affect the ability of Diablo to record, process, summarize and report financial data and (ii) any fraud, whether or not material, that involves management or other employees who have a significant role in the internal controls of Diablo.

(g)Allowance for Loan Losses.

(i)THE ALLOWANCE FOR LOAN LOSSES SHOWN ON THE Diablo Financial Statements as of September 30, 2006 (and as shown on any financial statements to be delivered by Diablo to Heritage pursuant to Section 7.2(b) hereof), to the knowledge of Diablo, as of such date was (and will be as of such subsequent Diablo Financial Statements) adequate in all respects to provide for losses, net of recoveries relating to loans previously charged off, on loans outstanding, and contained (or will contain) an additional amount of unallocated reserves for future losses at a level considered adequate under the standards applied by applicable regulatory authorities and based upon generally accepted practices. To the knowledge of Diablo, the aggregate principal amount of loans contained (or that will be contained) in the loan portfolio of Diablo as of September 30, 2006 (and as of the dates of any financial statements to be delivered by Diablo to Heritage pursuant to Section 7.2(b) hereof), in excess of such reserve, was (and will be) fully collectible. Diablo has calculated its allowance for loan losses in accordance with GAAP as applied to banking institutions and in accordance with all applicable rules and regulations.

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(ii)The Disclosure Schedule lists all Nonperforming Assets as of September 30, 2006. The sum of the aggregate amount of all Nonperforming Assets (as defined below) and all troubled debt restructurings (as defined under GAAP) on the books of Diablo as of September 30, 2006 does not exceed 0.25% of total loans at the date hereof. “Nonperforming Assets” shall mean (i) all loans and leases (A) that are contractually past due 90 days or more in the payment of principal and/or interest, (B) that are on nonaccrual status, (C) where a reasonable doubt exists, in the reasonable judgment of Diablo, as to the timely future collectibility of principal and/or interest, whether or not interest is still accruing or the loan is less than 90 days past due, (D) where the interest rate terms have been reduced and/or the maturity dates have been extended subsequent to the agreement under which the loan was originally created due to concerns regarding the borrower’s ability to pay in accordance with such initial terms, (E) where a specific reserve allocation exists in connection therewith, or (F) that have been classified “Doubtful,”“Loss” or the equivalent thereof by any regulatory authority, and (ii) all assets classified as real estate owned (“REO”) and other assets acquired through foreclosure or repossession. Other than as set forth in the Diablo Disclosure Schedule, Diablo has no Nonperforming Assets as defined herein.

(h)LOANS; Investments.

(i)EXCEPT AS OTHERWISE set forth in the Disclosure Schedule, each loan reflected as an asset on the Diablo Financial Statements dated as of September 30, 2006, and each loan originated or acquired after such date, constitutes the legal, valid and binding obligation of the obligor named therein, enforceable in accordance with its terms, except to the extent that the enforceability thereof may be limited by bankruptcy, insolvency, reorganization, moratorium or similar laws or equitable principles or doctrines. Except as set forth in the Diablo Disclosure Schedule, all such loans are, and at the Effective Time will be, free and clear of any security interest, lien, encumbrance or other charge and do not, and will not at the Effective Time, include any provision for prepayment penalties in violation of any law or regulation. All currently outstanding loans of Diablo, including any current extensions of any loan, were solicited, originated and currently exist in material compliance with all applicable requirements of federal and state law and regulations promulgated thereunder. There are no oral modifications or amendments or additional agreements related to the loans that are not reflected in Diablo’s records, and to the knowledge of Diablo no claim of defense as to the enforcement of any loan has been asserted, and Diablo has no knowledge of any acts or omissions that would give rise to any claim or right of rescission, set off, counterclaim or defense. Except as set forth in the Disclosure Schedule, there is no loan or other asset of Diablo that has been classified by Diablo or its examiners as “Watchlist,”“Special Mention,”“Substandard,”“Doubtful” or “Loss” (identified by borrower, outstanding amounts and summary of loan terms).

(ii)All guarantees of indebtedness owed to Diablo, including but not limited to those of the Federal Housing Administration, the Small Business Administration, and other state and federal agencies, are, to the knowledge of Diablo, valid and enforceable, except to the extent enforceability thereof may be limited by applicable bankruptcy, insolvency, reorganization, moratorium or similar laws or equitable principles or doctrines.

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(iii)Except as set forth in the Disclosure Schedule and except for pledges to secure public and trust deposits, none of the investments reflected in the Diablo Financial Statements dated as of September 30, 2006 under the heading “Investment Securities,” and none of the investments made by Diablo since September 30, 2006, is subject to any restriction, whether contractual or statutory, which materially impairs the ability of Diablo to freely dispose of such investment at any time, other than those restrictions imposed on securities held for investment under GAAP. With respect to all material repurchase agreements to which Diablo is a party, Diablo has a valid, perfected first lien or security interest in the government securities or other collateral securing each such repurchase agreement, and the value of the collateral securing each such repurchase agreement equals or exceeds the amount of the debt secured by such collateral under such agreement. Except as set forth in the Disclosure Schedule and except for a transaction involving less than $50,000, Diablo has not sold or otherwise disposed of any assets in a transaction in which the acquiror of such assets or other person has the right, either conditionally or absolutely, to require Diablo to repurchase or otherwise reacquire any such assets.

(iv)Set forth in the Disclosure Schedule is a complete and accurate list of each investment and debt security, mortgage-backed and related securities, marketable equity securities and securities purchased under agreements to resell owned by Diablo showing as of September 30, 2006 the carrying values and estimated fair values of investment and debt securities, the gross carrying value and estimated fair value of the mortgage-backed and related securities and the estimated cost and estimated fair value of the marketable equity securities.

(v)All United States Treasury securities, obligations of other United States Government agencies and corporations, obligations of States of United States and their political subdivisions, and other investment securities classified as “held to maturity” and “available for sale” held by Diablo, as reflected in the Diablo Financial Statements dated September 30, 2006 were classified and accounted for in accordance with GAAP.

(i)TITLE to Assets. Diablo has good title to all of its assets and properties reflected in the Diablo Financial Statements or acquired subsequent thereto, free and clear of liens, mortgages, security interests, encumbrances or charges of any kind (“Encumbrances”), except (i) as described in the Disclosure Schedule, (ii) as noted in the Diablo Financial Statements, (iii) statutory liens not yet delinquent, (iv) consensual landlord liens, (v) minor defects and irregularities in title and encumbrances that do not materially impair the use thereof for the purpose for which they are held, (vi) pledges of assets in the ordinary course of business to secure public funds deposits, and (vii) those assets and properties disposed of for fair value in the ordinary course of business since September 30, 2006.

(j)Real Estate. Diablo’s Disclosure Schedule sets forth a list of all real property or premises owned as the date hereof and all real property that Diablo is in the process of foreclosing (whether by) judicial process or by power of sale or otherwise in the process of acquiring title to, and all indebtedness secured by any Encumbrance thereon, and (ii) all real property or premises leased or subleased in whole or part of Diablo, together with (x) a description of the locations thereof, (y) a description of each real property lease, sublease, installment purchase, or similar arrangement to which Diablo is a party, and (z) a description of each contract for the purchase, sale or development of real estate to which Diablo is a party. Diablo has good and marketable title to the real property, and valid leasehold interests in the leaseholds, set forth in the Disclosure Schedule, free and clear of all Encumbrances, except (A) for rights of lessors, co-lessees or subleases in such matters that are reflected in the lease; (B) Encumbrances incurred in the ordinary course of business, if any, that, to the knowledge of Diablo, (i) are not substantial in character, amount or extent, (ii) do not materially interfere with present use, of the property subject thereto or affected thereby, and (iv) do not otherwise materially impair the conduct of business of Diablo; or (C) as set forth in the Disclosure Schedule. Diablo, as lessee, has the right under valid and subsisting leases to occupy, use and possess all property leased by Diablo, as identified in the Disclosure Schedule, and, to the knowledge of Diablo, there has not occurred under any such lease any breach, violation or default. Except as set forth in the Disclosure Schedule and except with respect to deductibles under insurance policies set forth in the Disclosure Schedule, Diablo has not experienced any uninsured damage or destruction with respect to the properties identified in the Disclosure Schedule. Diablo enjoys peaceful possession under all leases for the use of real or personal property under which Diablo is the lessee, and, to the knowledge of Diablo, all leases to which Diablo is a party are valid and enforceable in all material respects in accordance with the terms thereof except as may be limited by bankruptcy, insolvency, moratorium or other similar laws affecting creditors’ rights generally and by general principals of whether applied in a proceeding at law or in equity. Diablo is not in default with respect to any such lease, and to the knowledge of Diablo no event has occurred which with the lapse of time or the giving of notice, or both, would constitute a default under any such lease. True and correct copies of each such lease have been delivered to Heritage.

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(k)Material Contracts. Except as set forth in the Disclosure Schedule (all items listed or required to be listed in the Disclosure Schedule as a result of this Section 5.1(k) being referred to herein as “Diablo Scheduled Contracts”), Diablo is not a party or otherwise subject to: (i) any employment, deferred compensations, bonus or consulting contract; (ii) any advertising, brokerage, licensing, dealership, representative or agency relationship or contract; (iii) any contract or agreement that would restrict Heritage or the surviving corporation after the Effective Time from competing in any line of business with any Person or using or employing the services of any Person; (iv) any lease of personal property providing for annual lease payments by or to Diablo in excess of $25,000 per annum other than financing leases entered into in the ordinary course of business in which Diablo is lessor and leases of real property presently used by Diablo as banking offices; (v) any mortgage, pledge, conditional sales contract, security agreement, option, or any other similar agreement with respect to any interest of Diablo (other than as mortgagor or pledgor in the ordinary course of their banking business or as mortgagee, secured party or deed of trust beneficiary in the ordinary course of Diablo’s business) in personal property having a value of $25,000 or more; (vi) any agreement to acquire equipment or any commitment to make capital expenditures of $10,000 or more; (vii) any agreement for the sale of any property or assets in which Diablo has an ownership interest or for the grant of any preferential right to purchase any such property or asset; (viii) any agreement for the borrowing of any money (other than liabilities or interbank borrowings made in the ordinary course of their banking business and reflected in the financial records of Diablo); (ix) any guarantee or indemnification which involves the sum of $25,000 or more, other than letters of credit or loan commitments issued in the normal course of business; (x) any supply, maintenance or landscape contracts not terminable by Diablo without penalty on 30 days or less notice and which provides for payments in excess of $25,000 per annum; (xi) any contract of participation with any other bank in any loan entered into by Diablo subsequent to December 31, 2005 in excess of $25,000, or any sales of assets of Diablo with recourse of any kind to Diablo, or any agreement providing for the sale or servicing of any loan or other asset which constitutes a “recourse arrangement” under applicable regulation or policy promulgated by a Governmental Authority (except for agreements for the sale of guaranteed portions of loans guaranteed in part by the U.S. Small Business Administration and related servicing agreements); (xii) any other agreement of any other kind, including for data processing and similar services, which involves future payments or receipts or performances of services or delivery of items requiring aggregate payment of $10,000 or more to or by Diablo other than payments made under or pursuant to loan agreements, participation agreements and other agreements for the extension of credit in the ordinary course of Diablo’s business; (xiii) any material agreement, arrangement or understanding not made in the ordinary course of business; (xiv) any agreement, arrangement, policy or understanding relating to the employment, election, retention in office or retirement, change of control or severance of any present or former director, officer or employee of Diablo; (xv) any agreement, arrangement or understanding pursuant to which any payment (whether severance pay or otherwise) became or may become due to any director, officer or employee of Diablo upon execution of this Agreement or upon or following consummation of the transactions contemplated hereby (either alone or in connection with the occurrence of any additional acts or events); or (xvi) any written agreement, supervisory agreement, resolution, memorandum of understanding, consent order, cease and desist order, capital order, or condition of any regulatory order or decree with or by the DFI or FDIC or any other Government Authority.

Diablo has made available to Heritage true and correct copies of all Diablo Scheduled Contracts, including all amendments and supplements. Diablo has performed in all material respects all of the obligations required to be performed by it to date under the Diablo Scheduled Contracts, and is not in material default under, or in material breach of, any term or provision of Diablo Scheduled Contracts and no event has occurred that, with the giving of notice or the passage of time, or both, would constitute a default or breach any the Scheduled Contract. To Diablo’s knowledge, no party to a Diablo Scheduled Contract is in or has given notice of default thereunder.

(l)DEPOSIT SUMMARY. Diablo has made available to Heritage a summary of the amounts and types of the deposits held by Diablo as of September 30, 2006 and the weighted average interest rates being paid thereon as of such date (the “Deposit Summary”). The Deposit Summary and other data and information provided by Diablo, relating to assets, liabilities and business of Diablo are true in all material respects as of the date thereof.

(m)Intellectual Property. Diablo owns or possesses valid and binding licenses and other rights to use without payment all material patents, copyrights, trade secrets, trade names, service marks and trademarks used in its business; and Diablo has not received any notice with respect thereto that asserts the rights of others. Diablo has in all material respects performed all the obligations required to be performed by them, and is not in default in any material respect under any licenses, contract, agreement, arrangement or commitment relating to any of the foregoing.

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(n)Undisclosed Liabilities. Diablo does not have any material liability or obligation, accrued, absolute, contingent or otherwise and whether due or to become due or material liabilities for federal, state or local taxes or assessments or material liabilities under any agreement that are not reflected in or disclosed in the Diablo Financial Statements, except (i) those liabilities and expenses incurred in connection with the transaction contemplated by this Agreement or incurred in the ordinary course of business and consistent with prudent business practices since September 30, 2006 or (ii) as disclosed in the Disclosure Schedule. Diablo does not know of any basis for the assertion against it of any liability, obligation or claim (including, without limitation, that of any regulatory authority) that is likely to result in or cause a Material Adverse Effect on Diablo.

(p)Compliance with Laws and Permits. Except as set forth in the Disclosure Schedule, Diablo is in compliance with, and is not in default (or with the giving of notice or the passage of time will be in default) under, or in violation of, (i) any provision of its Articles of Incorporation or Bylaws (ii) any permit, concession, grant, franchise, license, authorization, (iii) order, judgment, writ, injunction, decree, arbitration ruling, award or, (iv) any law, statute, federal, state or local law, ordinance, rule or regulation applicable to Diablo or its assets, operations, properties or businesses now conducted or heretofore conducted, which noncompliance or violation would, individually or in the aggregate, reasonably be anticipated to have a Material Adverse Effect. Diablo has all material licenses and permits that are necessary for the conduct of its business, and such licenses are in full force an effect, except for any failure to be in full force and effect that would not, individually or in the aggregate, have a Material Adverse Effect on Diablo.

(q)Insider Loans. The Disclosure Schedule contains a listing, current as of the date of this Agreement, of all outstanding extensions of credit to any of Diablo’s executive officers and directors and their related interests (as defined under Federal Reserve Board Regulation O) made by Diablo, all of which have been made in compliance with Regulation O, which listing is true, correct and complete in all material respects.

(r)Community Reinvestment Act. Diablo is in Compliance with the Community Reinvestment Act (12 U.S.C. Section 2901 et seq.) (“Community Reinvestment Act”) and all regulations promulgated thereunder, and Diablo has provided Heritage access to copies of Diablo’s current Community Reinvestment Act Statement, all letters and written comments received by Diablo since January 1, 2003 pertaining thereto and any responses by Diablo to such comments. Diablo had a rating of “satisfactory” or better as of its most recent Community Reinvestment Act compliance examination and knows of no reason why it would not receive a rating of “satisfactory” or better at its next Community Reinvestment Act compliance examination or why any other governmental entity may seek to restrain, delay or prohibit the transactions contemplated by this Agreement as a result of any act or omission of Diablo under the Community Reinvestment Act.

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(s)Fair Lending Laws. Diablo is in material compliance with the Fair Lending Laws and all regulations promulgated thereunder. Diablo has not received any notices of any violation of said acts or any of the regulations promulgated thereunder, nor does Diablo have any notice of, or knowledge of, any threatened administrative inquiry, proceeding or investigation with respect to Diablo’s compliance with said acts.

(t)Consumer Compliance Laws. All loans of Diablo have been made substantially in accordance with all applicable statutes and regulatory requirements at the time such loan or any renewal thereof, including without limitation Regulation Z (12 C.F.R. Section 226 et seq.) issued by the Federal Reserve, the Federal Consumer Credit Protection Act (15 U.S.C. Section 601 et seq.) and all statutes and regulations governing the operations of California banking corporations.

(u)Bank Secrecy Act. Diablo is in material compliance with the Bank Secrecy Act (31 U.S.C. Section 5322 et seq.) (“Bank Secrecy Act”) and all regulations promulgated thereunder or related state or federal anti-money laundering laws, regulations and guidelines including (i) those provisions and federal regulations requiring (a) the filing of reports, such as Currency Transaction Reports and Suspicious Activity Reports, (ii) the maintenance of records and (iii) the exercise of due diligence in identifying customers, and Diablo has properly certified all foreign deposit accounts and has made all necessary tax withholdings on all of its deposit accounts.

(v)Patriot Act. Diablo has adopted such procedures and policies as are, in the reasonable judgment of Diablo management, necessary or appropriate to comply with Title III of the USA Patriot Act (Pub. L. No. 107-56) (“Patriot Act”) and is in such compliance in all material respects.

(w)Regulatory Matters. (i) Diablo is not a party or subject to any order, decree, agreement, memorandum of understanding or similar arrangement with or a commitment letter or similar submission to, or extraordinary supervising letter from any Governmental Authority, (ii) has not been advised by, or has knowledge of facts which are reasonably expected to give rise to an advisory notice by, any Regulatory Authority that such Regulatory Authority is contemplating issuing or requesting (or is considering the appropriateness of issuing or requesting) any order, decree, agreement, memorandum of understanding, commitment letter, supervising letter or similar submission, and (iii) except for normal examinations conducted by a Governmental Authority in the regular course of the business of Diablo, or as set forth in the Disclosure Schedule, no Governmental Authority has initiated any proceeding or, to the knowledge of Diablo threatened, any investigation, into the business or operations of Diablo since December 31, 2005. To the knowledge of Diablo, there is no material unresolved violation, criticism or exception by any Governmental Authority with respect to any report or statement relating to any examination of Diablo.

(x)Bank Regulation Reports. Diablo has timely filed all material reports, including Reports of Condition and Income (“Call Reports”), together with any amendments required to be made with respect thereto, that it was required to file since January 1, 2003 with (i) the DFI, (ii) the FDIC or (iii) any other bank regulatory Governmental Authority, and has paid all fees and assessments due and payable in connection therewith. As of their respective dates (and without giving effect to any amendments or modifications filed after the date of this Agreement with respect to reports and documents filed before the date of this Agreement), each of such reports and documents, including the financial statements, exhibits, and schedules thereto, complied in all material respects with all of the statutes, rules and regulations enforced or promulgated by the authority with which they were filed and did not contain any untrue statement of a material fact or omit to state any material fact necessary in order to make the statements made therein, in light of the circumstances under which they were made, not misleading. Diablo has previously made available to Heritage true and correct copies of all DFI and FDIC filings made during calendar years 2004, 2005, and 2006.

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(y)Absence of Certain Changes or Events. Except as set forth in the Disclosure Schedule, since December 31, 2005, there has not been (i) any change, event, development or effect which, individually or together with any other change, event, development or effect, has had or would reasonably be expected to have a Material Adverse Effect on Diablo; (ii) any amendment to the Articles of Incorporation or Bylaws of Diablo; (iii) any declaration, setting aside or payment of any dividend or any other distribution in respect of the capital stock of Diablo; or (iv) any change by Diablo in accounting principles or methods or tax methods, except as required or permitted by, the Financial Accounting Standards Board or by any Governmental Authority having jurisdiction over Diablo. Except as set forth in the Disclosure Schedule or the contemplation of this transaction since December 31, 2005, Diablo has carried on its businesses in all material respects in the ordinary course.

(z)Taxes.

(i)DIABLO has or will have timely and properly filed or caused to be filed with the appropriate taxing authorities all Tax Returns that are required to be filed by or with respect to it. To the knowledge of Diablo, such returns are true and correct and complete in all material respects. All Taxes which have become due pursuant to such Tax Returns or pursuant to assessments received by Diablo, as well as all other taxes due and payable, except to the extent adequately reserved therefor in accordance with GAAP have been paid. With respect to any taxable year or period beginning prior to and ending after the Closing Date, Diablo will timely pay in full or accrue in accordance with GAAP all Taxes and Tax liabilities for the period ending at the Effective Time. Diablo has not been the subject of any audit or other examination of Taxes by the tax authorities of any state or locality and no such audit or other examination is pending or, to Diablo’s knowledge, contemplated, nor has Diablo received any notices from any taxing authority relating to any issue which could materially affect the Tax liability of Diablo. No waiver has been granted extending the time for examination of any Diablo Tax Returns. Diablo has properly accrued all liabilities for Taxes.

(ii)Diablo has not been included in any “consolidated”“unitary” or “combined” Tax Return provided for under the laws of any jurisdiction or any state or locality with respect to Taxes, for any taxable period.

(iii)the Disclosure Schedule sets forth, for each taxable period ending during the period beginning January 1, 2003, and ended December 31, 2006, all jurisdictions in which Diablo (A) has filed an income or franchise Tax Return or (B) has been included in a consolidated, combined, group, or unitary income or franchise Tax Return.

(iv)Diablo has complied in all material respects with all applicable laws, rules and regulations relating to the payment and withholding of Taxes and has duly and timely withheld from amounts due to employees and others on account of salaries, wages and other compensation or payments due and has paid over to the appropriate taxing authorities all amounts required to be so withheld and paid over for all periods under all applicable laws.

(v)Diablo has provided Heritage access to copies of (A) all income, franchise or other Tax Returns of Diablo relating to the taxable periods since January 1, 2003 and (B) any audit report issued relating to any Taxes due from or with respect to Diablo with respect to its income, assets or operation.

(vi)neither Diablo nor any other Person on its behalf has (A) agreed to or is required to make any adjustments pursuant to Section 481(a) of the Code or any similar provision of state, local or foreign law by reason of a change in accounting method initiated by Diablo or has any knowledge that the IRS has proposed in writing any such adjustment or change in accounting method, or has any application pending with any taxing authority requesting permission for any changes in accounting methods that relate to the business or operations of Diablo or (B) executed or entered into a closing agreement pursuant to Section 7121 of the Code or any predecessor provision thereof or any similar provision of state, local or foreign law with respect to Diablo.

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(vii)there is no contract or agreement under which Diablo has, or may at any time in the future have, an obligation to assume, share, or contribute to the payment of any portion of Taxes (or any amount calculated with reference to any portion of Taxes) of any other Person.

(viii)Diablo is not a party to any contract, plan or agreement, which, individually or collectively with respect to any Person, could give rise to the payment of any amount that would not be deductible by Diablo or a successor by reason of Section 280G or Section 162(m) of the Code, but determined without regard to the effects of any payment made pursuant to any obligation entered into after the Effective Time.

(ix)Diablo is not contesting any Tax liability, has not granted any power-of-attorney related to Tax matters to any Person, or received or requested any private tax ruling addressed specifically to Diablo from any taxing authority (foreign or domestic).

(x)no action, suit, proceeding, investigation, arbitration, audit, claim or assessment is presently or, to the knowledge of Diablo, proposed to be asserted or commenced by any taxing authority with regard to any Taxes imposed on Diablo, or for which Diablo may, to the knowledge of Diablo, be liable. No issue has been asserted and not abandoned by any tax authority in any examination of Diablo by any taxing authority that, if raised with respect to the same or substantially similar facts arising in any other period not so examined, would result in a deficiency for such other period, if upheld.

(xi)Diablo has not initiated any adjustment pursuant to Section 481 of the Code (or any similar provision of other laws or regulations) by reason of a change in accounting method or otherwise or entered into any agreement with any Government Authority under Treasury Regulations Section 1.481-4 to take the amount of any Section 481 adjustments into account over a time period that extends beyond Diablo’s current tax year.

(xii)there are no liens for Taxes (other than for Taxes not yet due and payable) upon the assets of Diablo.

(xiii)no indebtedness of Diablo consists of “corporate acquisition indebtedness” within the meaning of Section 279 of the Code or bears interest that is otherwise nondeductible pursuant to Section 163 of the Code.

(xiv)Diablo is not a “United States real property holding corporation” within the meaning of Section 897(c)(2) of the Code.

(xv)no claim has ever been made by any taxing authority in a jurisdiction where Diablo does not file Tax Returns that it is, or may be, subject to taxation by that jurisdiction.

(xvi) Diablo has not engaged in a “confidential corporate tax shelter” within the meaning of Section 6111(d) of the Code and Treasury Regulations Section 301.6111-2, as in effect prior to the enactment of the American Jobs Creation Act of 2004, or a “reportable transaction” within the meaning of Treasury Regulation Section 1.6011-4(b).

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(aa)TRUST ADMINISTRATION. Diablo does not presently exercise trust powers, including, but not limited to, trust administration, and has not exercised such trust powers for a period of at least 3 years prior to the date hereof. The term “trusts” includes (i) any and all common law or other trusts between an individual, corporation or other entities and Diablo, as trustee or co-trustee, including, without limitation, pension or other qualified or nonqualified employee benefit plans, compensation, testamentary, inter vivos, charitable trust indentures; (ii) any and all decedents’ estates where Diablo is serving or has served as a co-executor or sole executor, personal representative or administrator, administrator de bonis non, administrator de bonis non with will annexed, or in any similar fiduciary capacity; (iii) any and all guardianships, conservatorships or similar positions where Diablo is serving or has served as a co-grantor or a sole grantor or a conservator or a co-conservator of the estate, or any similar fiduciary capacity; and (iv) any and all agency and/or custodial accounts and/or similar arrangements, including plan administrator for employee benefit accounts, under which Diablo is serving or has served as an agent or custodian for the owner or other party establishing the account with or without investment authority.

(bb)Labor and Other Employment. Except as set forth in the Disclosure Schedule, (i) Diablo is in compliance in all material respects with all applicable federal and California or other applicable law respecting employment and employment practices, terms and conditions of employment and wages and hour, and has not and is not engaged in any unfair labor practice as determined by the National Labor Relations Board (“NLRB”); (ii) no unfair labor practice charge or complaint against Diablo is pending before the NLRB; (iii) there is no labor strike, slowdown, stoppage or material labor dispute pending or, to the knowledge of Diablo, threatened against or involving Diablo; (iv) to the knowledge of Diablo, no representation question exists respecting the employees of Diablo; (v) no collective bargaining agreement is currently being negotiated by Diablo and Diablo is not and has not been a party to a collective bargaining agreement; (vi) Diablo is not experiencing and has not experienced any material labor difficulty during the last three years; (vii) no grievance or arbitration proceeding is pending or to Diablo’s knowledge currently threatened; (viii) Diablo does not have any Equal Employment Opportunity Commission or any other Governmental Authority charges or other claims of employment discrimination pending or, to Diablo’s knowledge, currently threatened against Diablo; (ix) Diablo does not have any wage and hour claim or investigation pending before or by any Governmental Authority, and to its knowledge no such claim or investigation has been threatened; (x) Diablo has not had any occupation health and safety claims against it; (xi) Diablo is in compliance in all material respects with the terms and provisions of the Immigration Reform and Control Act of 1986, as amended, and all related regulations promulgated thereunder (the “Immigration Laws”); and (xii) there has been no “mass layoff” or “plant closing” by Diablo as defined in the Federal Workers Adjustment Retraining and Notification Act (“WARN”) or state law equivalent, or any other mass layoff that would trigger notice pursuant to WARN or state law equivalent within 90 days prior to the Closing Date. To the knowledge of Diablo, Diablo has never been the subject of any inspection or investigation relating to its compliance with or violation of the Immigration Laws, nor has it been warned, fined or otherwise penalized by reason of any such failure to comply with the Immigration Laws, nor is any such proceeding pending or to Diablo’s knowledge, threatened. Except as set forth in the Disclosure Schedule, there exists no employment, consulting, severance, indemnification agreement or deferred compensation agreement between Diablo and any director, officer or employee of the Company or any agreement that would give any Person the right to receive payment from Diablo as a result of the merger.

(cc)Employee Benefit Plans.

(i)EACH EMPLOYEe Plan is listed in the Disclosure Schedule. For purposes of this Agreement, the term “Employee Plans” shall mean (i) all “employee benefit plans” (as such term is defined in Section 3(3) of ERISA) of which Diablo or any member of the same controlled group of corporations, trades or businesses as Diablo within the meaning of Section 4001(a)(14) of ERISA (for purposes of this Section, an “ERISA Affiliate”) is a sponsor or participating employer or as to which Diablo or any of its ERISA Affiliates makes contributions or is required to make contributions and (ii) any employment, severance or other agreement, plan, arrangement or policy of Diablo or of any of its ERISA Affiliates (whether written or oral) providing for insurance coverage (including self-insured arrangements), workers’ compensation, disability benefits, supplemental unemployment benefits, vacation benefits, retirement benefits, or for profit sharing, deferred compensation, bonuses, stock options, stock appreciation, stock awards, stock based compensation or other forms of incentive compensation or post-termination insurance, compensation or benefits.

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(ii)Except as set forth in the Disclosure Schedule, (A) neither Diablo nor any of its ERISA Affiliates maintains or sponsors, or makes or is required to make contributions to any Employee Plan, (B) none of the Employee Plans is a “multiemployer plan,” as defined in Section 3(37) of ERISA, (C) none of the Employee Plans is a “defined benefit pension plan” within the meaning of Section 3(35) of ERISA, (D) each of the Employee Plans has been administered and maintained in material compliance with all terms, conditions and provisions of such Employee Plan and all provisions of ERISA, the Code, the Consolidated Omnibus Budget Reconciliation Act of 1985 (“COBRA”) and all other applicable laws, and (E) all government reports and filings required by law have been properly and timely filed and all information required to be distributed to participants or beneficiaries has been distributed with respect to each Employee Plan. Neither Diablo nor any ERISA Affiliate has any formal plan or commitment whether legally binding or not, to create any additional Employee Plan, or modify or change any existing Employee Plan that would affect any employee or terminated employee of Diablo or any ERISA Affiliate.

(iii)Except as set forth in the Disclosure Schedule, the consummation of the transactions contemplated by this Agreement will not (A) entitle any employee of Diablo to severance pay under any Employee Plan, (B) accelerate the funding, time of payment or vesting or trigger any payment of compensation or benefits under, increase the amount payable or trigger any other material obligation pursuant to, any of the Employee Plans or (C) result in any breach or violation of, or default under, any of the Employee Plans.

(iv)Diablo has delivered or made available to Heritage true and complete copies of: (A) each of the Employee Plans and any related funding and service agreements thereto (including insurance contracts, investment management agreements, subscription and participation agreements and recordkeeping contracts) including all amendments, (B) the currently effective summary plan description and summary of material modifications pertaining to each of the Employee Plans, (C) the three most recent annual reports for each of the Employee Plans (including all relevant schedules), (D) the most recently filed PBGC Form 1 (if applicable); and (E) the most recent IRS determination letter for each Employee Plan which is intended to constitute a qualified plan under Section 401 of the Code and any requests for rulings, determinations, or opinions pending with respect to an Employee Plan with the IRS or any other governmental agency.

(v)With respect to each Employee Plan that is subject to Title IV of ERISA (i) no amount is due or owing from Diablo or its ERISA Affiliates to the Pension Benefit Guaranty Corporation or to any “multiemployer plan” as defined in Section 3(37) of ERISA on account of any withdrawal therefrom and (ii) no such Employee Plan has been terminated other than in accordance with ERISA or at a time when the Employee Plan was not sufficiently funded to satisfy all liabilities thereof. The transactions contemplated hereunder, including without limitation the termination of the Employee Plans at or prior to the Effective Time, shall not result in any such withdrawal or other liability under any applicable laws.

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(vi)To the knowledge of Diablo, none of the Employee Plans, nor any trust created thereunder nor any trustee, fiduciary or administrator thereof, has engaged in any transaction which could reasonably be expected to subject Diablo to any material tax or material penalty on prohibited transactions imposed by Section 4975 of the Code or Section 406 of ERISA or to any material civil penalty imposed by Section 502 of ERISA. None of the Employee Plans subject to Title IV of ERISA has been completely or partially terminated nor has there been any “reportable event,” as such term is defined in Section 4043(b) of ERISA, with respect to any of such Employee Plans within the 12 month period ending on the date hereof, nor has any notice of intent to terminate been filed or given with respect to any such Employee Plan. There has been no withdrawal by Diablo or any of its ERISA Affiliates that is a substantial employer from a single-employer plan which is a Employee Plan and which has two or more contributing sponsors at least two of whom are not under common control, as referred to in Section 4063(b) of ERISA.

(vii)None of the Employee Plans nor any trust created thereunder has incurred any “accumulated funding deficiency” as such term is defined in Section 412 of the Code, whether or not waived. Neither Diablo nor any of its ERISA Affiliates has provided or is required to provide any security to any Employee Plan pursuant to Section 401(a)(29) of the Code. Each of the Employee Plans which is intended to be a qualified plan under Section 401(a) of the Code has received a favorable determination letter from the IRS and Diablo has no knowledge of any fact which could adversely affect the qualified status of any such Employee Plan. All contributions required to be made to each of the Employee Plans under the terms of the Employee Plan, ERISA, the Code or any other applicable laws have been timely made. The Diablo Financial Statements properly reflect all amounts required to be accrued as liabilities to date under each of the Employee Plans. Except as set forth in the Disclosure Schedule, there is no Employee Plan or other contract, agreement or benefit arrangement covering any employee of Diablo which, individually or collectively, would give rise to the payment of any amount which would constitute an “excess parachute payment” (as defined in Section 280G of the Code).

(viii)Each Employee Plan which is a “nonqualified deferred compensation plan” (within the meaning of Section 409A of the Code) that Diablo is a party to has been operated and administered in compliance with Section 409A of the Code and IRS Notice 2005-1 and the other proposed and final guidance under Section 409A of the Code.

(ix)No Employee Plan which is a nonqualified deferred compensation plan has been “materially modified” (within the meaning of IRS Notice 2005-1) at any time after October 3, 2004, and no event has occurred that would be treated by Section 409A(b) of the Code as a transfer of property for purposes of Section 83 of the Code.

(x)There have occurred and there exists no pending or, to Diablo’s knowledge, threatened litigation, investigations, proceedings, disputes, actions or controversies involving the Employee Plans with any of the IRS, Department of Labor, Pension Benefit Guaranty Corporation, any current or former participant in the Employee Plans or any other person claiming rights under the Employee Plans.

(xi)Other than as set forth in the Disclosure Schedule, to the knowledge of Diablo, neither Diablo nor any of its ERISA Affiliates has used the services of (A) workers for more than one year who have been provided by a third party contract labor supplier (e.g., an outside temporary placement agency) or who may otherwise be eligible to participate in any of the Employee Plans or to an extent that would reasonably be expected to result in the disqualification of any of the Employee Plans or the imposition of penalties or excise taxes with respect to the IRS, the Department of Labor, the Pension Benefit Guaranty Corporation or any other Governmental Authority, (B) temporary employees who have been directly hired by Diablo or any of its ERISA Affiliates for more than six months or who may otherwise be eligible to participate in any of the Employee Plans or to an extent that would reasonably be expected to result in disqualification of any of the Employee Plans or the imposition of penalties or excise taxes with respect to the IRS, the Department of Labor, the Pension Benefit Guaranty Corporation or any other Governmental Authority or (C) individuals who have provided services to Diablo or any of its ERISA Affiliates as independent contractors for more than six months or who may otherwise be eligible to participate in the Employee Plans or to an extent that would reasonably be expected to result in the disqualification of any of the Employee Plans or the imposition or penalties or excise taxes with respect to the IRS, the Department of Labor, the Pension Benefit Guaranty Corporation or any other Governmental Authority.

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(dd)DERIVATIVES. Diablo is not a party to or has agreed to enter into an exchange traded or over-the-counter equity, interest rate, foreign exchange or other swap, forward, future, option, cap, floor or collar or any other contract that is not included on the balance sheet and is a derivative contract (including various combinations thereof) or owns securities that are referred to generically as “structured notes,”“high risk mortgage derivatives,”“capped floating rate notes,” or “capped floating rate mortgage derivatives.”

(ee)Environmental. Except as set forth in the Disclosure Schedule:

(i)All of the properties and operations of Diablo are in compliance in all material respects with all Environmental Laws applicable to such properties and operations.

(ii)Diablo has all material permits, licenses, and authorizations which are required for its respective operations under Environmental Laws.

(iii)No Hazardous Substances exist on or within, or have been used, generated, stored, treated, manufactured, produced, processed, transported, disposed of on, or released from, any of the properties of Diablo in regulated quantities or concentrations, except in accordance in all material respects with Environmental Laws. Diablo has no knowledge that any prior owners, occupants or operators of any such property or any other property in which it has a security interest, ever deposited, disposed of, or allowed to be deposited or disposed of, in, on, or under or handled or processed on, or released, emitted or discharged from, such properties any Hazardous Substances in regulated quantities or concentrations except in accordance in all material respects with Environmental Laws, or to the knowledge of Diablo that any prior or present owners, occupants or operators of any properties in which it holds a security interest, mortgage or other lien or interest and would be deemed an “owner or operator” of such property under any Environmental Law, deposited or disposed of, in, on or under or handled and/or processed on, or released, emitted or discharged from, such properties any Hazardous Substances except in accordance in all material respects with Environmental Laws. The use which Diablo has made and makes of its properties will not result in the use, generation, storage, transportation, accumulation, disposal or release of any Hazardous Substance in regulated quantities or concentrations on, in, or from any of such properties, except in accordance in all material respects with applicable Environmental Laws.

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(iv)There is no action, suit, proceeding, investigation, or inquiry before any court, administrative agency or other Governmental Authority pending, or, to the knowledge of Diablo, threatened against Diablo relating to any material violation of any applicable Environmental Law, nor does Diablo have any reason to believe that any of the above will be forthcoming. To its knowledge, Diablo does not have any material liability for remedial action with respect to a violation of an Environmental Law, nor has it received any written requests for information relating to any alleged material violations of any Environmental Law from any Governmental Authority with respect to the condition, use, or operation of any of its properties nor has it received any notice from any Governmental Authority or any written notice from any other person with respect to any alleged material violation of or alleged material liability for any remedial action under any Environmental Law, nor does Diablo have any reason to believe that any of the above will be forthcoming.

(v)Diablo has made available to Heritage true and complete copies and results of any reports, studies, analyses, or monitoring possessed or initiated by Diablo pertaining to Hazardous Substances, including any Phase I or Phase II reports, relating to properties owned by Diablo.

(vi)As used in this Section, the term “Environmental Law” means, but is not limited to, any and all Federal, state and local laws, statutes, charters or ordinances, and any rules, regulations, binding interpretation, promulgated policy, court order or consent decree issued pursuant to any of the foregoing which pertains to health and safety as it related to Hazardous Substance handling or exposure or protection of the environment, including the Comprehensive Environmental Response Compensation and Liability Act of 1980, 42 U.S.C. Section 9601, et seq. (“CERCLA”), the Resource Conservation and Recovery Act of 1976, 42 U.S.C. Section 6901, et seq. (“RCRA”), the Occupational Safety and Health Act, 29 U.S.C. Section 651, et seq. (as it relates to the use of, or exposure to, Hazardous Substances), the Clean Air Act, 42 U.S.C. Section 7401, et seq., the Clean Water Act, 33 U.S.C. Section 1251, et seq., the Toxic Substance Control Act, 15 U.S.C. Section 2601, et seq., the Carpenter-Presley-Tanner Hazardous Substance Account Act, as amended, Chapter 6.8 of the California Health and Safety Code, Section 25300, et seq., and the Hazardous Waste Control Law, Chapter 6.5 of the California Health and Safety Code, Section 25100, et seq. as it relates to Hazardous Substance handling or exposure (the latter two statutes being referred to herein as the “State Acts”), and any and all regulations promulgated thereunder, and all similar laws, regulations, and requirements of any Governmental Authority having jurisdiction over the environmental activities of Diablo, its Subsidiaries or of their respective properties as such laws, regulations, and requirements may be in effect on the date hereof.

(vii)As used in this Section, the term “Hazardous Substance” shall mean (A) any “hazardous waste” as defined by CERCLA and the State Acts, as such acts are in effect on the date hereof, and any and all regulations promulgated thereunder; (B) any “hazardous substance” as such term is defined by CERCLA; (C) any “regulated substance” as defined by the State Acts; (D) asbestos requiring abatement, removal or encapsulation pursuant to the requirements of Governmental Authorities; (E) polychlorinated biphenyls; (F) petroleum products; (G) ”hazardous chemicals” or “extremely hazardous substances” in quantities sufficient to require reporting, registration, notification and/or optional treatment or handling under the Emergency Planning and Community Right to Know Act of 1986, as amended; (H) any “hazardous chemical” in levels that would result in exposure greater than is allowed by permissible exposure limits established pursuant to the Occupational Safety and Health Act of 1970; (I) any substance that requires reporting, registration, notification, removal, abatement and/or special treatment, storage, handling or disposal, under Sections 6, 7 and 8 of the Toxic Substance Control Act (15 U.S.C. Section 2601); (J) any toxic or hazardous chemical described in 29 C.F.R. 1910.1000-1047 in levels that would result in exposure greater than those allowed by the permissible exposure limits pursuant to such regulations; and (K) any (1) ”hazardous waste,” (2) ”solid waste” capable of causing a “release or threatened release” that present an “imminent and substantial endangerment” to the public health and safety of the environment, (3) ”solid waste” that is capable of causing a “hazardous substance incident,” (4) ”solid waste” with respect to which special requirements are imposed by applicable Governmental Authorities upon the generation, transportation thereof as such terms are defined and used within the meaning of the State Acts or (E) any “pollutant” or “toxic pollutant” as such term is defined in the Federal Clean Water Act, 33 U.S.C. Sections 1251-1376, as amended, by Public Law 100-4, February 4, 1987, and the regulations promulgated thereunder, including 40 C.F.R. Sections 122.1 and 122.26.

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(viii)As used in this Section, the term “properties” shall include: all real estate property now owned or leased by Diablo and property as to which Diablo holds any security interest, deed of trust, mortgage or other lien and would be deemed an “owner or operator” of such property pursuant to any Environmental Law.

(ff)INSURANCE. Diablo has in effect policies of insurance with respect to its assets and business against such casualties and contingencies and in such types and forms as in the judgment of its management are appropriate for its business, operations, properties and assets. Diablo has made available to Heritage copies of all policies of insurance and bonds carried and owned by Diablo as of the date hereof, which copies are complete and accurate in all material respects. Diablo is not in default under any such policy of insurance or bond such that it is reasonably likely to be cancelled. No notice of cancellation or material amendments has been received with respect to existing material policies and no coverage thereunder with respect to any material claims is being disputed.

(gg)Fairness Opinion. Diablo has received from Howe Barnes Hoefer & Arnett, Inc., a fairness opinion, dated as of the date of this Agreement, to the effect that the Merger Consideration is fair to the holders of Diablo Common Stock from a financial point of view.

(hh)Governmental Approvals And Other Conditions. Diablo has not to its knowledge taken or intend to take any action, nor does it have knowledge of any fact or circumstance, that in its judgment would materially impede or delay the consummation of the transactions contemplated by this Agreement or the ability of the parties to obtain any approval of any regulatory authority required for the transactions contemplated by this Agreement or to perform their covenants and agreements under this Agreement. To the knowledge of Diablo, there is no reason relating specifically to Diablo why (a) the approvals that are required to be obtained from regulatory authorities having approval authority in connection with the transactions contemplated hereby should not be granted, (b) such regulatory approvals should be subject to a condition which would differ from conditions customarily imposed by such regulatory authorities in orders approving acquisitions of the type contemplated hereby or (c) any of the conditions precedent as specified in Article IX hereof to the obligations of any of the parties hereto to consummate the transactions contemplated hereby are unlikely to be fulfilled within the applicable time period or periods required for satisfaction of such condition or conditions.

(ii)Fees. Other than financial advisory services performed for Diablo by Howe Barnes Hoefer & Arnett, Inc. pursuant to the terms of the engagement agreement included in the Disclosure Schedule, neither Diablo nor any of its officers, directors, employees or agents, has employed any broker or finder or incurred any liability for any financial advisory fees, brokerage fees, commissions or finder’s fees in connection with this Agreement or the transactions contemplated hereby.

(jj)Statements True and Correct. None of the information supplied or to be supplied by Diablo for inclusion in the Form S-4 or in the Proxy Statement, or incorporated by reference therein, will, in the case of the Proxy Statement, when it is first mailed to the shareholders of Diablo, contain any untrue statement of a material fact or omit to state any material fact necessary in order to make the statements made therein, in light of the circumstances under which such statements are made, not misleading or, in the case of the Form S-4, when it becomes effective, be false or misleading with respect to any material fact, or omit to state any material fact necessary in order to make the statements therein not misleading, or, in the case of the Proxy Statement or any amendment thereof or supplement thereto, at the time of the meeting of shareholders of Diablo, be false or misleading with respect to any material fact or omit to state any material fact necessary to correct any statement or remedy any omission in any earlier communication with respect to the solicitation of any proxy at the Diablo Shareholders’ Meeting. Notwithstanding anything to the contrary set forth in this Section 5.2(kk), Diablo makes no representation or warranty with respect to any information supplied by Heritage or HBC for inclusion in the Form S-4 or Proxy Statement.

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(kk)Accurate Disclosure. Diablo agrees that through the Effective Time, each of its reports and other filings required to be filed with any applicable bank regulatory Governmental Authority will comply in all material respects with all of the applicable statutes, rules and regulations enforced or promulgated by such Governmental Authority with which it will be filed and none will contain any untrue statement of a material fact or omit to state a material fact required to be stated therein or necessary to make the statements therein, in light of the circumstances under which they will be made, not misleading. Any financial statement contained in any such report, or other filing that is intended to present the financial position of Diablo will fairly present, in all material respects, the financial position of Diablo and will be prepared in accordance with GAAP consistently applied during the periods involved. Notwithstanding anything to the contrary set forth in this Section 5.1(kk), Diablo makes no representation or warranty with respect to any information supplied by Heritage or HBC for inclusion in such reports.

Section 5.2REPRESENTATIONS AND WARRANTIES OF Heritage. Heritage represents and warrants to Diablo that:

(a)ORGANIZATION.

(i)EACH OF HERITAGE AND HBC ARE CALIFORNIA CORPORATIONS duly organized, validly existing and in good standing under the laws of the State of California and each has all requisite power and authority, corporate and otherwise, to own, operate and lease their respective assets and properties and to carry on their respective business substantially as it has been and is now being conducted. Each of Heritage and HBC are duly qualified to do business and is in good standing in each jurisdiction where the character of their respective assets or properties owned or leased by it or the nature of the business transacted by it requires that it be so qualified, except where the failure to so qualify would not have a Material Adverse Effect on Heritage and HBC.

(ii)Each of Heritage and HBC have all requisite corporate power and authority to enter into this Agreement and, (subject to the approval of this Agreement by its shareholder in the case of HBC) and the receipt of all requisite regulatory approvals and the expiration of any applicable waiting periods, to consummate the transactions contemplated hereby.

(iii)HBC is authorized by the DFI in accordance with the California Financial Code to conduct a commercial banking business. The deposits of HBC are insured by the FDIC in the manner and fullest extent provided by applicable law and all premiums and assessments required to be paid in connection therewith have been paid when due.

(iv)True and complete copies of the Articles of Incorporation and Bylaws of Heritage and HBC, as amended to date, have been delivered to Diablo. The corporate record books, transfer books and stock ledgers of Heritage and HBC are complete and accurate in all material respects and reflect all meetings, consents and other material actions of the organizers, incorporators, stockholders, Boards of Directors and committees of the Boards of Directors of Heritage and HBC, and all transactions in its capital stock, since their respective inceptions.

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(b)AUTHORIZATION. The execution, delivery and performance of this Agreement and the consummation of the transactions contemplated hereby and thereby have been duly approved and authorized by each of the respective boards of directors of Heritage and HBC, and all necessary corporate action on the part of Heritage and HBC has been taken, subject to the approval of this Agreement and the Merger by the affirmative vote of a majority of the outstanding shares of HBC Common Stock (all of which are owned by Heritage). This Agreement has been duly executed and delivered by Heritage and HBC and constitutes the valid and binding obligation of each of them and is enforceable against each of them, except to the extent that enforceability thereof may be limited by applicable bankruptcy, insolvency, reorganization, moratorium, receivership, conservatorship or similar laws or equitable principles or doctrines.

(c)Conflictsand Approvals. Subject to the second sentence of this Section 5.2(c), the execution and delivery of this Agreement does not, and the consummation of the transactions contemplated hereby and thereby will not, conflict with or result in any violation, breach or termination of, or default or loss of a material benefit under, permit the acceleration of any obligation under, require the giving of notice or obtaining consent under, or result in the creation of any material lien, charge or encumbrance on any property or assets under, any provision of the Articles of Incorporation or Bylaws of Heritage or HBC, or any mortgage, indenture, lease, agreement or other instrument, permit, concession, grant, franchise, license, judgment, order, decree, statute, law, ordinance, rule or regulation applicable to either of them or their respective properties, other than any such conflicts, violations or defaults which (i) will be cured or waived prior to the Effective Time. No consent, approval, order or authorization of, or registration, declaration or filing with, any Governmental Authority is required by or with respect to Heritage or HBC in connection with the execution and delivery of this Agreement or the consummation by Heritage and HBC of the transactions contemplated hereby or thereby except for: (a) the filing and approval of all required regulatory applications or notifications by Heritage, Diablo and/or HBC for approval of the transactions contemplated by this Agreement; (b) the filing by Heritage of the Form S-4, which Diablo shall include the Proxy Statement for use in connection with the Diablo Shareholders’ Meeting and the SEC’s order declaring the Form S-4 effective; (c) the filing of the Merger Agreement and certificates of merger with respect to the Merger with the California Secretary of State and Commissioner; (d) filings and approval with and from the DFI and FRB, and (e) any filings, approvals or no-action letters with or from state securities authorities.

(d)Subsidiary. Except for subsidiary grantor trusts identified in the Heritage Financial Statements, neither Heritage nor HBC owns or controls any subsidiary. Neither Heritage HBC has any equity interest, direct or indirect, in any other bank or corporation or in any partnership, joint venture or other business enterprise or entity, except as acquired through settlement of indebtedness, foreclosure, the exercise of creditors’ remedies or in a fiduciary capacity, and the business carried on by Heritage and HBC have not been conducted through any other direct or indirect subsidiary or Affiliate of Heritage or HBC.

(e)Capitalization. The entire authorized capital stock of Heritage consists of (i) 30,000,000 shares of Heritage Common Stock, of which 11,656,943 are issued and outstanding, 752,983 additional shares of which have been reserved for issuance to holders of outstanding stock options under the Heritage 2004 Stock Option Plan and the Heritage 1994 Tandem Stock Option Plan (“Heritage Stock Option Plans”), and (ii) 10,000,000 shares of preferred stock, no par value per share, of which no shares are issued and outstanding. Except for options issued under the Heritage Stock Option Plans and 51,000 shares issuable pursuant to a Restricted Stock Agreement dated March 17, 2005 between Heritage and its Chief Executive Officer, there are no (i) other outstanding equity securities of any kind or character, including but not limited to preferred stock, (ii) outstanding subscriptions, options, convertible securities, rights, warrants, calls or other agreements or commitments of any kind issued or granted by, or binding upon, Heritage to purchase or otherwise acquire any security of or equity interest in Heritage or (iii) outstanding subscriptions, options, rights, warrants, calls, convertible securities, irrevocable proxies or other agreements or commitments obligating Heritage to issue any shares of, restricting the transfer of or otherwise relating to shares of its capital stock of any class. All of the issued and outstanding shares of Heritage Common Stock have been duly authorized, validly issued and are fully paid and non-assessable, and have not been issued in violation of the preemptive rights of any person. Such shares of Heritage Common Stock have been issued in full compliance with applicable law.

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(f)Heritage SEC Reports.

(i)HERITAGE HAS FILED ALL REPORTS, STATEMENTS, FORMS, SCHEDULES, REGISTRATION STATEMENTS, PROSPECTIVE, PROXY STATEMENT AND OTHER DOCUMENTS REQUIRED TO BE FILED WITH THE SEC PURSUANT TO THE SECURITIES EXCHANGE ACT OF 1934, AS AMENDED (“Exchange Act”), Exchange Act or the Securities Act, as the case may be, since December 31, 2003 (“Heritage SEC Reports”). Each of the Heritage SEC Reports, at the time of its filing, complied in all material respects, and each of Heritage SEC Reports to be filed after the date hereof, shall comply in all material respects, with the requirements of the Exchange Act or Securities Act, as applicable, and the rules and regulations of the SEC promulgated thereunder and other federal, state and local laws, rules and regulations applicable to such documents, and did not at the time filed, and will not, if filed subsequent to the date hereof, contain any untrue statement of a material fact or omit to state any material fact required to be stated therein or necessary in order to make the statements therein, in light of the circumstances under which they were made or will be made, not misleading.

(ii)Each required form, report and document containing financial statements that Heritage has filed with or furnished to the SEC since July 31, 2002 was accompanied by the certifications required to be filed or furnished by Heritage’s Chief Executive Officer and Chief Financial Officer pursuant to the Sarbanes-Oxley Act, and at the time of filing or submission of each such certification, such certification (i) was true and accurate and complied with the Sarbanes-Oxley Act, (ii) did not contain any qualifications or exceptions to the matters certified therein, except as otherwise permitted under the Sarbanes-Oxley Act, and (iii) has not been modified or withdrawn. As of the date of this Agreement, neither Heritage nor any of its officers has received notice from any governmental entity questioning or challenging the accuracy, completeness, content, form or manner of filing or furnishing of such certifications.

(g)FINANCIAL STATEMENTS and Accounting Records. Heritage has furnished to Diablo true and complete copies of (i) the audited consolidated balance sheets of Heritage as of December 31, 2004 and 2005, and the related audited statements of income, stockholders’ equity and cash flows for the years ended December 31, 2003, 2004 and 2005, (ii) an unaudited consolidated balance sheet of Heritage as of September 30, 2006, and the related unaudited statement of income for the nine-month period ended September 30, 2006 (such balance sheets and the related statements of income, stockholders’ equity and cash flows are collectively referred to herein as the “Heritage Financial Statements”). The Heritage Financial Statements fairly present, in all material respects, the financial position of Heritage as of the respective dates thereof and the results of operations and cash flows of Heritage for the periods then ended, in conformity with GAAP, applied on a basis consistent with prior periods (subject, in the case of the unaudited interim financial statements, to normal year-end adjustments and the fact that they do not contain all of the footnote disclosures required by GAAP). Heritage makes and keeps accurate books and records and maintains a system of internal accounting controls over financial reporting that are sufficient to provide reasonable assurance that transactions are properly recorded and records are kept which accurately and fairly reflect, in all material respects, financial activities of Heritage, so as to permit the preparation of Heritage’s financial statements in conformity with GAAP. Since December 31, 2005, Heritage has not been advised of (i) any significant deficiencies in the design or operation of internal controls that could adversely affect the ability of Heritage to record, process, summarize and report financial data and (ii) any fraud, whether or not material, that involves management or other employees who have a significant role in the internal controls of Heritage.

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(h)Title to Assets. Each of Heritage and HBC have good and indefeasible title to all of their respective assets and properties reflected in the Heritage Financial Statements or acquired subsequent thereto, free and clear of Encumbrances, except (i) as noted in the Heritage Financial Statements, (ii) statutory liens not yet delinquent, (iii) consensual landlord liens, (iv) minor defects and irregularities in title and encumbrances that do not materially impair the use thereof for the purpose for which they are held, (v) pledges of assets in the ordinary course of business to secure public funds deposits, and (vi) those assets and properties disposed of for fair value in the ordinary course of business since September 30, 2006.

(i)Litigation. There are no actions, claims, suits, investigations, reviews or other legal, quasi-judicial or administrative proceedings of any kind or nature now pending or, to the knowledge of Heritage, threatened against or affecting Heritage or HBC, or for which Heritage or HBC is obligated to indemnify a third party at law or in equity, by or before any Governmental Authority or any of its properties which, if adversely determined, would have, individually or in the aggregate, a Material Adverse Effect on Heritage and HBC (taken as a whole), and Heritage does not know or have any reason to be aware of any basis for the same. No legal action, suit or proceeding or judicial, administrative or governmental investigation is pending or, to the knowledge of Heritage, threatened against Heritage or HBC that questions the validity of this Agreement or the agreements contemplated hereby, including, but not limited to, the Merger Agreement, or any actions taken or to be taken by Heritage or HBC pursuant hereto or thereto or seeks to enjoin or otherwise restrain the transactions contemplated hereby or thereby.

(j)Compliance with Laws and Permits. Each of Heritage and HBC is in compliance with, and is not in default (or with the giving of notice or the passage of time will be in default) under, or in violation of, (i) any provision of their respective Articles of Incorporation or Bylaws, (ii) any permit, concession, grant, franchise, license, authorization, order, judgment, writ, injunction, decree, award or, (iii) any law, statute, federal, state or local law, ordinance, rule or regulation applicable to Heritage or HBC or their respective assets, operations, properties or businesses now conducted or heretofore conducted, including the Community Reinvestment Act, Fair Lending Laws, Regulation Z, the Bank Secrecy Act and the Patriot Act, which noncompliance or violation would, individually or in the aggregate, reasonably be anticipated to have a Material Adverse Effect on Heritage and HBC (taken as a whole). Each of Heritage and HBC have all material licenses and permits that are necessary for the conduct of their respective business, and such licenses are in full force an effect, except for any failure to be in full force and effect that would not, individually or in the aggregate, have a Material Adverse Effect on Heritage and HBC (taken as a whole).

(k)Regulatory Actions. (i) Neither Heritage nor HBC is not a party or subject to any order, decree, agreement, memorandum of understanding or similar arrangement with or a commitment letter or similar submission to, or extraordinary supervising letter from any Governmental Authority or (ii) has been advised by, or has knowledge of facts which are reasonably expected to give rise to an advisory notice by, any Regulatory Authority that such Regulatory Authority is contemplating issuing or requesting (or is considering the appropriateness of issuing or requesting) any order, decree, agreement, memorandum of understanding, commitment letter, supervising letter or similar submission.

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(l)Bank Regulatory Reports. Each of Heritage and HBC have timely filed all material reports, registrations and statements, together with any amendments required to be made with respect thereto, that it was required to file since January 1, 2003 with (i) the DFI, (ii) the FDIC, (iii) Federal Reserve Board (“FRB”), and (iv) any other bank regulatory Governmental Authority, and has paid all fees and assessments due and payable in connection therewith. As of their respective dates (and without giving effect to any amendments or modifications filed after the date of this Agreement with respect to reports and documents filed before the date of this Agreement), each of such reports and documents, including the financial statements, exhibits, and schedules thereto, complied in all material respects with all of the statutes, rules and regulations enforced or promulgated by the authority with which they were filed and did not contain any untrue statement of a material fact or omit to state any material fact necessary in order to make the statements made therein, in light of the circumstances under which they were made, not misleading.

(m)Absence of Certain Changes or Events. Since December 31, 2005, there has not been (i) any change, event, development or effect which, individually or together with any other change, event, development or effect, has had or would reasonably be expected to have a Material Adverse Effect on Heritage and HBC (taken as a whole); (ii) any amendment to the Articles of Incorporation or Bylaws of Heritage or HBC; (iii) any declaration, setting aside or payment of any dividend or any other distribution in respect of the capital stock of Heritage, other than regular quarterly dividends; or (iv) any change by Heritage in accounting principles or methods or tax methods, except as required or permitted by, the Financial Accounting Standards Board or by any Governmental Authority having jurisdiction over Heritage or HBC. Except for contemplation of this transaction since December 31, 2005, Heritage and HBC have carried on their respective businesses in all material respects in the ordinary course.

(n)Statements True and Correct. None of the information supplied or to be supplied by Heritage and HBC for inclusion in the Form S-4 or in the Proxy Statement, or incorporated by reference therein, will, in the case of the Proxy Statement, when it is first mailed to the shareholders of Diablo, contain any untrue statement of a material fact or omit to state any material fact necessary in order to make the statements made therein, in light of the circumstances under which such statements are made, not misleading or, in the case of the Form S-4, when it becomes effective, be false or misleading with respect to any material fact, or omit to state any material fact necessary in order to make the statements therein not misleading, or, in the case of the Proxy Statement or any amendment thereof or supplement thereto, at the time of the meeting of shareholders of Diablo, be false or misleading with respect to any material fact or omit to state any material fact necessary to correct any statement or remedy any omission in any earlier communication with respect to the solicitation of any proxy at the Diablo Shareholders’ Meeting. Notwithstanding anything to the contrary set forth in this Section 5.2(n), Heritage makes no representation or warranty with respect to any information supplied by Diablo for inclusion in the Form S-4 or Proxy Statement.

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(o)Accurate Disclosure. Heritage and HBC agree that through the Effective Time, each of its reports and other filings required to be filed with any applicable bank regulatory Governmental Authority will comply in all material respects with all of the applicable statutes, rules and regulations enforced or promulgated by such Governmental Authority with which it will be filed and none will contain any untrue statement of a material fact or omit to state a material fact required to be stated therein or necessary to make the statements therein, in light of the circumstances under which they will be made, not misleading. Any financial statement contained in any such report, or other filing that is intended to present the financial position of Heritage or HBC (or as on a consolidated basis) will fairly present, in all material respects, the financial position of Heritage and HBC (or as on a consolidated basis) and will be prepared in accordance with GAAP consistently applied during the periods involved. Notwithstanding anything to the contrary set forth in this Section 5.2(o). Neither Heritage nor HBC makes no representation or warranty with respect to any information supplied by Diablo for inclusion in any such reports.

(p)Fees. Except for fees paid to RBC Capital Markets, neither Heritage nor HBC, or any of their respective officers, directors, employees or agents has entered into any agreement or arrangement with any broker or finder that could require Heritage or HBC to pay any financial advisory fees, brokerage fees, commissions or finder’s fees in connection with this Agreement or the transactions contemplated hereby.

(q)Community Reinvestment Act. HBC is in Compliance with the Community Reinvestment Act (12 U.S.C. Section 2901 et seq.) (“Community Reinvestment Act”) and all regulations promulgated thereunder, and Heritage has provided Diablo access to copies of HBC’s current Community Reinvestment Act Statement, all letters and written comments received by Heritage or HBC since January 1, 2003 pertaining thereto and any responses by Heritage or HBC to such comments. HBC had a rating of “satisfactory” or better as of its most recent Community Reinvestment Act compliance examination and knows of no reason why it either would not receive a rating of “satisfactory” or better at its next Community Reinvestment Act compliance examination or why any other governmental entity may seek to restrain, delay or prohibit the transactions contemplated by this Agreement as a result of any act or omission of HBC under the Community Reinvestment Act.

(r)Bank Secrecy Act. Heritage and HBC are in material compliance with the Bank Secrecy Act (31 U.S.C. Section 5322 et seq.) and all regulations promulgated thereunder or related state or federal anti-money laundering laws, regulations and guidelines including (i) those provisions and federal regulations requiring (a) the filing of reports, such as Currency Transaction Reports and Suspicious Activity Reports, (ii) the maintenance of records and (iii) the exercise of due diligence in identifying customers, and Heritage and HBC have properly certified all foreign deposit accounts and have made all necessary tax withholdings on all of its deposit account.

(s)Patriot Act. Heritage and HBC have adopted such procedures and policies as are, in the reasonable judgment of their respective managements, necessary or appropriate to comply with Title III of the USA Patriot Act (Pub. L. No. 107-56) and is in such compliance in all material respects.

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(t)Taxes. Heritage and HBC have (i) duly and timely filed (including applicable extensions granted without penalty) all material Tax Returns required to be filed at or prior to the Effective Time, and to the knowledge of Heritage, such Tax Returns are true and correct and complete in all material respects, and (ii) paid in full or made adequate provision in the consolidated financial statements of Heritage (in accordance with GAAP) for all Taxes, with such provisions being based on estimates made by Heritage in good faith. No deficiencies for any Taxes have been proposed or assessed in writing with respect to Heritage or HBC, other than amounts which have been otherwise provided for or which are immaterial to the financial statements of Heritage. There are no Liens for Taxes upon the assets of Heritage or HBC except for statutory liens for current Taxes not yet due. Neither HBC nor Heritage has requested any extension of time within which to file any Tax Returns in respect of any fiscal year which have not since been filed and no waiver has been requested or granted extending the time for examination of any Heritage or HBC Tax Returns. Neither Heritage nor HBC is a party to any agreement providing for the allocation or sharing of Taxes (other than such an agreement exclusively between Heritage and HBC).

(u)Absence of Undisclosed Liabilities. To the knowledge of Heritage, and except for items for which reserves have been established in Heritage’s most recent audited consolidated balance sheets and interim unaudited consolidated balance sheets, which have been delivered to Diablo and which do not reflect any overstated assets, neither Heritage nor HBC has incurred, and is not legally obligated with respect to, any material indebtedness, liability (including, without limitation, a liability arising out of an indemnification, guarantee, hold harmless or similar arrangement) or obligation (accrued or contingent, whether due or to become due, and whether or not subordinated to the claims of its general creditors), and that alone or when combined with all similar liabilities has, had, or could reasonably be expected to have, a Material Adverse Effect on Heritage. Other than any regular quarterly dividend by Heritage, no cash, stock or other dividend or any other distribution with respect to Heritage Common Stock has been declared, set aside or paid except in accordance with the Heritage Stock Option Plans and a Restricted Stock Agreement existing of the date hereof.

ARTICLE VI

COVENANTS OF HERITAGE AND HBC

Heritage and HBC covenant and agree with Diablo as follows:

Section 6.1MATERIAL ADVERSE CHANGES; REPORTS; FINANCIAL STATEMENTS; FILINGS.

(A)HERITAGE WILL PROMPTLY NOTIFY DIABLO OF ANY EVENT OF WHICH HERITAGE OBTAINS KNOWLEDGE WHICH MAY MATERIALLY AND ADVERSELY AFFECT THE BUSINESS, FINANCIAL CONDITION, OR RESULTS OF OPERATIONS OF EITHER HERITAGE OR HBC.

(b)HERITAGE WILL FURNISH TO DIABLO, (I) monthly unaudited consolidated balance sheets and statements of operations for Heritage and HBC; and (ii) as soon as available, all letters and communications sent by Heritage to its shareholders and all reports filed by Heritage or HBC with the SEC, the FRB, the FDIC, the DFI and any other Governmental Authority.

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Section 6.2RULE 144 Compliance. From and after the Effective Time, Heritage shall file all reports with the SEC necessary to permit the shareholders of Diablo who may be deemed “underwriters” (within the meaning of Rule 145 under the Securities Act) of the Diablo Common Stock to sell Heritage Common Stock received by them in connection with the Merger pursuant to Rules 144 and 145(d) under the Securities Act if they would otherwise be so entitled.

Section 6.3Access. Between the date hereof until the Effective Time, Heritage and HBC will authorize and permit Diablo, its representatives, accountants and counsel, to have reasonable access during normal business hours, on two (2) Business Days notice and in such manner as will not unreasonably interfere with the conduct of the businesses of Heritage and HBC, to all properties, books, records, branch operating reports, branch audit reports, operating instructions and procedures, tax returns, tax settlement letters, contracts and documents, and all other information with respect to their business affairs, financial condition, assets and liabilities as Diablo may from time to time reasonably request. Heritage and HBC shall permit Diablo, its representatives, accountants and counsel to make copies of such books, records and other documents and to discuss the business affairs, condition (financial and otherwise), assets and liabilities of Heritage and HBC with such third Persons, including, without limitation, its directors, officers, employees, accountants, counsel and creditors, as is necessary or reasonably appropriate for the purposes of familiarizing itself with the businesses and operations of Heritage and HBC, obtaining any necessary orders, consents or approvals of the transactions contemplated by this Agreement by any Governmental Authority and conducting an evaluation of the assets and liabilities of Heritage and HBC.

Section 6.4Listing of Heritage Stock. Heritage shall use commercially reasonable efforts to have the shares of Heritage Common Stock to be issued in the Merger listed on the NASDAQ Global Select Market as of the Effective Date upon notice of issuance.

Section 6.5Appointment of Heritage Directors. Prior to the Effective Time Heritage shall take all the necessary steps so that at the Effective Time (i) the number of directors of Heritage shall be increased by two and (ii) John J. Hounslow and Mark E. Lefanowicz shall be added to the Heritage board of directors and serve until their successors are duly elected and qualified. Following the Effective Time, (i) Heritage shall nominate Hounslow and Lefanowicz as directors at the Heritage annual meetings for 2007 (if the Effective Time precedes the Heritage Annual Meeting for 2007), and (ii) Heritage shall nominate Hounslow and Lefanowicz as directors at the Heritage Annual Meetings for 2008 and 2009, provided they have satisfactorily complied with Heritage board of director’s policies in effect from time to time, and, if the Effective Time shall precede the Heritage annual meeting for 2007, for 2007.

Section 6.6Participation in Subsequent Transactions. During the period that this Agreement is pending prior to the Effective Time, Heritage shall not enter into any agreement with any unaffiliated third party concerning any purchase or acquisition of Heritage or HBC or substantially all of their respective assets by any unaffiliated third party through any type of corporate reorganization, stock acquisition or exchange, asset purchase or other similar transaction (a “Heritage Transaction”) unless such Heritage Transaction expressly provides (i) for the assumption of the obligations under the terms of this Agreement by Heritage or any successor entity and (ii) that the shareholders of Diablo upon exchange of their Diablo Common Stock will be entitled to receive consideration in such Heritage Transaction as if their shares of Diablo Common Stock had been converted into Heritage Common Stock at the effective time of such Heritage Transaction, without giving effect to any adjustment to the Exchange Ratio that would have otherwise been required pursuant to Section 2.2(a)(ii) hereof.

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Section 6.7Benefit Plans.

(A)SUBJECT TO SECTION 6.7(B), (C) AND (D), AS SOON AS ADMINISTRATIVELY PRACTICABLE AFTER THE EFFECTIVE TIME, HERITAGE AND HBC SHALL TAKE ALL REASONABLE ACTION SO THAT EMPLOYEES OF DIABLO SHALL BE ENTITLED TO PARTICIPATE IN EACH EMPLOYEE BENEFIT PLAN, PROGRAM OR ARRANGEMENT OF HERITAGE AND HBC OF GENERAL APPLICABILITY (THE “HERITAGE AND HBC BENEFIT PLANS”) TO THE SAME EXTENT AS SIMILARLY-SITUATED EMPLOYEES OF HERITAGE AND HBC (IT BEING UNDERSTOOD THAT INCLUSION OF THE EMPLOYEES OF DIABLO IN THE HERITAGE AND HBC BENEFIT PLANS MAY OCCUR AT DIFFERENT TIMES WITH RESPECT TO DIFFERENT PLANS), PROVIDED HOWEVER, THAT COVERAGE SHALL BE CONTINUED UNDER CORRESPONDING BENEFIT PLANS OF DIABLO UNTIL SUCH EMPLOYEES ARE PERMITTED TO PARTICIPATE IN THE HERITAGE AND HBC BENEFIT PLANS AND PROVIDED FURTHER, HOWEVER, THAT NOTHING CONTAINED HEREIN SHALL REQUIRE HERITAGE OR HBC TO MAKE ANY GRANTS TO ANY FORMER EMPLOYEE OF DIABLO UNDER ANY DISCRETIONARY EQUITY COMPENSATION PLAN OF HERITAGE AND HBC. HERITAGE AND HBC SHALL CAUSE EACH HERITAGE AND HBC BENEFIT PLAN IN WHICH EMPLOYEES OF DIABLO ARE ELIGIBLE TO PARTICIPATE TO RECOGNIZE, FOR PURPOSES OF DETERMINING ELIGIBILITY TO PARTICIPATE IN, THE VESTING OF BENEFITS AND FOR ALL OTHER PURPOSES (BUT NOT FOR ACCRUAL OF PENSION BENEFITS OR ALLOCATION OF SHARES UNDER THE HERITAGE ESOP PLAN) UNDER THE HERITAGE AND HBC BENEFITS PLANS, THE SERVICE OF SUCH EMPLOYEES WITH DIABLO TO THE SAME EXTENT AS SUCH SERVICE WAS CREDITED FOR SUCH PURPOSE BY DIABLO, PROVIDED, HOWEVER, THAT SUCH SERVICE SHALL NOT BE RECOGNIZED TO THE EXTENT THAT SUCH RECOGNITION WOULD RESULT IN A DUPLICATION OF BENEFITS. NOTHING HEREIN SHALL LIMIT THE ABILITY OF HERITAGE AND HBC TO AMEND OR TERMINATE ANY OF DIABLO’S BENEFIT PLANS IN ACCORDANCE WITH AND TO THE EXTENT PERMITTED BY THEIR TERMS AT ANY TIME PERMITTED BY SUCH TERMS.

(b)AT AND FOLLOWING THE EFFECTIVE TIME, HERITAGE AND HBC SHALL HONOR, AND SHALL CONTINUE TO BE OBLIGATED TO PERFORM, IN ACCORDANCE WITH THEIR TERMS, AND BENEFIT OBLIGATIONS TO, AND CONTRACTUAL RIGHTS OF FORMER EMPLOYEES OF DIABLO EXISTING AS OF THE EFFECTIVE DATE, AS WELL AS ALL EMPLOYMENT, SEVERANCE, DEFERRED COMPENSATION, “CHANGE-IN-CONTROL” AGREEMENTS, PLANS OR POLICIES OF DIABLO SET FORTH ON SECTION 5.1(K) OF THE DISCLOSURE SCHEDULE (UNLESS TERMINATED BY ANY AGREEMENT ENTERED INTO AS OF OR AFTER THE DATE HEREOF), PROVIDED SUCH AGREEMENTS, PLANS OR POLICIES ARE NOT SUPERSEDED BY SIMILAR AGREEMENT, PLANS OR POLICIES OF HERITAGE OR HBC, PROVIDED FURTHER, THIS PROVISION SHALL NOT PREVENT HERITAGE OR HBC FROM AMENDING, SUSPENDING, OR TERMINATING ANY SUCH AGREEMENTS TO THE EXTENT PERMITTED BY THE RESPECTIVE TERMS OF SUCH AGREEMENTS PLANS OR POLICIES.

(c)Heritage in its sole discretion, may elect to terminate the Diablo 401(k) Plan or to discontinue contributions to the Diablo 401(k) Plan following the Effective Time, to cause Diablo to terminate the Diablo 401(k) Plan to be effective at the Effective Time, or to merge the Diablo 401(k) Plan with and into the Heritage 401(k) Plan after the Effective Time. In no event shall the Diablo 401(k) Plan be merged with and into the Heritage 401(k) Plan, however, unless Heritage determines, in its reasonable judgment, that: (i) the Diablo 401(k) Plan is a qualified plan under Section 401(a) of the Code, both as to the form of the Diablo 401(k) Plan and as to its operation; and (ii) there are no facts in existence that would be reasonably likely to adversely affect the qualified status of the Diablo 401(k) Plan. If Heritage determines in its sole discretion not to merge the Diablo 401(k) Plan into the Heritage 401(k) Plan and that the Diablo 401(k) Plan should be terminated prior to the Effective Time, Diablo agrees to use its commercially reasonable efforts to have the Diablo 401(k) Plan terminated prior to the Effective Time and to obtain an IRS determination that the Diablo 401(k) Plan continues to be qualified upon termination.

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(d)Employees of Diablo who are covered under Diablo dental and health insurance plans immediately prior to the Effective Date shall become eligible to participate in any of the medical, dental, disability or other health plans of Heritage or HBC. Heritage shall, or shall cause HBC to, (i) waive any preexisting conditions (subject, in the case of plans other than medical plans (which medical plans include, among other benefits, in-patient/out-patient hospital care, mental health and prescription coverage), to Heritage’s reasonable efforts to obtain carrier approval), waiting periods and actively at work requirements under such plans, and (ii) cause such plans to honor any expenses incurred by such employees and their beneficiaries under similar plans of Diablo during the portion of the calendar year prior to such participation for purposes of satisfying applicable deductibles, co-insurance requirements and maximum out-of-pocket expenses. Notwithstanding the foregoing, no such action will cause the plans to violate applicable legal requirements.

Section 6.8COMPLIANCE WITH ANTI-MONEY LAUNDERING LAWS. From the date hereof through the Effective Time, Heritage and HBC will not take any action or omit to take any action that may result, individually or in the aggregate with any other actions or omissions, in a material violation of the Bank Secrecy Act, the anti-money laundering laws and regulations or the policies and procedures of Heritage or HBC with respect to the foregoing.

ARTICLE VII

CONVENANTS OF DIABLO

Diablo covenants and agrees with Heritage and HBC as follows:

Section 7.1ACCESS. (a) Between the date hereof and the Effective Time, Diablo will authorize and permit Heritage, its representatives, accountants and counsel, to have access during normal business hours, on two (2) Business Days notice and in such manner as will not unreasonably interfere with the conduct of the businesses of Diablo, to all properties, books, records, branch operating reports, branch audit reports, operating instructions and procedures, tax returns, tax settlement letters, contracts and documents, and all other information with respect to its business affairs, financial condition, assets and liabilities as Heritage may from time to time reasonably request. Diablo shall permit Heritage, its representatives, accountants and counsel to make copies of such books, records and other documents and to discuss the business affairs, condition (financial and otherwise), assets and liabilities of Diablo with such third Persons, including, without limitation, its directors, officers, employees, accountants, counsel and creditors, as is necessary or reasonably appropriate for the purposes of familiarizing itself with the businesses and operations of Diablo, obtaining any necessary orders, consents or approvals of the transactions contemplated by this Agreement by any Governmental Authority and conducting an evaluation of the assets and liabilities of Diablo. Upon reasonable request by Heritage, Diablo shall make its chief financial officer and controller available to discuss with Heritage and its representatives Heritage’s ongoing due diligence and review of Diablo’s operations. Diablo will cause its independent outside auditors to make available to Heritage, its accountants, counsel and other agents, such personnel, work papers and other documentation of such firm relating to its work papers and its audits of the books and records of Diablo as may be requested by Heritage in connection with its review of the foregoing matters.

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(b)THE CHAIRMAN OF THE BOARD OR PRESIDENT OF HERITAGE, OR IN THEIR ABSENCE ANOTHER REPRESENTATIVE OF HERITAGE SHALL BE INVITED BY DIABLO TO ATTEND ALL REGULAR AND SPECIAL board of directors and committee meetings of Diablo from the date hereof until the Effective Time. Diablo shall inform Heritage of all such Board meetings at least five (5) Business Days in advance of each such meeting; provided, however, that the attendance of such representative of Heritage shall not be permitted at any meeting, or portion thereof, for the sole purpose of discussing the transaction contemplated by this Agreement or the obligations of Diablo under this Agreement or matters involving attorney-client privilege.

Section 7.2MATERIAL ADVERSE CHANGES; REPORTS; FINANCIAL STATEMENTS; FILINGS Notifications.

(A)DIABLO WILL PROMPTLY NOTIFY HERITAGE (I) OF ANY EVENT OF WHICH DIABLO OBTAINS KNOWLEDGE WHICH MAY MATERIALLY AND ADVERSELY AFFECT THE BUSINESS, FINANCIAL CONDITION, PROSPECTS OR RESULTS OF OPERATIONS OF DIABLO; OR (II) ANY EVENT, DEVELOPMENT OR CIRCUMSTANCE OTHER THAN THE TRANSACTIONS CONTEMPLATED BY THIS AGREEMENT THAT, TO THE KNOWLEDGE OF DIABLO, WILL OR, WITH THE PASSAGE OF TIME OR THE GIVING OF NOTICE OR BOTH, IS REASONABLY EXPECTED TO RESULT IN THE LOSS TO DIABLO OF THE SERVICES OF ANY EXECUTIVE OFFICER OF DIABLO (NO KNOWLEDGE WILL BE IMPUTED TO DIABLO FOR PURPOSES OF THIS SUBSECTION (A) OF ANY SUCH EVENT, DEVELOPMENT OR CIRCUMSTANCE IF IT IS KNOWN ONLY BY THE EXECUTIVE OFFICER WHOSE SERVICES WILL BE LOST).

(b)DIABLO WILL FURNISH TO HERITAGE, AS SOON AS PRACTICABLE, BUT IN NO EVENT LATER THAN 20 DAYS AFTER THE END OF THE MONTH (I) A COPY OF ANY REPORT SUBMITTED TO THE BOARD OF DIRECTORS OF DIABLO AND ACCESS TO THE WORKING PAPERS RELATED THERETO AND COPIES OF OTHER OPERATING OR FINANCIAL REPORTS PREPARED FOR MANAGEMENT OF ANY OF ITS BUSINESSES AND ACCESS TO THE WORKING PAPERS RELATED THERETO provided, however, that Diablo need not furnish Heritage any privileged communications of or memoranda prepared by its legal counsel in connection with the transactions contemplated by, and the rights and obligations of Diablo under this Agreement; (ii) monthly unaudited balance sheets and statements of operations for Diablo; (iii) as soon as available, all letters and communications sent by Diablo to its shareholders and all reports filed by Diablo with the DFI and FDIC and any other Governmental Authority; and (iv) such other reports as Heritage may reasonably request relating to Diablo.

(c)Diablo shall promptly upon learning of such information, advise Heritage in writing of any event or any other transaction within its knowledge whereby any Person or related group of Persons acquires, directly or indirectly, record or beneficial ownership or control (as defined in Rule 13d-3 promulgated by the SEC under the Exchange Act) of 5% or more of the outstanding Diablo Common Stock prior to the record date fixed for the Diablo Shareholders’ Meeting or any adjourned meeting thereof to approve this Agreement and the transactions contemplated herein.

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(d)Diablo shall notify Heritage regarding receipt from any tax authority of any notification of the commencement of an audit, any request to extend the statue of limitations, any statutory notice of deficiency, any revenue agent’s report, any notice of proposed assessment, or any other similar notification of potential adjustments to the tax liabilities of Diablo, or any actual or threatened collection enforcement activity by any tax authority with respect to tax liabilities of Diablo.

Section 7.3CERTAIN LOANS AND OTHER EXTENSIONS OF Diablo. Diablo will promptly inform Heritage of the amounts and categories of any loans, leases or other extensions of credit that have been classified by any Governmental Authority or by any internal or external loan reviewer of Diablo as “Substandard,”“Doubtful,”“Loss” or any comparable classification, providing with respect to each such credit the aggregate dollar amount, the classification category, credit type and office. Diablo will furnish to Heritage, as soon as practicable, and in any event by the earlier of (i) five (5) Business Days of the information becoming available or (ii) 20 days after the occurrence of such event, schedules including a listing of the following: (a) loans or leases charged off during the previous month, showing with respect to each such loan or lease, the credit type and office; (b) loans or leases written down during the previous month, including with respect to each the original amount, the write-off amount, credit type and office; (c) other real estate or assets owned, stating with respect to each its credit type; (d) a reconciliation of the allowance for loan and lease losses, identifying specifically the amount and sources of all additions and reductions to the allowance (which may be by reference to specific portions of another schedule furnished pursuant to this Section 7.3 and, in the case of unallocated adjustments, shall disclose the methodology and calculations through which the amount of such adjustment was determined). Diablo will promptly provide to Heritage (and not later than 5 days after delivery) reports, write-ups and other documents provided to the Diablo Board of Directors Loan Committee and Diablo Officers Loan Committee.

Section 7.4Delivery Of Supplements To Disclosure Schedule. Diablo will promptly supplement or amend the Disclosure Schedule with respect to any matter hereafter arising which, if existing or occurring at or prior to the date of this Agreement, would have been required to be set forth or described in such Disclosure Schedule or which is necessary to correct any information in the Disclosure Schedule or in any representation and warranty made by Diablo which has been rendered inaccurate thereby. For purposes of determining the accuracy of the representations and warranties of Diablo contained in Article IX hereof in order to determine the fulfillment of the conditions set forth in Section 9.2(a) and 9.2(b) hereof as of the date of this Agreement, the Disclosure Schedule shall be deemed to include only that information contained therein on the date of this Agreement.

Section 7.5Shareholder Approval. Diablo shall seek and shall use its best efforts to obtain the approval of its shareholders, in accordance with the applicable provisions of the Diablo’s Articles of Incorporation and Bylaws, the CGCL and this Agreement, at a duly called and noticed meeting of the Diablo shareholders to be held for the purpose of voting to adopt this Agreement (the “Diablo Shareholders’ Meeting”) and subject to the fiduciary duties as set forth in Section 7.6, the Diablo board of directors shall (i) recommend adoption of this Agreement and the approval of the Merger by the Diablo Shareholders (the “Diablo Board Recommendation”), (ii) solicit and use its best efforts to obtain such adoption and approval, and (iii) not withdraw, amend or modify in any manner adverse to Heritage, the Diablo Board Recommendation or take any other action or make any public statement in connection with the Diablo Shareholders’ Meeting inconsistent with the Diablo Board Recommendation, subject to Section 7.6. Notwithstanding any change in Diablo Board recommendation, this Agreement shall be submitted to the Diablo Shareholders at the Diablo Shareholders’ Meeting for the purpose of approving this Agreement, the Merger and nothing contained in Section 7.6 or this Section 7.5 shall relieve Diablo of such obligation. Diablo shall use its best efforts to cause the Diablo Shareholders Meeting to be held on the first date as is reasonably practicable after the date hereof or such other date as the parties shall mutually agree. In addition, during the term of this Agreement, Diablo shall not submit to the vote of the Diablo Shareholders any Acquisition Proposal other than the Merger.

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Section 7.6Certain Transactions.

(a)DIABLO shall and shall cause its Affiliates and any of its respective officers, directors, employees, representatives, consultants, investment bankers, attorneys, accountants and other agents immediately to, cease any discussions or negotiations with any other Person or Persons that may be ongoing with respect to any Acquisition Proposal. Diablo will not and will cause its Affiliates, and any of its respective officers, directors, employees, representatives, consultants, investment bankers, attorneys, accountants or other agents not to take, any action (i) to encourage, solicit, initiate or facilitate, directly or indirectly, the making or submission of any Acquisition Proposal, (ii) to enter into any agreement, arrangement or understanding with respect to any Acquisition Proposal, or to agree to approve or endorse any Acquisition Proposal or enter into any agreement, arrangement or understanding that would require Diablo to abandon, terminate or fail to consummate the Merger, or any other transaction contemplated by this Agreement, (iii) to initiate or participate in any way in any discussions or negotiations with, or furnish or disclose any information to, any Person (other than Heritage) in connection with any Acquisition Proposal, (iv) to facilitate or further in any other manner any inquiries or the making or submission of any proposal that constitutes, or may reasonably be expected to lead to, any Acquisition Proposal or (v) to grant any waiver or release under any standstill, confidentiality or similar agreement entered into by Diablo or any of its Affiliates or representatives; provided, however, that prior to obtaining the approval of the Diablo Shareholders pursuant to Section 7.5 (but in no event after obtaining the approval of the Diablo Shareholders pursuant to Section 7.5), Diablo, in response to an unsolicited Acquisition Proposal that did not result from a breach of this Section 7.6(a) and otherwise in compliance with its obligations under Section 7.6(c), may participate in discussions with or furnish information to, any Person (other than Heritage) which makes such unsolicited Acquisition Proposal if (A) such action is taken subject to a confidentiality agreement with terms taken as a whole not more favorable to such third party than the terms of the Diablo Confidentiality Agreement (as in effect on the date hereof) and (B) after consultation with independent financial advisors, and after receiving written advice from outside legal counsel to Diablo, a majority of the members of the entire Diablo board of directors reasonably determines in good faith by resolution that such Acquisition Proposal is a Superior Proposal and that it is necessary to take such actions in order to comply with the fiduciary duties of Diablo board of directors under applicable law. Without limiting the foregoing, Heritage and Diablo agree that any violation of the restrictions set forth in this Section 7.6(a) by any Affiliate, officer, director, employee, representative, consultant, investment banker, attorney, accountant or other agent of Diablo, whether or not such Person is purporting to act on behalf of Diablo, or any of its Affiliates, shall constitute a breach by Diablo of this Section 7.6(a). Diablo shall enforce, to the fullest extent permitted under applicable law, the provisions of any standstill, confidentiality or similar agreement entered into by Diablo or any of its Affiliates or representatives including, but not limited to, where necessary to obtaining injunctions to prevent any breaches of such agreements and to enforce specifically the term and provisions thereof in any court having jurisdiction.

(b)Neither the Diablo board of directors nor any committee thereof shall (i) withdraw, modify or amend, or propose to withdraw, modify or amend, in a manner adverse to Diablo, the Diablo Board Recommendation, (ii) approve or recommend, or propose to approve or recommend, any Acquisition Proposal or (iii) resolve to do any of the foregoing; provided, however, that Diablo may recommend to the Diablo Shareholders an Acquisition Proposal and, in connection therewith, withdraw or modify its approval or recommendation of the Merger if (w) Diablo has complied with its obligations under Section 7.6(a) and (c), (x) the Acquisition Proposal is a Superior Proposal, (y) all the conditions to Diablo’s right to terminate this Agreement in accordance with Section 10.l(f) have been satisfied (including the expiration of the five (5) Business Day period described therein and the payment of all amounts required pursuant to Section 10.2(b) and (z) simultaneously with such withdrawal, modification or recommendation, this Agreement is terminated in accordance with Section 10.l(f).

(c)In addition to the obligations of Diablo set forth in paragraph (a), on the date of receipt or occurrence thereof, Diablo shall advise Heritage of any request for information with respect to any Acquisition Proposal or of any Acquisition Proposal, or any inquiry, proposal, discussion or negotiation with respect to any Acquisition Proposal, the terms and conditions of such request, Acquisition Proposal, inquiry, proposal, discussion or negotiation and Diablo shall, within two (2) Business Days of the receipt thereof, promptly provide to Heritage copies of any written materials received by Diablo in connection with any of the foregoing, and the identity of the Person making any such Acquisition Proposal or such request, inquiry or proposal or with whom any discussion or negotiation is taking place. Diablo shall keep Heritage fully informed of the status and material details (including amendments or proposed amendments) of any such request or Acquisition Proposal and keep Heritage fully informed as to the material details of any additional information requested of or provided by Diablo and as to the details of all continuing discussions or negotiations with respect to any such request, Acquisition Proposal, inquiry or proposal, and shall provide to Heritage within two (2) Business Days of receipt thereof all written materials received by Diablo with respect thereto. Diablo shall promptly provide to Heritage any non-public information concerning Diablo, provided to any other Person in connection with any Acquisition Proposal which was not previously provided to Heritage.

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(d)Diablo shall immediately request each Person which has heretofore executed a confidentiality agreement in connection with its consideration of acquiring Diablo or any portion thereof to return all confidential information heretofore furnished to such Person by or on behalf of Diablo, and Diablo shall use its commercially reasonable efforts to have such information returned.

Section 7.7SHAREHOLDER AGREEMENTS. Each director and executive officer of Diablo, as a shareholder of Diablo Common Stock, has executed and delivered to Heritage on the date of this Agreement a shareholder agreement (each, a “Shareholder Agreement”) substantially in the form attached hereto as Exhibit B, committing each such person, among other things, to vote his or her shares of Diablo Common Stock in favor of this Agreement and the Merger at the shareholders’ meeting held for that purpose, granting a proxy for such shares to Heritage, and to certain representations and covenants.

Section 7.8Affiliates. At or prior to the Diablo Shareholders Meeting, (a) Diablo shall deliver to Heritage a letter identifying all persons who are then “affiliates” of Diablo for purposes of Rule 145 under the Securities Act and (b) Diablo shall advise the persons identified in such letter of the resale restrictions imposed by applicable securities laws and shall use its best efforts to obtain from each person identified in such letter a written agreement substantially in the form attached hereto as Exhibit C. Diablo shall use reasonable efforts to obtain from any person who becomes an affiliate of Diablo after Diablo’s delivery of the letter referred to above, and on or prior to the date of the Diablo Shareholders’ Meeting to approve this Agreement, a written agreement substantially in the form attached as Exhibit C hereto as soon as practicable after obtaining such status.

Section 7.9Access to Operations. Diablo shall afford to Heritage and its authorized agents and representatives, access, during normal business hours, to the operations, books, and other information relating to Diablo for the sole purpose of assuring an orderly transition of operations, including any data processing conversion, in the Merger. Heritage shall give reasonable notice for access to Diablo, and the date and time of such access will then be mutually agreed to by Heritage and Diablo. Heritage’s access shall be conducted in a manner which does not unreasonably interfere with Diablo’s normal operations, customers and employee relations and which does not interfere with the ability of Diablo to consummate the transactions contemplated by this Agreement.

Section 7.10Access to Employees. Diablo shall cooperate with Heritage with respect to any formal meetings or interviews with one or more employees called or arranged by Diablo and held for the purpose of discussing the transactions contemplated by this Agreement or their effect on such employees, with Heritage given the opportunity to participate in such meetings or interviews. This section 7.10 is not intended to apply to casual conversations about the transaction or informal meetings initiated by employees, or to prohibit discussion in general, but rather to allow Heritage a role in the formal presentation of the transaction to employees, and an opportunity to participate in the significant, formal meetings at which the transaction is explained and discussed. Heritage shall have the right, but not the obligation, within thirty (30) Business Days prior to the Effective Day, to provide training to employees of Diablo who will become employees of Heritage. Such training shall be at the expense of Heritage and shall be conducted during normal business hours. At the request of Heritage, Heritage shall compensate employees, in accordance with Diablo’s customary policies and practices, for the employee’s time being trained by Heritage. Diablo shall cooperate with Heritage to make such employees available for such training prior to Closing. Nothing in this Section 7.10 is intended, nor shall it be construed, to confer any rights or benefits upon any Persons other than Heritage, HBC or Diablo.

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Section 7.11Transition. Commencing following the date hereof, and in all cases subject to applicable law and regulation, Diablo shall cooperate with Heritage and HBC to facilitate the integration of the parties and their respective businesses. Without limiting the generality of the foregoing, from the date hereof through the Closing Date and consistent with the performance of their day-to-day operations and the continuous operation of Diablo in the ordinary course of business, Diablo shall use its reasonable efforts to provide reasonable support, including requesting reasonable support from its outside contractors and vendors, and to reasonably assist Heritage and HBC in performing all tasks deemed reasonably necessary to integrate their respective businesses. Diablo shall cooperate with Heritage in minimizing the extent to which any contracts will continue in effect following the Effective Time, provided that this provision shall not require Diablo to give notice to any vendor that would result in the inability of Diablo to continue to operate its business in the ordinary course should the transactions contemplated by this Agreement not be consummated. Among other things, Diablo shall cooperate with Heritage to establish a mutually agreeable project plan to effectuate the conversion; use their commercially reasonable efforts to have Diablo’s outside contractors continue to support both the conversion effort and its needs until the conversion can be established; provide, or use its commercially reasonable efforts to obtain from any outside contractors, all data or other files and layouts requested by Heritage for use in planning the conversion, as soon as reasonably practicable.

Section 7.12Stock Options. Prior to the Effective Time, Diablo shall (a) use its best efforts to cause each holder of stock options, as listed in its Disclosure Schedule, to exchange any unexercised options prior to the Effective Time for the cash set forth in Section 2.4 and (b) take all actions necessary to cancel and terminate the Stock Option Plan, such cancellation and termination to be effective at the Effective Time. Each holder of such canceled Diablo stock options shall acknowledge that upon payment of such amount set forth in Section 2.4, no further liability shall accrue to Diablo or any successor thereto.

Section 7.13Third Party Consents; Estoppel; Title. Diablo shall use its reasonable efforts to obtain and deliver to Heritage prior to the Effective Time:

(a)ALL THIRD PARTY CONSENTS TO THEIR RESPECTIVE MORTGAGES, NOTES, LEASES, FRANCHISES, AGREEMENTS, LICENSES AND PERMITS AS MAY BE NECESSARY TO PERMIT THE MERGER AND THE TRANSACTIONS CONTEMPLATED HEREIN TO BE CONSUMMATED WITHOUT A MATERIAL DEFAULT, ACCELERATION, BREACH OR LOSS OF RIGHTS OR BENEFITS THEREUNDER WITH RESPECT TO ANY SUCH ITEM WHICH IS MATERIAL TO DIABLO;

(b)Lessor Estoppel Certificates, in the form satisfactory to Heritage, as applicable, relative to each of the leased properties identified the Disclosure Schedule; and

(c)Documentation and proper recording thereof necessary to transfer title to any real property owned by Diablo to HBC.

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ARTICLE VIII

FURTHER COVENANTS OF HERITAGE AND DIABLO

Section 8.1FORM S-4 and Proxy Statement.

(a)AS PROMPTLY AS PRACTICABLE BUT IN NO EVENT LATER THAN 30 BUSINESS DAYS FOLLOWING EXECUTION OF THIS AGREEMENT, PROVIDED THAT SUCH PERIOD SHALL BE EXTENDED TO THE EXTENT THAT ANY DELAY IS SOLELY ATTRIBUTABLE TO DIABLO’S FAILURE TO PROVIDE REQUIRED INFORMATION IN A TIMELY MANNER, HERITAGE SHALL, WITH COOPERATION OF DIABLO, PREPARE AND FILE WITH THE SEC A FORM S-4, IN WHICH THE PROXY STATEMENT WILL BE INCLUDED AS A PROSPECTUS. THE parties hereto agree to provide the information necessary for inclusion in the Proxy Statement and Form S-4. Each of the parties will use its respective best efforts to have the Form S-4 declared effective under the Securities Act as promptly as practicable after it is filed. Subject to the provisions of Section 11.12, Heritage shall pay the costs (except Diablo’s legal and accounting fees) associated with the preparation and filing of the Form S-4, including the filing fees with the SEC and state securities law agencies. At the time the Form S-4 becomes effective, the Form S-4 will comply in all material respects with the provisions of Securities Act and the published rules and regulations thereunder, and will not contain any untrue statement of a material fact or omit to state a material fact required to be stated therein or necessary to make the statements therein not false or misleading, and at the times of mailing thereof to the Diablo Shareholders, at the times of the Diablo Shareholders’ Meeting and at the Effective Time, the Proxy Statement and prospectus included as part of the Form S-4, as amended or supplemented by any amendment or supplement filed by Heritage, will not contain any untrue statement of a material fact or omit to state any material fact necessary to make the statements therein not false or misleading.

(b)After the date of the filing of the Form S-4 with the SEC, each of the parties agrees promptly to notify the other of and to correct any information furnished by such party that shall have become false or misleading in any material respect and to cooperate with the other to take all steps necessary to file with the SEC and have declared effective or cleared by the SEC any amendment or supplement to the Form S-4 so as to correct such information and to cause the Proxy Statement and prospectus as so corrected to be disseminated to the Diablo Shareholders to the extent required by applicable law.

(c)Heritage shall take all required action with appropriate Governmental Authority under state securities or blue sky laws in connection with the issuance of Heritage Common Stock pursuant to this Agreement.

Section 8.2APPROPRIATE ACTIONS; CONSENTS; FILINGS.

(a)THE PARTIES SHALL USE THEIR REASONABLE COMMERCIAL EFFORTS TO (I) TAKE, OR CAUSE TO BE TAKEN, ALL APPROPRIATE ACTION, AND DO, OR CAUSE TO BE DONE, ALL THINGS NECESSARY, PROPER OR ADVISABLE UNDER APPLICABLE LAW OR OTHERWISE IN ORDER TO CONSUMMATE AND MAKE EFFECTIVE THE TRANSACTIONS CONTEMPLATED BY THIS AGREEMENT THAT ARE INTENDED TO BE CONSUMMATED PRIOR TO THE EFFECTIVE TIME AS PROMPTLY AS PRACTICABLE HEREAFTER. WITHIN 30 BUSINESS DAYS OF EXECUTING THIS AGREEMENT, HERITAGE, WITH THE COOPERATION OF DIABLO (PROVIDED THAT SUCH PERIOD SHALL BE EXTENDED TO THE EXTENT THAT ANY DELAY IS SOLELY ATTRIBUTABLE TO DIABLO’S FAILURE TO PROVIDE REQUIRED INFORMATION IN A TIMELY MANNER), SHALL FILE ALL REQUIRED APPLICATIONS TO (I) OBTAIN FROM ANY GOVERNMENTAL AUTHORITY ANY REQUIRED APPROVALS REQUIRED TO BE OBTAINED OR MADE BY, OR TO AVOID OR CAUSE TO BE WITHDRAWN OR TERMINATED, WITHOUT PREJUDICE TO THE PARTIES, ANY ACTION OR PROCEEDING BY ANY GOVERNMENTAL AUTHORITY, IN CONNECTION WITH THE AUTHORIZATION, EXECUTION AND DELIVERY OF THIS AGREEMENT AND THE CONSUMMATION OF THE MERGER AS CONTEMPLATED HEREBY, AND (III) MAKE ALL NECESSARY FILINGS, AND THEREAFTER MAKE ANY OTHER REQUIRED SUBMISSIONS, WITH RESPECT TO THIS AGREEMENT, THE MERGER REQUIRED UNDER (A) THE BHCA, (B) THE CALIFORNIA FINANCIAL CODE, (C) THE FEDERAL DEPOSIT INSURANCE ACT, (D) THE EXCHANGE ACT, (E) THE SECURITIES ACT, AND ANY OTHER APPLICABLE FEDERAL OR STATE SECURITIES LAWS, AND (F) ANY OTHER APPLICABLE LAW; PROVIDED, HOWEVER, THAT HERITAGE, HBC AND DIABLO SHALL COOPERATE WITH EACH OTHER IN CONNECTION WITH THE PREPARATION AND MAKING OF ALL SUCH FILINGS, INCLUDING, IF REQUESTED AND SUBJECT TO APPLICABLE LAWS REGARDING THE EXCHANGE OF INFORMATION BY PROVIDING COPIES OF ALL SUCH DOCUMENTS TO THE NON-FILING PARTY AND ITS ADVISORS PRIOR TO FILING AND, IF REQUESTED, TO ACCEPT ALL REASONABLE ADDITIONS, DELETIONS OR CHANGES SUGGESTED IN CONNECTION THEREWITH PROVIDED, HOWEVER, THAT THE REVIEWING PARTY AGREES TO ACT REASONABLY AND AS PROMPTLY AS PRACTICABLE. HERITAGE AND DIABLO SHALL FURNISH TO EACH OTHER ALL INFORMATION REASONABLY REQUIRED FOR ANY APPLICATION OR OTHER FILING UNDER APPLICABLE LAW IN CONNECTION WITH THE TRANSACTIONS CONTEMPLATED BY THIS AGREEMENT.

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(b)THE PARTIES SHALL GIVE ANY NOTICES TO THIRD PARTIES, AND USE, REASONABLE EFFORTS TO OBTAIN ANY THIRD PARTY CONSENTS, (I) NECESSARY, PROPER OR ADVISABLE TO CONSUMMATE THE TRANSACTIONS CONTEMPLATED IN THIS AGREEMENT OR (II) DISCLOSED IN THE DISCLOSURE SCHEDULE. IN THE EVENT THAT ANY PARTY SHALL FAIL TO OBTAIN ANY SUCH THIRD PARTY CONSENT, THAT PARTY SHALL USE ITS COMMERCIALLY REASONABLE EFFORTS, AND SHALL TAKE ANY SUCH ACTIONS REASONABLY REQUESTED BY THE OTHER PARTY, TO MINIMIZE ANY ADVERSE EFFECT ON THE CONSUMMATION OF THE MERGER ON HERITAGE, HBC AND DIABLO, AND THEIR RESPECTIVE BUSINESSES RESULTING, OR WHICH COULD REASONABLY BE EXPECTED TO RESULT AFTER THE EFFECTIVE TIME, FROM THE FAILURE TO OBTAIN SUCH CONSENT.

Section 8.3COOPERATION. Each party covenants that it will use its commercially reasonable efforts to bring about the transactions contemplated by this Agreement as soon as practicable, unless this Agreement is terminated as provided herein. Subject to the terms and conditions herein provided, each of the parties hereto agrees to use all commercially reasonable efforts to take, or cause to be taken, all action, and to do, or cause to be done, all things necessary, proper or advisable under applicable laws and regulations to consummate and make effective the transactions contemplated by this Agreement at the earliest practicable time. In case at any time after the Effective Time any further action is necessary or desirable to carry out the purposes of this Agreement, the proper officers and/or directors of the parties, shall take all such necessary action. Each party shall use its reasonable best efforts to preserve for itself and the other parties hereto each available legal privilege with respect to the confidentiality of their negotiations and related communications, including the attorney-client privilege.

Section 8.4Establishment of Accruals. After all of the conditions set forth in Article IX have been satisfied or waived, if requested by Heritage, on the Business Day immediately prior to the Effective Date, Diablo shall, to the extent consistent with GAAP, establish such additional accruals and reserves as may be necessary to conform its accounting and credit loss reserve practices and methods to those of Heritage and HBC (as such practices and methods are to be applied to Diablo from and after the Effective Time) and reflect Heritage’s plans with respect to the conduct of Diablo’s business following the Merger and to provide for the costs and expenses relating to the consummation by Diablo of the transactions contemplated by this Agreement. The establishment of such accrual and reserves shall not, in and of itself, constitute a breach of any representation or warranty of Diablo contained in the Agreement or constitute a material adverse change in the business, operations, prospects or financial condition of Diablo. Diablo shall cooperate in all respects with Heritage and its directions authorized by this Section 8.4.

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Section 8.5[Intentionally deleted]

Section 8.6Publicity. The initial press release announcing this Agreement shall be a joint press release and thereafter Heritage and Diablo shall consult with each other in issuing any press releases or otherwise making public statements with respect to the transactions contemplated hereby and in making any filings with any Governmental Authority or with any national securities exchange with respect thereto. If any party hereto, on the advice of counsel, determines that a disclosure is required by law or by any applicable self-regulatory organization, it may make such disclosure without the consent of the other parties, but only after affording the other parties a reasonable opportunity to review and comment upon the disclosure.

Section 8.7Notices and Communications. Heritage shall consult with Diablo, and Diablo upon request shall assist Heritage and HBC, with respect to (a) sending necessary or appropriate customer notifications and communications as prepared by Heritage or HBC with Diablo’s approval, which approval shall not be unreasonably withheld, to advise such customers of the impending transaction and of Heritage or HBC’s plans following the Effective Time, and (b) taking or causing to be taken at the direction of and as agent for Diablo, all actions necessary to comply with the provisions of WARN, with respect to all employees of Diablo covered by such act who are to be terminated by Heritage or HBC within sixty days following the Effective Time, including the issuance of notices to such employees.

Section 8.8Insurance Policies Assignment.

(a)DIABLO agrees to make commercially reasonable efforts to obtain consent to partial or complete assignments of any of their respective insurance policies if requested to do so by Heritage, to the extent necessary to maintain the benefits to Heritage of such policies as they apply to Diablo. Diablo shall also inform Heritage no later than the Effective Time of any material unfiled insurance claims of which it has knowledge and for which it believes coverage exists.

(b)Diablo and Heritage shall cooperate to determine the most appropriate methodology to obtain “tail” insurance coverage at such limits, mutually agreeable to the parties, for Errors and Omissions, Bankers and Blanket Bond coverage.

Section 8.9INDEMNIFICATION OF DIRECTORS AND OFFICERS. (a) Heritage agrees that all rights to indemnification or exculpation now existing in favor of the directors, officers, employees and agents (the “Indemnified Parties”) of Diablo as provided in its Articles of Incorporation, Bylaws, charter documents, indemnification agreements or otherwise in effect as of the date hereof with respect to matters occurring prior to the Effective Time, shall survive the Merger and shall continue in full force and effect. Heritage further agrees that, following consummation of the Merger, to the greatest extent permitted by California law and the Articles of Incorporation and Bylaws of Heritage as in effect of the date hereof, it shall indemnify, defend and hold harmless individuals who were officers and directors of Diablo as of the date hereof or immediately prior to the Effective Time for any costs, expenses, judgments, fines, damages, liabilities, claims or losses incurred in connection with or arising out of their actions while a director or officer, including any claim, action, suit, proceeding or investigation, whether civil, criminal, administrative or investigative, arising out of, or pertaining to, matters existing or occurring at, or prior to, the Effective Time (but excluding matters relate to any claims Heritage or HBC may have against such Indemnified parties as a result of the terms of this Agreement) and shall pay the expenses, including attorneys’ fees, of such individual in advance of the final resolution of any claim to the fullest extent permitted under applicable law and upon demand by each such individual, provided, however such individuals shall first execute an undertaking acceptable to Diablo to return such advances in the event it is finally determined such indemnification is not allowed under applicable law. If Heritage or any of its successors or assigns (i) shall consolidate with or merge into any other corporation or entity and shall not be the continuing or surviving corporation or entity of such consolidation or merger or (ii) shall transfer all or substantially all of its properties and assets to any individual, corporation or other entity, then, and in each such case, proper provisions shall be made so that the successors and assigns of Heritage shall assume all of the obligations set forth in this Section 8.9.

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(b)PRIOR TO THE EFFECTIVE TIME, DIABLO SHALL PURCHASE A “TAIL POLICY” COVERING PERSONS SERVING AS OFFICERS AND DIRECTORS OF DIABLO PRIOR TO THE EFFECTIVE TIME FOR A PERIOD OF UP TO FIVE (5) YEARS FROM THE EFFECTIVE TIME WITH RESPECT TO ACTS OR OMISSIONS OCCURRING PRIOR TO THE EFFECTIVE TIME WHICH WERE COMMITTED BY SUCH OFFICERS AND DIRECTORS IN THEIR CAPACITY AS SUCH, PROVIDED SUCH “TAIL POLICY” SHALL NOT EXCEED 150% OF THE PREMIUM PAID BY DIABLO ON ITS DIRECTORS AND OFFICERS LIABILITY POLICY IN EFFECT AS OF THE DATE HEREOF.

(c)The provisions of this Section 8.9 are intended to be for the benefit of, and shall be enforceable by, each of the Indemnified Parties, their heirs and their representatives.

Section 8.10CONFIDENTIALITY. All information disclosed by one party to any other party to this Agreement, whether prior or subsequent to the date of this Agreement including, without limitation, any information obtained pursuant to this Agreement or the negotiations relating to this Agreement, shall be kept confidential by such other party and shall not be used by such other party otherwise as herein contemplated. In the event that this Agreement is terminated, each party shall return all documents furnished hereunder, shall destroy all documents or portions thereof prepared by such other party that contain information furnished by another party pursuant hereto and, in any event, shall hold all information confidential unless or until such information is or becomes a matter of public knowledge. The Confidentiality Agreements shall remain in full force and effect following the Effective Time or termination of this Agreement.

ARTICLE IX

CONDITIONS TO THE PARTIES’ OBLIGATIONS TO CLOSE

Section 9.1CONDITIONS TO EACH Party’s Obligations to Close. The respective obligations of Heritage and HBC, on the one hand, and Diablo, on the other, to consummate the Merger and the other transactions contemplated hereby are subject to the satisfaction or waiver at or prior to the Effective Time of each of the following conditions:

(a)THIS AGREEMENT AND THE MERGER AND THE TRANSACTIONS CONTEMPLATED HEREBY SHALL HAVE RECEIVED ALL REQUISITE APPROVALS OF THE DIABLO SHAREHOLDERS AT THE DIABLO SHAREHOLDERS’ MEETING.

(b)NO JUDGMENT, DECREE, INJUNCTION, ORDER OR PROCEEDING SHALL BE OUTSTANDING OR THREATENED BY ANY GOVERNMENTAL AUTHORITY WHICH PROHIBITS OR RESTRICTS THE CONSUMMATION OF, OR THREATENS TO INVALIDATE OR SET ASIDE, THE MERGER SUBSTANTIALLY IN THE FORM CONTEMPLATED BY THIS AGREEMENT, UNLESS COUNSEL TO THE PARTY AGAINST WHOM SUCH ACTION OR PROCEEDING WAS INSTITUTED OR THREATENED RENDERS TO THE OTHER PARTIES HERETO A FAVORABLE OPINION THAT SUCH JUDGMENT, DECREE, INJUNCTION, ORDER OR PROCEEDING IS WITHOUT MERIT AND COUNSEL TO THE OTHER PARTY CONCURS WITH SUCH OPINION.

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(c)NO STATUTE, RULE, REGULATION, ORDER, INJUNCTION OR DECREE SHALL BE OUTSTANDING OR THREATENED BY ANY GOVERNMENTAL AUTHORITY WHICH PROHIBITS OR MATERIALLY RESTRICTS THE CONSUMMATION OF, OR THREATENS TO INVALIDATE OR SET ASIDE, THE MERGER SUBSTANTIALLY IN THE FORM CONTEMPLATED BY THIS AGREEMENT OR WHICH WOULD NOT PERMIT THE BUSINESSES PRESENTLY CARRIED ON BY DIABLO, HERITAGE OR HBC TO CONTINUE MATERIALLY UNIMPAIRED FOLLOWING THE EFFECTIVE TIME, UNLESS COUNSEL TO THE PARTY OR PARTIES AGAINST WHOM SUCH ACTION OR PROCEEDING WAS INSTITUTED OR THREATENED RENDERS TO THE OTHER PARTY OR PARTIES HERETO A FAVORABLE OPINION THAT SUCH STATUTE, RULE, REGULATION, ORDER, INJUNCTION OR DECREE IS WITHOUT MERIT AND COUNSEL TO THE OTHER PARTY CONCURS WITH SUCH OPINION.

(d)ALL REQUIRED APPROVALS FROM GOVERNMENTAL AUTHORITIES SHALL HAVE BEEN OBTAINED AND ARE IN FULL FORCE AND EFFECT AND ANY AND ALL APPLICABLE WAITING PERIODS SHALL HAVE EXPIRED OR TERMINATED.

(e)The Form S-4 shall have been declared effective by the SEC and shall not be the subject of any proceedings seeking or threatening a stop order. Heritage shall have received all authorizations as necessary to issue the Heritage Common Stock to consummate the Merger.

(f)The shares of Heritage Common Stock to be issued in the Merger shall be approved for listing on the NASDAQ Global Select Market subject to official notice of issuance.

Section 9.2ADDITIONAL CONDITIONS TO OBLIGATIONS OF Heritage and HBC to Close. The obligations of Heritage and HBC to consummate the Merger and the other transactions contemplated hereby are subject to the satisfaction or waiver at or prior to the Effective Time of each of the following conditions:

(a)REPRESENTATIONS AND WARRANTIES. The representations and warranties of Diablo set forth in this Agreement (disregarding for all purposes of this Section 9.2(a) (i) any qualification or exception for, or reference to, materiality in such representations or warranties and (ii) any use of the terms “material,”“materially,”“in all material respects,”“Material Adverse Effect” or similar terms or phrases in such representations or warranties) shall be true and correct in all respects as of the date of this Agreement and as of the Effective Time as though made on and as of the Effective Time (except that representations and warranties that by their terms speak specifically as of the date of this Agreement or another specific date shall be true and correct as of such date); provided, however, that no representation or warranty of Diablo contained herein shall be deemed untrue or incorrect as a consequence of the existence or absence of any fact, circumstance or event unless such fact, circumstance or event, individually or when taken together with all other facts, circumstances or events inconsistent with any representations or warranties contained in Section 5.1 has had or would be reasonably likely to have a Material Adverse Effect with respect to Diablo; provided, further, that the representations and warranties contained in (x) Sections 5.1(e) shall be deemed untrue and incorrect if not true and correct except to a de minimis extent (relative to Section 5.1(e) taken as a whole), (y) Section 5.1(a)(i), 5.1(f), 5.1(i), and 5.1(jj) shall be deemed untrue and incorrect if not true and correct in all material respects, and (z) Section 5.1(a)(ii), 5.1(b), 5.1(y)(i), 5.1(gg), 5.1(ii) and 5.1(jj) shall be deemed untrue and incorrect if not true and correct in all respects.

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(b)Each of the covenants and agreements of Diablo contained in this Agreement to be performed at or before the Effective Time shall have been duly performed in all material respects.

(c)Any and all approvals or consents of any Governmental Authority which are necessary to consummate the Merger and the transactions contemplated hereby shall have been granted without the imposition of any conditions which Heritage deems, in its reasonable opinion, to materially adversely affect it or be materially burdensome.

(d)Between the date of this Agreement and the Effective Time, there shall not have occurred any event that has had or could reasonably be expected to have, either individually or in the aggregate, a Material Adverse Effect on Diablo, whether or not such event, change or effect is reflected in the Disclosure Schedule as amended or supplemented after the date of this Agreement.

(e)Diablo shall have redeemed in full the Diablo Preferred Stock immediately prior to the Effective Date for $32.00 per share in cash and for no other consideration, and pursuant to its terms.

(f)Concurrently with the execution and delivery of this Agreement, each director and executive officer who is a shareholder of Diablo shall have executed and delivered to Heritage the Shareholder Agreement in the form attached as Exhibit B.

(g)Heritage shall have received the written affiliates’ agreement described in Section 7.8 hereof and in the form attached hereto as Exhibit C.

(h)The employment agreements, consulting agreements, termination agreements and non-compete agreements entered into as of the date hereof with the Key Employees shall not have been revoked, terminated or disavowed.

(i)Heritage shall have received an opinion of Buchalter Nemer, a professional corporation in form and substance reasonably satisfactory to Heritage, to the effect that, on the basis of facts, representations and assumptions, set forth in such opinion, which are consistent with the state of facts existing, at the Effective Time, the Merger will qualify as a reorganization under Section 368 of the Code.

(j)Diablo shall have obtained all third party consents listed on Schedule 9.2(j) of the Disclosure Schedule.

(k)Heritage shall have received the resignation of each Diablo director effective as of the Effective Time.

(l)The Dissenting Common Stock shall not exceed 5% of the Diablo Common Stock.

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  (m)At least four Business Days prior to the Effective Time, Diablo shall provide Heritage with Diablo’s financial statements presenting the financial condition of Diablo as of the close of business on the last day of the last month ended prior to the Effective Time and Diablo’s results of operations for the following periods: (i) September 30, 2006 through December 31, 2006 and (ii) January 1, 2007 through the close of business on the last day of the last month ended prior to the Effective Time of the Merger (the “Closing Financial Statements”). Such financial statements shall have been prepared in all material respects in accordance with GAAP (except as noted thereto and subject to recurring audit adjustments normal in nature and amount) and other applicable legal and accounting requirements, and reflect all period-end accruals and other adjustments. Such financial statements shall be accompanied by a certificate of Diablo’s chief financial officer, dated as of a date no earlier than two (2) Business Days prior to the Effective Time, to the effect that such financial statements continue to reflect accurately, as of the date of the certificate, the financial condition of Diablo in all material respects.

(n)On the close of business on the last day of the month preceding the Closing Date, the Tangible Equity Capital of Diablo shall be within two percent (2%) of the following target (which target shall be increased dollar for dollar for any proceeds received by Diablo for the exercise of stock options under the Stock Option Plan in accordance with Section 2.4). If the Closing Date is:

On or before March 31, 2007	$18.3 million
After March 31, 2007 and on or before April 30, 2007	$18.6 million
After April 30, 2007 and on or before May 31, 2007	$18.9 million
After May 31, 2007	$19.1 million

“Tangible Equity Capital” means shareholders’ equity of Diablo reflected on the Closing Financial Statements (including common stock, paid in capital, retained earnings and excluding the Diablo Preferred Stock) (x) minus goodwill and any other intangible assets, and (y) without giving effect to any impact from gains or losses on available for sale securities, and (z) without recognizing any change to Diablo’s equity resulting from actions taken by Diablo pursuant to or permitted by this Agreement (including those actions required by Section 9.2(p)) or with the written consent of Heritage or any expenses incurred in connection with this Agreement or the transactions contemplated hereunder (but excluding from this provision (z) the amounts paid to the holders of the Diablo Preferred Stock in accordance with Section 9.2(e)).

(o)AT THE CLOSE OF BUSINESS ON THE LAST DAY OF THE MONTH PRECEDING THE EFFECTIVE TIME, TOTAL DEPOSITS (EXCLUDING BROKER DEPOSITS) OF DIABLO, CALCULATED PURSUANT TO GAAP AND ANY REGULATORY REQUIREMENTS, SHALL NOT BE LESS THAN EIGHTY-FIVE PERCENT (85%) OF THE AVERAGE OF TOTAL DEPOSITS FOR DIABLO FOR THE SIX-MONTH PERIOD ENDING ON THE LAST DAY OF THE SAME MONTH IN THE PRECEDING YEAR.

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(p)DIABLO SHALL HAVE AMENDED OR REPLACED ITS OUTSTANDING STOCK OPTION AGREEMENTS TO THE EXTENT REQUIRED TO PROVIDE THAT NONE OF THE OUTSTANDING DIABLO STOCK OPTIONS PROVIDE FOR A DEFERRAL OF COMPENSATION WITHIN THE MEANING OF SECTION 409A OF THE CODE, THE PROPOSED TREASURY REGULATIONS THEREUNDER, AND OTHER EXISTING GUIDANCE ISSUED BY THE INTERNAL REVENUE SERVICE RELATING THERETO.

(q)Diablo shall have delivered at Closing to Heritage the following:

(i)TRUE, CORRECT AND COMPLETE COPIES OF THE ARTICLES OF Incorporation of Diablo and all amendments thereto, duly certified as of a recent date by the California Secretary of State.

(ii)A certificate, dated as of a recent date, issued by the DFI, duly certifying as to the organization of Diablo under the laws of the State of California and authorization to conduct commercial banking business within the State of California.

(iii)A certificate of status dated as of a recent date, issued by the California Secretary of State, duly certifying as to the good legal standing of Diablo under the laws of the State of California.

(iv)A certificate of good standing, dated as of a recent date, issued by the California Franchise Tax Board, duly certifying as to the good standing of Diablo in the State of California.

(v)A certificate, dated as of a recent date, issued by the FDIC, duly certifying that the deposits of Diablo are insured by the FDIC pursuant to the Federal Deposit Insurance Act.

(vi)A certificate, dated as of the Closing Date, executed by the Corporate Secretary or other appropriate executive officer of Diablo, pursuant to which such officer shall certify: (A) the due adoption by the board of directors of Diablo of corporate resolutions attached to such certificate authorizing the execution and delivery of this Agreement and the other agreements and documents contemplated hereby, including, but not limited to, the Merger Agreement, and the taking of all actions contemplated hereby and thereby; (B) the due adoption by the shareholders of Diablo of resolutions authorizing the Merger and the execution and delivery of this Agreement and the Merger Agreement and the other agreements and documents contemplated hereby and thereby and the taking of all actions contemplated hereby and thereby; (C) the incumbency and true signatures of those officers of Diablo duly authorized to act on its behalf in connection with the transactions contemplated by this Agreement and to execute and deliver this Agreement and the Merger Agreement and other agreements and documents contemplated hereby and thereby and the taking of all actions contemplated hereby and thereby on behalf of Diablo; (D) that the copy of the Bylaws of Diablo attached to such certificate is true and correct and such Bylaws have not been amended except as reflected in such copy; and (E) a true and correct copy of the list of the Diablo Shareholders as of the Closing Date.

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(vii)A certificate, dated as of the Closing Date, executed by an executive officer of Diablo, pursuant to which Diablo shall certify, to the knowledge of such executive officer, that (A) all of the representations and warranties made in Section 5.1 of this Agreement are true and correct in all material respects on and as of the date of such certificate as if made on such date and that, except as expressly permitted by this Agreement, (B) have been no Material Adverse Effect with respect to Diablo since the date of this Agreement, and (C) Diablo has performed and complied in all material respects with all of its obligations and agreements required to be performed on or prior to the Closing Date under this Agreement.

(viii)All other documents required to be delivered to Heritage by Diablo under the provisions of this Agreement, and all other documents, certificates and instruments as are reasonably requested by Heritage or its counsel for the purpose of evidencing the accuracy of any representation or warranty, the performance or compliance with any obligation or covenant or satisfaction of any condition.

Section 9.3ADDITIONAL CONDITIONS TO OBLIGATIONS OF Diablo to Close. The obligations of Diablo to consummate the Merger and the other transactions contemplated herein are subject to the satisfaction or waiver, at or prior to the Effective Time, of each of the following conditions:

(a)THE REPRESENTATIONS AND WARRANTIES OF HERITAGE AND HBC SET FORTH IN THIS AGREEMENT (DISREGARDING FOR ALL PURPOSES OF THIS SECTION 9.3(a) (i) any qualification or exception for, or reference to, materiality in such representations or warranties and (ii) any use of the terms “material,”“materially,”“in all material respects,”“Material Adverse Effect” or similar terms or phrases in such representations or warranties) shall be true and correct in all respects as of the date of this Agreement and as of the Effective Time as though made on and as of the Effective Time (except that representations and warranties that by their terms speak specifically as of the date of this Agreement or another specific date shall be true and correct as of such date); provided, however, that no representation or warranty of Heritage or HBC contained herein shall be deemed untrue or incorrect as a consequence of the existence or absence of any fact, circumstance or event unless such fact, circumstance or event, individually or when taken together with all other facts, circumstances or events inconsistent with any representations or warranties contained in Section 5.2 has had or would be reasonably likely to have a Material Adverse Effect with respect to Heritage and HBC (taken as a whole); provided, further, that the representations and warranties contained in Sections 5.2(a)(i), 5.2(g), and 5.2(h) shall be deemed untrue and incorrect if not true and correct in all materials respects and (z) Sections 5.2(a)(ii), 5.2(b), 5.2(m)(i) and 5.2(p) shall be deemed untrue and incorrect if not true and correct in all respects.

(b)Each of the covenants and agreements of Heritage and HBC to be performed at or before the Effective Time shall have been duly performed in all material respects.

(c)Between the date of this Agreement and the Effective Time, there shall not have occurred any event that has had or could reasonably be expected to have, either individually or in the aggregate, a Material Adverse Effect on Heritage and HBC (taken as a whole).

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(d)Diablo shall have received an opinion of Bingham McCutchen LLP in form and substance reasonably satisfactory to Diablo, to the effect that, on the basis of facts, representations and assumptions, set forth in such opinion, which are consistent with the state of facts existing, at the Effective Time, the Merger will qualify as a reorganization under Section 368 of the Code.

(e)Heritage shall have delivered at the Closing the following:

(i)TRUE, CORRECT AND COMPLETE COPIES OF THE ARTICLES OF Incorporation and all amendments thereto, of Heritage and HBC, duly certified as of a recent date by the California Secretary of State.

(ii)Certificates of status, dated as of a recent date, issued by the California Secretary of State, duly certifying as to the good legal standing of each of Heritage and HBC under the laws of the State of California.

(iii)Certificates of good standing, dated as of a recent date, issued by the California Franchise Tax Board, duly certifying as to the good standing of each of Heritage and HBC in the State of California.

(iv)A certificate, dated as of a recent date, issued by the DFI, duly certifying as to the organization of HBC under the laws of the State of California and authorization to conduct commercial banking business within the State of California.

(v)A certificate, dated as of the Closing Date, executed by the Secretary or an Assistant Secretary of Heritage pursuant to which such officer shall certify: (A) the due adoption by the board of directors of Heritage of corporate resolutions attached to such certificate authorizing the execution and delivery of this Agreement and the other agreements and documents contemplated hereby and the taking of all actions contemplated hereby and thereby; (B) the incumbency and true signatures of those officers of Heritage duly authorized to act on its behalf in connection with the transactions contemplated by this Agreement and to execute and deliver this Agreement and other agreements and documents contemplated hereby and the taking of all actions contemplated hereby and thereby on behalf of Heritage, (C) that there is no stop order or proceeding in place seeking or threatening or stop order is in place relating to the Form S-4 and (D) that the copy of the Bylaws of Heritage attached to such certificate is true and correct and such Bylaws have not been amended except as reflected in such copy.

(vi)A certificate, dated as of the Closing Date, executed by the Secretary or an Assistant Secretary of HBC pursuant to which such officer shall certify: (A) the due adoption by the board of directors of HBC of corporate resolutions attached to such certificate authorizing the execution and delivery of this Agreement and the other agreements and documents contemplated hereby and the taking of all actions contemplated hereby and thereby; (B) the incumbency and true signatures of those officers of HBC duly authorized to act on its behalf in connection with the transactions contemplated by this Agreement and to execute and deliver this Agreement and other agreements and documents contemplated hereby and the taking of all actions contemplated hereby and thereby on behalf of Heritage, and (C) that the copy of the Bylaws of Heritage attached to such certificate is true and correct and such Bylaws have not been amended except as reflected in such copy.

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(vii)A certificate, dated as of the Closing Date, executed by a duly authorized officer of Heritage, pursuant to which Heritage shall certify, to the best knowledge of such officer, that (i) all of the representations and warranties made in Section 5.2 of this Agreement are true and correct in all material respects on and as of the date of such certificate as if made on such date and that, except as expressly permitted by this Agreement, there shall have been no Material Adverse Effect with respect to Heritage and HBC (taken as a whole) since the date of this Agreement, and (ii) Heritage and HBC have performed and complied in all material respects with all of its obligations and agreements required to be performed on or prior to the Closing Date under this Agreement.

(viii)All other documents required to be delivered to Diablo by Heritage or HBC under the provisions of this Agreement, and all other documents, certificates and instruments as are reasonably requested by Diablo or its counsel for the purpose of evidencing the accuracy of any representation or warranty, the performance or compliance with any obligation or covenant or satisfaction of any condition.

ARTICLE X

TERMINATION

Section 10.1TERMINATION. This Agreement may be terminated at any time prior to the Effective Time:

(a)BY THE MUTUAL WRITTEN CONSENT OF THE BOARDS OF DIRECTORS OF HERITAGE AND DIABLO;

(b)WITH WRITTEN NOTICE BY HERITAGE OR DIABLO IF THERE SHALL HAVE BEEN A FINAL JUDICIAL OR REGULATORY DETERMINATION (AS TO WHICH ALL PERIODS FOR APPEAL SHALL HAVE EXPIRED AND NO APPEAL SHALL BE PENDING) THAT ANY MATERIAL PROVISION OF THIS AGREEMENT IS ILLEGAL, INVALID OR UNENFORCEABLE (UNLESS THE ENFORCEMENT THEREOF IS WAIVED BY THE AFFECTED PARTY) OR DENYING ANY REGULATORY APPLICATION THE APPROVAL OF WHICH IS A CONDITION PRECEDENT TO A PARTY’S OBLIGATIONS HEREUNDER;

(c)WITH WRITTEN NOTICE BY HERITAGE OR DIABLO ON OR AFTER SEPTEMBER 30, 2007, IN THE EVENT THE MERGER HAS NOT BEEN CONSUMMATED BY SUCH DATE (PROVIDED, HOWEVER, THAT THE RIGHT TO TERMINATE UNDER THIS SECTION 10.1(C) SHALL NOT BE AVAILABLE TO ANY PARTY WHOSE FAILURE TO PERFORM AN OBLIGATION HEREUNDER HAS BEEN THE CAUSE OF, OR HAS RESULTED IN, THE FAILURE OF THE MERGER TO OCCUR ON OR BEFORE SUCH DATE);

(d)WITH WRITTEN NOTICE BY HERITAGE OR DIABLO AT ANY TIME AFTER THE DIABLO SHAREHOLDERS FAIL TO APPROVE THIS AGREEMENT AND THE MERGER BY THE REQUISITE VOTE AT THE DIABLO SHAREHOLDERS’ MEETING;

(e)WITH WRITTEN NOTICE BY HERITAGE OR DIABLO, IN THE EVENT OF A MATERIAL BREACH BY THE OTHER PARTY OF ANY REPRESENTATION, WARRANTY, COVENANT OR AGREEMENT CONTAINED HEREIN OR IN ANY SCHEDULE OR DOCUMENT DELIVERED PURSUANT HERETO, WHICH BREACH WOULD RESULT IN THE FAILURE TO SATISFY THE CLOSING CONDITIONS SET FORTH IN SECTION 9.2(A) OR 9.2(B) IN THE CASE OF HERITAGE, OR SECTION 9.3(A) OR 9.3(B) IN THE CASE OF DIABLO, AND WHICH BREACH EITHER IS NOT REASONABLY CAPABLE OF BEING CURED OR, IF REASONABLY CAPABLE OF BEING CURED, HAS NOT BEEN CURED WITHIN THIRTY (30) DAYS AFTER WRITTEN NOTICE OF SUCH BREACH IS GIVEN BY THE NON-BREACHING PARTY (AND THE NON-BREACHING PARTY ITSELF IS NOT IN MATERIAL BREACH WITH RESPECT TO ITS OWN OBLIGATIONS UNDER THIS AGREEMENT;

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(f)WRITTEN NOTICE BY DIABLO, IF AN ACQUISITION PROPOSAL THAT IS A SUPERIOR PROPOSAL IS RECEIVED AND A MAJORITY OF THE MEMBERS OF THE ENTIRE DIABLO BOARD OF DIRECTORS REASONABLY DETERMINES IN GOOD FAITH (AFTER RECEIVING ADVICE OF OUTSIDE LEGAL COUNSEL TO DIABLO AND INDEPENDENT FINANCIAL ADVISORS), THAT IT IS NECESSARY TO TERMINATE THIS AGREEMENT AND ENTER INTO AN AGREEMENT TO EFFECT THE SUPERIOR PROPOSAL IN ORDER TO COMPLY WITH THE FIDUCIARY DUTIES OF THE DIABLO BOARD OF DIRECTORS UNDER APPLICABLE LAW; PROVIDED, HOWEVER, THAT DIABLO MAY NOT TERMINATE THIS AGREEMENT PURSUANT TO THIS SECTION 10.1(F) UNLESS AND UNTIL

(i)FIVE (5) BUSINESS DAYS HAVE ELAPSED FOLLOWING DELIVERY TO HERITAGE OF A WRITTEN NOTICE OF SUCH DETERMINATION BY THE DIABLO BOARD OF DIRECTORS AND DURING SUCH FIVE (5) BUSINESS DAY PERIOD DIABLO HAS INFORMED HERITAGE OF THE TERMS AND CONDITIONS OF SUCH SUPERIOR PROPOSAL AND THE IDENTITY OF THE PERSON MAKING SUCH SUPERIOR PROPOSAL, AND HAS ENGAGED IN GOOD FAITH NEGOTIATIONS (INCLUDING BY MAKING ITS OFFICERS, DIRECTORS AND ITS FINANCIAL AND LEGAL ADVISORS REASONABLY AVAILABLE TO NEGOTIATE) TO AMEND THIS AGREEMENT TO REFLECT ANY REVISED PROPOSAL BY HERITAGE SO THAT THE TRANSACTIONS CONTEMPLATED HEREBY MAY BE EFFECTED AND THE DIABLO BOARD OF DIRECTORS MAY CONTINUE TO RECOMMEND THE ADOPTION OF THIS AGREEMENT AND THE APPROVAL OF THE MERGER (“Revised Heritage Proposal”),

(ii)at the end of such five (5) Business Day period, and after taking into account any Revised Heritage Proposal, the Acquisition Proposal continues to constitute a Superior Proposal, and a majority of the members of the entire Diablo board of directors (after receiving advice of outside legal counsel to Diablo and independent financial advisors) continues to reasonably determine in good faith that it is necessary to terminate this Agreement and enter into an agreement to effect the Superior Proposal in order to comply with the fiduciary duties of Diablo board of directors under applicable law; and

(iii)if a Revised Heritage Proposal has been made, and such Acquisition Proposal has been modified or amended prior to the Diablo board of directors’ re-determination above, the Diablo board of directors has (A) first notified Heritage of the revised terms and conditions of such Acquisition Proposal and the identity of the Person making such Acquisition Proposal, (B) established a deadline, and notified Heritage and the Person making such Acquisition Proposal thereof, to occur not less than three (3) nor more than seven (7) Business Days after giving such notice, for the submission of final proposals from both Heritage and such Person, and (C) within seven (7) Business Days after such deadline, has again reasonably determined in good faith (after receiving advice of outside legal counsel to Diablo and independent financial advisors) that such Acquisition Proposal remains a Superior Proposal and has notified Heritage of such determination; and

(iv)(A) prior to such termination by Diablo, Heritage has received the Termination Fee in immediately available funds and (B) simultaneously or substantially simultaneously with such termination Diablo enters into a definitive acquisition, merger or similar agreement to effect the Superior Proposal.

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(G)WRITTEN NOTICE BY HERITAGE, IF:

(I)THE DIABLO BOARD OF DIRECTORS SHALL HAVE: (A) FAILED TO NOTICE OR SOLICIT PROXIES FOR THE DIABLO SHAREHOLDERS’ MEETING IN ACCORDANCE WITH SECTION 7.5; (B) FAILED TO MAKE THE DIABLO BOARD RECOMMENDATION OR WITHDRAWN, OR ADVERSELY AMENDED, MODIFIED OR CHANGED, OR RESOLVED TO WITHDRAW OR ADVERSELY AMEND, MODIFY OR CHANGE, THE DIABLO BOARD RECOMMENDATION; (C) APPROVED OR RECOMMENDED, OR RESOLVED TO APPROVE OR RECOMMEND, TO THE DIABLO SHAREHOLDERS AN ACQUISITION PROPOSAL OTHER THAN THAT CONTEMPLATED BY THIS AGREEMENT; (D) ENTERED INTO, OR RESOLVED TO ENTER INTO, ANY AGREEMENT WITH RESPECT TO AN ACQUISITION PROPOSAL; OR (E) RECOMMENDED THAT THE DIABLO SHAREHOLDERS TENDER THEIR SHARES IN ANY TENDER OFFER OR EXCHANGE OFFER THAT IS COMMENCED OTHER THAN BY HERITAGE; OR

(II)DIABLO, OR ANY OF ITS REPRESENTATIVES SHALL HAVE MATERIALLY BREACHED SECTION 7.6.

(iii)DIABLO SHALL HAVE EXERCISED A RIGHT SPECIFIED IN SECTION 7.6 WITH RESPECT TO AN ACQUISITION PROPOSAL AND SHALL DIRECTLY OR THROUGH AGENTS AND REPRESENTATIVES, CONTINUED DISCUSSIONS WITH A PERSON CONCERNING AN ACQUISITION PROPOSAL FOR MORE THAN 15 BUSINESS DAYS AFTER THE DATE OF SUCH ACQUISITION PROPOSAL.

(H)BY HERITAGE WITHIN THREE (3) BUSINESS DAYS FOLLOWING THE DETERMINATION DATE IF THE AVERAGE CLOSING PRICE IS LESS THAN $23.50.

For purposes hereof, the following terms have the following meanings:

(i)“Average Closing Price” shall mean the average of the closing prices of Heritage Common Stock on NASDAQ Global Select Market for the 20 consecutive trading days ending on the Determination Date, rounded to four decimal places, whether or not trades occurred on those days (subject to adjustment as provided below and provided that if no trades of Heritage Common Stock shall occur on a given trading day the closing price thereof on the next preceding day when a trade shall have occurred shall be deemed to be the closing price on such day for the purposes hereof). In the event Heritage pays, declares or otherwise effects a stock split, reverse stock split, reclassification or stock dividend or stock distribution with respect to Heritage Common Stock between the date of this Agreement and the Effective Time, appropriate adjustments will be made to the Average Heritage Closing Price of Heritage Common Stock.

(ii)“Determination Date” shall mean the fifth Business Day prior to the day on which the Closing is scheduled by Heritage and Diablo.

(iii)“Trading Day” shall mean day on which trading generally takes place on NASDAQ Global Select Market and on which trading in Heritage Common Stock has not been halted or suspended.

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Section 10.2EFFECT OF TERMINATION.

(a)SURVIVAL. In the event of termination of this Agreement as provided in Section 10.1, this Agreement shall forthwith become void and of no effect except that the provisions of this Section 10.2, Section 8.8 and Section 8.12, and the entirety of Article XI shall survive any termination of this Agreement pursuant to Section 10.1.

(b)Termination Fee. Diablo shall pay Heritage a termination fee in the amount of Three Million Three Hundred Eighty Thousand Dollars ($3,380,000) in the manner and at the time set forth in Section 10.2 (“Termination Fee”), in the event that this Agreement is terminated as follows:

(I)IF HERITAGE SHALL TERMINATE THIS AGREEMENT PURSUANT TO SECTION 10.1(G);

(II)IF DIABLO SHALL TERMINATE THIS AGREEMENT PURSUANT TO SECTION 10.1(F); OR

(III)IN THE EVENT THAT (A) AN ACQUISITION PROPOSAL INVOLVING DIABLO SHALL HAVE BEEN PUBLICLY ANNOUNCED, COMMENCED OR OTHERWISE BECOME PUBLICLY KNOWN OR ANY PERSON SHALL HAVE PUBLICLY ANNOUNCED AN INTENTION (WHETHER OR NOT CONDITIONAL) TO MAKE AN ACQUISITION PROPOSAL INVOLVING DIABLO, AND (B) THEREAFTER THIS AGREEMENT IS TERMINATED BY EITHER HERITAGE OR DIABLO PURSUANT TO (X) SECTION 10.1(C) FOR FAILURE OF THE MERGER TO BE CONSUMMATED BY THE DATE SPECIFIED THEREIN AND SUCH FAILURE DIABLO FAILING TO PERFORM ITS OBLIGATIONS UNDER THIS AGREEMENT OR (Y) SECTION 10.1(D) FOR FAILURE OF DIABLO SHAREHOLDERS TO APPROVE THE ADOPTION OF THIS AGREEMENT, AND (C) WITHIN TWELVE (12) MONTHS OF THE TERMINATION OF THIS AGREEMENT, DIABLO CONSUMMATES OR, WITHIN SIX (6) MONTHS OF THE TERMINATION OF THIS AGREEMENT, ENTERS INTO OR AN ACQUISITION PROPOSAL WITH RESPECT TO DIABLO.

Payment of the Termination Fee to Heritage, pursuant to this Section 10.2(b), shall be the sole and exclusive liability of Diablo to and the sole remedy of Heritage for any termination of this Agreement as set forth in paragraphs (i), (ii) and (iii) of this Section 10.2(b), or the actions, events, occurrences or circumstances giving rise to any such termination.

(c)PAYMENT OF TERMINATION FEE. If the Termination Fee becomes payable pursuant to Section 10.2(b), it shall be paid by wire transfer of immediately available funds to an account designated by Heritage, within three (3) Business Days after termination of this Agreement in the case of a termination described in paragraph 10.2(b)(i) or within three (3) Business Days after the consummation of the Acquisition Proposal in the case of a termination set forth in paragraph 10.2(b)(iii), and prior to termination of this Agreement in the case of a termination described in paragraph of 10.2(b)(ii). Diablo acknowledges that the agreements contained in this Section 10.2 are an integral part of the transactions contemplated by this Agreement, and that without such agreements Heritage would not have entered into this Agreement, and that such amounts are liquidated damages and do not constitute a penalty. The parties agree that it would be impracticable or extremely difficult to fix actual damages and the amounts set forth in Section 10.2(b) are reasonably intended to compensate for expenses incurred in connection with the negotiation of this Agreement and any lost opportunity resulting from the pendency of the transactions contemplated by this Agreement. If Diablo fails to promptly pay Heritage the amounts due under Section 10.2(b) within the time period specified herein, Diablo shall pay all costs and expenses (including attorneys’ fees) incurred by Heritage in connection with any action, including the filing of any lawsuit, taken to collect payment of such amounts, together with the interest as required under Section 10.2(f).

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(d)Effect of Termination pursuant to Section 10.1(e). Notwithstanding anything to the contrary that may be contained in Section 10.2(b), if this Agreement is terminated by Heritage as provided in Section 10.1(e) or by Diablo as provided in Section 10.1(e), and the event that entitled such party (the “Terminating Party”) to terminate this Agreement pursuant to Section 10.1(e), as the case may be, was a willful and material breach by the other party (a “Breaching Party”) of any representation, warranty or covenant of such Breaching Party set forth in this Agreement, the Terminating Party shall have all rights and remedies available to it under this Agreement or at law to recover from the Breaching Party, all damages, losses, costs and expenses that the Terminating Party incurs by reason of such willful and material breach by the Breaching Party and the resulting termination of this Agreement.

(e)Effect of Other Terminations. No party shall have any liability of any kind or nature to the other parties by reason of any termination of this Agreement pursuant to Section 10.1 or the action, events, occurrences or circumstances that caused this Agreement to be terminated, except as and to the extent provided in this Article X. In no event and under no circumstance shall any officer, director, shareholder, employee or independent contractor of any party have any liability whatsoever to the other parties by reason of any termination of this Agreement or the action, events, occurrences or circumstances that caused this Agreement to be terminated.

(f)Payments. All payments that a party becomes obligated to make to the other party pursuant to Section 10.2(b) or 10.2(d) or Section 11.12 shall be made by wire transfer of immediately available funds to an account designated by Heritage or Diablo, as applicable, when due. If a party obligated to make such payment (a “Payor Party”) fails to pay any such amount when payment thereof is due to the other party, the unpaid amount shall bear interest at the prime rate of interest printed in The Wall Street Journal on the date such payment was required to be made until it is paid in full and the other party shall be entitled to recover such accrued interest and its costs and expenses (including. reasonable attorneys’ fees and expenses) incurred in its efforts to collect such amount from the Payor Party (whether or not litigation is instituted).

ARTICLE XI

OTHER MATTERS

Section 11.1CERTAIN DEFINITIONS; INTERPRETATIONS. As used in this Agreement, the following terms shall have the meanings indicated:

“Acquisition Proposal” shall mean (i) any inquiry, proposal or offer (including any proposal to the Diablo Shareholders) from any Person or group relating to any direct or indirect acquisition or purchase of substantially all of the assets of Diablo or twenty percent (20%) or more of the Diablo Common Stock, (ii) any tender offer or exchange offer that, if consummated, would result in any Person beneficially owning twenty percent (20%) or more of any class of equity securities of Diablo, (iii) any sale of any class of equity securities or securities convertible or exchangeable into or any agreement evidencing the right to acquire equity securities representing twenty percent (20%) or more of the voting power of Diablo, (iv) any merger, consolidation, business combination, recapitalization, liquidation, dissolution or similar transaction involving Diablo, or (v) a public announcement of another Person (other than Heritage or HBC) of an unsolicited bona fide proposal, plan or intention to do any of the foregoing.

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“Affiliate” of any Person means any Person directly or indirectly controlling, controlled by, or under common control with, such Person; provided, however, that, for the purposes of this definition, “control” (including with correlative meanings, the terms “controlled by” and “under common control with”), as used with respect to any Person, means the possession, directly or indirectly, of the power to direct or cause the direction of the management and policies of such Person, whether through the ownership of voting securities or partnership interests, by contract or otherwise, and as used with respect to any party, means any Person who is an “affiliate” of that party within the meaning of Rule 405 promulgated under the Securities Act.

“Agreement”has the meaning set forth in the introductory paragraph of this Agreement.

“ALLL” shall mean the allowance for loan and lease losses, as determined in accordance with GAAP and RAP.

“Average Closing Price” has the meaning set forth in Section 10.1(h)(i).

“Bank Secrecy Act” has the meaning set forth in Section 5.1(u).

“BHCA” shall mean Bank Holding Company Act of 1956, as amended.

“Breaching Party” has the meaning set forth in Section 10.2(d).

“Business Day” shall mean any day other than a Saturday, Sunday, national holiday or any other day on which national banks operating in California are permitted or required to close.

“Call Reports” has the meaning set forth in Section 5.1(x).

“Cash Consideration” has the meaning set forth in Section 2.2(a)(i).

“Cash Conversion Number” has the meaning set forth in Section 2.3(a).

“Cash Election” has the meaning set forth in Section 2.2(a)(i).

“Cash Election Number” has the meaning set forth in Section 2.3(b)(i).

“Cash Election Shares” has the meaning set forth in Section 2.2(a)(i).

“Cash Per Share Amount” has the meaning set forth in Section 2.2(a)(i).

“CERCLA” has the meaning set forth in Section 5.1(ee).

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“CGCL”has the meaning set forth in Section 1.1(a).

“Closing” has the meaning set forth in Section 1.2(b).

“Closing Date” has the meaning set forth in Section 1.2(b).

“Closing Financial Statements” has the meaning set forth in Section 9.2(m).

“COBRA” has the meaning set forth in Section 5.1(cc)(ii).

“Code”has the meaning set forth in Paragraph F of the Recitals.

“Commissioner” has the meaning set forth in Section 1.1(d).

“Community Reinvestment Act” has the meaning set forth in Section 5.1(r).

“Confidentiality Agreements” means the Diablo Confidentiality Agreement and the confidentiality agreement between Heritage and Diablo dated November 26, 2006.

“Deposit Summary” has the meaning set forth in Section 5.1(l).

“Determination Date” has the meaning set forth in Section 10.1(h)(ii).

“DFI” has the meaning set forth in Section 5.1(a).

“Diablo”has the meaning set forth in the introductory paragraph of this Agreement.

“Diablo Board Recommendation” has the meaning set forth in Section 7.5.

“Diablo Common Stock” has the meaning set forth in Section 2.1(c).

“Diablo Confidentiality Agreement” shall mean the Confidentiality Agreement dated November 6, 2006 between Diablo and Heritage.

“Diablo Financial Statements” has the meaning set forth in Section 5.1(f).

“Diablo Preferred Stock” has the meaning set forth in Section 5.1(e).

“Diablo Scheduled Contracts” has the meaning set forth in Section 5.1(k).

“Diablo Shareholders” shall mean holders of the Diablo Common Stock.

“Diablo Shareholders Meeting” has the meaning set forth in Section 7.5.

“Disclosure Schedule” has the meaning set forth in Section 5.1.

“Dissenting Common Stock” has the meaning set forth in Section 2.1(d).

“Election” has the meaning set forth in Section 3.1(a).

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“Election Form” has the meaning set forth in Section 3.3(a).

“Election Deadline” has the meaning set forth in Section 3.1(d).

“Effective Date.” has the meaning set forth in Section 1.2(a).

“Effective Time” has the meaning set forth in Section 1.2(a).

“Employee Plans” has the meaning set forth in Section 5.1(cc)(i).

“Encumbrances” has the meaning set forth in Section 5.1(i).

“Environmental Law” has the meaning set forth in Section 5.1(ee)(vi).

“ERISA” shall mean the Employee Retirement Income Security Act of 1974, as amended, and all regulations thereunder.

“ERISA Affiliate” has the meaning set forth in Section 5.1(cc)(i).

“Exchange Act” has the meaning set forth in Section 5.2(f)(i).

“Exchange Agent” has the meaning set forth in Section 3.1(d).

“Exchange Agent Agreement” has the meaning set forth in Section 3.1(d).

“Exchange Fund” has the meaning set forth in Section 3.2.

“Exchange Ratio” shall mean the quotient obtained by dividing the Per Share Consideration by the Average Closing Price.

“Fair Lending Laws” shall mean, collectively, the Equal Credit Act (15 U.S.C. Section 1691, et seq., the Fair Housing Act (420 U.S.C. Section 3601, et seq. or the Home Mortgage Disclosure Act (12 U.S.C. Section 2801, et seq.).

“FDIC” has the meaning set forth in Section 5.1(a).

“Financial Code” has the meaning set forth in Section 1.1(a).

“Form of Election” has the meaning set forth in Section 3.1(b).

“Form S-4” shall mean registration statement on Form S-4, and such amendments thereto, that is filed with the SEC to register the shares of Heritage Common Stock to be issued in the Merger under the Securities Act and includes the Proxy Statement that will be used to solicit proxies for the Diablo Shareholders Meeting.

“FRB”has the meaning set forth in Section 5.2(l).

“GAAP” shall mean generally accepted accounting principles, consistently applied from period to period, applicable to banks or bank holding companies for the period in question.

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“Governmental Authority” shall mean any state or federal court, judicial forum, arbitral, tribunal, administration agency, commission, department, board, bureau or regulatory agency, authority or other governmental agency.

“Hazardous Substance” has the meaning set forth in Section 5.1(ee)(vii).

“HBC”has the meaning set forth in the introductory paragraph of this Agreement.

“HBC Common Stock” has the meaning set forth in Section 2.1(b).

“Heritage”has the meaning set forth in the introductory paragraph of this Agreement.

“Heritage Common Stock” has the meaning set forth in Section 2.1(a).

“Heritage Financial Statements” has the meaning set forth in Section 5.2(g).

“Heritage SEC Reports” has the meaning set forth in Section 5.2(f)(i).

“Heritage Stock Option Plans” has the meaning set forth in Section 5.2(e).

“Heritage Transaction” has the meaning set forth in Section 6.6.

“Holder” has the meaning set forth in Section 3.1.

“Immigration Laws” has the meaning set forth in Section 5.1(bb).

“Indemnified Parties” has the meaning set forth in Section 8.9.

“Key Employee” shall mean those individuals identified in Schedule 11.1(k).

“Knowledge” or “Knowledge” shall mean the knowledge obtained after conducting an investigation reasonable under the circumstances of the subject matter thereof.

“Letter of Transmittal” has the meaning set forth in Section 3.3(a).

“Loans” has the meaning in Section 4.2(t).

“Material Adverse Effect” with respect to any Person, means any event, change, occurrence, effect, fact, violation or circumstance having a material adverse effect on (i) the ability of such Person or its Subsidiaries to perform its obligations under this Agreement or to consummate the transactions contemplated hereby on a timely basis or (ii) the business, results of operations or financial condition of such Person and its Subsidiaries, taken as a whole; provided, however, that effects relating to (a) the economy in general, which in each case do not affect such Person disproportionately, (b) changes affecting the banking industry generally which in each case do not affect such Person disproportionately or (c) the announcement of the transactions contemplated hereby or other communication by Heritage of its plans or intentions with respect to the business of Heritage or HBC shall be deemed to not constitute a “Material Adverse Effect” or to be considered in determining whether a “Material Adverse Effect” has occurred.

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“Merger” has the meaning set forth in Paragraph C of the Recitals.

“Merger Agreement” has the meaning set forth in Section 1.1(a).

“Merger Consideration” has the meaning set forth in Section 2.2(a).

“NASDAQ” shall mean the National Association of Securities Dealers Automated Quotation.

“NLRB” has the meaning set forth in Section 5.1(bb).

“Non-Election Shares” has the meaning set forth in Section 2.2(a)(i).

“Nonperforming Assets” has the meaning set forth in Section 5.1(g)(ii).

“Notices” has the meaning set forth in Section 11.6.

“parties” shall mean the parties to this Agreement.

“Patriot Act” has the meaning set forth in Section 5.1(v).

“Payor Party” has the meaning set forth in Section 10.2(f).

“Permit” or “permit” means any permit, authorization, license, certificate, approval and/or clearance of any Governmental Authority necessary for a Person to own, lease and operate its properties or to carry on its businesses substantially in the manner as those businesses are being conducted as of the date hereof.

“Per Share Consideration” shall mean (i) $23.00, if the Average Closing Price is less than or equal to $24.55, and (ii) if the Average Closing Price is greater than $24.55, then the Per Share Consideration shall mean the quotient equal to (A) the sum of (x) the product of the Total Stock Consideration times the Average Closing Price plus (y) $15,012,876 divided by (B) 2,502,146.

“Person” includes an individual, corporation, partnership, association, trust, limited liability company, joint venture or unincorporated organization and Governmental Authority.

“properties” has the meaning set forth in Section 5.1(ee)(viii).

“Proxy Statement” shall mean the proxy statement that is included as part of the Form S-4 and used to solicit proxies for the Diablo Shareholders’ Meeting, and prospectus used to offer and sell the shares of Heritage Common Stock to be issued in the Merger.

“RAP” shall mean regulatory accounting principles, if any, applicable to a particular person.

“RCRA” has the meaning set forth in Section 5.1(ee)(vi).

“REO” has the meaning set forth in Section 5.1(g)(ii).

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“Revised Heritage Proposal” has the meaning set forth in Section 10.1(f)(i).

“SEC” shall mean the U.S. Securities and Exchange Commission.

“Securities Act” has the meaning set forth in Section 3.3(i).

“Share Adjustment” has the meaning set forth in Section 2.2(b).

“Shareholder Agreement” has the meaning set forth in Section 7.7.

“Shortfall Number” has the meaning set forth in Section 2.3(b)(ii).

“State Acts” has the meaning set forth in Section 5.1(ee)(vi).

“Stock Consideration” has the meaning set forth in Section 2.2(a)(ii).

“Stock Election” has the meaning set forth in Section 2.2(a)(ii).

“Stock Election Shares” has the meaning set forth in Section 2.2(a)(ii).

“Stock Option Plan” has the meaning set forth in Section 2.4.

“Subsidiary” or “Subsidiaries” with respect to a person, means any other person the stock or equity of which is more than 50% owned by such person either alone or through or together with any other Subsidiary.

“Superior Proposal” shall mean a bona fide binding written offer not solicited by or on behalf of Diablo made by a Person to acquire all of the Diablo Common Stock pursuant to a tender offer, a merger or a sale of all of the assets of the Diablo (i) on terms which a majority of the members of the entire Diablo Board (based on the written advice of an independent investment bank) reasonably determines in good faith to have a higher value than the consideration to be received by the Diablo Shareholders (in their capacity as such) in the transactions contemplated hereby (after any modification of the transactions contemplated hereby proposed by Heritage in accordance with Section 7.6 and 10.1(f)), (ii) which is reasonably capable of being consummated (taking into account, among other things, all legal, financial, regulatory and other aspects of such proposal and the identity of the Person making such proposal) and (iii) that is not conditioned on obtaining any financing.

“Tangible Equity Capital” has the meaning set forth in Section 9.2(n).

“Taxes” shall mean any federal, state, local, or foreign income, gross receipts, license, payroll, employment, excise, severance, stamp, occupation, premium, windfall profits, environmental (including taxes under Code Section 59A), customs duties, capital stock, franchise, profits, withholding, social security (or similar), unemployment, disability, real property, personal property, sales, use, transfer, registration, value added, alternative or add-on minimum, estimated, or other taxes, or assessments in the nature of taxes, of any kind whatsoever, including any interest, penalty, or addition thereto, whether disputed or not.

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“Tax Return” shall mean any return, declaration, report, claim for refund, or information return or statement relating to Taxes, including any schedule or attachment thereto, and including any amendment thereof.

“Terminating Party” has the meaning set forth in Section 10.2(d).

“Termination Fee” has the meaning set forth in Section 10.2(b).

“Total Cash Consideration” shall mean $15,012,876, plus the product of (i) the number of shares of Diablo Common Stock issued from and after December 31, 2006 upon the exercise of stock options and the payment of the exercise price therefor all in accordance with the Stock Option Plan, times (ii) the Per Share Consideration. If the Average Closing Price is less than $24.55, then the Total Cash Consideration shall be increased by an amount equal to the product of (x) 1,732,298 and (y) the difference between $24.55 and the Average Closing Price.

“Total Stock Consideration” shall mean (i) 1,732,298, if the Average Closing Price is less than $27.44, and (ii) if the Average Closing Price is greater than or equal to $27.44 then the Total Stock Consideration shall mean 1,732,298 minus the number of shares equal to (A) .6666 times the difference between the Average Closing Price and $27.44 multiplied by 1,732,298, divided by (B) the Average Closing Price.

“Trading Day” has the meaning set forth in Section 10.1(h)(ii).

“Treasury Shares” has the meaning set forth in Section 2.1(e).

“WARN” has the meaning set forth in Section 5.1(bb)(xii).

The table of contents and headings contained in this Agreement offer ease of reference only and shall not affect the meaning or interpretation of this Agreement. Whenever the words “include”, “includes”, or “including” are used in this Agreement, they shall be deemed followed by the words “without limitation”. Any singular term in this Agreement shall be deemed to include the plural, and any plural term, the singular.

Section 11.2NON-SURVIVAL OF REPRESENTATIONS, WARRANTIES AND COVENANTS. Except for Articles II, III and XI and for Sections 6.2, 6.7, and 8.9, none of the respective representations, warranties, obligations, covenants, and agreements of the parties shall survive the Effective Time.

Section 11.3Waiver and Modification. Prior to the Effective Time, any provision of this Agreement may be (a) waived, in whole or in part, by the party benefited by the provision or by both parties or (b) amended or modified at any time (including the structure of the transaction) by an agreement in writing between the parties hereto, approved by their respective boards of directors, provided, however, that any amendment which reduces the amount or changes the form of the consideration to be delivered to the Diablo shareholders in the Merger shall not be valid after the Agreement is approved by the shareholders of Diablo without any subsequent approval by the shareholders of Diablo.

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Section 11.4Counterparts. This Agreement may be executed in counterparts each of which shall be deemed to constitute an original, but all of which together shall constitute one and the same instrument.

Section 11.5Governing Law, Jurisdiction and Venue. This Agreement shall be governed by, and interpreted in accordance with, the laws of the State of California (however, not to the exclusion of any applicable Federal law), without regard to California statutes or judicial decisions regarding choice of law questions. The parties hereby irrevocably submit to the jurisdiction of the courts of the State of California and the federal courts of the United States of America located in the Northern District of the State of California solely in respect of the interpretation and enforcement of the provisions of this Agreement and of the documents referred to in this Agreement, and in respect of the transactions contemplated herein and therein, and hereby waive, and agree not to assert, as a defense in any action, suit or proceeding for the interpretation or enforcement hereof or of any such document, that it is not subject thereto or that such action, suit or proceeding may not be brought or is not maintainable in said courts or that the venue thereof may not be appropriate or that this Agreement or any such document may not be enforced in or by such courts, and the parties hereto irrevocably agree that all claims with respect to such action or proceeding shall be heard and determined in such California state or federal court. The parties hereby consent to and grant any such court jurisdiction over the person of such parties and over the subject matter of such dispute and agree that mailing of process or other papers in connection with any such action or proceeding in the manner provided in Section 11.6 or in such other manner as may be permitted by law, shall be valid and sufficient service thereof. The prevailing party shall be entitled to recover all reasonable costs and expenses, including attorneys’ fees, or charges and disbursements incurred in connection with any such action, suit or proceeding.

Section 11.6Notices. All notices, requests, acknowledgements and other communications hereunder (collectively, “Notices”) to a party shall be in writing and delivered by hand, Federal Express (or other reputable overnight delivery service), facsimile or certified mail to such party at its address set forth below or to such other address as such party may specify by notice to the other party hereto. All Notices given by facsimile shall be deemed to have been given upon receipt of confirmation by the sender of such Notice; all other Notices shall be deemed to have been given when received.

If to Diablo to:

Diablo Valley Bank

3189 Danville Boulevard, Suite 255

Alamo, California 94507

Attention: John J. Hounslow

Facsimile: (925) 314-2850

with a copy to:

Bingham McCutchen LLP

3 Embarcadero Center

San Francisco, CA 94111

Attention: James M. Rockett

Facsimile: (415) 393-2286

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If to Heritage or HBC, to:

Heritage Commerce Corp.

150 Almaden Blvd.

San Jose, California 95113

Attention: Walter T. Kaczmarek

Facsimile: (408) 534-4940

with a copy to:

Buchalter Nemer

A Professional Corporation

1000 Wilshire Boulevard, Suite 1500

Los Angeles, CA 90017-2457

Attention: Mark A. Bonenfant

Phone: (213) 891-5020

Facsimile: (213) 630-5669

Section 11.7ENTIRE AGREEMENT. Except for the agreements entered into as of this date or contemplated by this Agreement, the Shareholders’ Agreements and the Confidentiality Agreements, this Agreement (including the Disclosure Schedule attached hereto and incorporated herein) represents the entire understanding of the parties hereto with respect to the transactions contemplated hereby and supersedes any and all other oral or written agreements heretofore made.

Section 11.8Binding Effect; Assignment. This Agreement shall be binding upon and shall inure to the benefit of the parties hereto and their respective successors and assigns; provided, however, that this Agreement may not be assigned by either party hereto without the prior written consent of the other party.

Section 11.9Severability. If any provision of this Agreement or the application of any such provision to any person or circumstance shall be held invalid, illegal or unenforceable in any respect by a court of competent jurisdiction, such invalidity, illegality or unenforceability shall not affect any other provision hereof.

Section 11.10No Third party Beneficiaries. Except with respect to Section 6.16, this Agreement is made solely for the benefit of the parties to this Agreement and their respective successors and permitted assigns, and no other person or entity shall have or acquire any right by virtue of this Agreement.

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Section 11.11Specific Performance. The parties hereto agree that irreparable damage would occur in the event that any of the provisions of this Agreement were not performed in accordance with their specific terms or were otherwise breached. Each party acknowledges that there is not an adequate remedy at law to compensate the other parties relating to the non-consummation of the Merger. To this end, each party, to the extent permitted by law, irrevocably waives any defense it might have based on the adequacy of a remedy at law which might be asserted as a bar to specific performance, injunctive relief or other equitable relief. It is accordingly agreed that the parties shall be entitled to seek an injunction or injunctions to prevent breaches of this Agreement and to enforce specifically the terms and provisions hereof in any court of the U.S. or any state having jurisdiction, this being in addition to any other remedy to which they are entitled at law or in equity.

Section 11.12Expenses. Subject to Section 10.2, each party hereto shall pay its own costs and expenses incurred in connection with the Merger, including, without limitation, attorneys’ fees, charges and disbursements and filing or other fees payable in connection with all applications, notifications and report forms and notices to be filed with any Governmental Authority pursuant to the terms of this Agreement; provided, however, that the costs and expenses of printing and mailing the Form S-4 and the Proxy Statement shall be borne by Heritage unless the Merger does not occur, in which event such costs and expenses shall be borne equally by the parties hereto; and provided, further, that (a) if this Agreement is terminated by Heritage pursuant to Section 10.1(e), Diablo shall promptly and in any event within five Business Days following such termination pay Heritage all reasonable expenses incurred by Heritage in connection with this Agreement and the transactions contemplated by this Agreement; provided, however, that (i) any prior payment made by Diablo pursuant to Section 10.2(b) shall be credited to any payment due under this Section 11.12 or (ii) any payment made by Diablo under this Section 11.12 shall be credited to subsequent payment due pursuant to Section 10.2(b), and (b) if this Agreement is terminated by Diablo pursuant to Section 10.1(e), Heritage shall promptly and in any event within five Business Days following such termination pay Diablo all expenses incurred by Diablo in connection with this Agreement and the transactions contemplated by this Agreement.

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IN WITNESS WHEREOF, the parties hereto have caused this Agreement to be executed by their duly authorized officers as of the day and year first above written.

HERITAGE COMMERCE CORP

By:_____________________

Walter T. Kaczmarek,

Chief Executive Officer

HERITAGE BANK OF COMMERCE

By:_____________________

Walter T. Kaczmarek,

President

DIABLO VALLEY BANK

By:____________________

John J. Hounslow,

Chairman of the Board

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EXHIBIT A

FORM OF AGREEMENT OF MERGER

Agreement of Merger, dated as of ____________, 2007, by and between HERITAGE BANK OF COMMERCE (“HBC”) and DIABLO VALLEY BANK (“Diablo”).

WITNESSETH:

WHEREAS, HBC is a California-chartered commercial bank having its principal place of business in San Jose, California and a wholly-owned subsidiary of Heritage Commerce Corp, a California corporation (“Heritage”); and

WHEREAS, Diablo is a California-chartered commercial bank having its principal place of business in Alamo, California; and

WHEREAS, Heritage, HBC, and Diablo have entered into an Agreement and Plan of Merger, dated as of February ___, 2007 (the “Agreement”), pursuant to which Diablo will merge with and into HBC (the “Merger”); and

WHEREAS, Diablo and HBC desire to merge on the terms and conditions herein provided.

NOW, THEREFORE, in consideration of the premises and the mutual covenants and agreements herein contained, the parties hereto, intending to be legally bound hereby, agree as follows:

1.Definitions. All capitalized terms not otherwise defined herein shall have the meanings specified in the Agreement.

2.The Merger. Subject to the terms and conditions of this Agreement of Merger, at the Effective Time, Diablo shall merge with and into HBC under the laws of the State of California. HBC shall be the surviving corporation of the Merger (the “Surviving Corporation”).

3.Articles of Incorporation and Bylaws. The Articles of Incorporation, as amended, and Bylaws of HBC in effect immediately prior to the Effective Time shall be the Articles of Incorporation and Bylaws of the Surviving Corporation, until altered, amended or repealed in accordance with their terms and applicable law.

4.Name; Offices. The name of the Surviving Corporation shall be “Heritage Bank of Commerce.” The main office of the Surviving Corporation shall be the main office of HBC immediately prior to the Effective Time. All branch offices of HBC which were in lawful operation immediately prior to the Effective Time shall continue to be the branch offices of the Surviving Corporation upon consummation of the Merger, subject to the opening or closing of any offices which may be authorized by HBC and applicable regulatory authorities after the date hereof.

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5.Directors and Executive Officers. The directors and executive officers of the Surviving Corporation immediately after the Merger shall be the directors and executive officers of HBC immediately prior to the Merger.

6.Effects of the Merger. At the Effective Time, the effect of the Merger shall be as provided in the General Corporation Law of the State of California. Without limiting the generality of the foregoing and subject thereto, at the Effective Time, all the property, rights, privileges, powers and franchises of Diablo shall vest in the Surviving Corporation, and all debts, liabilities, obligations, restrictions, disabilities and duties of Diablo shall become the debts, liabilities, obligations, restrictions, disabilities and duties of the Surviving Corporation.

7.Effect on Shares of Stock.

(a)Diablo. Subject to the other provisions of this Section 7, each share of Diablo Common Stock issued and outstanding immediately prior to the Effective Time (other than Dissenting Common Stock and Treasury Shares) shall at the election of the holder thereof, by virtue of the Merger, be converted into the right to receive the following without interest:

(i)for each share of Diablo Common Stock with respect to which an election to receive cash has been effectively made and not revoked or deemed revoked (a “Cash Election”), the right to receive in cash an amount (the “Cash Consideration”) equal to the Per Share Consideration (the “Cash Per Share Amount”) (collectively, the “Cash Election Shares”);

(ii)for each share of Diablo Common Stock with respect to which an election to receive stock has been effectively made and not revoked or deemed revoked (a “Stock Election”), the right to receive the fraction of a share of Heritage Common Stock (the “Stock Consideration”) equal to the Exchange Ratio (collectively, the “Stock Election Shares”); and,

(iii)for each share of Diablo Common Stock other than shares to which a Cash Election or a Stock Election has been effectively made and not revoked (collectively, the “Non-Election Shares”), the right to receive such Stock Consideration and/or Cash Consideration as is determined in accordance with the Agreement.

The Cash Consideration and Stock Consideration are sometimes referred to herein collectively on the “Merger Consideration.”

(b)If, between the date hereof and the Effective Time, the outstanding shares of Heritage Common Stock shall have been increased, decreased, changed into or exchanged for a different number or kind of shares or securities as a result of a reorganization, recapitalization, reclassification, stock dividend, stock split, reverse stock split, or other similar change in capitalization (a “Share Adjustment”), then the shares of Heritage Common Stock into which a share of Diablo Common Stock shall be converted pursuant to this Section 7 shall be appropriately and proportionately adjusted so that each shareholder of Diablo shall be entitled to receive the Exchange Ratio such shareholder would have received pursuant to such Share Adjustment had the record date therefor been immediately following the Effective Time.

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(c)HBC. At the Effective Time, each share of HBC Common Stock issued and outstanding immediately prior to the Effective Time shall not be effected by the Merger and shall remain as an issued and outstanding share of common stock of the Surviving Corporation.

8.Proration.

(a)Notwithstanding any other provision contained herein, the number of shares of Diablo Common Stock that will be converted into Cash Consideration pursuant to Section 7 shall be equal to the quotient obtained by dividing (x) the Total Cash Consideration, by (y) the Per Share Consideration (which, for this purpose, shall be deemed to include the Dissenting Common Stock determined as of the Effective Time) (the “Cash Conversion Number”). All other shares of Diablo Common Stock shall be converted into Stock Consideration.

(b)Within five (5) Business Days after the Effective Time, Heritage shall cause the Exchange Agent to effect the allocation among holders of Diablo Common Stock of rights to receive the Cash Consideration and the Stock Consideration as follows:

(i)If the aggregate number of shares of Diablo Common Stock with respect to which Cash Elections shall have been made (which, for this purpose, shall be deemed to include the Dissenting Common Stock determined as of the Effective Time) (the “Cash Election Number”) exceeds the Cash Conversion Number, then all Stock Election Shares and all Non-Election Shares shall be converted into the right to receive the Stock Consideration, and Cash Election Shares of each holder thereof will be converted into the right to receive the Cash Consideration in respect of that number of Cash Election Shares equal to the product obtained by multiplying (x) the number of Cash Election Shares held by such holder by (y) a fraction, the numerator of which is the Cash Conversion Number and the denominator of which is the Cash Election Number (with the Exchange Agent to determine, consistent with Section 8(a), whether fractions of Cash Election Shares shall be rounded up or down), with the remaining number of such holder’s Cash Election Shares being converted into the right to receive the Stock Consideration; and

(ii)If the Cash Election Number is less than the Cash Conversion Number (the amount by which the Cash Conversion Number exceeds the Cash Election Number being referred to herein as the “Shortfall Number”), then all Cash Election Shares shall be converted into the right to receive the Cash Consideration and the Non-Election Shares and Stock Election Shares shall be treated in the following manner:

(a)If the Shortfall Number is less than or equal to the number of Non-Election Shares, then all Stock Election Shares shall be converted into the right to receive the Stock Consideration, and the Non-Election Shares of each holder thereof shall convert into the right to receive the Cash Consideration in respect of that number of Non-Election Shares equal to the product obtained by multiplying (x) the number of Non-Election Shares held by such holder by (y) a fraction, the numerator of which is the Shortfall Number and the denominator of which is the total number of Non-Election Shares (with the Exchange Agent to determine, consistent with Section 8(a), whether fractions of Non-Election Shares shall be rounded up or down), with the remaining number of such holder’s Non-Election Shares being converted into the right to receive the Stock Consideration; or

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(b)If the Shortfall Number exceeds the number of Non-Election Shares, then all Non-Election Shares shall be converted into the right to receive the Cash Consideration, and Stock Election Shares of each holder thereof shall convert into the right to receive the Cash Consideration in respect of that number of Stock Election Shares equal to the product obtained by multiplying (x) the number of Stock Election Shares held by such holder by (y) a fraction, the numerator of which is the amount by which (1) the Shortfall Number exceeds (2) the total number of Non-Election Shares, and the denominator of which is the total number of Stock Election Shares (with the Exchange Agent to determine, consistent with Section 8(a), whether fractions of Stock Election Shares shall be rounded up or down), with the remaining number of such holder’s Stock Election Shares being converted into the right to receive the Stock Consideration.

9.Counterparts. This Agreement of Merger may be executed in one or more counterparts, each of which shall be deemed to be an original but all of which together shall constitute one agreement.

10.Governing Law. This Agreement of Merger shall be governed in all respects, including, but not limited to, validity, interpretation, effect and performance, by the laws of the State of California.

11.Amendment. Subject to applicable law, this Agreement of Merger may be amended, modified or supplemented only by written agreement of Diablo and HBC at any time prior to the Effective Time, except that after the Diablo Shareholders Meeting, no amendment shall be made which by law requires further approval by the shareholders of Diablo without obtaining such approval.

12.Waiver. Any of the terms or conditions of this Agreement of Merger may be waived at any time by whichever of the parties hereto is, or the shareholders of which are, entitled to the benefit thereof by action taken by the Board of Directors of such waiving party.

13.Assignment. This Agreement of Merger may not be assigned by any party hereto without the prior written consent of the other party.

14.Termination. This Agreement of Merger shall terminate upon the termination of the Agreement prior to the Effective Time in accordance with its terms.

15.Conditions Precedent. The obligations of the parties under this Agreement of Merger shall be subject to the satisfaction or waiver at or prior to the Closing of all of the conditions to the Merger set forth herein and in the Agreement.

16.Effectiveness of Merger. The Merger shall be effective at the date and time filed with California Secretary of State or as set forth in such filing.

[Signature Page to Follow]

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IN WITNESS WHEREOF, the parties hereto have caused this Agreement to be executed by their duly authorized officers as of the day and year first above written.

HERITAGE BANK OF COMMERCE

By:_____________________

Name:

Title:

By:_____________________

     Name:

Title: Secretary

DIABLO VALLEY BANK

By:____________________

Name:

Title:

By:____________________

          Name:

            Title: Secretary

A-5

EXHIBIT B

SHAREHOLDER AGREEMENT

This SHAREHOLDER AGREEMENT (“Shareholder Agreement”) is made and entered into as of February 8, 2007 by and between Heritage Commerce Corp, a California corporation (“Heritage”), and the person signatory hereto (the “Shareholder”).

WHEREAS, Heritage, Heritage Bank of Commerce, a California banking corporation (“HBC”) and Diablo Valley Bank, a California banking corporation (“Diablo”), have entered into that certain Agreement and Plan of Merger (the “Agreement”), dated as of February 8, 2007, pursuant to which Diablo will be merged (the “Merger”), with and into HBC whereupon each share of Diablo common stock (“Diablo Common Stock”) will be converted into the right to receive the consideration set forth in the Agreement; and

WHEREAS, as a condition to its willingness to enter into the Agreement, Heritage has required that each executive officer and director of Diablo, as an owner of Diablo Common Stock, enter into, and the Shareholder has agreed to enter into, this Shareholder Agreement.

NOW, THEREFORE, in consideration of the foregoing, for good and valuable consideration, the parties hereby agree as follows:

1.Representations and Warranties of the Shareholder. The Shareholder hereby represents and warrants to Heritage as follows:

(a)Authority; No Violation. The Shareholder has all necessary power and authority to enter into and perform all of such Shareholder’s obligations hereunder. The execution, delivery and performance of this Shareholder Agreement by the Shareholder will not violate any other agreement to which such Shareholder is a party, including any voting agreement, shareholders’ agreement, trust agreement or voting trust. This Shareholder Agreement has been duly and validly executed and delivered by the Shareholder (and the Shareholder’s spouse, if the Shares (as defined below) constitute community property) and constitutes a valid and binding agreement of the Shareholder and such spouse, enforceable against the Shareholder and the Shareholder’s spouse in accordance with its terms.

(b)Ownership of Shares. The Shareholder is the beneficial owner or record holder of the number of shares of Diablo Common Stock indicated under the Shareholder’s name on the signature page hereto (the “Existing Shares”, and together with any shares of Diablo Common Stock acquired by the Shareholder after the date hereof, the “Shares”) and, as of the date hereof, the Existing Shares constitute all the shares of Diablo Common Stock owned of record or beneficially by the Shareholder. With respect to the Existing Shares, subject to applicable community property laws, the Shareholder has sole voting power and sole power to issue instructions with respect to the matters set forth in Section 2 hereof, sole power of disposition, sole power to demand appraisal rights and sole power to engage in actions set forth in Section 2 hereof, with no restrictions on the voting rights, rights of disposition or otherwise, subject to applicable laws and the terms of this Agreement.

B-1

2.Voting Agreement and Agreement Not to Transfer.

(a)The Shareholder hereby agrees to vote all of the Shares held by the Shareholder (i) in favor of the Merger, the Agreement and the transactions contemplated by the Agreement; (ii) against any action or agreement that would result in a breach in any material respect of any covenant, representation or warranty or any other obligation or agreement of Diablo under the Agreement; and (iii) except with the prior written consent of Heritage or as otherwise contemplated in the Agreement, against the following actions (other than the Merger and the transactions contemplated by the Agreement): (A) any extraordinary corporate transactions, such as a merger, consolidation or other business combination involving Diablo; (B) any sale, lease or transfer of a material amount of the assets of Diablo; (C) any change in the majority of the board of Diablo; (D) any material change in the present capitalization of Diablo; (E) any amendment of Diablo’s Articles of Incorporation; (F) any other material change in Diablo’s corporate structure or business; or (G) any other action which is intended, or could reasonably be expected to, impede, interfere with, delay, postpone, discourage or materially adversely affect the contemplated economic benefits to Heritage of the transactions contemplated by the Agreement. The Shareholder shall not enter into any agreement or understanding with any person or entity prior to the Termination Date (as defined below) to vote or give instructions after the Termination Date in any manner inconsistent with clauses (i), (ii) or (iii) of the preceding sentence.

(b)Until the earlier of the termination of this Agreement or the Effective Time, the Shareholder will not, directly or indirectly: sell, transfer, exchange, pledge, assign, hypothecate, encumber, tender or otherwise dispose of (collectively, a “Transfer”), or enforce or permit execution of the provisions of any redemption, share purchaser or sale, recapitalization or other agreement with Diablo or any other Person or enter into any contract, option or other agreement, arrangement or understanding with respect to the Transfer of, directly or indirectly, any of the Shares or any securities convertible into or exercisable for Shares, any other capital stock of Diablo or any interest in any of the foregoing with any Person; enter into swap or any other agreement or any transaction that transfers, in whole or in part, directly or indirectly, the economic consequence of ownership of the Shares; solicit, initiate, encourage, or facilitate, any inquiries or the making of any proposal or offer with respect to any Acquisition Proposal; take any action that would make any of such Shareholder’s representations or warranties contained herein untrue or incorrect in any material respect or have the effect of preventing or disabling such Shareholder from performing such Shareholder’s obligations under this Agreement.

3.Cooperation. The Shareholder agrees that he/she will not directly or indirectly solicit any inquiries or proposals from any person relating to any proposal or transaction for the disposition of the business or assets of Diablo or any of its subsidiaries, or the acquisition of voting securities of Diablo or any subsidiary of Diablo or any business combination between Diablo or any subsidiary of Diablo and any person other than Heritage or HBC

4.Shareholder Capacity. The Shareholder is entering this Shareholder Agreement in his or her capacity as the record or beneficial owner of the Shareholder’s Shares, and not in his or her capacity as a director of Diablo. Nothing in this Shareholder Agreement shall be deemed in any manner to limit the discretion of any Shareholder to take any action, or fail to take any action, in his or her capacity as a director of Diablo, that may be required of such Shareholder in the exercise of his or her duties and responsibilities as a director of Diablo.

B-2

5.Termination. The obligations of the Shareholder shall terminate upon the consummation of the Merger. If the Merger is not consummated, the obligations of the Shareholder hereunder shall terminate upon the termination of the Agreement.

6.Specific Performance. The Shareholder acknowledges that damages would be an inadequate remedy to Heritage for an actual or prospective breach of this Agreement and that the obligations of the Shareholder hereto shall be specifically enforceable.

7.Miscellaneous.

(a)Definitional Matters.

(i)Unless the context otherwise requires, “person” shall mean a corporation, association, partnership, joint venture, organization, business, individual, trust, estate or any other entity or group (within the meaning of Section 13(d)(3) of the Exchange Act).

(ii)All capitalized terms used but not defined in this Shareholder Agreement shall have the respective meanings that the Agreement ascribes to such terms.

(iii)The descriptive headings herein are inserted for convenience of reference only and are not intended to be part of or to affect the meaning or interpretation of this Shareholder Agreement.

(b)Entire Agreement. This Shareholder Agreement constitutes the entire agreement between the parties hereto with respect to the subject matter hereof and supersedes all other prior agreements and understandings, both written and oral, among the parties, or any of them, with respect to the subject matter hereof.

(c)Parties in Interest. This Shareholder Agreement shall be binding upon and inure solely to the benefit of each party hereto and their respective successors, assigns, heirs, executors, administrators and other legal representatives. Nothing in this Shareholder Agreement, express or implied, is intended to confer upon any other person any rights or remedies of any nature whatsoever under or by reason of this Shareholder Agreement.

(d)Certain Events. Shareholder agrees that this Agreement and the obligations hereunder shall attach to the Shares owned by Shareholder and shall be binding upon any Person to which legal ownership of such Shares shall pass, whether by operation of law or otherwise, including, without limitation, the Shareholder’s heirs, executors, guardians, administrators, trustees or successors. Notwithstanding any Transfer of such Shares by a Shareholder, such Shareholder shall remain liable for the performance of all obligations of the transferor under this Agreement.

(e) Assignment. This Shareholder Agreement shall not be assigned without the prior written consent of the other party hereto, and any purported assignment without such consent shall be null and void.

B-3

(f)Modifications. This Shareholder Agreement shall not be amended, altered or modified in any manner whatsoever, except by a written instrument executed by the parties hereto.

(g)Governing Law. This Agreement and the legal relations between the parties hereto shall be governed by and construed in accordance with the laws of the state of California, without regard to the conflict of laws rules thereof. The state or federal courts located within the state of California shall have exclusive jurisdiction over any and all disputes between the parties hereto, whether in law or equity, arising out of or relating to this Agreement and the agreements, instruments and documents contemplated hereby and the parties consent to and agree to submit to the jurisdiction of such courts. Each of the parties hereby waives and agrees not to assert in any such dispute, to the fullest extent permitted by applicable law, any claim that (i) such party is not personally subject to the jurisdiction of such courts, (ii) such party and such party’s property is immune from any legal process issued by such courts or (iii) any litigation or other proceeding commenced in such courts is brought in an inconvenient forum. The parties hereby agree that mailing of process or other papers in connection with any such action or proceeding in the manner provided in Section 8(l), or in other manner as may be permitted by law, shall be valid and sufficient service thereof and hereby waive any objections to service accomplished in the manner herein provided.

(h)Confidentiality. Shareholder shall keep confidential, shall not use in a manner in competition with or detrimental to Heritage, all confidential or proprietary information relating to Heritage and HBC and their respective businesses, except as required by applicable law and except for information which is available to the public on the date hereof, or thereafter becomes available to the public other than as a result of a breach of this provision or any other confidentiality agreement governing such information to which the Shareholder is a party.

(i)Reliance on Counsel and Other Advisors. Shareholder has consulted with such legal, financial, technical or other experts as it deems necessary or desirable before entering into this Agreement.

(j)Validity. The invalidity or unenforceability of any provision of this Shareholder Agreement shall not affect the validity or enforceability of any other provision of this Shareholder Agreement, each of which shall remain in full force and effect.

(k)Counterparts. This Shareholder Agreement may be executed in two or more counterparts, each of which shall be deemed to be an original, but all of which shall constitute one and the same agreement.

(l)Notices. Any notices or other communications required or permitted hereunder shall be in writing and shall be deemed duly given upon (i) transmitter’s confirmation of a receipt of a facsimile transmission, (ii) confirmed delivery by a standard overnight carrier or (iii) the expiration of five business days after the day when mailed by certified or registered mail, postage prepaid, addressed at the following addresses (or at such other address as the parties hereto shall specify by like notice):

B-4

If to Heritage, to:

Heritage Commerce Corp

150 Almaden Boulevard

San Jose, CA 95113

Attention: Walter T. Kaczmarek

Facsimile: (408) 534-4940

with a copy to:

Buchalter Nemer

1000 Wilshire Boulevard, Suite 1500

Los Angeles, CA 90017-2457

Attention: Mark A. Bonenfant

Facsimile: 213-896-0400

If to the Shareholder, to the address noted on the signature page hereto.

IN WITNESS WHEREOF, the parties hereto have executed this Shareholder Agreement as of the date first above written.

HERITAGE COMMERCE CORP

By:_______________________

Walter T. Kaczmarek

SHAREHOLDER:

__________________________

Name:________________________________

Number of Shares: ______________________

Address for Notices: ____________________

                            __________________

                            __________________

B-5

EXHIBIT C

DATE

[At or prior to Shareholders Meeting]

Heritage Commerce Corp

150 Almaden Boulevard

San Jose, CA 95113

Ladies and Gentlemen:

I have been advised that as of the date hereof I may be deemed to be an “affiliate” of Diablo Valley Bank, a California banking corporation (“Diablo”), as the term “affiliate” is (i) defined for purposes of paragraphs (c) and (d) of Rule 145 (“Rule 145”) of the Rules and Regulations (the “Rules and Regulations”) of the Securities and Exchange Commission (the “SEC”) under the Securities Act of 1933, as amended (the “Act”). I have been further advised that pursuant to the terms of the Agreement and Plan of Merger, dated as of February __, 2007 (the “Merger Agreement”), by and among you (“Heritage”), Heritage Bank of Commerce, a California banking corporation (“HBC”) and Diablo, Diablo will be merged with and into HBC, and that as a result of the Merger, I may be eligible to receive shares of Heritage Common Stock (as defined in the Merger Agreement) in exchange for shares of Diablo Common Stock (as defined in the Merger Agreement) owned by me.

I hereby represent, warrant and covenant to Heritage that in the event I receive any Heritage Common Stock pursuant to the Merger:

1.I shall not make any sale, transfer or other disposition of the Heritage Common Stock in violation of the Act or the Rules and Regulations.

2.I have carefully read this letter and the Merger Agreement and discussed its requirements and other applicable limitations upon my ability to sell, transfer or otherwise dispose of Heritage Common Stock to the extent I believed necessary, with my counsel or with counsel for Diablo.

3.I have been advised that the issuance of Heritage Common Stock to me pursuant to the Merger Agreement will be registered with the SEC on a registration statement on Form S-4. However, I have also been advised that, since at the time the Merger will be submitted to the shareholders of Diablo for approval, I may be an “affiliate” of Diablo, any sale or disposition by me of any of the Heritage Common Stock may, under current law, only be made in accordance with the provisions of paragraph (d) of Rule 145 under the Act, pursuant to an effective registration statement under the Act or pursuant to an exemption thereunder. I agree that I will not sell, transfer, or otherwise dispose of Heritage Common Stock issued to me in the Merger unless (i) such sale, transfer or other disposition has been registered under the Act; (ii) such sale, transfer or other disposition is made in conformity with the volume and other limitations of Rule 145 promulgated by the SEC under the Act; or (iii) in the written opinion of counsel, which opinion and counsel shall be reasonably acceptable to Heritage, such sale, transfer or other disposition is otherwise exempt from registration under the Act.

C-1

4.I understand that Heritage is under no obligation to register the sale, transfer or other disposition of the Heritage Common Stock by me or on my behalf or to take any other action necessary to make compliance with an exemption from registration available other than its obligations to maintain current in its reports under the Securities Exchange Act of 1939.

5.I understand that stop transfer instructions will be given to Heritage’s transfer agents with respect to Heritage Common Stock and that there will be placed on the certificates for the Heritage Common Stock issued to me, or any substitutions therefor issued during the period referred to in Rule 145(d), a legend stating in substance:

“The securities represented by this certificate have been issued in a transaction to which Rule 145 promulgated under the Securities Act of 1933 applies and may be sold or otherwise transferred only in compliance with the requirements of Rule 145 or pursuant to a registration statement under said act or an exemption from such registration.”

It is understood and agreed that this letter agreement shall terminate and be of no further force and effect and the legend set forth in paragraph (5) above shall be removed by delivery of substitute certificates without such legend, and the related stop transfer restrictions shall be lifted forthwith, if (i) any such shares of Heritage Common Stock shall have been registered under the Act for sale, transfer or other disposition by me or on my behalf and are sold, transferred or otherwise disposed of, or (ii) any such shares of Heritage Common Stock are sold in accordance with the provisions of paragraphs (c), (e), (f) and (g) of Rule 144 promulgated under the Act, or (iii) I am not at the time an affiliate of Heritage and have been the beneficial owner of the Heritage Common Stock for at least one year (or such other period as may be prescribed by the Act, and the rules and regulations promulgated thereunder), and Heritage has filed with the SEC all of the reports it is required to file under the Securities Exchange Act of 1934, as amended, during the preceding 12 months or as specified in Rule 144, or (iv) I am not and have not been for at least three months an affiliate of Heritage and have been the beneficial owner of the Heritage Common Stock for at least two years (or such other period as may be prescribed by the Act and the Rules and Regulations), or (v) Heritage shall have received a letter from the Staff of the SEC, or a written opinion of counsel, which opinion and counsel shall be reasonably acceptable to Heritage, to the effect that the stock transfer restrictions and the legend are not required.

Sincerely,

____________________

Dated: _______________________

Accepted this _____ day of __________, 2007

HERITAGE COMMERCE CORP

By:       ________________________

Name:  ________________________

Title:    ________________________

C-2

Schedule 9.2(j)

Closing Consents

1. Pleasanton office lease for 300 Main Street, Pleasanton, California 94566.

2. Administrative office lease for 3189 Danville Blvd., Suite 225, Alamo, California 94507.

3. Danville office lease for Diablo Valley Bank, Inc. for 402 Railroad Ave., Suite 101, Danville, California 94526.

4. Office located at 3236 Stone Valley Road West, Alamo, California.

Schedule 9.2(j)

Schedule 11.1(k)

Key Employees

John Hounslow

James Mayer

Catherine Conn

William Keller

Michael Skubic

Schedule 11.1(k)

EX-21.1

Exhibit 21.1

Subsidiaries of the registrant

Bank subsidiary

Heritage Bank of Commerce - State of Incorporation, California

Non-bank subsidiaries

1. Heritage Capital Trust I

2. Heritage Commerce Corp Statutory Trust I

3. Heritage Statutory Trust II

4. Heritage Commerce Corp Statutory Trust III

EX-23.1

Exhibit 23.1

CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

We consent to the incorporation by reference in Registration Statement’s No. 333-59277, 333-95167, 333-65884, 333-117431, 333-40384, and 333-135400 on Form S-8 of our report dated March 30, 2005 on the consolidated financial statements of Heritage Commerce Corp and subsidiary appearing in this Annual Report on Form 10-K of Heritage Commerce Corp and subsidiary for the year ended December 31, 2006.

/s/ Deloitte & Touche LLP

San Francisco, California

March 15, 2007

EX-23.2

Exhibit 23.2

CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

We consent to the incorporation by reference in Registration Statement No. 333-59277, 333-95167, 333-65884, 333-117431, 333-40384, and 333-135400 on Form S-8 of Heritage Commerce Corp of our report dated March 15, 2007 with respect to the consolidated financial statements of Heritage Commerce Corp, on management's assessment of the effectiveness of internal control over financial reporting and on the effectiveness of internal control over financial reporting, which report appears in the Annual Report on Form 10-K of Heritage Commerce Corp for the year ended December 31, 2006.

/s/Crowe Chizek and Company LLP

Oak Brook, Illinois

March 15, 2007

EX-31.1

Exhibit 31.1

CERTIFICATIONS UNDER SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002

REGARDING THE ANNUAL REPORT ON FORM 10-K

FOR THE YEAR ENDED DECEMBER 31, 2006

I, Walter T. Kaczmarek, certify that:

1.   I have reviewed this Annual Report on Form 10-K for the Year Ended December 31, 2006 of Heritage Commerce Corp;

2.   Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3.   Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4.   The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

(a)   Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

(b)   Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

(c)   Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

(d)   Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's fourth fiscal quarter of 2006 that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and

 5.   The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions):

(a)   All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and

(b)   Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting.

Date: March 16, 2007

      /s/  Walter T. Kaczmarek

        Walter T. Kaczmarek

                                                                                                                          Chief Executive Officer

EX-31.2

Exhibit 31.2

CERTIFICATIONS UNDER SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002

REGARDING THE ANNUAL REPROT ON FORM 10-K

FOR THE YEAR ENDED DECEMBER 31, 2006

I, Lawrence D. McGovern, certify that:

1.   I have reviewed this Annual Report on Form 10-K for the Year Ended December 31, 2006 of Heritage Commerce Corp;

2.   Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3.   Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4.   The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

(a)   Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

(b)   Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

(c)   Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

(d)   Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's fourth fiscal quarter of 2006 that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and

5.   The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions):

(a)   All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and

(b)   Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting.

Date: March 16, 2007

     /s/ Lawrence D. McGovern

                                                                                                                        Lawrence D. McGovern

                                                                                                                        Chief Financial Officer

EX-32.1

Exhibit 32.1

CERTIFICATION PURSUANT TO

18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

REGARDING THE ANNUAL REPORT ON FORM 10-K

FOR THE YEAR ENDED DECEMBER 31, 2006

In connection with the Annual Report of Heritage Commerce Corp (the "Company") on Form 10-K for the year ending December 31, 2006 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Walter T. Kaczmarek, Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that:

(1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

(2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

March 16, 2007

/s/ Walter T. Kaczmarek

                                                                                                      Walter T. Kaczmarek

                                                                                                       Chief Executive Officer

EX-32.2

Exhibit 32.2

CERTIFICATION PURSUANT TO

18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

REGARDING THE ANNUAL REPORT ON FORM 10-K

FOR THE YEAR ENDED DECEMBER 31, 2006

In connection with the Annual Report of Heritage Commerce Corp (the "Company") on Form 10-K for the year ending December 31, 2006 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Lawrence D. McGovern, Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that:

(1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

(2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

March 16, 2007

/s/ Lawrence D. McGovern

      Lawrence D. McGovern

      Chief Financial Officer