10-K 1 a2223348z10-k.htm 10-K


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549



FORM 10-K



ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2014.

Commission file number: 000-25020

GRAPHIC

(Exact name of registrant as specified in its charter)

California   77-0388249
(State or other jurisdiction of
incorporation or organization)
  (I.R.S. Employer
Identification No.)

1222 Vine Street,
Paso Robles, California 93446
(Address of principal executive offices) (Zip Code)
(805) 369-5200
(Registrant's telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

Title of each class   Name of exchange on which registered
Common Stock, no par value   The NASDAQ Capital Market

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 o No ý

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

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 ý No o

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

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 the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or smaller reporting company. See definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. Large accelerated filer o Accelerated filer [X] Non-accelerated filer o Smaller reporting company o

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

The aggregate market value of the common equity held by non-affiliates of the registrant at June 30, 2014 was $172.6 million based on the closing sales price of a share of Common Stock of $7.63 as of June 30, 2014.

As of February 24, 2015, the registrant had 33,916,151 shares of Common Stock outstanding.


Table of Contents

Documents Incorporated By Reference

The information required in Part III, Items 10 through 14 are incorporated herein by reference to the registrant's definitive proxy statement for the 2015 annual meeting of shareholders.


Heritage Oaks Bancorp
and Subsidiaries

Table of Contents

 
   
  Page
Part I        

Item 1.

 

Business

 

4
Item 1A.   Risk Factors   13
Item 1B.   Unresolved Staff Comments   21
Item 2.   Properties   21
Item 3.   Legal Proceedings   21
Item 4.   Mine Safety Disclosures   22

Part II

 

 

 

 

Item 5.

 

Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

23
Item 6.   Selected Financial Data   27
Item 7.   Management's Discussion and Analysis of Financial Condition and Results of Operations   28
Item 7A.   Quantitative and Qualitative Disclosures About Market Risk   59
Item 8.   Financial Statements and Supplementary Data   62
Item 9.   Changes in and Disagreements with Accountants on Accounting and Financial Disclosure   126
Item 9A.   Controls and Procedures   126
Item 9B.   Other Information   126

Part III

 

 

 

 

Item 10.

 

Directors, Executive Officers and Corporate Governance

 

127
Item 11.   Executive Compensation   127
Item 12.   Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters   127
Item 13.   Certain Relationships and Related Transactions, and Director Independence   127
Item 14.   Principal Accounting Fees and Services   127

Part IV

 

 

 

 

Item 15.

 

Exhibits, Financial Statement Schedules

 

128

Signatures

 

129

Exhibit Index

 

130

Certifications

 

133

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Part I

Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995

This Annual Report on Form 10-K may contain 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. You can find many (but not all) of these statements by looking for words such as "approximates," "believes," "expects," "anticipates," "estimates," "intends," "plans," "would," "may" and other similar expressions in this Annual Report on Form 10-K. With respect to any such forward-looking statements, the Company claims the protection of the safe harbor provided for in the Private Securities Litigation Reform Act of 1995. The Company cautions investors that any forward-looking statements presented in this Annual Report on Form 10-K, or those that the Company may make orally or in writing from time to time, are based on the beliefs of, on assumptions made by, and information available to, Company management at the time such statements are first made. Actual outcomes will be affected by known and unknown risks, trends, uncertainties and factors that are beyond the Company's control or ability to predict. Although the Company believes that management's beliefs and assumptions are reasonable, they are not guarantees of future performance and some will inevitably prove to be incorrect. As a result, the Company's actual future results can be expected to differ from management's expectations, and those differences may be material and adverse to the Company's business, results of operations and financial condition. Accordingly, investors should use caution in relying on forward-looking statements to anticipate future results or trends.

Some of the risks and uncertainties that may cause the Company's actual results, performance or achievements to differ materially from those expressed include the following:

    A renewed downturn in the overall economy, including the California real estate market.

    The effect of the current low interest rate environment or changes in interest rates on our net interest margin.

    Changes in the Company's business strategy or development plans.

    Our ability to attract and retain qualified employees.

    A failure or breach of our operational security systems or infrastructure or those of our customers, our third party vendors or other service providers, including as a result of a cyber-attack.

    Environmental conditions, including the prolonged drought in California, natural disasters such as earthquakes, landslides, and wildfires that may disrupt business, impede operations, or negatively impact the ability of certain borrowers to repay their loans and/or the values of collateral securing loans.

    The possibility of an unfavorable ruling in a legal matter, and the potential impact that it may have on earnings, reputation, or the Bank's operations.

    The likelihood that any expansionary activities will be impeded while the Federal Deposit Insurance Corporation's and California Department of Business Oversight's joint Consent Order remains outstanding, and that we will be unable to comply with the requirements set forth in the Consent Order, which could result in restrictions on our operations.

    The other risks set forth in the Company's reports filed with the U.S. Securities and Exchange Commission. For further discussion of these and other factors, see "Item 1A. Risk Factors."; and

    The Company's success at managing the risks involved in the foregoing items.

Any forward-looking statements in this Annual Report on Form 10-K and all subsequent written and oral forward-looking statements attributable to the Company or any person acting on behalf of the Company are expressly qualified in their entirety by the cautionary statements contained or referred to in this section. The Company does not undertake any obligation to release publicly any revisions to forward-looking statements in this Annual Report on Form 10-K to reflect events or circumstances after the date of this Annual Report on Form 10-K, and hereby specifically disclaims any intention to do so, unless required by law.

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Item 1.   Business

Organizational Structure and History

Heritage Oaks Bancorp (the "Company") is a California corporation organized in 1994 and registered as a bank holding company. The Company acquired all of the outstanding common stock of Heritage Oaks Bank (the "Bank") and its subsidiaries in 1994. The Bank is licensed by the California Department of Business Oversight, Division of Financial Institutions ("DBO") and commenced operation in January 1983. As a California state bank, the Bank is subject to primary supervision, examination and regulation by the DBO and the Federal Deposit Insurance Corporation ("FDIC"). The Bank is also subject to certain other federal laws and regulations. The deposits of the Bank are insured by the FDIC up to the applicable limits. As used in this Annual Report on Form 10-K, any reference to the term "Management" refers to the executive management team of the Company and its subsidiaries.

The Company formed Heritage Oaks Capital Trust II ("Trust II") in October 2006. Trust II is a statutory business trust formed under the laws of the State of Delaware and is a wholly-owned, non-financial, non-consolidated subsidiary of the Company. The Company also acquired Mission Community Capital Trust I ("Trust III") and Santa Lucia Bancorp (CA) Capital Trust ("Trust IV") as part of the acquisition of Mission Community Bancorp. These trusts are statutory business trusts, and are wholly-owned, non-financial, non-consolidated subsidiaries of the Company. Additionally, the Company has incorporated a subsidiary, CCMS Systems, Inc., which is currently inactive and has not been capitalized.

The Company is authorized to engage in a variety of banking activities with the prior approval of the Board of Governors of the Federal Reserve System (the "Federal Reserve Board"), the Company's principal regulator. However, banking activities primarily occur at the Bank. As a legal entity separate and distinct from its subsidiaries, the Company's principal source of funds is dividends received from the Bank, as well as, capital and/or debt it directly raises. Legal limitations are imposed on the amount of dividends that may be paid by the Bank to the Company. See Item 1. Business – Supervision and Regulation and Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities – Dividends.

Banking Activities

Headquartered in Paso Robles, California, the Bank is a community-oriented financial services firm that provides banking products and services to small and medium sized businesses and consumers. Products and services are offered primarily through 12 retail branches located on the Central Coast of California, in San Luis Obispo and Santa Barbara Counties and through other direct channels, including a loan production office in Ventura County.

Business Strategy

The Company's business objective is to be the leading community bank on the Central Coast of California to targeted businesses and consumers. We seek to achieve this objective by employing our business strategies as follows:

Deliver Superior Customer Service

We believe that it is imperative for us to deliver superior customer service to be successful. The pursuit of superior customer service is not a slogan for us but rather a fundamental aspect of our culture. A key element to superior customer service is providing authority to local decision makers so that customers are given a quick response to their financial needs, while at the same time providing the proper tools to the local decision makers to ensure that the products and services offered are profitable for us.

Enhance Product Delivery to Our Customers

We believe that our customers should have a positive experience at every point of contact with us. The primary point of contact with our customers continues to be our retail offices. We continue to implement user-friendly technologies for our customers who want to interact with us through electronic channels such as the internet,

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phone, or other mobile devices. We currently offer online banking, bill pay, and cash management; remote deposit capture; Automated Clearing House ("ACH") and positive payments; automatic payroll deposits; eDelivery; prepaid gift and payroll cards; some advanced function ATMs; and mobile banking. We expect to continue to expand our electronic delivery channels as customer preferences change and newer devices and technologies are developed. We believe the combination of high touch service in retail locations and user-friendly electronic banking services enhances our customer experience. It also provides us additional delivery channels to attract more customers.

Maintain Strong Brand Awareness

We expend a considerable amount of resources maintaining and enhancing our retail brand. We believe that our brand should reflect the superior customer service we offer as a community bank and our commitment to the communities where we operate. Maintaining strong brand awareness requires a consistent brand design; effective use of marketing and merchandising; participation and sponsorship in community based events; and usage of multiple media sources. We hold service marks issued by the U.S. Patent and Trademark Office for the "Acorn" design; the "Oakley" design; and the tag lines "Deeply Rooted in Your Hometown", "Heritage Oaks Bank – Expect More." We have also filed "intent to use" and we are currently establishing "proof of use" for the tag line "Heritage Oaks Bank – We're Central to the Coast", and anticipate that we will obtain full registration of this service mark in 2015. We continually evaluate the effectiveness of our brand and from time to time will take steps to improve our overall brand awareness in the markets we serve.

Increase Market Share in Existing Markets and Expand into New Markets

During the economic downturn, there were a number of community banks, which operated in the Central Coast of California, that were acquired by larger commercial banks. We believe these acquisitions provide us with the opportunity to increase market share in San Luis Obispo and Santa Barbara Counties and potentially expand into new markets contiguous to these counties, such as our 2012 expansion in Ventura County with the opening of a loan production office. In the past we have regularly evaluated opportunities to either open de novo retail offices; purchase branches from other financial institutions; or to acquire financial institutions in proximity to our geographic footprint, as evidenced by our December 2012 purchase of the Morro Bay branch of Coast National Bank and our merger with Mission Community Bancorp ("Mission Community") and Mission Community Bank, which closed in February 2014. We will continue to evaluate branching and acquisition opportunities going forward, however, our ability to act upon such opportunities will likely be impeded while the Consent Order, which is more fully discussed below, is in place.

The Company believes the combination with Mission Community creates a more valuable retail and business community banking franchise, with a low cost core deposit base, strong capital ratios, attractive net interest margins, lower operating costs, and better overall returns for the shareholders of the combined institution. It also should create a banking platform that is well positioned for future growth. In connection with the combination, the Company added two experienced banking professionals from Mission Community, Howard N. Gould and Stephen P. Yost, to its Board of Directors.

Community Service

We strongly believe in enhancing the economic vitality and welfare of the communities where we work and live. In 2014, Bank employees provided approximately 1,700 hours in direct volunteer support of local community activities, projects, and events. The Bank also provided in-kind support throughout the year including providing meeting rooms, and giving surplus furniture and used computers to local partners. Bank employees also serve on boards of local non-profit and charitable organizations. Finally, we donated over $0.4 million during 2014 to local organizations to support community related activities.

Products and Services

We offer a full array of financial products and services to targeted businesses and consumers. We regularly monitor our customers' financial needs to determine whether we should design or offer new products and services. We also regularly monitor the pricing and profitability of these financial products and services to ensure that we are able to achieve a reasonable rate of return for the risks we assume in offering such products

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and services. The Bank offers to its commercial clients commercial loans secured by real estate, other commercial loans and lines of credit, agricultural loans, construction financing, other real estate loans and Small Business Administration ("SBA") loans. For consumers, the Bank offers residential mortgages, equity lines of credit and other consumer loans. The Bank employs relationship managers focused on the development and origination of new loan and banking relationships across the markets it serves. Deposits are obtained primarily through retail deposit gathering efforts as well as through commercial account relationships. Deposit products offered include personal and business checking and savings accounts, time deposit accounts, individual retirement accounts ("IRAs") and money market accounts. The Bank also offers online banking, mobile banking, wire transfers, safe deposit boxes, cashier's checks, traveler's checks, bank-by-mail, remote deposit capture, night depository services and other customary banking services.

Competition and Market

The banking and financial services industry in California generally, and in the Company's service area specifically, is highly competitive. In our primary market areas, money center banks and large regional banks generally hold dominant market share positions. By virtue of their larger capital bases, these institutions have significantly larger lending limits than we do and generally have more expansive branch networks. Competition also includes other community-focused commercial banks. In addition, credit unions also present a significant competitive challenge for us. Credit unions currently enjoy an exemption from income taxes and as a result can offer higher deposit rates and lower loan rates than we can on a comparable basis. Credit unions are not currently subject to certain regulatory constraints, such as the Community Reinvestment Act, which, among other things, requires us to implement procedures to make and monitor loans throughout the communities we serve. Adhering to such regulatory requirements raises the costs associated with our lending activities, and reduces potential operating margins.

As the industry becomes increasingly dependent upon and oriented toward technology-driven delivery systems, permitting transactions to be conducted by telephone, computer and the internet, non-bank institutions are able to attract funds and provide lending and other financial services without offices located in our primary service area. The increasingly competitive environment is a result primarily of changes in regulation, changes in technology and product delivery systems and the accelerating pace of consolidation among financial services providers.

In order to compete with other financial institutions in our service area, we principally rely upon direct personal contact with our customers and potential customers by executive officers, directors and employees, local advertising programs, and specialized services. We emphasize to our customers the advantages of dealing with a locally owned and community oriented bank. We also seek to provide special services and programs for businesses and individuals in our primary service area who are employed in the agricultural, professional, municipal and business fields, such as loans for equipment, tools of trade or expansion of practices or businesses.

The economy in the Company's primary market area (San Luis Obispo, Santa Barbara and Ventura Counties) is based primarily on agriculture, hospitality, light industry, oil and retail trade. Additionally, the local economy in San Luis Obispo County and to a lesser degree Santa Barbara County is dependent on the level of employment generated by state and local government agencies. Services supporting these industries have also developed in the areas of medical, financial and educational services. The populations of San Luis Obispo County, the City of Santa Maria (in Northern Santa Barbara County), and the City of Santa Barbara totaled approximately 276,000, 102,000, and 90,000 respectively, according to the most recent data provided by the U.S. Census Bureau.

The moderate climate allows a year round growing season in the local economy's agricultural sector. The Central Coast's leading agricultural industry is the production of wine grapes and the related production of premium quality wines. Vineyards in production have grown significantly over the past several years throughout the Company's service area. Additionally, fruit, nut, and vegetable farming, as well as cattle ranching, represent major parts of the agriculture industry in the Company's market area. Furthermore, access to numerous recreational activities and destinations including beaches, mountains, lakes, and wineries provide a relatively stable tourism industry from many areas including the Los Angeles/Orange County basin, the San Francisco Bay area and the San Joaquin Valley.

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The general business climate in 2008 through 2011 proved to be challenging not only on the national level, but within the state of California and more specifically the Company's primary market area. As the real estate market and general economic conditions waned throughout those years, the ability of borrowers to satisfy their obligations to the financial sector languished. Although the Company's primary market area has historically witnessed a more stable level of economic activity, the weakened state of the real estate market in conjunction with a decline in economic activity in the Company's primary market negatively impacted the credit quality of our loan portfolio.

Beginning in 2012 and continuing through 2014, the business climate has shown steady signs of improvement including improving to stabilizing real estate prices and a decline in the unemployment rates. The labor market information published by the California Employment Development Department in December 2014 shows the unemployment rate within California to be approximately 7.0%, compared to over 12% at the peak of the recent economic crisis in 2010.

Management remains cautiously optimistic that there will be continued slow but steady improvement in economic conditions in 2015 in our primary markets. Additionally, several local economists have recently reported that the improvements in unemployment, the tourism industry, housing and household income are all indicators of stabilization in our primary markets. However, there have been growing concerns regarding both the global economy and our nation's economy due primarily to excessive government debt as well as public perceptions of unsound fiscal policies. There are also growing concerns that the prolonged drought, which has affected most of California, could have adverse impacts on the Central Coast of California's critical agriculture market, and therefore our loan portfolio, in the future should drought conditions not ease. Should either of these uncertainties materialize they could eventually affect our local economy, and ultimately negatively impact the financial condition of borrowers to whom the Company has extended credit. In turn, the Company may suffer higher credit losses as a result.

Employees

At December 31, 2014, the Company employed 294 full-time equivalent employees. The Company's employees are not represented by a union or covered by a collective bargaining agreement. Management believes that its employee relations are positive.

Economic Conditions and Legislative and Regulatory Developments

The Company's profitability, like most financial institutions, is primarily dependent on interest rate differentials. Interest rates are highly sensitive to many factors that are beyond the Company's control and cannot be predicted, such as inflation, recession and unemployment, and the impact that future changes in domestic and foreign economic conditions might have on the Company. A more detailed discussion of the Company's interest rate risks and the mitigation of those risks is included in Item 7A. Quantitative and Qualitative Disclosures About Market Risk, in this Annual Report on Form 10-K.

The Company's business is also influenced by the monetary and fiscal policies of the Federal government and the policies of regulatory agencies. The Federal Reserve Board implements national monetary policies (with objectives such as maintaining price stability, stimulating growth and reducing unemployment) through its open-market operations in U.S. Government securities, by adjusting the required level of reserves for depository institutions subject to its reserve requirements, and by varying the target Federal funds and discount rates applicable to borrowings by depository institutions. The actions of the Federal Reserve Board in these areas influence the growth of bank loans, investments, and deposits and also affect interest earned on interest-earning assets and interest paid on interest-bearing liabilities. The nature and impact of any future changes in monetary and fiscal policies on the Company cannot be predicted.

From time to time, federal and state legislation is enacted that may have the effect of materially increasing the cost of doing business, limiting or expanding permissible activities, or affecting the competitive balance between banks and other financial services providers. In response to the economic downturn and financial industry instability, legislative and regulatory initiatives were introduced and are in varying stages of being implemented, which substantially intensify the regulation of the financial services industry.

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Moreover, in light of the economic environment over the last five to seven years, bank regulatory agencies have responded to concerns and trends identified in examinations. In the exercise of their supervisory and examination authority, the regulatory agencies have emphasized corporate governance, stress testing, enterprise risk management and other board responsibilities; anti-money laundering compliance, and enhanced high risk customer due diligence; vendor management; cyber security; and fair lending, and other consumer compliance obligations.

Supervision and Regulation

General

The Company is a legal entity separate and distinct from the Bank. As a bank holding company, the Company is regulated under the Bank Holding Company Act ("BHC Act") and is subject to inspection, examination and supervision by the Federal Reserve Board. It is also subject to the California Financial Code, as well as limited oversight by the DBO and the FDIC.

The Bank, as a California-chartered bank, is subject to primary supervision, examination and regulation by the DBO and the FDIC. If, as a result of an examination of a bank, the FDIC determines that the financial condition, capital resources, asset quality, earnings prospects, management, liquidity or other aspects of its operations are unsatisfactory, or that it or its management is violating or has violated any law or regulation, various remedies are available to the FDIC. Such remedies include the power to: enjoin "unsafe or unsound" practices; require affirmative action to correct any conditions resulting from any violation or practice; issue an administrative order that can be judicially enforced; direct an increase in capital; restrict growth; assess civil monetary penalties; remove officers and directors; institute a receivership; and, ultimately terminate the bank's deposit insurance, which would result in a revocation of its charter. The DBO separately holds many of the same remedial powers.

Regulatory Enforcement Actions

The federal and state bank regulatory agencies may respond to concerns and trends identified in examinations by issuing enforcement actions to, and entering into cease and desist orders, consent orders and memoranda of understanding with, financial institutions requiring action by management and boards of directors to address credit quality, liquidity, risk management and capital adequacy concerns, as well as other safety and soundness or compliance issues. Banks and bank holding companies are also subject to examination and potential enforcement actions by their state regulatory agencies.

On November 5, 2014, the Bank entered into a Stipulation to the Issuance of a Consent Order with the FDIC and the DBO, consenting to the issuance of a consent order ("the Consent Order") relating to identified deficiencies in the Bank's centralized Bank Secrecy Act and anti-money laundering compliance program, which is designed to comply with the requirements of the Bank Secrecy Act, the USA Patriot Act of 2001 and related anti-money laundering regulations (collectively, the "BSA/AML Requirements"). Per the Consent Order, the Bank must review, update and implement an enhanced Bank Secrecy Act/Anti-Money Laundering ("BSA/AML") risk assessment process based on the 2010 Federal Financial Institutions Examination Council BSA/AML Examination Manual. Some of the areas highlighted in the Consent Order include the requirements to: i) enhance customer due-diligence procedures; ii) improve the enhanced due diligence analysis for high-risk customers; iii) ensure the proper identification and reporting of suspicious activity; iv) address and correct the noted violations of law; v) ensure that there is sufficient and qualified staff; and vi) ensure that all staff are properly trained to carry out the BSA/AML programs. Certain activities, including expansionary activities, that otherwise require regulatory approval will likely be impeded while the Consent Order remains outstanding. Management and the Board have been working diligently to comply with the Consent Order and believe they have allocated sufficient resources to address the corrective actions required by the FDIC and DBO. Compliance and resolution of the Consent Order will ultimately be determined by the FDIC and DBO.

Bank Holding Company and Bank Regulation

Bank holding companies and their subsidiaries are subject to significant regulation and restrictions by Federal and State laws and regulatory agencies. Federal and State laws, regulations and restrictions, which may affect

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the cost of doing business, limit permissible activities and expansion or impact the competitive balance between banks and other financial services providers, are intended primarily for the protection of depositors and the FDIC deposit insurance fund ("DIF"), and secondarily for the stability of the U.S. banking system. They are not intended for the benefit of shareholders of financial institutions. The following discussion of key statutes and regulations to which the Company and the Bank are subject is a summary and does not purport to be complete nor does it address all applicable statutes and regulations. This discussion is qualified in its entirety by reference to the statutes and regulations referred to in this discussion.

The wide range of requirements and restrictions contained in both Federal and State banking laws include:

    Requirements that bank holding companies serve as a source of strength for their banking subsidiaries. In addition, the regulatory agencies have "prompt corrective action" authority to limit activities and order an assessment of a bank holding company if the capital of a bank subsidiary falls below capital levels required by the regulators.

    Limitations on dividends payable to shareholders.  The Company's ability to pay dividends on both its common and preferred stock are subject to legal and regulatory restrictions. A substantial portion of the Company's funds to pay dividends or to pay principal and interest on our debt obligations must be derived from dividends paid by the Bank.

    Limitations on dividends payable by bank subsidiaries.  These dividends are subject to various legal and regulatory restrictions. The federal banking agencies have indicated that paying dividends that deplete a depositary institution's capital base to an inadequate level would be an unsafe and unsound banking practice. Moreover, the federal agencies have issued policy statements that provide that bank holding companies and insured banks should generally only pay dividends out of current operating earnings.

    Safety and soundness requirements.  Banks must be operated in a safe and sound manner and meet standards applicable to internal controls, information systems, internal audit, loan documentation, credit underwriting, interest rate exposure, asset growth and compensation, as well as other operational and management standards. These safety and soundness requirements give bank regulatory agencies significant latitude in exercising their supervisory authority and their authority to initiate informal or formal enforcement actions.

    Requirements for approval of acquisitions and activities.  Prior approval or non-objection of the applicable federal regulatory agencies is required for most acquisitions and mergers and in order to engage in certain non-banking activities and activities that have been determined by the Federal Reserve Board to be financial in nature, incidental to financial activities, or complementary to a financial activity. Laws and regulations governing state-chartered banks contain similar provisions concerning acquisitions and activities.

    The Community Reinvestment Act (the "CRA").  The CRA requires that banks help meet the credit needs in their communities, including the availability of credit to low and moderate income individuals. If the Company or the Bank fails to adequately serve their communities, penalties may be imposed, including denials of applications for branches, to add subsidiaries and affiliates, or to merge with or purchase other financial institutions. In its last reported examination by the FDIC in August 2014, the Bank received a CRA rating of "Satisfactory."

    The Bank Secrecy Act, the USA Patriot Act, and other anti-money laundering laws.  These laws and regulations require financial institutions to assist U.S. Government agencies in detecting and preventing money laundering and other illegal acts by maintaining policies, procedures and controls designed to detect and report money laundering, terrorist financing, and other suspicious activity.

    Limitations on the amount of loans to one borrower and its affiliates and to executive officers and directors.

    Limitations on transactions with affiliates.

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    Restrictions on the nature and amount of any investments in, and ability to underwrite certain securities.

    Requirements for opening of branches intra- and interstate.

    Fair lending and truth in lending laws to ensure equal access to credit and to protect consumers in credit transactions.

    Provisions of the Gramm-Leach-Bliley Act of 1999 ("GLB Act") and other federal and state laws dealing with privacy for nonpublic personal information of customers.

TARP Participation and The Dodd-Frank Act

The implementation and impact of legislation and regulations enacted since 2008 in response to the U.S. economic downturn and financial industry instability continued in 2014 as modest recovery returned to many institutions in the banking sector. Many institutions, including the Company have repaid and repurchased U.S. Treasury investments under the Troubled Asset Relief Program ("TARP"). The Company participated in the Capital Purchase Program and on March 20, 2009 issued and sold 21,000 shares of its Series A Preferred Stock to Treasury and issued a warrant for the purchase of 611,650 shares of common stock, in exchange for $21.0 million. On July 17, 2013, the Company repurchased all 21,000 outstanding shares of the Series A Preferred Stock that were held by the United States Department of the Treasury (the "Treasury"), plus accrued but unpaid dividends for an aggregate of $21.2 million. Further, on July 30, 2013, the Company reached an agreement with the Treasury to repurchase the related warrant to purchase 611,650 shares of the Company's common stock for $1.6 million. The decision to repurchase the Preferred Stock and the outstanding warrant was made to mitigate the dilutive effect these instruments had on the common shareholders.

Certain provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank Act") are effective and have been fully implemented, including the revisions in the deposit insurance assessment base for FDIC insurance; the permanent increase in coverage to $250,000; and required disclosure and shareholder advisory votes on executive compensation. Implementation in 2014 of additional Dodd-Frank Act regulatory provisions included aspects of (i) the final new capital rules, and (ii) the so called "Volcker Rule" restrictions on certain proprietary trading and investment activities.

The compliance requirements under the final rules implementing the Volcker Rule vary based on the size of the banking entity and the scope of activities conducted. Banking entities with significant trading operations will be required to establish a detailed compliance program and their CEOs will be required to attest that the program is reasonably designed to achieve compliance with the final rules. Independent testing and analysis of an institution's compliance program will also be required. The final rules reduce the burden on smaller, less-complex institutions by limiting their compliance and reporting requirements. Additionally, a banking entity that does not engage in covered trading activities will not need to establish a compliance program. The Company and the Bank held no investment positions at December 31, 2014 that were subject to the final rules. Therefore, while these new rules may require us to conduct certain internal analysis and reporting, we believe that they will not require any material changes in our operations or business.

The Dodd-Frank Act provided for the creation of the Consumer Finance Protection Bureau ("CFPB") as an independent entity within the Federal Reserve Board with broad rulemaking, supervisory and enforcement authority over consumer financial products and services, including deposit products, residential mortgages, home-equity loans and credit cards. The CFPB's functions include investigating consumer complaints, conducting market research, rulemaking, supervising and examining bank consumer transactions, and enforcing rules related to consumer financial products and services. Bank's with $10 billion or more in assets are subject to CFPB regulations and guidance and are subject to examination by the CFPB. Banks with less than $10 billion in assets, including the Bank, will continue to be examined for compliance by their primary federal banking agency.

In 2014, the CFPB adopted revisions to Regulation Z, which implement the Truth in Lending Act, pursuant to the Dodd-Frank Act, and apply to all consumer mortgages (except home equity lines of credit, timeshare plans, reverse mortgages, or temporary loans). The revisions mandate specific underwriting criteria for home loans in

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order for creditors to make a reasonable, good faith determination of a consumer's ability to repay and establish certain protections from liability under this requirement for "qualified mortgages" meeting certain standards. In particular, it will prevent banks from making "no doc" and "low doc" home loans, as the rules require that banks determine a consumer's ability to pay based in part on verified and documented information. Because we do not originate "no doc" or "low doc" loans, and because it is our intention to originate loans that meet the definitions for a "qualified mortgage" under final regulations adopted by the CFPB, we do not believe this regulation will have a significant impact on our operations

Certain of the regulations to implement the Dodd-Frank Act have not yet been published for comment or adopted in final form and/or will take effect over several years, making it difficult to anticipate the overall financial impact on the Company and the Bank, our customers or the financial industry more generally. Individually and collectively, these proposed regulations resulting from the Dodd-Frank Act may materially and adversely affect the Company's and the Bank's business, financial condition, and results of operations.

Capital Adequacy Requirements

Bank holding companies and banks are subject to various regulatory capital requirements administered by state and federal banking agencies. New capital rules, described below, became effective on January 1, 2015, but many elements are being phased in over multiple future years. Capital adequacy guidelines and, additionally for banks, prompt corrective action regulations, involve quantitative measures of assets, liabilities, and certain off-balance sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators about components, risk weighting, and other factors. The risk-based capital guidelines for bank holding companies and banks require capital ratios that vary based on the perceived degree of risk associated with a banking organization's operations for both transactions reported on the balance sheet as assets, such as loans, and those recorded as off-balance sheet items, such as commitments, letters of credit and recourse arrangements. Bank holding companies and banks engaged in significant trading activity may also be subject to the market risk capital guidelines and be required to incorporate additional market and interest rate risk components into their risk-based capital standards. To the extent that the new rules are not fully phased in, the prior capital rules continue to apply.

Under the risk-based capital guidelines in place prior to the effectiveness of the new capital rules, there were three fundamental capital ratios: a total risk-based capital ratio, a Tier 1 risk-based capital ratio and a Tier 1 leverage ratio. To generally be deemed to be "well capitalized" for bank regulatory purposes a bank must have a total risk-based capital ratio, a Tier 1 risk-based capital ratio and a Tier 1 leverage ratio of at least ten percent, six percent and five percent, respectively. At December 31, 2014, the Company's and the Bank's total risk-based capital ratios were 14.38% and 13.88%; respectively; their Tier 1 risk-based capital ratios were 13.13% and 12.63%; respectively; and their leverage capital ratios were 10.22% and 9.83%, respectively, all of which ratios exceeded the minimum percentage requirements to generally be deemed to be "well-capitalized" for bank regulatory purposes. The federal banking agencies may require banks and bank holding companies subject to enforcement actions to maintain capital ratios in excess of the minimum ratios otherwise required to generally be deemed to be "well-capitalized" for bank regulatory purposes.

Failure to meet statutorily mandated capital guidelines or more restrictive ratios separately established for a financial institution could subject a bank or bank holding company to a variety of enforcement remedies, including issuance of a capital directive, the termination of deposit insurance by the FDIC, a prohibition on accepting or renewing brokered deposits, limitations on the rates of interest that the institution may pay on its deposits and other restrictions on its business. Significant additional restrictions can be imposed on FDIC-insured depository institutions that fail to meet applicable capital requirements under the regulatory agencies' prompt corrective action authority.

New Capital Rules

The federal bank regulatory agencies adopted final regulations in July 2013, which revised their risk-based and leverage capital requirements for banking organizations to meet requirements of the Dodd-Frank Act and to implement Basel III international agreements reached by the Basel Committee on Bank Supervision. Although many of the rules contained in these final regulations are applicable only to large, internationally active banks, some of them will apply on a phased in basis to all banking organizations, including the Company and the Bank.

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The following are among the new requirements that were phased in beginning January 1, 2015:

    An increase in the minimum Tier 1 capital ratio from 4.00% to 6.00% of risk-weighted assets.

    A new category and a required 4.50% of risk-weighted assets ratio is established for "common equity Tier 1" as a subset of Tier 1 capital limited to common equity.

    A minimum non-risk-based leverage ratio is set at 4.00%, eliminating a 3.00% exception for higher rated banks.

    Changes in the permitted composition of Tier 1 capital to exclude trust preferred securities, mortgage servicing rights and certain deferred tax assets and include unrealized gains and losses on available for sale debt and equity securities.

    A new additional capital conservation buffer of 2.5% of risk weighted assets over each of the required capital ratios that will be phased in from 2016 to 2019, which if not satisfied will result in limitations on the ability of the Bank to pay dividends, repurchase shares or pay discretionary bonuses.

    The risk-weights of certain assets for purposes of calculating the risk-based capital ratios are changed for high volatility commercial real estate acquisition, development and construction loans, certain past due non-residential mortgage loans and certain mortgage-backed and other securities exposures.

    An additional "countercyclical capital buffer" is required for larger and more complex institutions.

Prompt Corrective Action Provisions

The Federal Deposit Insurance Act requires the federal bank regulatory agencies to take "prompt corrective action" with respect to a depository institution if that institution does not meet certain capital adequacy standards, including requiring the prompt submission of an acceptable capital restoration plan. Depending on the bank's capital ratios, the agencies' regulations define five categories in which an insured depository institution will be placed: well-capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized. At each successive lower capital category, an insured bank is subject to more restrictions, including restrictions on the bank's activities, operational practices or the ability to pay dividends. Based upon its capital levels, a bank 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 hearing, determines that an unsafe or unsound condition, or an unsafe or unsound practice, warrants such treatment.

The prompt corrective action standards were changed when the new capital rule ratios became effective on January 1, 2015. Under the new standards, in order to be considered well-capitalized, the Bank is required to have met the new common equity Tier 1 ratio of 6.5%, an increased Tier 1 ratio of 8% (increased from 6%), a total capital ratio of 10% (unchanged) and a leverage ratio of 5% (unchanged). Both the Company and the Bank met these new capital standards when they became effective January 1, 2015.

Dividends

It is the Federal Reserve Board's policy that bank holding companies should generally pay dividends on common stock only out of income available over the past year, and only if prospective earnings retention is consistent with the organization's expected future needs and financial condition. It is also the Federal Reserve Board's policy that bank holding companies should not maintain dividend levels that undermine their ability to be a source of strength to its banking subsidiaries. The Federal Reserve Board also discourages dividend payment ratios that are at maximum allowable levels unless both asset quality and capital are very strong.

The Bank is a legal entity that is separate and distinct from its holding company. The Company is dependent on the performance of the Bank for funds which may be received as dividends from the Bank for use in the operation of the Company and the ability of the Company to pay dividends to shareholders. Future cash dividends by the Bank will also depend upon management's assessment of future capital requirements,

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contractual restrictions, and other factors. When phased in, the new capital rules will restrict dividends by the Bank if the additional capital conservation buffer is not achieved.

The power of the board of directors of the Bank to declare a cash dividend to the Company is subject to California law, which restricts the amount available for cash dividends to the lesser of a bank's retained earnings or net income for its last three fiscal years (less any distributions to shareholders made during such period). Where the above test is not met, cash dividends may still be paid, with the prior approval of the DBO, in an amount not exceeding the greatest of (1) retained earnings of the bank; (2) the net income of the bank for its last fiscal year; or (3) the net income of the bank for its current fiscal year.

Deposit Insurance

Substantially all of the deposits of the Bank are insured up to applicable limits by the DIF of the FDIC and are subject to deposit insurance assessments to maintain the DIF. All FDIC-insured institutions are also required to pay assessments to the FDIC to fund interest payments on bonds issued by the Financing Corporation ("FICO"), an agency of the Federal government established to recapitalize the predecessor to the DIF. These assessments will continue until the FICO bonds mature in 2017.

Securities Laws and Corporate Governance

The Company is subject to the disclosure and regulatory requirements of the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended, both as administered by the U.S. Securities and Exchange Commission (the "SEC"). As a company listed on the NASDAQ Capital Market, the Company is subject to NASDAQ listing standards for listed companies.

The Company is also subject to the Sarbanes-Oxley Act of 2002, provisions of the Dodd-Frank Act, and other federal and state laws and regulations which address, among other issues, required executive certification of financial presentations, corporate governance requirements for board audit committees and their members, disclosure of controls and procedures and internal control over financial reporting, auditing and accounting, executive compensation, and enhanced and timely disclosure of corporate information. NASDAQ has also adopted corporate governance rules, which are intended to allow shareholders and investors to more easily and efficiently monitor the performance of companies and their directors.

Where You Can Find More Information

Under Section 13 of the Securities Exchange Act of 1934, as amended, periodic and current reports must be filed with or furnished to the SEC. The Company electronically files or furnishes such reports with the SEC and any amendments thereto, including the following: Form 10-K, Form 10-Q, Form 8-K and Form DEF 14A. The SEC maintains an Internet site, www.sec.gov, through which all forms filed and furnished electronically may be accessed. Additionally, all forms filed with or furnished to the SEC and additional shareholder information is available free of charge on the Company's website: www.heritageoaksbancorp.com. The Company posts these reports to its website as soon as reasonably practicable after filing them with the SEC. The Company also posts its Committee Charters, Code of Ethics, Code of Conduct and Corporate Governance Guidelines on the Company website. None of the information on or hyperlinked from the Company's website is incorporated into this Annual Report on Form 10-K.

ITEM 1A.   Risk Factors

In the course of conducting its business operations, the Company is exposed to a variety of risks, some of which are inherent in the financial services industry and others of which are more specific to its own business. The following discussion addresses the most significant risks that could affect the Company's business, financial condition, liquidity, results of operations, and capital position. The risks identified below are not intended to be a comprehensive list of all risks faced by the Company. Additional risks and uncertainties that the Company is not aware of or that the Company currently deems immaterial may also impair our business.

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Renewed weakness in economic conditions could have a material and adverse effect on our business.

Our performance could be materially and adversely affected to the extent there is deterioration in business and economic conditions that have a direct or indirect adverse effect on us, our customers and our counterparties. These conditions could result in one of the following: (i) a decrease in the demand for loans and other products and services offered by us, (ii) a decrease in customer savings generally and a corresponding decrease in the demand for savings and investment products offered by us, and (iii) an increase in the number of customers and counterparties that become delinquent, file for protection under the bankruptcy laws and/or default on their loans and other obligations to us. An increase in the number of delinquencies, bankruptcies or defaults could result in a higher level of non-performing assets, provisioning for credit losses, and valuation adjustments on loans held-for-sale.

We are highly dependent on the real estate market on the Central Coast of California and a renewed downturn in the real estate market may have a material and adverse effect on our business.

A significant portion of our loan portfolio is collateralized by real estate. Although we have seen what we believe are the signs of stabilization in the local economies in which we operate, a renewed decline in economic conditions, the local housing market or rising interest rates could have an adverse effect on the demand for new loans (as evidenced by the downturn in mortgage lending activities in the second half of 2013), the ability of borrowers to repay outstanding loans, the value of real estate and other collateral securing loans or the value of real estate owned by us, any combination of which could materially and adversely impact our financial condition and results of operations.

In addition, a large portion of the loan portfolio is collateralized by real estate that is subject to risks related to acts of nature, including drought, earthquakes, floods and fires. To the extent that these events occur, they may cause uninsured damage and other loss of value to real estate that secures these loans, which may also materially and adversely impact our financial condition and results of operations.

Our results of operations and financial condition can be impacted by the effect of the drought in California on our agricultural and related business.

The Company provides financing to agricultural businesses and other industries dependent on agriculture in the Central Coast. We recognize the cyclical nature of the industry, often caused by fluctuating commodity prices and changing climatic conditions. The Company remains committed to providing credit to agricultural customers and will always have a material exposure to this industry. In addition, the State of California has been experiencing drought conditions since 2013. The lack of rain will have an adverse impact on our agricultural customers' operating costs, crop yields and crop quality, which could impact such customers' ability to repay their loans to us consistent with the terms of such loans. The longer the drought continues, the more significant this impact will become. As a result, the Company's results of operations, financial condition, cash-flows and stock price can be negatively influenced by the impact of the drought on the banking needs of our agricultural customers.

We have a concentration in commercial real estate loans.

We have a high concentration in commercial real estate ("CRE") loans. CRE loans are defined as construction, land development, other land loans, loans secured by multi-family (5 or more units) residential properties and loans secured by non-farm, non-residential properties. Following this definition, approximately 59.6% of our gross loans can be classified as CRE lending as of December 31, 2014. CRE loans generally involve a higher degree of credit risk than certain other types of lending due to, among other things, the generally large amounts loaned to individual borrowers. Losses incurred on loans to a small number of these borrowers could have a material and adverse impact on our operating results and financial condition. In addition, commercial real estate loans generally depend on the cash flow from the property to service the debt. Cash flow may be adversely affected by general economic conditions, which may result in non-performance by certain borrowers.

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The Company and the Bank are operating under enhanced regulatory supervision that could materially and adversely affect our business.

On November 5, 2014, the FDIC and DBO issued the Consent Order to the Bank. The issuance of the Consent Order relates to deficiencies identified by the FDIC and DBO in the Bank's centralized Bank Secrecy Act and Anti-money Laundering ("BSA/AML") compliance program, which is designed to comply with the BSA/AML requirements. Per the Consent Order, the Bank must review, update and implement an enhanced BSA/AML risk assessment process based on the 2010 Federal Financial Institutions Examination Council BSA/AML Examination Manual. Some of the areas highlighted in the Consent Order include the requirements to: i) enhance customer due-diligence procedures; ii) improve the enhanced due diligence analysis for high-risk customers; iii) ensure the proper identification and reporting of suspicious activity; iv) address and correct the noted violations of law; v) ensure that there is sufficient and qualified staff; and vi) ensure that all staff are properly trained to carry out the BSA/AML programs. Certain activities, including expansionary activities, that otherwise require regulatory approval will likely be impeded while the Consent Order remains outstanding. Our failure to comply with the Consent Order and successfully implement an enhanced BSA/AML Compliance Program may result in additional regulatory action, including civil money penalties against the Bank and its officers and directors or enforcement of the Consent Order through court proceedings, which could have a material and adverse effect on our business, results of operations, financial condition, cash flows and stock price.

The Company also generally expects more intense scrutiny from bank supervisors in the examination process and more aggressive enforcement of regulations on both the federal and state levels. Federal banking law grants substantial enforcement powers to federal banking regulators. This enforcement authority includes, among other things, the ability to assess civil money penalties, to issue cease and desist or removal orders and to initiate injunctive relief against banking organizations and institution-affiliated parties. These enforcement actions may be initiated for violations of laws and regulations and unsafe or unsound practices.

The cost and other effects of the full implementation of the Dodd-Frank Act remain unknown and may have a material and adverse effect on our business.

The full compliance burden and impact on our operations and profitability with respect to the Dodd-Frank Act remain uncertain, as the Dodd-Frank Act delegates to various federal agencies the task of implementing its many provisions through regulation. Although many of the provisions of the Dodd-Frank Act have been implemented, federal rules and policies in this area and the effects of their implementation will be further developing for some time to come. Individually and collectively, the regulations resulting from the Dodd-Frank Act may significantly increase our regulation and compliance obligations, thereby exposing us to higher costs and noncompliance risk, which could materially and adversely affect the Company's and the Bank's business, financial condition, and results of operations.

Further significant changes in banking laws or regulations, the interpretation of those rules and regulations, and changes in federal monetary policy could materially affect our business.

In addition to the Dodd-Frank Act discussed above, the banking industry is subject to extensive federal and state regulation. The implementation of new laws or changes in existing laws, including changes in the interpretations of such laws and related rules and regulations by regulators, courts or others, could have a negative impact on our business. Federal and state regulatory agencies also frequently adopt changes to their regulations or change the manner in which existing regulations are applied. Significant changes in these laws and regulations could materially and adversely affect our business. We cannot predict the substance or impact of any change in regulation, whether by regulators or as a result of legislation, or in the way such statutory or regulatory requirements are interpreted or enforced. Compliance with such current and potential regulation and scrutiny may significantly increase our costs, impede the efficiency of our business practices, require us to increase our regulatory capital and limit our ability to pursue business opportunities in an efficient manner.

Our business is also impacted by federal monetary policy, particularly as implemented through the Federal Reserve Board. Federal monetary policy significantly affects our credit conditions, primarily through open market operations in United States government securities, the discount rate for member bank borrowing, and

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bank reserve requirements. Changes in trade and monetary and fiscal policies and laws, including the interest rate policies of the Federal Reserve Board could have a material and adverse impact on our business and results of operations.

Implementation of new Basel III capital rules adopted by the federal bank regulatory agencies will require increased capital levels that we may not be able to satisfy and could impede our growth and profitability.

The new Basel III capital rules became effective January 1, 2015. The new rules increase minimum capital ratios, add a new minimum common equity ratio, add a new capital conservation buffer, and change the risk-weightings of certain assets. These changes will be phased in through 2019. As the rules are phased in they could have a material and adverse effect on our liquidity, capital resources and financial condition (See Item 1. Business – Supervision and Regulation, for a further discussion of Basel III).

Our business is subject to credit exposure and our allowance for loan losses may not be sufficient to cover actual loan losses.

We make various assumptions and judgments about the collectability of our loan portfolio, including the creditworthiness of our borrowers and the probability of such borrowers making payments, as well as the value of real estate and other assets serving as collateral for the repayment of many of our loans when considering the adequacy of the Company's allowance. If our assumptions are incorrect, our allowance for loan and lease losses may be insufficient to cover losses inherent in our loan portfolio, which may adversely impact our operating results. Our regulators, as an integral part of their regular examination process, periodically review our allowance for loan losses and may require us to increase it by recognizing additional provisions for loan losses or to decrease our allowance for loan losses by recognizing loan charge-offs. Any additional provisions for loan losses or charge-offs, as required by these regulatory agencies, could have a material and adverse effect on our financial condition and results of operations.

The Company's business is subject to interest rate risk and variations in interest rates may negatively affect its financial performance.

A substantial portion of the Company's income is derived from the differential or "spread" between the interest earned on loans, securities and other interest earning assets, and the interest paid on deposits, borrowings and other interest bearing liabilities. Interest rates are highly sensitive to many factors that are beyond the Company's control, including general economic conditions and the policies of various governmental and regulatory authorities. As interest rates change, net interest income is affected. With fixed rate assets (such as fixed rate loans and investment securities) and liabilities (such as certificates of deposit), the effect on net interest income depends on the cash flows associated with the maturity of the asset or liability. Asset/liability management policy may not be successfully implemented and from time to time the Company's risk position may not be balanced. An unanticipated rapid decrease or increase in interest rates could have an adverse effect on the spreads between the interest rates earned on assets and the rates of interest paid on liabilities, and therefore on the level of net interest income. For instance, any rapid increase in interest rates in the future could result in interest expense increasing faster than interest income because of fixed rate loans and longer term investments. Further, substantially higher interest rates could reduce loan demand and may result in slower loan growth than previously experienced. Any one of these occurrences would have a material and adverse effect on the Company's results of operation and financial condition. Conversely, lower interest rates could lead to lower net interest margin due to maturing loans being financed at a lower rate as well as increased refinancing activity to lock in lower rates.

Competition from within and outside the financial services industry may materially and adversely affect our business.

The financial services business in our market area is highly competitive. It is becoming increasingly competitive due to changes in regulation, technological advances and the accelerating pace of consolidation among financial services providers. We face competition in attracting and retaining core business relationships. Increasing levels of competition in the banking and financial services business may reduce our market share,

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decrease loan demand, cause the prices we charge for our services to fall, resulting in a decline in the rates we charge on loans and/or cause higher rates to be paid on deposits. Therefore, our results may differ in future periods depending upon the nature and level of competition.

Additionally, technology and other changes are allowing parties to complete financial transactions, which historically have involved banks, through alternative methods. For example, consumers can now maintain funds, which would have historically been held as bank deposits in brokerage accounts or mutual funds. Consumers can also complete transactions such as paying bills and/or transferring funds directly without the assistance of banks. The process of eliminating banks as intermediaries, known as "disintermediation," could result in the loss of fee income, as well as the loss of customer deposits and the related income generated from those deposits. The loss of these revenue streams and the lower cost deposits as a source of funds could have a material adverse effect on our financial condition and results of operations.

Liquidity risk could impair our ability to fund operations and negatively impact our financial condition.

Liquidity is essential to our business. An inability to raise funds through deposits, borrowings, the sale of loans and other sources could have a material and adverse effect on our liquidity. Our access to funding sources in amounts adequate to finance our activities could be impaired by factors that affect us specifically or the financial services industry in general. Factors that could detrimentally impact our access to liquidity sources include a decrease in the level of our business activity due to a market downturn or adverse regulatory action against us.

Declines in the market value of our investment portfolio may adversely affect our financial performance, liquidity and capital.

We maintain an investment portfolio that includes, but is not limited to, mortgage-backed securities, municipal securities and asset backed securities. The market value of investments in our portfolio has become increasingly volatile over the last few years, largely due to disruptions in the capital markets and fluctuations in long term interest rates. Due to increasing long term interest rates in 2014, we have seen a decline in the overall market value of our investment portfolio in 2014. The market value of investments may be affected by factors other than the underlying performance of the servicer of the securities, or the mortgages underlying the securities, such as changes in interest rates, credit ratings downgrades, adverse changes in the business climate, and a lack of liquidity in the secondary market for certain investment securities. Furthermore, problems at the federal and state government levels may trickle down to municipalities and adversely impact our investment in municipal bonds.

On a quarterly basis, we evaluate investments and other assets for impairment. We may be required to record impairment charges if our investments suffer a decline in value that is considered other-than-temporary. If we determine that a significant impairment has occurred, we would be required to charge the credit-related portion of the other-than-temporary impairment against earnings, which may have a material adverse effect on our results of operations in the periods in which the charges occur.

Loss of customer deposits could increase the Company's funding costs.

The Company relies on bank deposits to be a low cost and stable source of funding. The Company competes with banks and other financial services companies for deposits. If the Company's competitors raise the rates they pay on deposits, the Company's funding costs may increase, either because the Company raises its rates to avoid losing deposits or because the Company loses deposits and must rely on more expensive sources of funding. Higher funding costs reduce the Company's net interest margin and net interest income. Checking and savings account balances and other forms of customer deposits may decrease when customers perceive alternative investments, such as the stock market, as providing a better risk/return tradeoff. When customers move money out of bank deposits and into other investments, the Company may lose a relatively low cost source of funds, increasing the Company's funding costs and reducing the Company's net interest income.

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Failure to successfully execute our strategic plan may adversely affect our performance.

Our financial performance and profitability depend on our ability to execute our corporate strategies. Each year, our board of directors approves our long-term strategic plan and annual operating budget. Our near-term business strategy includes pursuing organic growth within our geographic footprint within the markets we currently serve. Our failure to achieve organic loan and deposit growth in our current market area may adversely impact our near-term financial performance goals. Other factors that may adversely affect our ability to attain our long-term financial performance goals include an inability to control non-interest expense, including, but not limited to, rising employee compensation, regulatory compliance and healthcare costs, limitations imposed on us through regulatory actions, and our inability to increase net-interest income due to continued downward pressure on interest rates.

We may not be able to attract and retain skilled people.

Our success depends, in large part, on our ability to attract and retain key people. Competition for the best people can be intense and we may not be able to hire people or to retain them without offering very high compensation. The unexpected loss of the services of one or more of our key personnel could have a material and adverse impact on our business because of the loss of their skills, knowledge of our market and years of industry experience and the difficulty of promptly finding qualified replacement personnel.

The bank regulatory agencies have published guidance and regulations which limit the manner and amount of compensation that banking organizations provide to employees. These regulations and guidance may materially and adversely affect our ability to retain key personnel. Due to these restrictions, we may not be able to successfully compete with other larger financial institutions to attract, retain and appropriately incentivize high performing employees. If we were to suffer such adverse effects with respect to our employees, our business, financial condition and results of operations could be materially and adversely affected.

The Company faces operational risks that may result in unexpected losses.

We are subject to certain operational risks, including, but not limited to, data processing system failures and errors, customer or employee fraud and catastrophic failures resulting from terrorist acts or natural disasters. We maintain a system of internal controls to mitigate against such occurrences and maintain insurance coverage for such risks that are insurable, but should such an event occur that is not prevented or detected by our internal controls, or is uninsured or in excess of applicable insurance limits, it could have a material and adverse impact on our business, financial condition and results of operations.

The Company is subject to significant financial and reputational risks from potential legal liability and regulatory action.

We face significant legal risks in our business, and the volume of claims and amount of damages and penalties claimed in litigation and regulatory proceedings against other financial institutions remain high. Increased litigation costs, substantial legal liability or significant regulatory action against us could negatively impact our financial condition and results of operations or cause significant reputational harm to the Company, which in turn could adversely impact its business prospects.

Impairment of goodwill or intangible assets would result in a charge to earnings.

Goodwill and intangible assets are evaluated for impairment annually or when events or circumstances indicate that the carrying value of those assets may not be recoverable. We may be required to record a charge to earnings during the period in which any impairment of goodwill or intangibles is determined.

The Company's information systems may experience an interruption or security breach that may result in unexpected losses.

We rely heavily on communications and information systems to conduct our business. Any failure, interruption or breach in security of these systems could result in failures or disruptions in our customer relationship management, general ledger, deposit, loan and other systems.

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Our computer systems and network infrastructure are subject to security risks and could be susceptible to cyber-attacks, such as denial of service attacks, hacking, terrorist activities or identity theft. Financial services institutions and companies engaged in data processing have reported breaches in the security of their websites or other systems, some of which have involved sophisticated and targeted attacks intended to obtain unauthorized access to confidential information, destroy data, disable or degrade service, or sabotage systems, often through the introduction of computer viruses or malware, cyber-attacks and other means. Denial of service attacks have been launched against a number of large financial services institutions.

Despite efforts to ensure the integrity of our systems, we will not be able to anticipate all security breaches of these types, nor will we be able to implement guaranteed preventive measures against such security breaches. Persistent attackers may succeed in penetrating defenses given enough resources, time and motive. The techniques used by cyber criminals change frequently, may not be recognized until launched and can originate from a wide variety of sources, including outside groups such as external service providers, organized crime affiliates, terrorist organizations or hostile foreign governments. These risks may increase in the future as we continue to increase our mobile-payment and other internet-based product offerings and expand our internal usage of web-based products and applications.

Even the most advanced internal control environment may be vulnerable to compromise. Targeted social engineering attacks are becoming more sophisticated and are extremely difficult to prevent. The successful social engineer will attempt to fraudulently induce employees, customers or other users of our systems to disclose sensitive information in order to gain access to its data or that of its clients.

A successful penetration or circumvention of system security could cause us serious negative consequences, including significant disruption of operations, misappropriation of confidential information, or damage to our computers or systems or those of our customers and counterparties. A successful security breach could result in violations of applicable privacy and other laws, financial loss to us or to our customers, loss of confidence in our security measures, significant litigation exposure, and harm to our reputation, all of which could have a material adverse effect on the Company.

Necessary changes in technology could be costly.

The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology-driven products and services. The effective use of technology increases efficiency and enables financial institutions to better serve customers and to reduce costs. Our future success depends, 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, as well as to create additional efficiencies in our operations. Many of our competitors have substantially greater resources to invest in technological improvements.

We may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to our customers. Failure to successfully keep pace with technological change affecting the financial services industry could have a material and adverse impact on our business, financial condition and results of operations.

The Company relies on third party service providers for key systems, placing us and our customers at risk if the vendor has service outages, work stoppages or is subjected to attacks on their IT systems that expose information relating to us and our customers.

The Company uses a third party software service provider to perform all of its transaction data processing. The Company also outsources other customer service applications, such as on-line banking, ACH and wire transfers, to third party vendors. If these service providers were to experience technical difficulties or incur any extended outages in services, it could have a material and adverse impact on the Company and its customers. Because such service providers service us and other banks, their systems could be affected by denial of service attacks directed at their other bank customers. In addition, third parties may seek to penetrate our vendors' IT systems, obtain information about us or our customers or access our customers' accounts, and exploit that information to wrongfully withdraw or transfer our customers' funds, which could have material and adverse impacts on our customers and the Company. Further, if the Company was required to switch service

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providers due to deterioration in service quality or other factors, there is no guarantee that it could obtain comparable services for a comparable price.

Our operations face severe weather, natural disasters, acts of war or terrorism and other external risks.

Severe weather, natural disasters, acts of war or terrorism and other adverse external events could have a significant impact on our ability to conduct business. Such events could affect the stability of our deposit base; impair the ability of borrowers to repay outstanding loans, impair the value of collateral securing loans, cause significant property damage, result in loss of revenue and/or cause us to incur additional expenses. The Central Coast of California is subject to earthquakes, fires and landslides. Operations in our market could be disrupted by both the evacuation of large portions of the population as well as damage and or lack of access to our banking and operation facilities. The local market that the Company serves is also currently facing drought conditions which could not only impact the largest industry in our market footprint, agriculture, but could have rippling effects on other industries, including hospitality. The occurrence of any such event could have a material and adverse effect on our business, financial condition and results of operations.

Maintaining our reputation as a community bank is critical to our success and the failure to do so may materially and adversely affect our performance.

We are a community bank and our reputation is one of the most valuable components of our business. As such, we strive to conduct our business in a manner that enhances our reputation. If our reputation is negatively affected by the actions of our employees, or otherwise, our business, operating results and financial condition may be materially and adversely affected.

We may enter into new lines of business or offer new products and services which expose us to additional risk or which are not successful.

We may enter into new lines of business or offer new products or services as new opportunities arise or as our business strategy changes. New lines of business or new products or services may involve significant business, reputational or regulatory risk, including increased regulatory scrutiny. The success of these efforts depends on many factors, including the competitive landscape, market adoption and successful implementation. We may experience significant losses to the extent that we invest significant time and resources to a new line of business, product or service and it is not successful. There can be no assurance that we can successfully manage these risks and failure to do so could have a material adverse effect on our financial condition or results of operations.

Our controls and procedures could fail or be circumvented.

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

Changes in accounting standards or tax legislation could have a negative impact on our business.

Our accounting policies and methods are fundamental to how we record and report our financial condition and results of operations. From time to time the Financial Accounting Standards Board and the SEC change the financial accounting and reporting standards that govern the preparation of our financial statements or elected representatives approve changes to tax laws that could affect our corporate taxes. These changes can be hard to predict and can materially impact how we record and report our financial condition and results of operations.

We depend on cash dividends from the Bank to meet our cash obligations.

As a holding company, dividends from our subsidiary bank provide a substantial portion of our cash flow used to service the interest payments on our trust preferred securities and any cash dividends to our preferred and

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common shareholders. Various statutory provisions restrict the amount of dividends the Bank can pay to us without regulatory approval. If the Bank is unable to generate the profits necessary to service the interest payments, or we are unable to obtain regulatory approval to make dividends from the Bank to the Company, our business, operating results and financial condition may be materially and adversely affected.

Our outstanding preferred stock impacts net income available to our common shareholders.

Our Series C Preferred Stock may be dilutive to common shareholders to the extent the Company is profitable and shareholders should consider the dilutive nature of these securities in their calculation of earnings per common share. Also, the Company's preferred stock will receive preferential treatment in the event of the Company's liquidation, dissolution or winding-down, which could have a material and adverse effect on common shareholders in the event of such liquidation.

The soundness of other financial institutions could adversely affect us.

Financial services institutions are interrelated as a result of trading, clearing, counterparty or other relationships. We have exposure to many different industries and counterparties, and we routinely execute transactions with counterparties in the financial industry, including brokers and dealers, commercial banks, investment banks, mutual and hedge funds, and other institutional clients. Many of these transactions expose us to credit risk in the event of default of our counterparty or client. In addition, our credit risk may be exacerbated when the collateral held by us cannot be realized upon or is liquidated at prices not sufficient to recover the full amount of the financial instrument exposure due us. Any such losses could have a material adverse effect on our financial condition and results of operations.

ITEM 1B.   Unresolved Staff Comments

None.

ITEM 2.   Properties

The Company's headquarters are located at 1222 Vine Street in Paso Robles, California. As of December 31, 2014, the Bank operates 12 branches within the Counties of San Luis Obispo and Santa Barbara. The Bank currently owns its headquarters and eight of its branches and leases the remaining branches and administrative facilities from various parties. The Bank also leases one location in Ventura County where it operates a loan production office. As of December 31, 2014, the Bank owns one vacant branch facility, which was acquired through the Mission Community acquisition, and is currently held for sale. The Company believes its facilities are adequate for its present needs. The Company believes that the insurance coverage on all properties is adequate for its present needs. Most of the leases contain multiple renewal options and provisions for rental increases, principally for changes in the cost of living index, property taxes and maintenance.

ITEM 3.   Legal Proceedings

The Bank is party to the following litigation:

Corona Fruits & Veggies, Inc., et al v. Heritage Oaks Bank, et al, Santa Barbara County Sup. Ct. case no. 1390870, filed 2/8/2012. Corona Fruits & Veggies, Inc. and related entities are seeking in excess of $2,000,000 in damages for a variety of claims including breach of contract, misrepresentation, interference with contractual relations and promissory estoppel. The alleged factual basis underlying the claims is that the Bank promised to extend agricultural and equipment financing to the plaintiffs and ultimately failed to do so, causing the plaintiffs' damages. The Bank denied that it acted improperly in any respect toward plaintiffs or that it breached a loan commitment to the plaintiffs. Trial commenced on July 24, 2014 and a statement of decision was entered into by the court on November 26, 2014. The court found against the plaintiffs and in favor of the Bank on its cross-complaint for indemnity. Judgment in favor of the Bank was entered in this case on January 20, 2015. The Bank does not expect the litigation to have a material impact on the Bank.

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Sandra Keller v. Heritage Oaks Bank, et al, U.S. District Court, Central District of California case no. CV-13-2049 CAS, filed 3/21/13. Sandra Keller, as guardian ad litem for Mary Mastagni, filed suit in federal court against the Bank and numerous other parties alleging damages from a conspiracy to commit elder financial abuse. The complaint was unclear as to the basis for the alleged damages against the Bank, and the Bank believes the complaint lacked any merit whatsoever. The federal court has dismissed the case.

Sandra Keller, et al vs. Heritage Oaks Bank, et al, Superior Court of San Luis Obispo County, case no CV-138124, filed 5/29/13. This is the identical complaint that was dismissed by the federal court. The Bank was served with process in September 2013 and has demurred. The plaintiffs filed a second amended complaint on June 30, 2014. The second amended complaint alleged that the bank negligently allowed, caused or conspired with certain other defendants to remove Mary Mastagni from control of a deposit account, that the Bank entered into a "side agreement" with certain defendants to take control of the proceeds from the proceeds received on the sale of certain pieces of real estate after foreclosure on loans made by the Bank, and generally that the Bank conspired with other defendants to commit elder abuse. At a hearing on the bank's demurrer on October 16, 2014, the following causes of action were dismissed: Breach of Trust, Constructive Fraud, Breach of Fiduciary Duty, violation of the Consumer Legal Remedies Act, Theft Under False Pretenses. The following causes of action remain: Financial Elder Abuse, Fraud, Unfair Competition, Negligence, Conversion, and Equitable Accounting. A case management hearing was held on January 26, 2015 with trial set for October 5, 2015. Discovery is ongoing. The Bank is vigorously defending the matter and does not expect the litigation to have a material impact on the Bank.

Grego v. Patel, Mission Asset Management, Inc., et al, Superior Court of San Luis Obispo County, case no. CV128369. This case was filed in 2013 against Mission Asset Management, Inc., ("MAM") formerly a subsidiary of Mission Community Bancorp which was acquired by the Bank on February 28, 2014. MAM successfully demurred to all causes of action but one; the remaining cause of action is for conversion of personal property which allegedly occurred subsequent to the foreclosure of a commercial loan secured by a hotel property. This cause of action was consolidated with two other cases involving unrelated defendants. In one of the consolidated cases, on January 23, 2015, the court ruled that Plaintiff had no current standing to bring the cause of action against any of the state court defendants. The court stayed all local proceedings for 120 days pending the Chapter 7 Bankruptcy Trustee's decision to appear in this case or abandon it. The Bank is vigorously defending the matter and does not expect the litigation to have a material impact on the Bank.

The outcome of the litigation summarized above and other legal and regulatory matters is inherently uncertain. While the Company does not believe that any such claims, lawsuits or regulations will have a material adverse effect on its financial condition or results of operations, unfavorable rulings could occur. Were an unfavorable ruling to occur, there exists the possibility of a material adverse impact on our liquidity, reputation, consolidated financial position, results of operations, and/or stock price. Except as indicated above, neither the Company nor the Bank is involved in any legal proceedings other than routine litigation incidental to the business of the Company or the Bank.

ITEM 4.   Mine Safety Disclosures

Not applicable.

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PART II

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

Market Information

The Company's common stock trades on the NASDAQ Capital Market under the symbol "HEOP." As of February 24, 2015, there were approximately 2,505 holders of record of the Company's common stock. The following table summarizes those trades of the Company's Common Stock on NASDAQ, setting forth the high and low sales prices for each quarterly period ended since January 1, 2013:

 
  Stock Price  
 
  High
  Low
 
 
     

Quarters Ended

             

December 31, 2014

  $ 8.51   $ 6.95  

September 30, 2014

  $ 7.94   $ 6.70  

June 30, 2014

  $ 8.35   $ 6.83  

March 31, 2014

  $ 8.48   $ 7.27  

December 31, 2013

 
$

8.10
 
$

5.95
 

September 30, 2013

  $ 7.00   $ 6.00  

June 30, 2013

  $ 6.34   $ 5.35  

March 31, 2013

  $ 5.90   $ 5.43  

Dividends

The Company's Board of Directors has responsibility for the oversight and approval of the declaration of dividends. The timing and amount of any future dividends will depend on the Company's near and long term earnings capacity, current and future capital position, investment opportunities, statutory and regulatory limitations, general economic conditions and other factors deemed relevant by the Company's Board of Directors. No assurances can be given that any dividends will be paid in the future or, if payment is made, no assurances can be given about the size of any such dividends or whether dividends will continue to be paid.

Dividends the Company declares are subject to the restrictions set forth in the California General Corporation Law (the "Corporation Law"). The Corporation Law provides that a corporation may make a distribution to its shareholders if the corporation's retained earnings equal at least the amount of the proposed distribution. The Corporation Law also provides that, in the event that sufficient retained earnings are not available for the proposed distribution, a corporation may nevertheless make a distribution to its shareholders if it meets two conditions, which generally stated are as follows: (i) the corporation's assets equal at least 1 and 1/4 times its liabilities, and (ii) the corporation's current assets equal at least its current liabilities or, if the average of the corporation's earnings before taxes on income and before interest expenses for the two preceding fiscal years was less than the average of the corporation's interest expenses for such fiscal years, then the corporation's current assets must equal at least 1 and 1/4 times its current liabilities. Additionally, the Federal Reserve Board has authority to limit the payment of dividends by bank holding companies, such as the Company, in certain circumstances, requiring, among other things, a holding company to consult with the Federal Reserve Board prior to payment of a dividend if the Company does not have sufficient recent earnings in excess of the proposed dividend.

The principal source of funds from which the Company may pay dividends is the receipt of dividends from the Bank. The availability of dividends from the Bank is limited by various statutes and regulations. The Bank is subject first to corporate restrictions on its ability to pay dividends. Further, the Bank may not pay a dividend if it would be undercapitalized after the dividend payment is made. The payment of cash dividends by the Bank is subject to restrictions set forth in the California Financial Code (the "Financial Code"). The Financial Code provides that a bank may not make a cash distribution to its shareholders in excess of the lesser of (a) bank's retained earnings; or (b) bank's net income for its last three fiscal years, less the amount of any distributions made by the bank or by any majority-owned subsidiary of the bank to the shareholders of the bank during such

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period. However, a bank may, with the approval of the DBO, make a distribution to its shareholders in an amount not exceeding the greatest of (a) its retained earnings; (b) its net income for its last fiscal year; or (c) its net income for its current fiscal year. In the event that the DBO determines that the shareholders' equity of a bank is inadequate or that the making of a distribution by the bank would be unsafe or unsound, the DBO may order the bank to refrain from making a proposed distribution. The FDIC may also restrict the payment of dividends if such payment would be deemed unsafe or unsound or if after the payment of such dividends, the bank would be included in one of the "undercapitalized" categories for capital adequacy purposes pursuant to federal law.

While the Federal Reserve Board has no general restriction with respect to the payment of cash dividends by an adequately capitalized bank to its parent holding company, the Federal Reserve Board might, under certain circumstances, place restrictions on the ability of a particular bank to pay dividends based upon peer group averages and the performance and maturity of the particular bank, or object to management fees to be paid by a subsidiary bank to its holding company on the basis that such fees cannot be supported by the value of the services rendered or are not the result of an arm's length transaction.

The Company paid cash dividends of $0.03 per share and $0.05 per share in the third and fourth quarters of 2014, respectively. Cash dividends were paid to holders of the Company's common stock and Series C Preferred Stock. Holders of the Company's Series C Preferred Stock are entitled to per share dividend equivalents to any dividends declared on the Company's common stock. The Company did not pay any dividends on its common stock in 2013.

On October 29, 2014, the Company entered into an Exchange Agreement with the holder of its Series C Preferred Stock. Pursuant to the terms of the Exchange Agreement the holder of Series C Preferred Stock would exchange 1,189,538 shares of the Series C Preferred Stock for shares of the Company's common stock on a one-for-one exchange ratio basis. On December 22, 2014, the Company and the holder of its Series C Preferred stock entered into a First Amendment to Exchange Agreement to allow for an initial exchange of Preferred Stock whereby 840,841 shares of Series C Preferred Stock would be exchanged for 840,841 shares of the Company's common stock. The initial closing took place on December 24, 2014. The Exchange Agreement was also amended to allow for a subsequent closing for the exchange of the remaining 348,697 shares of Series C Preferred Stock for shares of the Company's common stock on a mutually agreed upon date before March 31, 2015.

Repurchase of Common Stock

In the fourth quarter of 2014, the Company announced an agreement to repurchase up to $5.0 million of its outstanding common stock pursuant to a written plan compliant with Rule 10b5-1, and Rule 10b-18. Repurchase program activity will expire on June 30, 2015, or earlier upon the completion of the repurchase of $5.0 million of the Company's common stock, as well as under certain other circumstances set forth in the repurchase plan agreement. The Company has no obligation to repurchase any shares under this program, and may suspend or discontinue it at any time. All shares as part of the repurchase program will be cancelled and therefore no longer available for reissuance.

The table below provides a summary of repurchases of common stock during the fourth quarter of 2014:

 
  Total Number
of Shares
Purchased

  Weighted
Average Price
Paid Per Share

  Total Number of
Shares Purchased
as Part of Publicly
Announced Plans

  Dollar Value of
Shares That May
Yet Be Purchased
Under the Plan

 
   

Period

               

10/01/2014 – 10/31/2014

  –           $             –           –               $                      –        

11/01/2014 – 11/30/2014

  28,826           $        7.47           28,826               $        4,784,662        

12/01/2014 – 12/31/2014

  22,906           $        7.46           22,906               $        4,613,775        

Total

  51,732           $        7.47           51,732                

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Securities Authorized for Issuance Under Equity Compensation Plans

The following table provides information at December 31, 2014, with respect to shares of Company common stock that may be issued under the Company's existing equity compensation plans:

 
  Number of
Securities To Be
Issued Upon Exercise
of Outstanding Options

  Weighted Average
Exercise Price of
Outstanding Options

  Number of Securities
Remaining Available
For Future Issuance

 
 
     

Plan Category

                   

Equity compensation plans approved by security holders

    742,557 (1 ) $ 6.83     2,003,176  

Equity compensation plans not approved by security holders

    N/A     N/A     N/A
 
(1)
Under the 2005 Equity Based Compensation Plan, the Company is authorized to issue restricted stock awards. Restricted stock awards are not included in the table above. At December 31, 2014, there were 204,121 shares of restricted stock issued and outstanding. See also Note 12. Share-based Compensation Plans of the Consolidated Financial Statements, filed on this Form 10-K, for additional information on the Company's equity compensation plans.

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Stock Performance

The following chart compares the cumulative total shareholder return on the Company's common stock over the last five years with the cumulative total return of the Nasdaq Composite Index, the SNL Western Bank Index and two Company-selected groups of peer institutions (assuming the investment of $100 in each index on December 31, 2009 and reinvestment of all dividends). The Heritage Peer Group 1 consists of all publicly traded banks & thrifts in the United States with assets of between $750 million and $4 billion in assets as of 12/31/2014. The Heritage Peer Group 2 consists of all publicly traded banks & thrifts in California with assets of between $750 million and $4 billion at December 31, 2014.

The Company believes Heritage Peer Group 1 and Heritage Peer Group 2 better reflect the Company's asset size. Furthermore, the Company is evaluating the above indices in light of the MISN Transaction and intends, in the future, to utilize a targeted peer group that better reflects its business operations and aligns with its performance goals in its executive compensation practices. The Company does not expect to utilize the SNL Western Bank index in the future.

GRAPHIC

 
  For the Period Ended  
 
  12/31/09
  12/31/10
  12/31/11
  12/31/12
  12/31/13
  12/31/14
 
 
     

Index

                                     

Heritage Oaks Bancorp

    100.00     65.80     70.80     116.00     150.00     169.63  

NASDAQ Composite

    100.00     118.15     117.22     138.02     193.47     222.16  

SNL Western Bank

    100.00     113.31     102.37     129.18     181.76     218.14  

Heritage Peer Group 1

    100.00     111.76     104.44     124.39     159.28     174.85  

Heritage Peer Group 2

    100.00     113.27     111.18     149.74     190.64     211.88  

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Item 6.   Selected Financial Data

The following table compares selected financial data for the past five years. Explanations for the year-to-year changes may be found in Management's Discussion & Analysis in Item 7. and in the Company's Consolidated Financial Statements and the accompanying notes that are presented in Item 8. of this Form 10-K. The following data has been derived from the Consolidated Financial Statements of the Company and should be read in conjunction with those statements and the notes thereto, which are included in this report.

 
  At or For The Years Ended December 31,  
 
  2014
  2013
  2012
  2011
  2010
 
 
     

    (dollars in thousands, except per share data)  

Consolidated Income Data:

                               

Interest income

  $ 64,088   $ 45,393   $ 46,321   $ 48,227   $ 50,794  

Interest expense

    5,157     3,867     3,818     5,023     8,047  
       

Net interest income

    58,931     41,526     42,503     43,204     42,747  

Provision for loan losses

            7,681     6,063     31,531  
       

Net interest income after provision for loan and lease losses

    58,931     41,526     34,822     37,141     11,216  

Non-interest income

    9,575     12,875     12,548     9,730     10,747  

Non-interest expense

    54,792     36,563     36,131     37,318     41,283  
       

Income (loss) before income tax expense (benefit)

    13,714     17,838     11,239     9,553     (19,320 )

Income tax expense (benefit)

    4,749     6,997     (1,798 )   1,828     (1,760 )
       

Net income (loss)

    8,965     10,841     13,037     7,725     (17,560 )

Dividends and accretion on preferred stock

    168     898     1,470     1,358     5,008  
       

Net income (loss) available to common shareholders

  $ 8,797   $ 9,943   $ 11,567   $ 6,367   $ (22,568 )
       

Share Data:

                               

Earnings (loss) per common share – basic

  $ 0.27   $ 0.38   $ 0.44   $ 0.24   $ (1.30 )

Earnings (loss) per common share – diluted

  $ 0.27   $ 0.37   $ 0.44   $ 0.24   $ (1.30 )

Dividends declared per common share

  $ 0.08   $   $   $   $  

Divdend payout ratio

    30.59%     0.00%     0.00%     0.00%     0.00%  

Common book value per share

  $ 5.81   $ 4.84   $ 4.78   $ 4.17   $ 3.85  

Tangible common book value per share

  $ 4.92   $ 4.34   $ 4.27   $ 3.67   $ 3.33  

Actual shares outstanding at end of period

    33,905,060     25,397,780     25,307,110     25,145,717     25,082,344  

Weighted average shares outstanding – basic

    32,567,137     26,341,592     26,271,000     26,238,015     17,312,306  

Weighted average shares outstanding – diluted

    32,712,983     26,542,689     26,401,870     26,254,745     17,312,306  

Selected Consolidated Balance Sheet Data:

                               

Total cash and cash equivalents

  $ 35,580   $ 26,238   $ 34,116   $ 34,892   $ 22,951  

Total investments and other securities

  $ 355,580   $ 276,795   $ 287,682   $ 236,982   $ 223,857  

Total gross loans held for investment

  $ 1,193,483   $ 827,484   $ 689,608   $ 646,286   $ 677,303  

Allowance for loan and lease losses

  $ (16,802 ) $ (17,859 ) $ (18,118 ) $ (19,314 ) $ (24,940 )

Total assets

  $ 1,710,127   $ 1,203,651   $ 1,097,532   $ 987,138   $ 982,612  

Total deposits

  $ 1,394,804   $ 973,895   $ 870,870   $ 786,208   $ 798,206  

Federal Home Loan Bank borrowings

  $ 95,558   $ 88,500   $ 66,500   $ 51,500   $ 45,000  

Junior subordinated debt

  $ 13,233   $ 8,248   $ 8,248   $ 8,248   $ 8,248  

Total shareholders' equity

  $ 197,940   $ 126,427   $ 145,529   $ 129,554   $ 121,256  

Average assets

  $ 1,609,705   $ 1,119,334   $ 1,024,961   $ 976,988   $ 995,223  

Average earning assets

  $ 1,483,393   $ 1,031,578   $ 953,815   $ 916,356   $ 935,991  

Average shareholders' equity

  $ 182,186   $ 137,807   $ 137,392   $ 124,824   $ 121,865  

Selected Financial Ratios:

                               

Return (loss) on average assets

    0.56%     0.97%     1.27%     0.79%     –1.76%  

Return (loss) on average equity

    4.92%     7.87%     9.49%     6.19%     –14.41%  

Return (loss) on average tangible common equity

    5.84%     9.04%     11.55%     7.29%     –30.86%  

Net interest margin (1)

    3.97%     4.03%     4.46%     4.71%     4.57%  

Efficiency ratio (2)

    78.92%     71.29%     67.88%     67.98%     69.08%  

Non-interest expense to average assets

    3.40%     3.27%     3.53%     3.82%     4.15%  

Capital Ratios:

                               

Average equity to average assets

    11.32%     12.31%     13.40%     12.78%     12.24%  

Leverage Ratio

    10.22%     10.20%     12.32%     12.06%     10.83%  

Tier 1 Risk-Based Capital ratio

    13.13%     12.91%     15.55%     14.81%     13.94%  

Total Risk-Based Capital ratio

    14.38%     14.17%     16.81%     16.07%     15.21%  

Selected Asset Quality Ratios:

                               

Non-performing loans to total gross loans (3)

    0.88%     1.22%     2.51%     1.91%     4.85%  

Non-performing assets to total assets (4)

    0.62%     0.84%     1.58%     1.35%     4.02%  

Allowance for loan and lease losses to total gross loans

    1.41%     2.16%     2.63%     2.99%     3.68%  

Net charge-offs (recoveries) to average loans

    –0.01%     0.03%     1.32%     1.75%     2.96%  
(1)
Net interest margin represents net interest income as a percentage of average interest-earning assets.

(2)
The efficiency ratio is defined as total non-interest expense as a percentage of the combined: net interest income, non-interest income, excluding gains and losses on the sale of securities, gains and losses on the sale of other real estate owned ("OREO") and other OREO related costs, gains and losses on the sale of fixed assets, and amortization of intangible assets.

(3)
Non-performing loans are defined as loans that are past due 90 days or more, as well as loans placed on non-accrual status.

(4)
Non-performing assets are defined as all non-performing loans, and OREO assets.

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

The following discussion and analysis should be read in conjunction with the Heritage Oaks Bancorp's Consolidated Financial Statements and notes filed on this Form 10-K, herein referred to as "the Consolidated Financial Statements" included and incorporated by reference herein. "Bancorp" will be used in this discussion when referring only to the holding company as distinct from the consolidated company. "Bank" will be used when referring to Heritage Oaks Bank. The Bank together with the Bancorp are hereinafter collectively referred to as the "Company," "we" or "our."

Executive Overview

This overview of management's discussion and analysis highlights select information in the financial results of the Company and may not contain all of the information that is important to you. For a more complete understanding of financial condition, results of operations, trends, commitments, uncertainties, liquidity, capital resources and critical accounting policies and estimates, you should carefully read this entire document. Each of these items could have an impact on the Company's consolidated financial results.

Heritage Oaks Bancorp is a California corporation organized in 1994 to act as a holding company for Heritage Oaks Bank, which was founded in 1983, and serves San Luis Obispo, Santa Barbara and Ventura counties. As of December 31, 2014, the Bank operated two branch offices each in Paso Robles, and San Luis Obispo; single branch offices in Atascadero, Templeton, Cambria, Morro Bay, Arroyo Grande, Santa Maria, Goleta and Santa Barbara; as well as a single loan production office in Ventura/Oxnard.

The principal business of the Bank consists of attracting deposits and investing these funds primarily in commercial real estate ("CRE") and commercial business loans, loans secured by first mortgages on one-to-four single family residences, operating and real estate procurement loans for agricultural businesses, multi-family residential property loans and a variety of consumer loans. The Bank also originates one-to-four family residential mortgages for sale in the secondary market. During the first quarter of 2014, the Bank received approval to sell home loans directly to Fannie Mae. The Bank also provides SBA loans, as a member of the SBA's Preferred Lender Program. The Bank offers a variety of deposit accounts for both individuals and businesses with varying rates and terms, which generally include savings accounts, money market deposits, certificates of deposit and checking accounts. The Bank solicits deposits primarily in its market area, and accepts brokered deposits.

Other than holding the shares of the Bank, Bancorp conducts no significant activities. As a bank holding company, Bancorp generally is prohibited from acquiring direct or indirect ownership or control of more than 5 percent of the voting shares of any company which is not a bank or bank holding company, or from engaging directly or indirectly in activities other than those of banking, managing or controlling banks, or providing services for its subsidiaries. The principal exceptions to these prohibitions involve certain non-bank activities which, by statute or regulation or order of the Federal Reserve Board, have been identified as activities closely related to the business of banking or managing or controlling banks. In October 2006, Bancorp formed Heritage Oaks Capital Trust II ("Trust II"). Trust II is a statutory business trust formed under the laws of the State of Delaware and is a wholly-owned, non-financial, non-consolidated subsidiary of Bancorp, the sole purpose of which is to issue trust preferred securities. In conjunction with our acquisition of Mission Community Bank (discussed below), Bancorp assumed two additional trusts: Mission Community Capital Trust I ("Trust III"), and Santa Lucia Bancorp (CA) Capital Trust ("Trust IV"), both of which are statutory business trusts formed under the laws of the State of Delaware, the sole purpose of which is to issue trust preferred securities.

On February 28, 2014, the Company completed the acquisition of Mission Community Bancorp and its subsidiary Mission Community Bank (collectively "MISN", or the "MISN Transaction"). The total value of the transaction was $69.0 million, which was comprised of cash of $8.7 million and 7,541,326 shares of Bancorp's common stock valued at $60.3 million, based on the $7.99 closing price of Bancorp's stock on February 28, 2014. The operating results of MISN beginning on March 1, 2014 are included in the Company's results for the year ended December 31, 2014 and are presented in Note 2. Business Combination, of the Consolidated

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Financial Statements filed on this Form 10-K. The impact of the MISN Transaction to the Company's total loans and deposits was a 34% increase in total loans and 38% increase in total deposits as of February 28, 2014.

Strategic Initiatives

    Deliver superior customer service   by providing local decision making authority in the markets we serve so that customers are given a quick response to their financial needs, and by offering the latest banking technology through various access points, which allow our customers the ability to perform their banking transactions in whatever manner they desire. We provide customer service through our retail banking locations, over the phone, via the internet through our online banking platform, and through our mobile device application. We believe the combination of high touch service in our retail locations and user-friendly electronic banking services enhances our customer experience.

    Continue as a public company   with a common stock that is listed and traded on a national exchange. In addition to providing access to growth capital, we believe a "public currency" provides flexibility in structuring acquisitions and will allow us to attract and retain qualified management through equity-based compensation.

    Expand our commercial and agribusiness loan portfolios  to diversify both our customer base and maturities of the loan portfolio and to benefit from the low cost deposits associated with individual accounts and the professional, general business accounts connected to our commercial and agribusiness customers. The Bank successfully recruited and installed an agribusiness team in 2012 which contributed to a significant increase in the Bank's agribusiness lending presence in the Central Coast region of California.

    Enhance the residential lending product mix and loan sale alternatives  with Fannie Mae approval by originating qualified loans that are subsequently sold directly to Fannie Mae.

    Invest in infrastructure  in order to have the ability to scale efficiently and effectively, in line with our long-term goal of creating a community banking franchise of $3.0 billion to $5.0 billion in total assets. During the month of July, 2014 the Company successfully integrated the operating platform of Mission Community Bank into our existing banking platform. As of December 31, 2014, merger, restructuring, and integration activities related to the MISN Transaction and branch restructuring initiatives were substantially complete. Therefore, the financial impacts of these activities, such as the expenses incurred and liabilities accrued, were materially concluded and presented in the financial statements as of, and for the period ending, December 31, 2014.

Financial Highlights

The Company generated net income available to common shareholders of $8.8 million, or $0.27 per diluted common share, for the year ended December 31, 2014, as compared to net income available to common shareholders of $9.9 million, or $0.37 per diluted common share, for the year ended December 31, 2013 and $11.6 million, or $0.44 per diluted common share, for the year ended December 31, 2012.

Significant factors impacting the Company's net income for the year ending December 31, 2014 are discussed below:

    Net Interest Income:  We have continued to experience declining yields on our loan portfolio due to the historically low interest rate environment and increasing competition in our lending market; however, the impact of accretion from loans acquired through the MISN Transaction has significantly offset the impact of declining loan yields on our net interest income when compared to the year ending December 31, 2013. Net interest income increased for the year ended December 31, 2014, as compared to the same prior year period, due primarily to the increased interest income generated from MISN's loan and securities portfolios.

      Net interest income was $58.9 million, and the net interest margin was 3.97% for the year ended December 31, 2014 compared with $41.5 million, and 4.03%, for the same prior year period. Our net

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      interest margin declined by 6 basis points for the year 2014 as compared to 2013, which is primarily attributable to a decline in loan yields for the year ended December 31, 2014 and a lower proportion of average securities to earning assets as compared to the level reported in 2013. These negative factors were partially mitigated by both the MISN acquired loans' discount accretion and a decline in funding costs.

    Non-Interest Expense:   Non-interest expense increased by $18.2 million to $54.8 million for the year ended December 31, 2014, from $36.6 million for the prior year. The increase in non-interest expense for the year 2014, as compared to the same prior year period, was largely attributable to the addition of MISN's operating expenses and merger, restructure and integration related costs. We experienced year-over-year increases in the following expense categories with the primary driver attributable to the addition of MISN's operations and related purchase accounting adjustments:

    an increase of salaries and benefits of $4.5 million,

    an increase of occupancy and equipment expense of $1.7 million, and

    an increase of amortization of intangible expense of $0.7 million.

      MISN Transaction related merger, restructure, and integration costs of $9.2 million for the year ended December 31, 2014, also contributed $8.1 million to the year-over-year increase in non-interest expense. Professional services expense increased by $2.0 million for the year 2014 as compared to the same prior year period. Other expenses also contributed $0.9 million to the year-over-year increase in non-interest expense. These expense increases were all partially offset by a $0.4 million decline in the provision for mortgage loan repurchases. As of December 31, 2014 we believe that the merger, integration and restructuring costs related to the MISN Transaction are substantially complete.

    Provision for Loan and Lease Losses:  No provision for loan and lease losses was recorded for the years ended December 31, 2014 or 2013. Although we recorded net charge-offs of $1.1 million for the year ended December 31 2014, no additional provision was required to cover such charge-offs due to the positive trends in the credit quality of the loan portfolio, and level of non-performing and delinquent loans. As of December 31, 2014, MISN legacy loans have a $1.0 million allowance for loan and lease losses ("ALLL") allocated to them, which represents 0.41% of such loans. In addition to the ALLL allocated to acquired MISN loans, the remaining un-accreted purchase discounts on these loans is also available to absorb future losses. These discounts represent 3.07% of the remaining MISN loans at December 31, 2014.

    Non-interest Income:  Non-interest income declined by $3.3 million to $9.6 million for the year ended December 31, 2014 from $12.9 million for the prior year. The year-to-year decline in non-interest income is primarily attributable to a $3.3 million decrease in the gain on sale of investment securities due to a large gain recorded in the first quarter of 2013, which was attributable to the rebalancing effort we employed at that time to shorten the duration of the securities portfolio. Other offsetting increases and decreases within non-interest income include a decline in mortgage banking revenue of $1.3 million, and offsetting increases of $0.8 million of fees and service charges, and $0.5 million of other income.

Critical Accounting Policies and Estimates

Our accounting policies are integral to understanding the Company's financial condition and results of operations. Accounting policies management considers to be significant, including newly issued standards to be adopted in future periods, are disclosed in Note 1. Summary of Significant Accounting Policies, of the Consolidated Financial Statements filed on this Form 10-K. The following discussions should be read in conjunction with the Consolidated Financial Statements of this Form 10-K.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America ("U.S. GAAP") requires management to make estimates and assumptions that affect

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the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ materially and adversely from those estimates.

Estimates that are particularly susceptible to significant change relate to the determination of purchase accounting adjustments to the fair value of assets purchased and liabilities assumed through strategic acquisitions, the ALLL, the valuation of real estate acquired through foreclosure, the carrying value of the Company's net deferred tax assets, and estimates used in the determination of the fair value of certain financial instruments, and the determination of accruals for restructuring activities.

Fair Value of Assets Purchased and Liabilities Assumed through Strategic Acquisitions

When the Company acquires the assets and assumes the liabilities of other financial institutions, U.S. GAAP requires an assessment of the fair value of those individual assets and liabilities. This fair value may differ from the cost basis recorded on the acquired institution's financial statements. Management performs an initial assessment to determine which assets and liabilities must be designated for fair value analysis. Management typically engages experts in the field of valuation to perform the valuation of significant assets and liabilities and, after assessing the resulting fair value computation, will utilize such value in computing the initial purchase accounting adjustments for the acquired assets. It is possible that these values could be viewed differently through either alternative valuation approaches or if performed by different experts. Management is responsible for determining that the values determined by experts are reasonable. As of December 31, 2014, adjustments to the fair value of assets acquired and liabilities assumed in the MISN Transaction were complete. See also Note 2. Business Combination, and Note 8. Goodwill and Other Intangible Assets, of the Consolidated Financial Statements filed on this Form 10-K.

Allowance for Loan Losses and Valuation of Foreclosed Real Estate

In connection with the determination of the specific credit component of the ALLL for non-performing loans in the loan portfolio and the value of foreclosed real estate, management obtains independent appraisals at least once a year for significant properties. Although management uses available information to recognize losses on non-performing loans and foreclosed real estate, future additions to the ALLL may be necessary based on changes in local economic conditions or other factors outside our control.

The general portfolio component of the ALLL is determined by pooling loans by collateral type and purpose. These loans are then further segmented by an internal loan grading system that classifies the credit quality of loans as: pass, special mention, substandard and doubtful. Estimated loss rates are then applied to each segment according to loan grade to determine the amount of the general portfolio allocation. Estimated loss rates are determined through an analysis of historical loss rates for each segment of the loan portfolio, based on the Company's prior experience with such loans. In addition, qualitatively determined adjustments are made to the historical loss history to give effect to certain internal and external factors that may have either a positive or negative impact on the overall credit quality of the loan portfolio.

Loans and leases acquired through purchase or through a business combination are recorded at their fair value at the acquisition date. Credit discounts are included in the determination of fair value; therefore, an allowance for loan and lease losses is not recorded at the acquisition date. Should the Company's allowance for loan and lease losses methodology indicate that the credit discount associated with acquired, non-purchased credit impaired loans, is no longer sufficient to cover probable losses inherent in those loans, the Company will establish an allowance for those loans through a charge to provision for loan and lease losses. Acquired loans are evaluated upon acquisition for evidence of deterioration in credit quality since origination such that it is probable at acquisition that the Company will be unable to collect all contractually required payments. Such loans are classified as purchased credit impaired loans ("PCI loans"), while all other acquired loans are classified as non-PCI loans.

The Company has elected to account for PCI loans on an individual loan level. The Company estimates the amount and timing of expected cash flows for each loan. The expected cash flow in excess of the loan's carrying value, which is fair value on the date of acquisition, is referred to as the accretable yield, and is

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recorded as interest income over the remaining expected life of the loan. The excess of the loan's contractual principal and interest over expected cash flows is referred to as the non-accretable difference, and is not recorded in the Company's Consolidated Financial Statements.

Quarterly, management performs an evaluation of expected future cash flows for PCI loans. If current expectations of future cash flows are less than management's previous expectations, other than due to decreases in interest rates and prepayment assumptions, an allowance for loan and leases losses is recorded with a charge to current period earnings through provision for loan and lease losses. If there has been a probable and significant increase in expected future cash flows over that which was previously expected, the Company would first reduce any previously established allowance for loan and lease losses, and then record an adjustment to interest income through a prospective increase in the accretable yield.

Because of all the variables that go into the determination of both the specific and general allocation components of the ALLL, as well as the valuation of foreclosed real estate, it is reasonably possible that the ALLL and foreclosed real estate values may change in future periods and those changes could be material and have an adverse effect on our financial condition and results of operations. See also Note 5. Loans and Allowance for Loan and Lease Losses, of the Consolidated Financial Statements filed on this Form 10-K.

Realizability of Deferred Tax Assets

The Company uses an estimate of its future earnings in determining if it is more likely than not that the carrying value of its deferred tax assets will be realized over the period they are expected to reverse. If based on all available evidence, the Company believes that a portion or all of its deferred tax assets will not be realized, a valuation allowance must be established. See also Note 7. Income Taxes, of the Consolidated Financial Statements filed on this Form 10-K.

Fair Value of Financial Instruments

The degree of judgment utilized in measuring the fair value of financial instruments generally correlates to the level of observable pricing. Financial instruments with readily available active quoted prices, or for which fair value can be measured from actively quoted prices, generally will have a higher degree of observable pricing and a lesser degree of judgment utilized in measuring fair value. Conversely, financial instruments rarely traded or not quoted will generally have little or no observable pricing and a higher degree of judgment is utilized in measuring the fair value of such instruments. Observable pricing is impacted by a number of factors, including the type of financial instrument, whether the financial instrument is new to the market and the characteristics specific to the financial instrument, including but not limited to credit and duration profiles. See also Note 3. Fair Value of Assets and Liabilities, of the Consolidated Financial Statements filed on this Form 10-K.

Accrual for Restructuring Activities

From time to time the Company plans organizational restructuring activities to optimize the efficiency of its operations. U.S. GAAP allows the Company to accrue for certain future restructuring expenses, such as employee termination, retention and relocation costs, contract cancellation costs and fixed asset disposal costs, as long as the Company has adopted a board approved plan for restructuring activities and notified the affected personnel, landlords and vendors within a prescribed timeframe. See Note 16. Restructuring Activities, of the Consolidated Financial Statements filed on this Form 10-K.

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Results of Operations

Net Interest Income and Margin

Net interest income, the primary component of the net earnings of a financial institution, refers to the difference between the interest earned on loans, investments and other interest earning assets, and the interest paid on deposits and borrowings. The net interest margin ("NIM") is the amount of net interest income expressed as a percentage of average earning assets. Factors considered in the analysis of net interest income are the composition and volume of interest-earning assets and interest-bearing liabilities, the amount of non-interest-bearing liabilities, non-accruing loans, and changes in market interest rates.

The table below sets forth average balance sheet information, interest income and expense, average yields and rates and net interest income and margin for the years ended December 31, 2014, 2013 and 2012.

 
  For The Year Ended,
December 31, 2014
  For The Year Ended,
December 31, 2013
  For The Year Ended,
December 31, 2012
 
 
  Balance
  Yield/
Rate

  Income/
Expense

  Balance
  Yield/
Rate

  Income/
Expense

  Balance
  Yield/
Rate

  Income/
Expense

 
 
             

    (dollars in thousands)  

Interest Earning Assets

                                                       

Interest earning deposits in other banks

  $ 52,039     0.17%   $ 89   $ 15,466     0.21%   $ 33   $ 15,193     0.17%   $ 26  

Investment securities

    350,069     2.07%     7,238     262,504     2.09%     5,476     259,174     2.66%     6,896  

Other investments

    9,152     6.73%     616     6,590     4.16%     274     6,519     1.86%     121  

Loans (1) (2)

    1,072,133     5.24%     56,145     747,018     5.30%     39,610     672,929     5.84%     39,278  

Total interest earning assets

    1,483,393     4.32%     64,088     1,031,578     4.40%     45,393     953,815     4.86%     46,321  

Allowance for loan and lease losses

    (17,375 )               (17,937 )               (19,169 )            

Other assets

    143,687                 105,693                 90,315              

Total assets

  $ 1,609,705               $ 1,119,334               $ 1,024,961              

Interest Bearing Liabilities

                                                       

Interest bearing demand

  $ 103,781     0.11%   $ 114   $ 78,055     0.10%   $ 81   $ 67,986     0.11%   $ 77  

Savings

    93,593     0.10%     91     40,548     0.10%     40     35,769     0.10%     36  

Money market

    418,532     0.30%     1,247     302,998     0.33%     1,000     289,079     0.36%     1,034  

Time deposits

    278,292     0.76%     2,115     200,249     0.87%     1,739     183,803     1.00%     1,841  

Total interest bearing deposits

    894,198     0.40%     3,567     621,850     0.46%     2,860     576,637     0.52%     2,988  

Federal funds purchased

    8     0.76%             0.00%             0.00%      

Federal Home Loan Bank borrowing

    76,499     1.43%     1,091     59,063     1.42%     840     50,153     1.27%     638  

Junior subordinated debentures

    12,348     4.04%     499     8,248     2.02%     167     8,248     2.33%     192  

Total borrowed funds

    88,855     1.79%     1,590     67,311     1.50%     1,007     58,401     1.42%     830  

Total interest bearing liabilities

    983,053     0.52%     5,157     689,161     0.56%     3,867     635,038     0.60%     3,818  

Non interest bearing demand

    434,012                 282,060                 243,304              

Total funding

    1,417,065     0.36%     5,157     971,221     0.40%     3,867     878,342     0.43%     3,818  

Other liabilities

    10,454                 10,306                 9,227              

Total liabilities

    1,427,519                 981,527                 887,569              

Shareholders' Equity

                                                       

Total shareholders' equity

    182,186                 137,807                 137,392              

Total liabilities and shareholders' equity

  $ 1,609,705               $ 1,119,334               $ 1,024,961              

Net interest margin (3)

          3.97%   $ 58,931           4.03%   $ 41,526           4.46%   $ 42,503  

Interest rate spread

          3.80%                 3.84%                 4.26%        

Cost of deposits

          0.27%                 0.32%                 0.36%        
(1)
Non-accruing loans have been included in total loans.

(2)
Loan fees have been included in interest income.

(3)
Net interest margin represents net interest income as a percentage of average interest-earning assets.

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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 each of the years ended December 31, 2014 and 2013 and the amount of such change attributable to changes in average balances (volume) or changes in average yields and rates:

 
  For The Year Ended,
December 31, 2014
  For The Year Ended,
December 31, 2013
 
 
  Volume
  Rate
  Rate/
Volume

  Total
  Volume
  Rate
  Rate/
Volume

  Total
 
 
         

    (dollars in thousands)  

Interest income

                                                 

Interest bearing deposits in other banks

  $ 78   $ (6 ) $ (16 ) $ 56   $   $ 6   $ 1   $ 7  

Investment securities

    1,827     (53 )   (12 )   1,762     89     (1,477 )   (32 )   (1,420 )

Other investments

    107     169     66     342     1     150     2     153  

Loans

    17,239     (523 )   (181 )   16,535     4,324     (3,567 )   (425 )   332  

Net increase (decrease)

    19,251     (413 )   (143 )   18,695     4,414     (4,888 )   (454 )   (928 )

Interest expense

                                                 

Interest bearing demand

    27     8     (2 )   33     11     (7 )       4  

Savings

    52         (1 )   51     5         (1 )   4  

Money market

    381     (91 )   (43 )   247     50     (87 )   3     (34 )

Time deposits

    678     (220 )   (82 )   376     165     (239 )   (28 )   (102 )

Federal Home Loan Bank borrowing

    248         3     251     113     75     14     202  

Long term borrowings

    83     167     82     332         (25 )       (25 )

Net increase (decrease)

    1,469     (136 )   (43 )   1,290     344     (283 )   (12 )   49  

Total net increase (decrease)

  $ 17,782   $ (277 ) $ (100 ) $ 17,405   $ 4,070   $ (4,605 ) $ (442 ) $ (977 )

Discussion of 2014 Compared to 2013

For the years ended December 31, 2014 and 2013, net interest income was $58.9 million and $41.5 million, respectively, and our NIM was 3.97% and 4.03%, respectively. During 2014, the impact of the continued current low interest rate environment has had an adverse impact on yields on new and renewing loans. To a lesser extent, the change in the earning asset mix also had a negative impact on our NIM for 2014 due to a shift from higher yielding to lower yielding assets. However, the impact of accretion from the loans acquired through the MISN Transaction has greatly mitigated the impact of the decline in capital market interest rates and the change in asset mix on our earning asset yields, and has helped to stabilize our NIM in 2014 as compared to the prior year. The MISN loan discount accretion contributed 21 basis points to the yield on earning assets and NIM for the year 2014. During 2014, we also experienced an increase in interest income driven by increases in both the yield and average balance of Federal Home Loan Bank ("FHLB") stock, included in other investments in the table above, which helped to mitigate the decline in loan yields, and impact of the change in our asset mix in 2014, as compared to 2013.

Our earnings are directly influenced by changes in interest rates. The nature of our balance sheet can be summarily described as consisting of short duration assets and liabilities and slightly net asset sensitive, meaning that changes in interest rates have a slightly more immediate impact on asset yields than they do on liability rates. A large percentage of our interest sensitive assets and liabilities re-price immediately with changes in the Prime Rate and other capital markets interest rates. Declines in interest rates have resulted in a significant portion of the loan portfolio reaching floor rates. To the extent that overall interest rates rise, the Company will not experience the benefit of rising interest rates until such rates rise above such interest rate floors. However, modifications in the loan floor rates over the last twenty-four to thirty months, primarily as part of loan renewals, have further contributed to the decline in current yields on our loan portfolio but have effectively reduced the level of upward interest rate movement required to see future improvement in yields on impacted loans. See Item 7A. Qualitative and Quantitative Disclosures About Market Risk, included on this Form 10-K for further discussion of the Company's sensitivity to interest rate movements based on our current net asset sensitive profile, as well as the impacts of interest rate floors on the variable rate component of our loan portfolio.

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Loan discount accretion from the acquired MISN portfolio had the most significant impact on our earning asset yields and NIM during 2014 when compared to prior year. The yield on earning assets fell 8 basis points to 4.32% for the year ended December 31, 2014 compared to 2013, however, after removing the impact of MISN loan purchase discount accretion, our earning asset yield and NIM would have been 4.11% and 3.76%, respectively, for the year ended December 31, 2014. Other secondary factors to the prevailing rate environment and MISN acquired loan discount accretion, which were key drivers that impacted our NIM in both 2013 and 2012, such as foregone interest on non-accrual loans and troubled debt restructurings ("TDRs"), and accelerated fee income net of cost accretion from loan prepayments, had less of an impact on our NIM in 2014 than such factors had in 2013 and prior years. The combined impact to our NIM of these other factors was a 4 basis point reduction to our NIM for 2014 compared to a 9 basis point reduction for 2013.

For the year ended December 31, 2014, average interest-earning assets were $451.8 million, or 43.8%, greater than the amount reported for the year ended December 31, 2013. Growth in average earning assets for 2014 was largely driven by MISN acquired loans and securities balances, and secondarily by organic loan growth. Our earning asset mix for 2014, as compared to 2013, worsened slightly and contributed to a decline in overall earning asset yields. For example, average securities were 23.60% of average earning assets for the year ended December 31, 2014, down from 25.45%, for the year ended December 31, 2013. The declines experienced in average securities during 2014 were offset by an increase in lower yielding interest bearing balances in other banks. This decline was anticipated however, due to the Company's strategy, to retain excess liquidity during the period after the close of the MISN Transaction, in order to mitigate the possible impact of any potential run-off of MISN customer deposit balances to the Company's liquidity profile. Given the level of retention of MISN deposit balances as of December 31, 2014, the Company's Management no longer feels that this temporary liquidity strategy is necessary.

For the year ended December 31, 2014, the yield on the loan portfolio declined 6 basis points to 5.24%, from 5.30% for the year ended December 31, 2013. The decline in our loan yields during 2014 was largely attributable to the decline in interest rates on new loans issued and loans renewed, which decline was driven both by the historically low capital markets interest rate environment in 2014, and by increased competition in the Company's primary market area. However, as previously discussed, the accretion income from the loans acquired through the MISN Transaction significantly offset the negative impact of the decline related to new and renewed loan yields. The MISN loan discount accretion contributed 29 basis points to our loan yields during 2014. Other factors, including the impact of non-accrual loans and TDRs, and loan prepayment fee income acceleration, reduced our loan yields by a cumulative net 4 basis points during 2014, compared to a cumulative net 13 basis point reduction attributable to these components in 2013.

The Company invests excess liquidity primarily in agency mortgage backed securities and municipal securities, in an effort to maximize the yield on interest earning assets pending investment in new loan originations. However, during 2014 interest-earning cash balances increased as the Company sought to retain excess liquidity following the MISN Transaction. During 2014 we did not fundamentally change our interest rate risk strategy and therefore we maintained the composition and overall yield in our securities portfolio. We did, however realign the profile of the investment securities acquired through the MISN Transaction in order to align the increased securities balances attributable to MISN with our balance sheet management strategy. In doing so we sold and replaced the majority of the MISN securities portfolio.

The average balance of interest bearing liabilities increased by $293.9 million for the year ended December 31, 2014, compared to the level reported for the year ended December 31, 2013. The year to date increase in the average balance of interest bearing liabilities can be attributed primarily to the deposits, Federal Home Loan Bank borrowings and junior subordinated debentures assumed through the MISN Transaction. The MISN deposit portfolio also improved our liability mix and funding costs due to the higher level of non-interest bearing demand deposits, as a proportion of total deposits, MISN had on its balance sheet at the time of acquisition, relative to the proportion of the legacy Heritage Oaks deposit portfolio. The impact of MISN acquired deposits helped to increase our percentage of average non-interest bearing deposits to average deposits to 32.68% for the year ended December 31, 2014 from 31.20% for the same prior year period.

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The rate paid on interest bearing deposits declined by 6 basis points, to 0.40%, for the year ended December 31, 2014 as compared to the year ended December 31, 2013. This decline is in part due to the historically low interest rate environment that has existed for the last few years, but is also due to the more favorable funding cost profile of MISN acquired deposits and, to a lesser extent, our efforts to systematically lower our cost of deposits over this same time period. In addition to the favorable effects realized from these changes in our interest bearing deposits, our average non-interest bearing demand deposit balances have increased by $152.0 million, to $434.0 million, for the year ended December 31, 2014, largely due to the MISN Transaction. These increases in non-interest bearing demand deposit balances have served to reduce our total funding cost by 4 basis points to 0.36% for the year ended December 31, 2014. Management continues to believe that the increase in non-interest bearing demand deposits is indicative of money being held in highly liquid accounts pending the customer's determination of how best to invest the funds in light of today's low returns on traditional investments. This trend began to change during 2014 however, as we did begin to see an increase in deposit outflows, attributable to customers redeploying cash into real estate and other investments. As such, it is difficult to determine how long the increased levels of non-interest bearing demand deposits will remain at or near the current levels and therefore how long we will benefit from this low cost source of funds.

For the year ended December 31, 2014, the average rate paid on interest bearing liabilities was 0.52% as compared to 0.56% for the year ended December 31, 2013. The year over year decline can be attributed in large part to the lower cost deposits acquired through the MISN Transaction. This decline was partially offset by an increase in the cost of junior subordinated debentures which increased in 2014 by 202 basis points, or 100%, compared to the prior year. The increase in funding costs of junior subordinated debentures is directly related to the purchase discount on acquired MISN junior subordinated debentures, which purchase discount amortization increases the amount of interest expense, and cost of funding attributable to these debt instruments.

Discussion of 2013 Compared to 2012

For the years ended December 31, 2013 and 2012, net interest income was $41.5 million and $42.5 million, respectively, and NIM was 4.03% and 4.46%, respectively. During 2013, the impact of the continued historically low interest rate environment had an adverse impact on yields on new and renewing loans. In addition, the low interest rate environment and relative flatness of interest yield curves have had a two-fold impact on securities' yields as new investments typically provided lower yields, and existing investments in mortgage backed securities realized increased levels of refinancing of the underlying mortgages, which led to increased prepayment activity during most of 2013, which resulted in acceleration of the amortization of premiums paid on these securities. These factors have combined to reduce the yield on earning assets for the year ended December 31, 2013 by 46 basis points as compared to the year ended December 31, 2012. This improvement in the mix of earning assets, with a higher percentage of such assets invested in higher yielding loans, helped mitigate some of the downward pressures on NIM. The declines in the yield on earning assets was marginally offset by improvements in the cost of funds that were largely due to shifts in the composition of deposits from interest bearing accounts to more liquid non-interest bearing deposit accounts, coupled with reductions in the rates of interest paid on interest bearing deposits, largely due to new and renewing certificates of deposit bearing lower interest rates.

For the year ended December 31, 2013, average interest-earning assets were $77.8 million, or 8.2% higher than that reported for the year ended December 31, 2012. Growth in average earning assets for 2013 was largely driven by growth in the average loan balances of $74.1 million, or 11.0%, as compared to 2012. The Company's average investment in its securities portfolio increased by $3.3 million in 2013, as compared to 2012. The relative increase in higher yielding loans as compared to investment securities, served to mitigate the negative impact of declining yields on our NIM.

The decline in the yield on interest-earning assets for the year ended December 31, 2013 can be attributed to two key factors: declines in the average returns on the loan portfolio due to continued downward rate pressure on new loans and renewals; and declines in the yields on the investment securities purchased during 2013 due to continued market pressures on interest rates and the repositioning of the investment portfolio in the first quarter of 2013. The adverse impacts of the declines in investment security and loan yields during 2013 were partially offset by declines in the level of interest reversals and forgone interest on non-accruing loans and lost interest due to TDR rate concessions.

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For the year ended December 31, 2013, the yield on the loan portfolio declined 54 basis points to 5.30% from the year ended December 31, 2012. This decline was largely attributable to declines in interest rates on new loans issued and loans renewed, which was driven by increased competition in the Company's primary market area and the historically low capital market interest rates aimed at fostering the economic recovery. In addition, interest income for 2013 included $0.3 million of interest recoveries on the pay-off of non-accrual loans, as well as prepayment penalties and related accelerations of unearned fees on loan payoffs, which represented $0.1 million less than was realized in 2012. This decline in prepayment income in 2013 represented less than 1 basis point of the decline in yield in 2013 as compared to 2012. These downward pressures on loan yields were partially offset by a decline in the level of forgone interest on non-accrual loans from $1.4 million to $1.0 million for the years ended December 31, 2012 and 2013, respectively. Total forgone interest on non-accrual loans reduced the yield on the loan portfolio by 13 basis points for the year ended December 31, 2013, as compared to 15 basis points for the year ended December 31, 2012.

The Company invests excess liquidity primarily in agency mortgage backed securities and municipal securities, in an effort to maximize the yield on interest earning assets pending investment in new loan originations. Purchases made during the latter part of 2012, along with the impacts of efforts during the first quarter of 2013 to shorten the duration of the securities portfolio, by selling some of our longer-duration investments and replacing them with shorter duration instruments, has contributed to the decline in the overall yield on investment securities as the recently acquired investment securities currently yield considerably less than other investments in the portfolio. Assuming that the loan growth experienced during the second half of 2012 and 2013 continues during 2014, we should realize further improvement in the mix of interest earning assets, which should help mitigate further compression on our NIM, but no assurances can be given with respect to any of the foregoing.

The average balance of interest bearing liabilities was $54.1 million higher for the year ended December 31, 2013 than that reported for the year ended December 31, 2012. The increase in the average balance of interest bearing liabilities can be attributed to $45.2 million increase in average interest bearing deposits to $621.9 million for the year ended December 31, 2013. Growth in interest bearing deposits has been primarily the result of the ongoing efforts to gather deposits across the Bank's service territory, as well as the impacts of the Morro Bay branch acquisition completed in December 2012. Much of the growth in interest bearing deposits has been in lower cost deposit types, which has helped to control our overall cost of funds. In addition to the growth in interest bearing deposits, the level of average FHLB borrowings at December 31, 2013 increased $8.9 million, compared to the corresponding period in 2012, to support growth in the loan portfolio in 2013.

The rate paid on interest bearing deposits declined by 6 basis points, to 0.46%, for the year ended December 31, 2013 as compared to the year ended December 31, 2012. This decline is in part due to the historically low interest rate environment that has existed for the last few years, but is also due to our efforts to systematically lower our cost of deposits over this same time period. In addition to the favorable effects realized from these changes in our interest bearing deposits, our average non-interest bearing demand deposit balances have increased by $38.8 million, to $282.1 million, for the year ended December 31, 2013. These increases in non-interest bearing demand deposit balances have served to reduce our total funding cost by 3 basis points to 0.40% for the year ended December 31, 2013. Management believes that the increase in non-interest bearing demand deposits is indicative of money being held in highly liquid accounts pending the customer's determination of how best to invest the funds in light of today's low returns on traditional investments. As such, it is difficult to determine how long the increased levels of non-interest bearing demand deposits will remain at or near the current levels, and therefore how long we will benefit from this low cost source of funds.

For the year ended December 31, 2013, the average rate paid on interest bearing liabilities was 0.56% as compared to 0.60% for the year ended December 31, 2012. The year over year decline can be attributed in large part to the deposit portfolio rate reductions previously discussed. This decline was partially offset by an increase in funding costs for FHLB borrowings, due to a strategy designed to lock in historically low fixed rates on longer term borrowings, in order to match fund longer term fixed rate loans.

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Provision for Loan and Lease Losses

As more fully discussed in Note 5. Loans and Allowance for Loan and Lease Losses, of the Consolidated Financial Statements, filed on this Form 10-K, the allowance for loan and lease losses has been established for probable credit losses inherent in the loan portfolio. The allowance for loan and lease losses is maintained at a level considered by management to be adequate to provide for probable credit losses inherent in the loan portfolio as of the balance sheet date and is based on methodologies applied on a consistent basis with the prior year. Management's review of the adequacy of the allowance for loan and lease losses includes, among other things, an analysis of past loan loss experience and management's evaluation of the loan portfolio under current economic conditions.

The allowance for loan and lease losses is based on estimates, and actual losses may vary from current estimates, which variances could be material and could have an adverse effect on the Company's performance. The Company recognizes that the risk of loss will vary with, among other things: general economic conditions; the type of loan being made; the creditworthiness of the borrower over the term of the loan; and, in the case of a collateralized loan, the value of the collateral for such loans. The allowance for loan and lease losses represents the Company's best estimate of the amount necessary to provide for probable incurred credit losses inherent in the loan portfolio as of the balance sheet date. For additional information see the "Allowance for Loan and Lease Losses" discussion in the Financial Condition section of Management's Discussion and Analysis of Financial Condition and Results of Operations.

Discussion of 2014 Compared to 2013

A provision for loan and lease losses was not recorded for years ended December 31, 2014 or 2013. The lack of a loan and lease loss provision in 2014 and 2013 is reflective of the continuing improvements in the overall credit quality of the loan portfolio, the overall improvement in the charge-off history over the last two years, the improvement in property values that serve as collateral for a large portion of our loans, as well as the limited amount of new loans moving into non-accrual or TDR status, and therefore requiring specific reserves. Loans acquired through the MISN Transaction required $1.0 million of provisions for loan and lease losses through December 31, 2014, however, other components of our allowance for loan and lease losses such as the general, and specific reserve components, had offsetting provision recaptures. When such provision recaptures were aggregated with the required provision for MISN acquired loans and leases, and provisions to address increases in our qualitative factors, and unallocated portion of our ALLL, the result of these component provisions, and provision recaptures resulted in a net $0 provision for loan and lease losses for 2014.

As of December 31, 2014, the Company's allowance for loan and lease losses represented 1.46% of total gross loans compared to 2.16% as of December 31, 2013. The year to year decline in the allowance for loan and lease losses as a percentage of gross loans was primarily attributable to the addition of the MISN acquired loans to the denominator of this ratio which were initially recorded at fair value and had no associated loan loss provision. As of December 31, 2014 the $1.0 million portion of our allowance for loan and lease losses represented 0.41% of the MISN acquired loans while the allowance for loan and lease losses associated with the legacy Heritage Oaks loan portfolio was 1.76%. The remaining un-accreted purchase discount on MISN acquired loans, which is also available to absorb future credit losses on those loans and leases, represented 3.07% of the remaining MISN loan portfolio. For additional information see the "Allowance for Loan Losses" discussion in the Financial Condition section of Management's Discussion and Analysis of Financial Condition and Results of Operations.

Discussion of 2013 Compared to 2012

A provision for loan and lease losses was not recorded for year ended December 31, 2013 as compared to a provision for loan and lease losses of $7.7 million for the year ended December 31, 2012. The lack of a loan and lease loss provision in 2013 is reflective of the continuing improvements in the overall credit quality of the loan portfolio, the overall improvement in the charge-off history during 2013, the improvement in property values that serve as collateral for a large portion of our loans, as well as the limited amount of new loans moving into non-accrual status and therefore requiring specific reserves. As of December 31, 2013, the Company's allowance for loan and lease losses represented 2.16% of total gross loans. The level of loan and lease loss

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provisions that the Company experienced in 2012 was primarily attributable to increased reserve requirements associated with specific reserve calculations and related charge-offs for a few large impaired loans in the first half of 2012. For additional information see the "Allowance for Loan and Lease Losses" discussion in the Financial Condition section of Management's Discussion and Analysis of Financial Condition and Results of Operations.

Non-Interest Income

The table below sets forth changes for 2014, 2013, and 2012 in non-interest income:

 
   
   
   
  Variances  
 
  For the Years Ended
December 31,
 
 
  2013   2012  
 
  2014
  2013
  2012
  dollar
  percent
  dollar
  percent
 
 
         

    (dollars in thousands)  

Fees and service charges

  $ 5,312   $ 4,529   $ 4,350   $ 783     17.3%   $ 179     4.1%  

Net gain on sale of loans

    1,330     2,282     3,298     (952 )   –41.7%     (1,016 )   –30.8%  

Other mortgage fee income

    290     642     965     (352 )   –54.8%     (323 )   –33.5%  

Gain on sale of investment securities

    646     3,926     2,619     (3,280 )   –83.5%     1,307     49.9%  

Other income

    1,997     1,496     1,316     501     33.5%     180     13.7%  

Total

  $ 9,575   $ 12,875   $ 12,548   $ (3,300 )   –25.6%   $ 327     2.6%  

Discussion of 2014 Compared to 2013

Non-interest income decreased by $3.3 million, or 25.6%, for the year ended December 31, 2014 compared with the amount reported for 2013. The decline in non-interest income in 2014 was driven by a $3.3 million decrease in the gains realized on sale of investment securities and a $1.3 million decrease in the gain on sale and origination fee income for mortgage loans. The decline in mortgage originations over 2014 was directly correlated to a rise in long-term interest rates and corresponding decline in refinance activity for much of the year. However, our mortgage pipeline as of December 31, 2014 was stronger than it had been for the majority of 2014, and since the end of 2013, due to a recent decline in interest rates and corresponding increase in refinance activity. We remain cautious regarding our mortgage origination volume given that an upward move in rates could have a further adverse impact on the refinance market. However, we believe that this negative trend would be partially mitigated by an increase in purchase mortgage originations, as buyers have historically tended to accelerate purchase decisions in the face of a rising rate environment.

We generated $0.6 million of gains on sales of securities during 2014, which represented a $3.3 million decline compared to the prior year. Current year gains were the byproduct of managing our bond portfolio's effective duration, portfolio composition, and interest rate risk profile. Gains on sales of investment securities during 2013 were attributable to strategic repositioning activities executed in the first quarter of 2013 to shorten the effective duration, and reduce exposure to future unfavorable movements in interest rates, which involved the sale of securities with a carrying value of $89.3 million resulting in gains of $3.6 million. Offsetting these declines in the categories of non-interest income was a $0.8 million increase in fees and service charges, attributable to deposit accounts acquired through the MISN Transaction, and increased other income of $0.5 million attributable primarily to the MISN loan recoveries on loans which carried $0 value at the time of acquisition.

Discussion of 2013 Compared to 2012

Non-interest income increased by $0.3 million, or 2.6%, for the year ended December 31, 2013 compared with the amount reported for 2012. The primary drivers for the higher non-interest income was a $1.3 million increase in the gains realized on sale of investment securities and a $0.4 million increase in the gain realized on the sale of SBA loans, which is reflected in other income. As previously discussed, the Company sold securities with a carrying value of $89.3 million that resulted in gains of $3.6 million in the first quarter of 2013 in order to manage the duration and interest rate sensitivity of the bond portfolio. The gain on sale of SBA loans reflects the first SBA loan sales the Company has undertaken since 2010. These increases in non-interest income were largely offset by a $1.3 million reduction in mortgage gain on sale, largely due to a decline in refinance

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activity during the second half of 2013, and a $0.2 million reduction in gain on sale of other real estate owned ("OREO") due to the limited OREO sales activity in 2013 not yielding any gains. Our pipeline for potential mortgages as of December 31, 2013 remained lower than it was at the end of 2012 due primarily to increases in long term mortgage rates.

Non-Interest Expenses

The table below sets forth changes in non-interest expense for 2014, 2013 and 2012:

 
   
   
   
  Variances  
 
  For the Years Ended
December 31,
 
 
  2013   2012  
 
  2014
  2013
  2012
  dollar
  percent
  dollar
  percent
 
 
         

    (dollars in thousands)  

Salaries and employee benefits

  $ 23,476   $ 18,977   $ 18,304   $ 4,499     23.7%   $ 673     3.7%  

Occupancy and equipment

    6,576     4,891     4,900     1,685     34.5%     (9 )   –0.2%  

Information technology

    3,025     2,582     2,553     443     17.2%     29     1.1%  

Professional services

    4,801     2,833     3,546     1,968     69.5%     (713 )   –20.1%  

Regulatory assessments

    1,164     1,007     1,596     157     15.6%     (589 )   –36.9%  

Sales and marketing

    843     584     690     259     44.3%     (106 )   –15.4%  

Foreclosed asset costs and write-downs

    179     180     334     (1 )   –0.6%     (154 )   –46.1%  

Provision for mortgage loan repurchases

    127     570     1,192     (443 )   –77.7%     (622 )   –52.2%  

Amortization of intangible assets

    1,057     400     342     657     164.3%     58     17.0%  

Merger, restructure and integration

    9,190     1,051         8,139     774.4%     1,051     100.0%  

Other expense

    4,354     3,488     2,674     866     24.8%     814     30.4%  

Total

  $ 54,792   $ 36,563   $ 36,131   $ 18,229     49.9%   $ 432     1.2%  

Discussion of 2014 Compared to 2013

Total non-interest expense increased by approximately $18.2 million in 2014 as compared with 2013, and was primarily driven by an $8.1 million increase in merger, restructure and integration costs related to the MISN Transaction, and the addition of MISN related operating costs including a $4.5 million increase in salaries and employee benefit costs, and $1.7 million increase in occupancy and equipment costs. Merger, restructuring and integration costs incurred in 2014 were attributable to the restructuring plan, which the Company developed in the latter part of 2013, to consolidate branches and optimize headcount levels in conjunction with the merger and integration of Mission Community Bank's operations into the Company's operations. In addition, we experienced a $0.7 million increase in intangible asset amortization attributable to the $5.1 million core deposit intangible asset acquired as a result of purchase accounting in connection with the MISN Transaction. Information technology expense also increased by $0.4 million, attributable to the higher level of transactions we are now generating due primarily to the addition of MISN customer accounts to our core processing, on-line banking, and other banking systems. Professional services expense also increased by $2.0 million, and other expense increased by $0.9 million, during 2014 as compared to 2013. These cost increases were partially offset by a $0.4 million decline in mortgage repurchase provision expense.

The year over year increase in salaries and employee benefits was driven by the net impact of increases and decreases in the components of salaries and employee benefits. Components of salaries and employee benefits which increased in 2014 as compared to prior year, which were primarily attributable to the addition of MISN operations were: 1) employee base salaries, overtime and related payroll taxes of $4.2 million, 2) equity compensation plan expense of $0.5 million, and 3) employee group insurance expense of $0.4 million. Offsetting these increases was a reduction in mortgage origination commissions expense, which declined by $0.6 million, or 43%, in 2014 compared to 2013, which is consistent with the 44% year over year decline in mortgage gain on loan sales and other fee income.

The increase in professional services expense for 2014 was driven by increases in: 1) outsourced information technology services of $0.7 million, 2) $0.5 million of outsourced Bank Secrecy Act consulting services incurred to address the issues identified in our Consent Order, 3) a $0.3 million increase in legal expenses, and 4) a $0.3 million increase in audit and tax service provider costs.

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The increase in other expenses was attributable to a rise in several expense categories which experienced greater activity due to the MISN Transaction, such as a $0.3 million increase in telephone expense due to the initially larger branch network, and a $0.2 million increase in loan department expense, primarily driven by increased appraisal expense for classified MISN loans. Additional expense increases included a $0.2 million increase in fraud losses due to debit card compromises, such as the well-publicized Home Depot and Target customer account data breaches, and increased fraudulent check losses, as well as $0.1 million increases in each of the following expense categories: 1) the provision for unfunded loan commitments, attributable to the increased off-balance sheet commitments for MISN and newly originated agribusiness and commercial and industrial ("C&I") credit lines, 2) stationary and supplies expense related to increased customer notifications for MISN customers, 3) the reversal of a regulatory examination accrual in 2013 that did not repeat in 2014, and 4) increased courier costs, for the period after the MISN Transaction, and before our July systems integration, when we were operating on two core processing systems. Offsetting these expense increases was a $0.4 million reduction in the provision for mortgage loan repurchases, as the amount of new repurchase requests received and the estimated loss exposure attributable to those requests by the Bank were much less than those during the prior two years. We continue to believe that we have no critical deficiencies in our mortgage loan underwriting processes that could potentially give rise to any significant level of mortgage repurchase demands from our investors, and we continue to vigorously defend the Bank from false claims of defects in underwriting or borrower fraud.

Discussion of 2013 Compared to 2012

Total non-interest expense increased by approximately $0.4 million in 2013 as compared with 2012, and was primarily driven by a $1.1 million increase in merger and integration expenses related to the then pending MISN Transaction, a $0.7 million increase in salaries and employee benefit expenses, and $0.8 million increase in other expenses. The increase in merger and integration expenses reflect the expenses of due diligence, regulatory and SEC related filing costs, as well as initial integration planning expenses associated with the MISN Transaction, for which there were no comparable expenses in 2012.

The increased salary and benefit expenses were associated with increased expenses related to variable bonus plans in 2013, as 2013 included a full year of such bonus plans, whereas 2012 only included such plans for the second half of the year. Salaries and employee benefit expenses were also impacted by merit increases across the organization in 2013. The increase in other expenses were due to increases in other loan expenses due to increased loan production in 2013, as compared to 2012, and settlement expenses attributable to resolution of legal matters.

Off-setting these non-interest expense increases were decreases in provisions for mortgage repurchases, professional services and regulatory costs totaling $1.9 million. The decrease in the provision for potential mortgage repurchases in 2013 was largely driven by increased provisioning in 2012 for estimated losses related to new claims activity in the second quarter of 2012 associated with a group of related mortgages funded and sold in 2007. Management does not expect there to be any further material provisions required for this group of related loans. Total cash paid in settlement for mortgage repurchases has been $1.6 million in the prior 8 years. We do not believe the requests are in any way indicative of systemic problems with the Bank's underwriting or origination process of mortgage loans held for sale or that there is significant exposure to repurchase requests other than those arising from the group of related loans to the borrowers in question, which totaled $2.8 million, inclusive of the approximately $0.6 million of mortgage repurchases provided for in the first quarter of 2013.

The decline in professional services expenses in 2013 as compared to the corresponding period in 2012 is primarily related to the Company hiring consultants in 2012 to aid in identifying and implementing operating efficiency initiatives across the organization, which effort was largely completed in the second half of 2012. The decline in the level of regulatory costs is reflective of the favorable impacts on FDIC assessment expenses due to the termination of the Consent Order and the Written Agreement in the second and third quarters of 2012, respectively, and the termination of the Memoranda of Understanding ("MOU") with the FDIC, DBO and the Federal Reserve Bank of San Francisco in the second and third quarters of 2013.

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Provision for Income Taxes

For the year ended December 31, 2014, the Company recorded income tax expense of approximately $4.7 million, compared to $7.0 million in 2013, and an income tax benefit of $1.8 million in 2012. Our effective income tax rates were 34.6%, 39.2%, and (16.0%) for 2014, 2013, and 2012, respectively. The decline in our effective income tax rate and income tax expense incurred in 2014, as compared to 2013, is primarily attributable to a $4.1 million decline in income before income tax expense. A secondary contributor to the decline in our effective income tax rate, and income tax expense in 2014 was attributable to permanent differences between financial statement income and tax return income, which increased by $1.2 million or 106% for 2014 as compared to the prior year. These permanent differences recorded on the Company's tax return have historically represented a decrease in tax return income, as compared to financial statement income, because the largest components of these permanent differences are tax-exempt earnings from securities, and non-taxable earnings from the cash surrender value of bank owned life insurance, which are reported as income in our financial statements, but not as taxable income on the Company's tax return. The combined impact of a decrease in pre-tax earnings, and an increase in non-taxable temporary differences reduced our effective tax rate in 2014 to 34.6%, from 39.2% reported in 2013. Our effective income tax rate and income tax benefit in 2012 can be attributed to the Company's reversal of $5.6 million of deferred tax asset valuation allowance in 2012. The Company's effective income tax rate, exclusive of the impacts of the changes in the deferred tax asset valuation allowance, would have been 33.9% for 2012.

The determination as to whether a valuation allowance should be established against deferred tax assets is based on the consideration of all available evidence using a "more likely than not" standard. Management evaluates the realizability of the deferred tax assets on a quarterly basis. As a result of this evaluation in 2012, it was determined that 100% of the Company's deferred tax assets were now more likely than not recognizable as future tax benefits, resulting in the reversal of a previously established valuation allowance of $5.6 million. The reversal of the allowance in 2012 reflected the impacts of numerous factors, such as continued quarterly earnings and improvements in credit quality that provided adequate positive evidence as to the incremental recoverability of these deferred tax assets. Please see Note 7. Income Taxes, of the Consolidated Financial Statements, filed on this Form 10-K, for additional information concerning the Company's deferred tax assets.

Financial Condition

At December 31, 2014, total assets were approximately $1.7 billion, an increase of approximately $506.5 million or 42.1%, over that reported at December 31, 2013. The increase in total assets is primarily attributable to the $453.7 million acquired through the MISN Transaction, and secondarily to $85.2 million of organic loan growth. At December 31, 2014, total deposits were approximately $1,394.8 million, an increase of approximately $420.9 million, or 43.2%, over that reported at December 31, 2013. The increase in the level of deposits in 2014 is attributable primarily to $371.5 million of deposits acquired through the MISN Transaction, in addition to $49.4 million of organic deposit growth. The organic loan and deposit growth achieved in 2014 is reflective of the Bank's continuing focus to bring new customer relationships into the Bank and expand our existing customer relationships. A more detailed discussion about loans and deposits, as well as the other key elements of our financial condition follows.

Total Cash and Cash Equivalents

Total cash and cash equivalents were $35.6 million and $26.2 million at December 31, 2014, and December 31, 2013, respectively. This line item will vary depending on daily cash settlement activities and the amount of highly liquid assets needed, based on known events, such as the repayment of borrowings or loans expected to be funded in the near future, and actual cash on hand in the branches. The year to date increase is attributable primarily to an increase in liquidity driven by the increased size of the Company's balance sheet due to the MISN Transaction.

Investment Securities and Other Earning Assets

Other earning assets are comprised of Interest Earning Deposits Due from the Federal Reserve Bank, Federal Funds Sold (funds the Company lends on a short-term basis to other banks), investments in securities and short-term interest bearing deposits at other financial institutions. These assets are maintained for liquidity needs of the Company, collateralization of public deposits, and diversification of the earning asset mix.

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Securities Available for Sale

The Company manages its securities portfolio to provide a source of both liquidity and earnings. The Company has invested in a mix of securities including obligations of U.S. government agencies, mortgage backed securities and state and municipal securities. The Company has an Asset/Liability Committee that develops investment policies based upon the Company's operating needs and market circumstances. The Company's investment policy is formally reviewed and approved annually by the Board of Directors. The Asset/Liability Committee is responsible for reporting and monitoring compliance with the investment policy. Reports are provided to the Company's Board of Directors on a regular basis.

The following table provides a summary of investment securities by securities type as of December 31, 2014, 2013 and 2012 is as follows:

 
  December 31, 2014   December 31, 2013   December 31, 2012  
 
  Amortized
Cost

  Fair Value
  Amortized
Cost

  Fair Value
  Amortized
Cost

  Fair Value
 
 
             

    (dollars in thousands)  

Obligations of U.S. government agencies

  $ 19,562   $ 19,664   $ 6,243   $ 6,208   $ 7,307   $ 7,567  

Mortgage backed securities

                                     

U.S. government sponsored entities and agencies

    216,492     215,398     186,981     182,931     145,430     145,768  

Non-agency

    11,891     11,901     10,924     11,032     43,402     44,795  

State and municipal securities

    79,810     82,592     51,532     50,030     64,824     68,968  

Asset backed securities

    26,216     26,025     26,935     26,594     20,049     20,584  

Total available for sale securities

  $ 353,971   $ 355,580   $ 282,615   $ 276,795   $ 281,012   $ 287,682  

At December 31, 2014, the fair value of the investment portfolio was approximately $355.6 million or $78.8 million greater than that reported at December 31, 2013. The increase in the balance of the portfolio can be attributed primarily to $76.2 million of investment securities acquired through the MISN Transaction. We worked to reposition the portfolio acquired through the MISN Transaction to better align with the interest rate risk, duration, and types of securities which we typically invest in, over the course of the first and second quarters of 2014.

Securities available for sale are carried at fair value, with related net unrealized gains or losses, net of deferred income taxes, recorded as an adjustment to equity capital. At December 31, 2014, the securities portfolio had net unrealized gains, net of taxes, of approximately $0.9 million, an increase of approximately $4.4 million from the net unrealized loss position of $3.4 million reported at December 31, 2013. Fluctuations in the fair value of the investment portfolio in the last three years can be attributed to market turbulence and volatility in overall interest rates, stemming in part from continued economic conditions and uncertainty. All fixed and adjustable rate mortgage pools contain a certain amount of risk related to the uncertainty of prepayments of the underlying mortgages, which prepayments are directly impacted by interest rate changes. The Company uses computer simulation models to test the average life, duration, market volatility and yield volatility of adjustable rate mortgage pools under various interest rate assumptions to monitor volatility.

The majority of the Company's mortgage securities were issued by: The Government National Mortgage Association ("Ginnie Mae"), The Federal National Mortgage Association ("Fannie Mae"), and The Federal Home Loan Mortgage Corporation ("Freddie Mac"). These securities carry the full faith and guarantee of the issuing agencies and the U.S. Federal Government. At December 31, 2014, approximately $215.4 million or 94.8%, of the Company's mortgage related securities were issued by government agencies and government sponsored entities, such as those listed above.

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The following table sets forth the maturity distribution of available for sale securities in the investment portfolio and the weighted average yield for each category at December 31, 2014:

 
  December 31, 2014  
 
  One Year
or
Less

  Over 1
Through 5
Years

  Over 5 Years
Through 10
Years

  Over 10 Years
  Total
 
 
     

    (dollars in thousands)  

Obligations of U.S. government agencies

  $ 255   $ 1,125   $ 15,565   $ 2,719   $ 19,664  

Mortgage backed securities

                               

U.S. government sponsored entities and agencies

    34,347     86,403     49,322     45,326     215,398  

Non-agency

    3,011     8,383     507         11,901  

State and municipal securities

    974     14,483     63,118     4,017     82,592  

Asset backed securities

        2,532     11,603     11,890     26,025  

Total available for sale securities

  $ 38,587   $ 112,926   $ 140,115   $ 63,952   $ 355,580  

Amortized cost

  $ 38,674   $ 113,081   $ 137,909   $ 64,307   $ 353,971  

Weighted average yield

    1.95%     1.95%     2.59%     2.83%     2.36%  

Federal Home Loan Bank Stock

As a member of FHLB of San Francisco, the Company is required to hold a specified amount of FHLB capital stock based on the asset size of the Bank and the level of outstanding borrowings with the FHLB. As such, the amount of FHLB stock the Company carries can vary from one period to another based on, among other things, the current liquidity needs of the Company. At December 31, 2014, the Company held approximately $7.9 million in FHLB stock, an increase of $3.1 million, or 65.7%, from that reported at December 31, 2013, due primarily to the increase in size, and outstanding borrowings of the institution, which increase was attributable primarily to the MISN Transaction, and required an increase of investment in FHLB stock.

Loans

Summary of Market Conditions

The addition of a new sales team focused on our region's largest industry, agriculture, as well as the commercial and small business segments of the market, and single-family mortgages, has continued to contribute to net loan growth in 2014. Gross loans increased $366.0 million during the year ended December 31, 2014, of which $280.7 million can be attributed to loans acquired in the MISN Transaction at December 31, 2014. Excluding the impact of the loans acquired in the MISN Transaction, gross loans increased $85.2 million during the year ended December 31, 2014. This increase is attributable to the Bank's continued focus on organic loan growth in our region, as well as $27.2 million in selective multi-family loan purchases during the third quarter of 2014, which were acquired for portfolio diversification. We continue to see improving borrower activity and we anticipate that this increased activity in our existing markets, in conjunction with the Bank's new sales team and our expansion into Ventura and Santa Barbara Counties with the opening of loan production offices during 2012 and 2013, and a full service branch in Goleta late in 2014, have positioned the Bank for continued growth in the loan portfolio.

Although we are seeing some signs of stabilization in the local economies in which the Company operates, management realizes that a renewed decline in the global, national, state or local economies, and / or continued drought conditions on the Central Coast of California, may negatively impact local borrowers, as well as negatively impact values of real estate within our market footprint. As such, management continues to closely monitor credit trends and leading indicators for renewed signs of deterioration. The Bank employs stringent lending standards and remains very selective with regard to loan originations, including CRE, real estate construction, land and commercial loans, in an effort to effectively manage risk in the current credit environment. Additionally, purchased loans are evaluated under the same standards as originated loans. The Company is focused on monitoring credit in order to take proactive steps, when and if necessary, to mitigate any material adverse impacts on the Company.

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Table of Contents

Credit Quality

The Company's primary business is the extension of credit to individuals and businesses and the safekeeping of customers' deposits. The Company's policies concerning the extension of credit require risk analysis, including an extensive evaluation of the purpose for the loan request and the borrower's ability and willingness to repay the Bank as agreed. The Company also considers other factors when evaluating whether or not to extend new credit to a potential borrower. These factors include the current level of diversification in the loan portfolio and the impact that funding a new loan will have on that diversification, legal lending limit constraints and any regulatory limitations concerning the extension of certain types of credit.

The credit quality of the loan portfolio is impacted by numerous factors, including the economic environment in the markets in which the Company operates, which can have a direct impact on the value of real estate securing collateral-dependent loans. An inability of certain borrowers to continue to perform under the original terms of their respective loan agreements, in conjunction with declines in real estate collateral values, may result in increases in provisions for loan and lease losses that would, in turn, have an adverse impact on the Company's operating results. See also Note 5. Loans and Allowance for Loan and Lease Losses, of the Consolidated Financial Statements, filed on this Form 10-K, for a more detailed discussion concerning credit quality, including the Company's related policy.

Loans Held for Sale

Loans held for sale primarily consist of residential mortgage originations that have already been specifically designated for sale pursuant to correspondent mortgage loan investor agreements. There is minimal interest rate risk associated with these loans as purchase commitments are entered into with investors at the time the Company funds the loans. Settlement from the correspondents is typically within 30 days of funding the mortgage. At December 31, 2014, loans held for sale totaled $2.6 million compared to $2.4 million at December 31, 2013.

Under the terms of the mortgage purchase agreements, the purchaser has the right to require the Company to either repurchase the mortgage or reimburse losses incurred by the purchaser, which are determined to have been directly caused by borrower fraud, misrepresentation, or defects in underwriting subsequently discovered. Although the Company intends to vigorously challenge these and any future claims, the Company has a reserve of $0.5 million for potential repurchases at December 31, 2014, which is attributed to both outstanding and anticipated claims which are related to borrower fraud and/or claims of defects in underwriting.

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The table below sets forth the composition of the loan portfolio as of December 31, 2014, 2013, 2012, 2011, and 2010:

 
  December 31,  
 
  2014   2013   2012   2011   2010  
 
  Balance
  Percent
  Balance
  Percent
  Balance
  Percent
  Balance
  Percent
  Balance
  Percent
 
 
                     

    (dollars in thousands)  

Real Estate Secured

                                                             

Multi-family residential

  $ 78,645     6.6%   $ 31,140     3.8%   $ 21,467     3.1%   $ 15,915     2.5%   $ 17,637     2.6%  

Residential 1 to 4 family

    127,201     10.7%     88,904     10.7%     41,444     6.0%     20,839     3.2%     21,804     3.2%  

Home equity line of credit

    38,252     3.2%     31,178     3.8%     31,863     4.6%     31,047     4.8%     30,801     4.5%  

Commercial

    588,472     49.2%     432,203     52.1%     372,592     54.1%     357,499     55.4%     348,583     51.6%  

Farmland

    98,373     8.2%     50,414     6.1%     25,642     3.7%     8,155     1.3%     15,136     2.2%  

Land

    20,167     1.7%     24,523     3.0%     24,664     3.6%     26,454     4.1%     30,685     4.5%  

Construction

    24,493     2.1%     13,699     1.7%     19,716     2.9%     22,731     3.5%     43,919     6.5%  

Total real estate secured

    975,603     81.7%     672,061     81.2%     537,388     78.0%     482,640     74.8%     508,565     75.1%  

Commercial

                                                             

Commercial and industrial

    154,787     13.0%     119,121     14.4%     125,340     18.2%     141,065     21.8%     145,811     21.6%  

Agriculture

    55,101     4.6%     32,686     4.0%     21,663     3.1%     15,740     2.4%     15,168     2.2%  

Other

    14     0.0%     38     0.0%     61     0.0%     89     0.0%     153     0.0%  

Total commercial

    209,902     17.6%     151,845     18.4%     147,064     21.3%     156,894     24.2%     161,132     23.8%  

Installment

    7,723     0.7%     3,246     0.4%     4,895     0.7%     6,479     1.0%     7,392     1.1%  

Overdrafts

    255     0.0%     332     0.0%     261     0.0%     273     0.0%     214     0.0%  

Total gross loans

    1,193,483     100.0%     827,484     100.0%     689,608     100.0%     646,286     100.0%     677,303     100.0%  

Deferred loan fees

    (1,445 )         (1,281 )         (937 )         (1,111 )         (1,613 )      

Allowance for loan and lease losses

    (16,802 )         (17,859 )         (18,118 )         (19,314 )         (24,940 )      

Total net loans

  $ 1,175,236         $ 808,344         $ 670,553         $ 625,861         $ 650,750        

Loans held for sale

  $ 2,586         $ 2,386         $ 22,549         $ 21,947         $ 11,008        

Real Estate Secured

Other Real Estate Loans

The following table provides a break-down of the other real estate secured segment of the Company's loan portfolio as of December 31, 2014:

 
  December 31, 2014    
   
   
   
   
 
 
   
  Percent of
Total Risk
Based Capital

   
  Single
Largest
Loan (1)

   
 
 
  Balance
  Undisbursed
Commitment

  Total Bank
Exposure

  Percent
Composition

  Number
of Loans

  Owner
Occupied

 
 
     

    (dollars in thousands)  

Real Estate Secured

                                                 

Retail

  $ 86,607   $   $ 86,607     9.0%     47.9%     82   $ 9,000   $ 29,488  

Professional

    74,404     45     74,449     7.7%     41.2%     103     11,500     19,162  

Hospitality

    132,181     2,278     134,459     13.9%     74.4%     55     10,209     5,837  

Multi-family

    78,645     262     78,907     8.2%     43.7%     59     9,000     10,995  

Home equity lines of credit

    38,252     28,915     67,167     6.9%     37.2%     468     1,200     37,276  

Residential 1 to 4 family

    127,201     1,190     128,391     13.3%     71.1%     287     2,922     89,952  

Farmland

    98,373     3,316     101,689     10.5%     56.3%     66     6,900     65,146  

Healthcare / medical

    34,383         34,383     3.5%     19.0%     38     7,500     18,789  

Restaurants / hospitality

    22,729         22,729     2.3%     12.6%     19     13,713     8,020  

Commercial

    110,971     142     111,113     11.5%     61.5%     131     9,250     38,054  

Other

    127,197     321     127,518     13.2%     70.6%     169     7,480     75,263  

Total

  $ 930,943   $ 36,469   $ 967,412     100.0%     535.5%     1,477   $ 13,713   $ 397,982  
(1)
Amount reported reflects the original loan amount for the single largest loan that remains outstanding as of December 31, 2014.

At December 31, 2014, the other real estate secured segment of the loan portfolio represented approximately $930.9 million, or 78.0%, of total gross loans. When compared to that reported at December 31, 2013, this represents an increase of approximately $297.1 million, or 46.9%, of which $185.7 million can be attributed to loans acquired in the MISN Transaction.

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Table of Contents

At December 31, 2014, a total of $36.5 million of the real estate secured portfolio was risk graded as special mention, substandard or doubtful, with the largest single component being the commercial real estate segment, which represented $27.9 million. At December 31, 2013, other real estate secured balances graded special mention, substandard or doubtful totaled $22.9 million, of which $18.1 million can be attributed to commercial real estate loans. At December 31, 2014, special mention, substandard or doubtful other real estate secured loans acquired in the MISN Transaction totaled $16.6 million, of which $11.9 million were classified as commercial real estate. At December 31, 2014 and December 31, 2013, other real estate secured balances, including undisbursed commitments, represented 536% and 526%, respectively, of the Bank's total risk-based capital. The increase in this percentage not only reflects impacts of the MISN Transaction, but also the increase in real estate lending throughout 2014.

At December 31, 2014, approximately $398.0 million, or 42.8%, of the other real estate secured segment of the loan portfolio was considered owner occupied.

Construction

The following provides a break-down of the Bank's construction portfolio as of December 31, 2014:

 
  December 31, 2014    
   
   
   
 
 
   
  Percent of Total Risk Based Capital
   
  Single Largest Loan (1)
 
 
  Balance
  Undisbursed Commitment
  Total Bank Exposure
  Percent Composition
  Number of Loans
 
 
     

    (dollars in thousands)  

Construction

                                           

Single family residential

  $ 4,185   $ 1,885   $ 6,070     14.7%     3.4%     11   $ 2,250  

Single family residential – Spec. 

    905     967     1,872     4.5%     1.0%     4     1,000  

Tract

    811         811     2.0%     0.4%     2     812  

Multi-family

    701     1,988     2,689     6.5%     1.5%     2     2,500  

Commercial

    14,366     11,919     26,285     63.7%     14.6%     10     8,000  

Hospitality

    3,525     31     3,556     8.6%     2.0%     1     3,484  

Total

  $ 24,493   $ 16,790   $ 41,283     100.0%     22.9%     30   $ 8,000  
(1)
Amount reported reflects the original loan amount for the single largest loan that remains outstanding as of December 31, 2014.

At December 31, 2014, the construction portfolio represented approximately $24.5 million, or 2.1%, of total gross loans, an increase of $10.8 million, or 78.8%, from that reported at December 31, 2013, of which $3.5 million can be attributed to loans acquired in the MISN Transaction. Construction loans are typically granted for a one year period and then refinanced at the completion of the construction project into permanent loans with varying maturities. The ratio of total construction loans, including undisbursed commitments, to risk-based capital increased from 21% at December 31, 2013 to 23% at December 31, 2014. At December 31, 2013 and 2014, there were no construction loans risk graded special mention, substandard or doubtful.

Land

The following table provides a break-down of Company's land portfolio by property type as of December 31, 2014:

 
  December 31, 2014    
   
   
   
 
 
   
  Percent of
Total Risk
Based Capital

   
  Single
Largest
Loan (1)

 
 
  Balance
  Undisbursed
Commitment

  Total Bank
Exposure

  Percent
Composition

  Number
of Loans

 
 
     

    (dollars in thousands)  

Land

                                           

Single family residential

  $ 2,420   $   $ 2,420     10.0%     1.3%     20   $ 340  

Single family residential – Spec. 

    323         323     1.3%     0.2%     3     303  

Tract

    5,400     3,534     8,934     36.8%     4.9%     5     10,673  

Land – Multifamily

    2,887     527     3,414     14.1%     1.9%     3     3,100  

Commercial

    8,999     55     9,054     37.3%     5.0%     22     1,680  

Hospitality

    138         138     0.5%     0.1%     1     560  

Total

  $ 20,167   $ 4,116   $ 24,283     100.0%     13.4%     54   $ 10,673  
(1)
Amount reported reflects the original loan amount for the single largest loan that remains outstanding as of December 31, 2014.

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Table of Contents

At December 31, 2014, the land portfolio represented approximately $20.2 million, or 1.7%, of total gross loans, which represents a decrease of $4.4 million from that reported at December 31, 2013. The ratio of total land loans, including undisbursed commitments, to risk-based capital decreased from 20.0% at December 31, 2013 to 13.4% at December 31, 2014. As of December 31, 2014, a total of $6.9 million of the land portfolio was risk graded special mention, substandard or doubtful. This compares to $9.3 million of the land portfolio being risk graded special mention, substandard or doubtful as of December 31, 2013.

Commercial

Commercial loans, primarily consisting of C&I and agricultural loans, totaled $209.9 million at December 31, 2014. This represents an increase of $58.1 million over that reported at December 31, 2013.

C&I

The following table provides a break-down of the commercial and industrial segment of the commercial loan portfolio as of December 31, 2014:

 
  December 31, 2014    
   
   
   
 
 
   
  Percent of
Total Risk
Based Capital

   
  Single
Largest
Loan (1)

 
 
  Balance
  Undisbursed
Commitment

  Total Bank
Exposure

  Percent
Composition

  Number of
Loans

 
 
     

    (dollars in thousands)  

Commercial and Industrial

                                           

Agriculture

  $ 7,701   $ 2,353   $ 10,054     3.9%     5.6%     39   $ 2,000  

Oil gas and utilities

    2,091     724     2,815     1.1%     1.6%     7     888  

Construction

    13,086     27,321     40,407     15.5%     22.4%     159     5,000  

Manufacturing

    18,233     12,575     30,808     11.8%     17.1%     120     5,000  

Wholesale and retail

    17,385     8,491     25,876     9.9%     14.3%     150     2,500