10-K 1 a11-32061_110k.htm 10-K

Table of Contents

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 


FORM 10-K


 

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

For the fiscal year ended December 31, 2011.

 

or

 

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

For the transition period from _______ to _______.

 

Commission file number:  000-25020

 

GRAPHIC

 

Heritage Oaks Bancorp

(Exact name of registrant as specified in its charter)

 

California

 

77-0388249

(State or other jurisdiction of

 

(I.R.S. Employer

Incorporation or organization)

 

Identification No.)

 

1222 Vine Street,

Paso Robles, California 93446

(Address of principal executive offices, including 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

 

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 [  ]   No [X]

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. 

Yes [  ]   No [X]

 

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

 

Indicate by check mark 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 (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes [X]   No [  ]

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) 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 [  ].

 

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 [  ] Accelerated filer [  ] Non-accelerated filer [  ] Smaller reporting company [X] 

 

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

 

The aggregate market value of the voting and non-voting common equity held by non-affiliates of the Registrant at June 30, 2011 was $65.6 million.  As of February 13, 2012, the Registrant had 25,156,822 shares of Common Stock outstanding.

 

 

 



Table of Contents

 

Documents Incorporated By Reference

 

The information required in Part III, Items 10 through 14 are incorporated by reference to the registrant’s definitive proxy statement for the 2012 annual meeting of shareholders.

 

Heritage Oaks Bancorp

and Subsidiaries

 

Table of Contents

 

 

Page

Part I

 

 

 

 

 

Item 1.

Business

3

Item 1A.

Risk Factors

16

Item 1B.

Unresolved Staff Comments

26

Item 2.

Properties

26

Item 3.

Legal Proceedings

26

Item 4.

Mine Safety Disclosures

27

 

 

 

Part II

 

 

 

 

 

Item 5.

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

27

Item 6.

Selected Financial Data

30

Item 7.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

31

Item 7A.

Quantitative and Qualitative Disclosures About Market Risk

57

Item 8.

Financial Statements and Supplementary Data

60

Item 9.

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

110

Item 9A.

Controls and Procedures

110

Item 9B.

Other Information

111

 

 

 

Part III

 

 

 

 

 

Item 10.

Directors, Executive Officers and Corporate Governance

111

Item 11.

Executive Compensation

111

Item 12.

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

111

Item 13.

Certain Relationships and Related Transactions, and Director Independence

111

Item 14.

Principal Accounting Fees and Services

111

 

 

 

Part IV

 

 

 

 

 

Item 15.

Exhibits, Financial Statement Schedules

112

 

 

 

Signatures

 

113

 

 

 

Exhibit Index

 

114

 

 

 

Certifications

 

131

 

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Part I

 

Certain statements contained in this Annual Report on Form 10-K (“Annual Report”), including, without limitation, statements containing the words “believes”, “anticipates”, “intends”, “expects”, and words of similar impact, constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities and Exchange Act of 1934.  Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievements of the Company to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements.  Such factors include, among others, the following: the ongoing uncertainty about the economic environment both in the United States and in Europe, and the response of the federal and state governments and our regulators thereto, continued migration of classified loans, general economic and business conditions in those areas in which the Company operates, demographic changes, competition, fluctuations in interest rates, changes in business strategy or development plans, changes in governmental regulation, credit quality,  economic, political and global changes arising from the war on terrorism, the Bank’s beliefs as to the adequacy of its existing and anticipated allowance for loan losses, beliefs and expectations about, and requirements to comply with current regulatory enforcement actions taken by regulatory authorities having oversight of the Bank’s operations, financial policies of the United States government and continued weakness in the real estate markets within which we operate, and other factors referenced in this report, including in “Item 1A. Risk Factors.”  The Company disclaims any obligation to update any such factors or to publicly announce the results of any revisions to any of the forward-looking statements contained herein to reflect future events or developments.

 

Item 1.  Business

 

General

 

Heritage Oaks Bancorp (the “Company”, “we” or “our”) is a California corporation organized in 1994 to act as the holding company of Heritage Oaks Bank (the “Bank”).  In 1994, the Company acquired all of the outstanding common stock of the Bank in a holding company formation transaction.

 

In October 2006, the Company formed Heritage Oaks Capital Trust II (the “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 the Company.

 

In September 2007, the Company formed Heritage Oaks Capital Trust III (the “Trust III”).  Trust III was a statutory business trust formed under the laws of the state of Delaware and was a wholly-owned, non-financial, non-consolidated subsidiary of the Company.  In June of 2010, the Company repurchased all of the securities issued by Trust III, and dissolved the trust in December 2010.

 

Other than holding the shares of the Bank, the Company conducts no significant activities, although it is authorized, with the prior approval of the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”), the Company’s principal regulator, to engage in a variety of activities which are deemed closely related to the business of banking. The Company has also incorporated a subsidiary, CCMS Systems, Inc. which is currently inactive and has not been capitalized. The Company has no present plans to capitalize or activate this subsidiary, nor engage in such other permitted activities.  As a legal entity separate and distinct from its subsidiaries, the Company’s principal source of funds is, and will continue to be, dividends paid by and other funds advanced from the Bank and capital raised directly by the Company. 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 Services

 

The Bank was licensed by the California Department of Financial Institutions (“DFI”) and commenced operation in January 1983.  As a California state bank, the Bank is subject to primary supervision, examination and regulation by the DFI 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 thereof.

 

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The Company is headquartered in Paso Robles, California.  As of December 31, 2011, the Company has two branch offices in Paso Robles, San Luis Obispo and Santa Barbara, three branch offices in Santa Maria, and single branch locations in Arroyo Grande, Atascadero, Cambria, Morro Bay and Templeton.  During 2011, the Bank consolidated its San Miguel office into a nearby branch, and in January 2012, the Bank announced plans to consolidate branches located in Morro Bay, Orcutt, and Santa Barbara with other nearby branches in order to improve operating efficiency. The Bank conducts business in the counties of San Luis Obispo and Santa Barbara.  The Bank’s operations not only include branch expansion over the years through organic growth but also through the acquisitions of Hacienda Bank in 2003 and Business First Bank in 2007.  See Item 1. Business – Acquisitions and Dispositions for further discussion of the Company’s acquisition activity.

 

The Bank offers residential mortgage banking services, online banking, wire transfers, safe deposit boxes, issues cashier’s checks and money orders, sells travelers checks, provides bank-by-mail and night depository services and other customary banking services.  The Bank does not offer trust services or international banking services and does not plan to do so in the near future.

 

The Bank’s operating directives since inception have emphasized small business, commercial, and retail banking.  Most of the Bank’s customers are small to medium-sized businesses and retail customers.  The areas in which the Bank has directed virtually all of its lending activities are: commercial loans secured by real estate, commercial loans and lines of credit, consumer loans including residential mortgages, construction financing, and other real estate loans.  The Bank employs a direct sales force focused on the development and origination of new loans across each of the loan types noted. A more detailed discussion of the loan portfolio can be found under Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations and Note 3. Loans, of the consolidated financial statements, filed in this Form 10-K.

 

The Bank’s deposits are obtained primarily through retail deposit gathering efforts including promotional activities and advertising in the local media, as well as through commercial account relationships.  Product offerings include: personal and business checking and savings accounts, time deposit accounts, Individual Retirement Accounts (“IRAs”), and money market accounts.  A more detailed discussion of the Bank’s deposits can be found under Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations of this Form 10-K.

 

The principal sources of the Company’s consolidated revenues are (i) interest and fees on loans, (ii) interest on investments, (iii) service charges on deposit accounts and other charges and fees, (iv) mortgage banking fees and (v) miscellaneous income.

 

The Company has not engaged in any material research activities relating to the development of new services or the improvement of existing bank services, except as otherwise discussed herein.  There has been no significant change in the types of services offered by the Bank since its inception.  The Company has no present plans regarding “a new line of business” requiring the investment of a material amount of total assets.  Most of the Company’s business originates from San Luis Obispo and Santa Barbara Counties and there is no emphasis on foreign sources and application of funds.  The Company’s business, based upon performance to date, does not appear to be seasonal.  The Company does not have any customers that represent more than 10% of the Company’s consolidated revenues, and it operates in a single segment. Additionally, Management is unaware of any material effect upon the Company’s capital expenditures, earnings or competitive position as a result of federal, state or local environmental regulations.

 

The Bank holds service marks issued by the U.S. Patent and Trademark Office for the “Acorn” design, the “Oakley” design, “Deeply Rooted in Your Hometown” and “Heritage Oaks Bank – Expect More.”

 

Acquisition and Dispositions

 

Our strategy is to increase the Company’s earning assets and deposits both through organic growth and, when appropriate, through acquisitions.  Historically, the Company’s acquisitions have focused on expansion and diversification of the markets the Company serves, or strengthening its competitive position in existing markets, as evidenced by the Company’s acquisition of Hacienda Bank in 2003, which expanded the Bank’s position in Northern Santa Barbara County and Business First National Bank (“Business First”) in 2007, which added two branches to the Bank’s network and marked the Company’s entry into Southern Santa Barbara County.  Both of these acquisitions were merged into the Bank.

 

However, due to restrictions placed on the Company by the Consent Order and Written Agreement (as more fully discussed later in this Business Section), the Company has been precluded from undertaking any acquisitions since March of 2010. The Company continues to believe that strategic acquisitions will continue to be an element of its long-term growth potential and at such time as the Consent Order and Written Agreement are lifted, the Company will again begin evaluating acquisition opportunities that are consistent with its strategic growth plans.

 

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Employees

 

As of December 31, 2011, the Bank had 256 full-time equivalent employees.  The Bank’s employees are not represented by any collective bargaining agreement, and the Bank has not experienced a work stoppage. The Bank believes that its employee relations are positive.

 

Local Economic Climate

 

The economy in the Company’s primary market area (San Luis Obispo and Santa Barbara Counties) is based primarily on agriculture, tourism, 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 population of San Luis Obispo County, the City of Santa Maria (in Northern Santa Barbara County), and the City of Santa Barbara totaled approximately 270,000, 100,000, and 88,000 respectively, according to the most recent economic 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.  In addition, cattle ranching represents a major part of the agriculture industry in the Company’s market.  Furthermore, access to numerous recreational activities and destinations including lakes, mountains and beaches provide a relatively stable tourist industry from many areas including the Los Angeles/Orange County basin, the San Francisco Bay area and the San Joaquin Valley.

 

The general business climate in 2008 through 2010 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 the loan portfolio.  The labor market information published by the California Employment Development Department in December 2011 shows the unemployment rate within California to be approximately 10.9%, which is down modestly from its recent highs.  Within the Company’s primary market area, the labor market information also shows the unemployment rate within San Luis Obispo and Santa Barbara major metropolitan areas improving in 2011, as these areas exited 2011 with unemployment levels below 9%.

 

Management remains cautiously optimistic that 2011 has shown what appear to be the early signs that the Company’s primary market, may be beginning to stabilize as compared to the significant downward trends experienced during 2008, 2009 and 2010.  The signs of stabilization are not only reflected in the improving unemployment rates mentioned above, but we are also seeing a general improvement in the financial information being provided by our customers as part of their regular loan reviews.  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 can be no guarantee that the impacts of growing concerns about the global economy may not have trickle down effects on the local economy in which the Company operates. Should global economic conditions worsen and eventually affect our local economy, it could negatively impact the financial condition of borrowers to whom the Company has extended credit.  In this instance, the Company may suffer credit losses and be required to make further significant provisions to the allowance for loan losses.

 

Competition

 

Banking and the financial services industry in California generally, and in the Company’s service area specifically, is highly competitive.  The increasingly competitive environment is a result primarily of changes in regulation, changes in technology and product delivery systems, the accelerating pace of consolidation among financial services providers and the organization of new banking entities.  As it relates to lending opportunities, the other factor that has arisen over the last few years has been increased competition due to a smaller pool of quality lending opportunities as a result of the economic climate experienced since 2008.

 

In order to compete with other financial institutions in its service area, the Bank relies principally upon direct personal contact by officers, directors, employees, local advertising programs, and specialized services.  The Bank emphasizes to customers the advantages of dealing with a locally owned and community oriented institution.  The Bank also seeks to provide special services and programs for individuals in its primary service area who are employed in the agricultural, professional and business fields, such as loans for equipment, tools of trade or expansion of practices or businesses.  Larger banks may have a competitive advantage because of larger marketing campaigns and greater branch distribution.

 

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They also provide services, such as trust services, international banking, discount brokerage and insurance services, which the Bank is not currently authorized or prepared to offer.  To compensate for this, the Bank has made arrangements with correspondent banks and with others to provide such services for its customers.  For borrowers requiring loans in excess of the Bank’s legal lending limits, the Bank offers loans on a participating basis with correspondent banks and with other independent banks and will retain the portion of such loans  that are within its lending limit.

 

The financial services industry is undergoing rapid technological changes involving frequent introductions of new technology-driven products and services that have further increased competition.  There is no assurance that these technological improvements, if made, will increase the Company’s operational efficiency or that the Company will be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to our customers.

 

Effect of Government Policies and Recent Legislation

 

Banking is a business that depends largely on interest rate differentials to generate profits. In general, the difference between the interest rate received by the Company on loans extended to its customers and interest earned on securities held in its investment portfolio and the interest rate paid by the Company on deposits and other borrowings comprise the major portion of the Company’s earnings.  These rates are highly sensitive to many factors that are beyond the control of the Company.  Accordingly, the earnings and growth of the Company are subject to the influence of domestic and foreign economic conditions, including inflation, recession and unemployment.

 

The commercial banking business is not only affected by general economic conditions but is also influenced by the monetary and fiscal policies of the federal government and the policies of regulatory agencies, particularly the Federal Reserve Board, which are often implemented to address the economic conditions being experienced. The Federal Reserve Board implements national monetary policies (with objectives such as curbing inflation, combating recession and providing liquidity) through its open-market operations in U.S. Government securities, by adjusting the required level of reserves for financial institutions subject to its reserve requirements and by varying the 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. Such interest rates also effect the Bank’s pricing on loans and what is paid on deposits.  The nature and impact on the Company from future changes in monetary policies cannot be predicted.

 

From time to time, legislation is enacted which has the effect of increasing the cost of doing business, limiting or expanding permissible activities or affecting the competitive balance between banks and other financial institutions.  Proposals to change the laws and regulations governing the operations and taxation of banks, bank holding companies and other financial institutions are frequently made in Congress, in the California legislature and before various bank regulatory and other professional agencies, as is more fully discussed in Supervision and Regulation, below.

 

 

Supervision and Regulation

 

Regulatory Order and Written Agreement

 

The Bank became subject to a consent order (the “Order”), effective March 4, 2010, with the FDIC, its principal federal banking regulator, and the DFI which requires the Bank to take certain measures to improve its safety and soundness.  The Bank’s stipulation to the issuance by the FDIC and the DFI of the Order resulted from certain findings in a report of examination (“ROE”) resulting from an examination of the Bank conducted in September 2009. In stipulating to the issuance of the Order, the Bank did not concede the findings or admit to any of the assertions in the ROE.

 

On March 4, 2010, the Company entered into a written agreement (the “Written Agreement”) with the Federal Reserve Bank of San Francisco (“FRB”), which requires the Company to take certain measures to improve its safety and soundness. Under the Written Agreement, the Company is required to develop and submit for approval, a plan to maintain sufficient capital at the Company and the Bank within 60 days of the date of the Written Agreement. The Written Agreement further provides, among other things, that the Company shall not: declare or pay dividends without prior approval of the FRB, take dividends from the Bank, make any distribution of interest, principal or other sums on subordinated debt or trust preferred securities, incur, increase, or guarantee any debt.  The Company submitted the required Capital plan within the time required and has not paid any dividends to its stockholders, taken any dividends from the Bank or paid any interest, principal or other sums on its outstanding subordinated debt or trust preferred securities, nor has it incurred, increased or guaranteed any debt since the issuance of the Written Order and Written Agreement.

 

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Under the Order, the Bank is required to take certain measures as more fully discussed below.  The Bank immediately took steps to comply with the Order, the most significant of which was the completion of a capital raise of approximately $60.0 million in March 2010.  The Bank will continue to take all steps necessary to achieve full compliance with the Order.

 

Among the corrective actions required are for the Bank to develop and adopt a plan to maintain the minimum capital requirements for a “well-capitalized” bank, and to reach and maintain a Tier 1 leverage ratio of at least 10% and a Total Risk Based capital ratio of 11.5% at the Bank level beginning 90 days from the issuance of the Order.  As a result of the capital raise in March 2010 and a return to positive operating results in 2011, the Bank was able to exceed these minimum requirements and as of December 31, 2011 the Bank’s leverage ratio and total risk-based capital ratio were 11.85% and 15.77%, respectively and remain in compliance with the Order.  The Bank has been in compliance with this provision of the Order for eight consecutive quarters.

 

In addition, pursuant to the Order, the Bank must retain qualified management, must notify the FDIC and the DFI in writing when it proposes to add any individual to its Board of Directors, employ any new senior executive officer, or increase the duties and responsibilities of a senior executive officer, and must conduct an independent study of management and personnel structure of the Bank.  A consultant was retained to complete the required management study, the results of which were approved by the Board and an action plan to address the findings of such study was implemented during 2010.  The Bank has notified its regulators and received approval for new or changed executive officer roles since the Order’s issuance.

 

Under the Order, the Bank’s Board of Directors was directed to increase its participation in the affairs of the Bank, assuming full responsibility for the approval of sound policies and objectives and for the supervision of all the Bank’s activities.  The Board of Directors took additional steps to reevaluate such oversight and enhance, where appropriate, the frequency, duration, scope and depth of matters covered at its Board meetings in response to the current economic environment and concerns raised in the ROE.

 

In direct response to the ROE, a joint regulatory compliance committee of the Board of Directors was formed at both the Bank and Company levels to oversee the Bank’s and Company’s response to all regulatory matters, including the Order and the Written Agreement. Detailed tracking of the Order’s requirements, and the Bank’s progress in responding thereto, are reviewed and reported at such committee meetings, with regular reports then being provided by the committee to the full Board.  Further, and prior to the issuance of the Order, the Boards of both the Bank and the Company directed Chairman Michael Morris to temporarily increase his direct oversight of Management to ensure an appropriate response at both the Bank and Company to the concerns raised in the ROE. As a result of this increased oversight and the changes to Management, the Bank’s position significantly improved in 2010 and 2011.

 

The Order further required the Bank to increase its Allowance for Loan Losses (“ALLL”), as of the date of the ROE, by $3.5 million and to review and revise its ALLL methodology.  The Bank immediately increased the ALLL as required and revised its policy for determining the adequacy of the ALLL to include an assessment of market conditions and other qualitative factors. The Bank’s policy otherwise continues to provide for a comprehensive determination of the adequacy of its ALLL, which is reviewed at least once each calendar quarter.  The results of this review are reported to senior management and the Board, and any adjustments to the allowance must be recorded in the calendar quarter it is discovered, with an offsetting adjustment to current operating earnings.  Since the third quarter of 2009, the Company has recorded an additional $53.9 million of provisions and ended 2011 with $19.3 million in the ALLL allowance, which represents 2.99% of gross receivables and 156.2% of non-performing loans.

 

With respect to classified assets which existed as of the date of the ROE, the Order also requires the Bank to charge-off or collect all assets classified as “Loss” and one-half of the assets classified as “Doubtful,” and within 180 days of the Order, to reduce its level of assets classified as “Substandard” as of the date of the ROE to no more than the greater of $50.0 million or 50% of Tier 1 capital plus the ALLL.  As of December 31, 2009, the Bank met the requirement to charge-off or collect all assets classified as “Loss” and one-half of the assets classified as “Doubtful” as of the date of the ROE.  The Bank complied with the requirement of the ROE in this regard and reduced the specific group of classified assets identified in the ROE to less than $50 million or 50% of Tier 1 capital plus ALLL well before the 180 day deadline.  As of December 31, 2011, total classified assets remaining from the specific pool identified in the 2009 ROE was $7.7 million or 5.8% of Tier 1 capital plus ALLL.  Although the total level of classified assets as of December 31, 2010 remained elevated, due to the continued migration of loans to classified status during 2010, the Bank was able to reduce the level of classified assets significantly in 2011, through a combination of sales of troubled loans, charge-offs and recoveries, customer work outs and improvements in customer credit quality. Total classified assets at December 31, 2011 were $60.0 million or 44.3% of Tier 1 capital plus ALLL.

 

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The Order requires that the Bank develop or revise, adopt and implement a plan, which must be approved by the FDIC and DFI, to reduce the concentration in Commercial Real Estate loans, particularly focusing on reducing loans for construction and land development.  In addition, the Bank was required to develop a plan for reducing the number of pass graded loans designated as “watch list” credits to an acceptable level, and develop or revise its written lending and collection policies to provide more effective guidance and control over the Bank’s lending function.  The Bank believes it has accomplished all of these requirements.

 

The Order restricts the Bank from taking certain actions without the prior written consent of the FDIC and the DFI, including paying cash dividends, and from extending additional credit to certain types of borrowers. The Bank has not paid dividends to the Company. In addition, the Company has not paid cash dividends on common stock since the first quarter of 2008 nor has it paid cash dividends on Series A Preferred Stock since the Order was issued in March 2010.  In addition, the Bank has put processes and controls in place to ensure extensions of credit, directly or indirectly, are not granted to those who are related to borrowers of loans charged-off or classified as “Loss”, “Substandard” or “Doubtful” and that new loans or advances to borrowers whose loans are classified “Substandard” or “Doubtful” have prior Board approval.  The Bank has also acknowledged that neither the loan committee nor the Board of Directors will approve any extension to a borrower classified “Substandard” or “Doubtful” without first collecting all past due interest in cash.

 

The Order further requires the Bank to develop or revise, adopt and implement a revised liquidity policy that adequately addresses liquidity needs and reduces reliance on non-core funding sources.  The Order also requires the Bank to adopt a contingency funding plan to adequately address contingency funding sources and appropriately reduce contingency funding reliance on off-balance sheet sources and develop an adequate amount of on-balance sheet liquidity for contingency funding purposes.  The Bank has since revised its current liquidity policy and has developed a contingency funding plan.  The Bank’s liquidity ratio has also increased significantly since the Order’s inception.

 

The Order also requires that the Bank prepare and submit a revised business plan, that is to include a comprehensive budget, and a 3 year strategic plan, and to further revise its investment policy.  The Bank has since prepared a comprehensive budget, revised the investment policy and developed a revised business plan and 3 year strategic plan, all of which are reviewed and updated on at least an annual basis.

 

Management believes it has taken the required steps to substantially address the terms of the Order and Written Agreement.  However ultimately, compliance with the Order and Written Agreement will continue to be determined by the issuing regulatory agencies through quarterly monitoring and future examinations. The Bank’s most recent regulatory examination concluded in early 2012 and a final report of examination is still pending.  Therefore, the Company and the Bank cannot confirm compliance with the full scope of the Order or the Written Agreement at this time.

 

The forgoing discussion of the Order and Written Agreement are qualified by reference to the complete text of the Order and Written Agreement, which can be found in the Current Reports on Form 8-K filed with the SEC on March 10, 2010, and March 8, 2010, respectively.  See also Note 22. Regulatory Order and Written Agreement, of the consolidated financial statements, filed in this Form 10-K.

 

General

 

The Company and the Bank are extensively regulated under both federal and state law.  These regulations are intended primarily for the protection of depositors and the deposit insurance fund, and secondarily for the stability of the U.S. banking system. They are not intended for the benefit of shareholders of financial institutions. From time to time, federal and state legislation is enacted which 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.  Set forth below is a summary description of certain laws that relate to the regulation of the Company and the Bank.  The description does not purport to be complete and is qualified in its entirety by reference to the applicable laws and regulations.  The following requirements and limitations are separate and distinct from the Order and Written Agreement, discussed above.

 

The Company

 

The Company is a bank holding company within the meaning of the Bank Holding Company Act of 1956, as amended (the “Bank Holding Company Act”), and is registered as such with, and subject to the supervision of, the Federal Reserve Board.  The Company is required to file quarterly and annual reports with the Federal Reserve Board, and such additional information as the Federal Reserve Board may require pursuant to the Bank Holding Company Act.  The Federal Reserve Board may conduct examinations of bank holding companies and related subsidiaries.

 

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The Company is required to obtain the approval of the Federal Reserve Board before it may acquire all or substantially all of the assets of any bank, or ownership or control of the voting shares of any bank if, after giving effect to such acquisition of shares, the Company would own or control more than 5% of the voting shares of such bank.  Prior approval of the Federal Reserve Board is also required for the merger or consolidation of the Company with another bank holding company.

 

The Company is prohibited by the Bank Holding Company Act, except in certain statutorily prescribed instances, from acquiring direct or indirect ownership or control of more than 5% of the outstanding voting shares of any company that is not a bank or bank holding company and from engaging, directly or indirectly, in activities other than those of banking, managing or controlling banks or furnishing services to its subsidiaries.  However, the Company may, subject to the prior approval of the Federal Reserve Board, engage in any, or acquire shares of companies engaged in, activities that are deemed by the Federal Reserve Board to be so closely related to banking or managing or controlling banks as to be a proper incident thereto.  See discussion under “Financial Modernization Legislation” below for additional information.

 

The Federal Reserve Board may require that the Company terminate an activity or terminate control of or liquidate or divest subsidiaries or affiliates when the Federal Reserve Board determines that the activity or the control or the subsidiary or affiliates constitutes a significant risk to the financial safety, soundness or stability of any of its banking subsidiaries.  The Federal Reserve Board also has the authority to regulate provisions of certain bank holding company debt, including authority to impose interest ceilings and reserve requirements on such debt.  Under certain circumstances, the Company must file written notice and obtain approval from the Federal Reserve Board prior to purchasing or redeeming its equity securities.

 

Under the Federal Reserve Board’s regulations, a bank holding company is required to serve as a source of financial and managerial strength to its subsidiary banks and may not conduct its operations in an unsafe and unsound manner.  In addition, it is the Federal Reserve Board’s policy that in serving as a source of strength to its subsidiary banks, a bank holding company should stand ready to use available resources to provide adequate capital funds to its subsidiary banks during periods of financial stress or adversity and should maintain the financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary banks.  A bank holding company’s failure to meet its obligations to serve as a source of strength to its subsidiary banks will generally be considered by the Federal Reserve Board to be an unsafe and unsound banking practice, or a violation of the Federal Reserve Board’s regulations, or both.  The Dodd-Frank Act (discussed in more detail below) added additional guidance regarding the source of strength doctrine and directed the federal bank regulatory agencies to promulgate new regulations to increase the capital requirements for bank holding companies to a level that matches those of their subsidiary banking institutions.

 

The Company and the Bank are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit, sale or lease of property or furnishing of services.  For example, with certain exceptions, neither  the Company nor the Bank may condition an extension of credit to a customer on either (1) a requirement that the customer obtain additional services provided by us or (2) an agreement by the customer to refrain from obtaining other services from a competitor.

 

The Bank

 

The Bank is chartered under the laws of the State of California and its deposits are insured by the FDIC to the extent provided by law.  The Bank is subject to the supervision of, and is regularly examined by, the DFI and the FDIC. For the Bank, such supervision and regulation includes comprehensive reviews of all major aspects of the Bank’s business and condition.

 

Various requirements and restrictions under the laws of the United States and the State of California affect the operations of the Bank.  Federal and California statutes relate to many aspects of the Bank’s operations, including reserves against deposits, interest rates payable on deposits, loans, investments, mergers and acquisitions, borrowings, dividends and locations of branch offices.  Further, the Bank is required to maintain certain levels of capital.

 

If, as a result of an examination of a bank, the FDIC or the DFI should determine that the financial condition, capital resources, asset quality, earnings prospects, management, liquidity, or other aspects of a bank’s operations are unsatisfactory or that a bank or its respective management is violating or has violated any law or regulation, various remedies are available to these regulatory agencies.

 

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Such remedies include the power to enjoin “unsafe or unsound” practices, to 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, and ultimately to terminate deposit insurance, which for a California chartered bank would result in a revocation of the bank’s charter.

 

Please also refer to the section entitled “Regulatory Order and Written Agreement” discussed earlier in the “Supervision and Regulation” section of Item 1. Business of this Form 10-K.

 

Capital Standards

 

The federal banking agencies have adopted risk-based capital adequacy guidelines intended to provide a measure of capital that reflects the degree of risk associated with a banking organization’s operations for both transactions resulting in asset recognition on the balance sheet, and the extension of credit facilities such as letters of credit and recourse arrangements, which are recorded as off balance sheet items.  Under these guidelines, nominal dollar amounts of assets and credit equivalent amounts of off balance sheet items are multiplied by one of several risk adjustment percentages, which range from 0% for assets with low credit risk, such as certain U.S. Treasury securities, to 100% for assets with relatively high credit risk, such as loans.

 

A banking organization’s risk-based capital ratios are determined by dividing its qualifying capital by its total risk adjusted assets and off balance sheet items.  A banking organization’s or holding company’s capital is generally classified into one of two tiers.  Tier I capital consists primarily of common equity, non-cumulative perpetual preferred stock (cumulative perpetual preferred stock for bank holding companies) and minority interests in certain subsidiaries, less most intangible assets, any disallowed portion of deferred tax assets and certain other limitations.  Tier II capital may consist of a limited amount of the allowance for loan losses, cumulative preferred stock, long term preferred stock, eligible term subordinated debt and certain other instruments with characteristics of equity.  The inclusion of elements of Tier II capital is subject to certain other requirements and limitations of the federal banking agencies.  The federal banking agencies require a minimum ratio of total qualifying capital to risk-adjusted assets of 8%, a minimum ratio of Tier I capital to risk-adjusted assets of 4%, and a minimum amount of Tier I capital to total assets, referred to as the leverage ratio, of 4%. However, the Bank’s Order requires higher levels of capital including a leverage ratio of 10% and a total risk-based capital ratio of 11.5%.

 

Regulatory agencies have the discretion to set individual minimum capital requirements for specific institutions at levels significantly above the minimum guidelines and ratios.  Future changes in regulations or practices could further reduce the amount of capital recognized or increase the minimum amount of capital required for capital adequacy purposes.  Such a change could affect the ability of the Company to grow and could restrict the amount of profits, if any, available for the payment of dividends. In addition, the DFI has authority to take possession of the business and properties of a bank in the event that the tangible shareholders’ equity of a Bank is less than the greater of (i) 3% of the bank’s total assets or (ii) $1,000,000.

 

For additional details see Note 12. Regulatory Matters, of the consolidated financial statements, filed in this Form 10-K.  See also “Capital” within Management’s Discussion and Analysis of Financial Condition and Results of Operations of this Form 10-K.

 

Prompt Corrective Action and Other Enforcement Mechanisms

 

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

 

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Additionally, a holding company’s inability to serve as a source of strength to its subsidiary banking organizations could serve as an additional basis for a regulatory action against the holding company.  Please also refer to the section entitled “Regulatory Order and Written Agreement” discussed earlier in the “Supervision and Regulation” section of Item 1. Business of this Form 10-K.

 

Safety and Soundness Standards

 

The Federal Deposit Insurance Corporation Improvement Act (“FDICIA”) imposes certain specific restrictions on transactions and requires federal banking regulators to adopt overall safety and soundness standards for depository institutions related to internal control, loan underwriting, documentation and asset growth.  Among other things, FDICIA limits the interest rates paid on deposits by undercapitalized institutions, restricts the use of brokered deposits, limits the aggregate extensions of credit by a depository institution to an executive officer, director, principal shareholder or related interest and reduces deposit insurance coverage for deposits offered by undercapitalized institutions for deposits by certain employee benefits accounts.  The federal banking agencies may require an institution to submit to an acceptable compliance plan as well as have the flexibility to pursue other more appropriate or effective courses of action given the specific circumstances and severity of an institution’s noncompliance with one or more standards.

 

Federal Deposit Insurance Reform

 

The FDIC currently maintains the Deposit Insurance Fund (the “DIF”), which was created in 2006 in the merger of the Bank Insurance Fund and the Savings Association Insurance Fund.  The deposit accounts of our subsidiary bank are insured by the DIF to the maximum amount provided by law.  The general insurance limit is $250 thousand, but for non-interest bearing transaction accounts, there is unlimited insurance coverage until January 1, 2013.  This insurance is backed by the full faith and credit of the United States Government.

 

As insurer, the FDIC is authorized to conduct examinations of and to require reporting by DIF-insured institutions.  It also may prohibit any DIF-insured institution from engaging in any activity the FDIC determines by regulation or order to pose a serious threat to the DIF.  The FDIC also has the authority to take enforcement actions against insured institutions.

 

The FDIC assesses deposit insurance premiums on each insured institution quarterly based on annualized rates for one of four risk categories. Under the rules in effect through March 31, 2011, these rates are applied to the institution’s deposits.  Each institution is assigned to one of four risk categories based on its capital, supervisory ratings and other factors.  Well capitalized institutions that are financially sound with only a few minor weaknesses are assigned to Risk Category I.  Risk Categories II, III and IV present progressively greater risks to the DIF.  A range of initial base assessment rates applies to each Risk Category, subject to adjustments based on an institution’s unsecured debt, secured liabilities and brokered deposits, such that the total base assessment rates after adjustments range from 7 to 24 basis points for Risk Category I, 17 to 43 basis points for Risk Category II, 27 to 58 basis points for Risk Category III, and 40 to 77.5 basis points for Risk Category IV.

 

As required by the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), more fully described below, the FDIC has adopted rules effective April 1, 2011, under which insurance premium assessments are based on an institution’s total assets minus its tangible equity (defined as Tier 1 capital) instead of its deposits.  Under these rules, an institution with total assets of less than $10 billion will be assigned to a Risk Category as described above, and a range of initial base assessment rates will apply to each category, subject to adjustment downward based on unsecured debt issued by the institution and, except for an institution in Risk Category I, adjustment upward if the institution’s brokered deposits exceed 10% of its domestic deposits, to produce total base assessment rates.  Total base assessment rates range from 2.5 to 9 basis points for Risk Category I, 9 to 24 basis points for Risk Category II, 18 to 33 basis points for Risk Category III, and 30 to 45 basis points for Risk Category IV, all subject to further adjustment upward if the institution holds more than a de minimis amount of unsecured debt issued by another FDIC-insured institution. The FDIC may increase or decrease its rates by 2.0 basis points without further rulemaking.  In an emergency, the FDIC may also impose a special assessment.

 

For a bank that has had total assets of $10 billion or more for four consecutive quarters, effective for assessments for the second quarter of 2011 and payable at the end of September 2011, FDIC regulations require the bank to be assessed quarterly for deposit insurance under a scorecard method. The scorecard method uses a performance score and a loss severity score, which are combined and converted into an initial base assessment rate.  The performance score is based on measures of the bank’s ability to withstand asset-related stress and funding-related stress and weighted CAMELS ratings. The loss severity score is a measure of potential losses to the FDIC in the event of the bank’s failure. Under a formula, the performance score and loss severity score are combined and converted to a total score that determines the bank’s initial base assessment rate. The FDIC has the discretion to alter the total score based on factors not captured by the scorecard.  The resulting initial base assessment rate is subject to adjustments downward based on long term unsecured debt issued by the bank, to adjustment upward based on long term unsecured debt held by the bank that is issued by other FDIC-insured institutions, and to further adjustment upward if the bank’s brokered deposits exceed 10% of its domestic deposits.  Modifications to the scorecard method may apply to certain “highly complex institutions.”

 

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In addition, all institutions with deposits insured by the FDIC are required to pay assessments to fund interest payments on bonds issued by the Financing Corporation, a mixed-ownership government corporation established to recapitalize a predecessor to the Deposit Insurance Fund.  These assessments will continue until the Financing Corporation bonds mature in 2019.

 

Insurance of deposits may be terminated by the FDIC upon a finding that the institution has engaged or is engaging in unsafe and unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC or written agreement entered into with the FDIC. The management of the Bank does not know of any practice, condition or violation that might lead to termination of deposit insurance.

 

On November 12, 2009, the FDIC adopted regulations that required insured depository institutions to prepay on December 30, 2009, their estimated quarterly risk-based assessments for the fourth quarter of 2009 and all of 2010, 2011 and 2012, along with their quarterly risk-based assessment for the fourth quarter of 2009. Because of its condition at the time, the Bank was not required to pre-pay any assessments.

 

Pursuant to the Dodd-Frank Act, the FDIC has established 2.0% as the designated reserve ratio (DRR), that is, the ratio of the DIF to insured deposits. The FDIC has adopted a plan under which it will meet the statutory minimum DRR of 1.35% by September 30, 2020, the deadline imposed by the Dodd-Frank Act.  The Dodd-Frank Act requires the FDIC to offset the effect on institutions with assets less than $10 billion of the increase in the statutory minimum DRR to 1.35% from the former statutory minimum of 1.15%.  The FDIC has not yet announced how it will implement this offset or how larger institutions will be affected by it.

 

On November 9, 2010 and January 18, 2011, the FDIC (as mandated by Section 343 of the Dodd-Frank Act) adopted rules providing for unlimited deposit insurance for traditional noninterest-bearing transaction accounts and IOLTA accounts for two years starting December 31, 2010.  This coverage applies to all insured deposit institutions, and there is no separate FDIC assessment for the insurance.   Furthermore, this unlimited coverage is separate from, and in addition to, the coverage provided to depositors with respect to other accounts held at an insured depository institution.

 

The Dodd-Frank Wall Street Reform and Consumer Protection Act

 

On July 21, 2010, President Obama signed into law the sweeping financial regulatory reform act entitled the “Dodd-Frank Wall Street Reform and Consumer Protection Act” (the “Dodd-Frank Act”) that implements significant changes to the regulation of the financial services industry, including provisions that, among other things:

 

·                  Centralize responsibility for consumer financial protection by creating a new agency within the Federal Reserve Board, the Bureau of Consumer Financial Protection, with broad rulemaking, supervision and enforcement authority for a wide range of consumer protection laws that would apply to all banks and thrifts. Smaller financial institutions, including the Bank, primarily will be subject to the supervision and enforcement of their primary federal banking regulator with respect to the federal consumer financial protection laws.

 

·                  Apply the same leverage and risk-based capital requirements that apply to insured depository institutions to bank holding companies.

 

·                  Require the FDIC to seek to make its capital requirements for banks countercyclical so that the amount of capital required to be maintained increases in times of economic expansion and decreases in times of economic contraction.

 

·                  Change the assessment base for federal deposit insurance from the amount of insured deposits to consolidated assets less tangible capital.

 

·                  Implement corporate governance revisions, including executive compensation and proxy access by stockholders.

 

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·                  Make permanent the $250,000 limit for federal deposit insurance and increase the cash limit of Securities Investor Protection Corporation protection from $100,000 to $250,000, and provide unlimited federal deposit insurance until January 1, 2013 for non-interest bearing demand transaction accounts at all insured depository institutions.

 

·                  Repeal the federal prohibitions on the payment of interest on demand deposits effective July 21, 2011, thereby permitting depository institutions to pay interest on business transaction and other accounts.

 

Many aspects of the Dodd-Frank Act are subject to rulemaking by various regulatory agencies and will take effect over several years, making it difficult to anticipate the overall financial impact on the Company, its customers or the financial industry more generally. Provisions in the legislation that require revisions to the capital requirements of the Company and the Bank could require the Company and the Bank to seek additional sources of capital in the future.

 

Financial Services Modernization Legislation

 

On November 12, 1999, the Gramm-Leach-Bliley Act of 1999 (the “Financial Services Modernization Act”) was signed into law.  The Financial Services Modernization Act is intended to modernize the banking industry by removing barriers to affiliation among banks, insurance companies, the securities industry and other financial service providers.  It provides financial organizations with the flexibility of structuring such affiliations through a holding company structure or through a financial subsidiary of a bank, subject to certain limitations.  The Financial Services Modernization Act establishes a new type of bank holding company, known as a financial holding company, which may engage in an expanded list of activities that are “financial in nature,” which include securities and insurance brokerage, securities underwriting, insurance underwriting and merchant banking.  The Company has not sought “financial holding company” status and has no present plans to do so.

 

The Financial Services Modernization Act also sets forth a system of functional regulation that makes the Federal Reserve Board the “umbrella supervisor” for holding companies, while providing for the supervision of the holding company’s subsidiaries by other federal and state agencies.

 

In addition, the Bank is subject to other provisions of the Financial Services Modernization Act, including those relating to the Community Reinvestment Act, privacy and safe-guarding confidential customer information, regardless of whether the Company elects to become a financial holding company or to conduct activities through a financial subsidiary of the Bank.  The Company does not, however, currently intend to file notice with the Federal Reserve Board to become a financial holding company or to engage in expanded financial activities through a financial subsidiary of the Bank.

 

Community Reinvestment Act

 

The Bank is subject to certain fair lending requirements and reporting obligations involving home mortgage lending operations and Community Reinvestment Act (“CRA”) activities.  The CRA generally requires the federal banking agencies to evaluate the record of a financial institution in meeting the credit needs of their local communities, including low and moderate income neighborhoods.  In addition to substantial penalties and corrective measures that may be required for a violation of certain fair lending laws, the federal banking agencies may take compliance with such laws and CRA into account when regulating and supervising other activities.  When a bank holding company applies for approval to acquire a bank or another bank holding company, the Federal Reserve Board will review the assessment of each subsidiary bank of the applicant bank holding company and such records may be the basis for denying the application.  A bank’s compliance with its CRA obligations is based on a performance-based evaluation system which bases CRA ratings on an institution’s lending service and investment performance, resulting in a rating by the appropriate bank regulatory agency of “outstanding,” “satisfactory,” “needs to improve” or “substantial noncompliance.”  In its last reported examination by the FDIC in 2008, the Bank received a CRA rating of “Satisfactory.”  The Bank was examined for CRA compliance in November, 2011, but has not received a final rating at this time.

 

Privacy

 

Federal banking rules limit the ability of banks and other financial institutions to disclose non-public information about consumers to nonaffiliated third parties.  Pursuant to these rules, financial institutions must provide initial notices to customers about privacy policies that describe the conditions under which the institutions may disclose non-public information to nonaffiliated third parties and affiliates. In addition, financial institutions must provide annual privacy policy notices to current customers and a reasonable method for customers to “opt out” of disclosures to nonaffiliated third parties.

 

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These privacy provisions affect how consumer information is transmitted through diversified financial companies and conveyed to outside vendors.  We have implemented our privacy policies in accordance with the law.  In recent years, a number of states have implemented their own versions of privacy laws.  For example, in 2003, California adopted standards that are more restrictive than federal law, allowing bank customers the opportunity to bar financial companies from sharing information with affiliates.

 

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

 

USA Patriot Act of 2001

 

On October 26, 2001, The Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism, or the Patriot Act, of 2001 was signed into law. Among other things, the Patriot Act (i) prohibits banks from providing correspondent accounts directly to foreign shell banks; (ii) imposes due diligence requirements on banks opening or holding accounts for foreign financial institutions or wealthy foreign individuals; (iii) requires financial institutions to establish an anti-money-laundering compliance program; and (iv) eliminates civil liability for persons who file suspicious activity reports.

 

The Patriot Act also increases governmental powers to investigate terrorism, including expanded government access to account records and to make rules to implement the Patriot Act.  On March 9, 2006, the USA Patriot Improvement and Reauthorization Act was signed into law which extended and modified the original act.  While we believe the Patriot Act, as amended and reauthorized, may, to some degree, affect our operations, we do not believe that it will have a material adverse effect on our business and operations.

 

Transactions between Affiliates

 

Transactions between a bank and its “affiliates” are quantitatively and qualitatively restricted under the Federal Reserve Act.  The Federal Reserve Board issued Regulation W on October 31, 2002 which comprehensively implements Sections 23A and 23B of the Federal Reserve Act.  Sections 23A and 23B and Regulation W restrict loans by a depository institution to its affiliates, asset purchases by a depository institution from its affiliates and other transactions between a depository institution and its affiliates.  Regulation W unifies in one public document the Federal Reserve Board’s interpretations of Section 23A and 23B.  Regulation W had an effective date of April 1, 2003.  As the sole active subsidiary of the Company, the Bank’s only affiliate transaction relationship under the auspices of the Federal Reserve Act is its relationship with the Company.

 

Predatory Lending

 

The term “predatory lending,” much like the terms “safety and soundness” and “unfair and deceptive practices,” is far-reaching and covers a potentially broad range of behavior.  As such, it does not lend itself to a concise or a comprehensive definition.  But typically predatory lending involves at least one, and perhaps all three, of the following elements: making unaffordable loans based on the assets of the borrower rather than on the borrower’s ability to repay an obligation, or asset-based lending; inducing a borrower to refinance a loan repeatedly in order to charge high points and fees each time the loan is refinanced, or loan flipping; and engaging in fraud or deception to conceal the true nature of the loan obligation from an unsuspecting or unsophisticated borrower.

 

Federal Reserve Board regulations aimed at curbing such lending significantly widened the pool of high-cost home-secured loans covered by the Home Ownership and Equity Protection Act of 1994, a federal law that requires extra disclosures and consumer protections to borrowers.

 

The following loan transaction characteristics trigger coverage under the Home Ownership and Equity Protection Act of 1994: interest rates for first lien mortgage loans in excess of 8 percentage points above comparable Treasury securities; subordinate-lien loans of 10 percentage points above Treasury securities; and fees such as optional insurance and similar debt protection costs paid in connection with the credit transaction, when combined with points and fees if deemed excessive.

 

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In addition, the regulation bars loan flipping by the same lender or loan servicer within a year.  Lenders also will be presumed to have violated the law which says loans shouldn’t be made to people unable to repay them, unless they document that the borrower has the ability to repay.  Lenders that violate the rules face cancellation of loans and penalties equal to the finance charges paid.  The Company does not expect these rules and potential state action in this area to have a material impact on our financial condition or results of operations.

 

Bank Secrecy Act and Money Laundering Control Act

 

In 1970, Congress passed the Currency and Foreign Transactions Reporting Act, otherwise known as the Bank Secrecy Act (the “BSA”), which established requirements for recordkeeping and reporting by banks and other financial institutions.  The BSA was designed to help identify the source, volume and movement of currency and other monetary instruments into and out of the United States in order to help detect and prevent money laundering connected with drug trafficking, terrorism and other criminal activities.  The primary tool used to implement BSA requirements is the filing of Suspicious Activity Reports.  Today, the BSA requires that all banking institutions develop and provide for the continued administration of a program reasonably designed to assure and monitor compliance with certain recordkeeping and reporting requirements regarding both domestic and international currency transactions.  These programs must, at a minimum, provide for a system of internal controls to assure ongoing compliance, provide for independent testing of such systems and compliance, designate individuals responsible for such compliance and provide appropriate personnel training.

 

 

Government Actions in Response to the Financial Crises

 

Emergency Economic Stabilization Act

 

In response to the financial crisis affecting the banking system and financial markets in recent years, the Emergency Economic Stabilization Act (“EESA”) was signed into law on October 3, 2008 and established the Troubled Asset Relief Program (“TARP”). As part of TARP, the United States Department of the Treasury (“Treasury”) established the Capital Purchase Program (“CPP”) to provide up to $700 billion of funding to eligible financial institutions through the purchase of capital stock and other financial instruments for the purpose of stabilizing and providing liquidity to the U.S. financial markets. In connection with EESA, there have been numerous actions by the FRB, Congress and the Treasury, the FDIC, the SEC and others to further the economic and banking industry stabilization efforts under EESA. It remains unclear at this time what further legislative and regulatory measures will be implemented under EESA affecting the Company.

 

The Company participated in the CPP 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, in exchange for $21.0 million.  For further details on the Company’s participation in the CPP, please see Note 21. Preferred Stock, of the consolidated financial statements filed in this Form 10-K.  Because of the Company’s participation in the CPP, it is subject to certain limitations on executive compensation and the payment of dividends.

 

American Recovery and Reinvestment Act of 2009

 

On February 17, 2009, the American Recovery and Reinvestment Act of 2009 (“ARRA”) was signed into law.  ARRA is intended to provide tax breaks for individuals and businesses, direct aid to distressed states and individuals and provide infrastructure spending.  In addition, ARRA imposes new executive compensation and expenditure limits on all previous and future TARP recipients and expands the class of employees to whom the limits and restrictions apply.  ARRA also provides the opportunity for additional repayment flexibility for existing TARP recipients.  Among other things, ARRA prohibits the payment of bonuses, other incentive compensation and severance to certain highly paid employees (except in the form of restricted stock subject to specified limitations and conditions) and requires each TARP recipient to comply with certain other executive compensation related requirements.  These provisions modify the executive compensation provisions that were included in EESA and, in most instances, apply retroactively for so long as any obligation arising from financial assistance provided to the recipient under TARP remains outstanding.

 

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In addition, ARRA directs the Treasury to review previously-paid bonuses, retention awards and other compensation paid to the senior executive officers and certain other highly-compensated employees of each TARP recipient to determine whether any such payments were excessive, inconsistent with the purposes of ARRA or the TARP, or otherwise contrary to the public interest. If the Treasury determines that any such payments have been made by a TARP recipient, the Treasury will seek to negotiate with the TARP recipient and the subject employee for appropriate reimbursements to the U.S. government (not the TARP recipient) with respect to any such compensation or bonuses. ARRA also permits the Treasury, subject to consultation with the appropriate federal banking agency, to allow a TARP recipient to repay any assistance previously provided to such TARP recipient under the TARP, without regard to whether the TARP recipient has replaced such funds from any source, and without regard to any waiting period. Any TARP recipient that repays its TARP assistance pursuant to this provision would no longer be subject to the executive compensation provisions under ARRA.

 

Future Legislation and Regulatory Initiatives

 

Various other legislative and regulatory initiatives, including proposals to overhaul the banking regulatory system are from time to time introduced in Congress and state legislatures, as well as regulatory agencies. Future legislation regarding financial institutions may change banking statutes, the operating environment of the Company and the Bank in substantial and unpredictable ways and could increase or decrease the cost of doing business, limit or expand permissible activities or affect the competitive balance depending upon whether any of this potential legislation will be enacted. If enacted, the effect of implementing regulations could impact positively or negatively, the financial condition or results of operations of the Company and/or the Bank. The nature and extent of future legislative and regulatory changes affecting financial institutions is unpredictable at this time. The Company cannot determine the ultimate effect that such potential legislation, if enacted, would have upon its financial condition or operations.

 

Where You Can Find More Information

 

Under the Securities Exchange Act of 1934 Sections 13 and 15(d), periodic and current reports must be filed with the SEC. The Company electronically files the following reports with the SEC: Form 10-K (Annual Report), Form 10-Q (Quarterly Report), Form 8-K (Current Report), insider ownership reports and Form DEF 14A (Proxy Statement).  The Company may file additional forms. The SEC maintains an Internet site, www.sec.gov, in which all forms filed electronically may be accessed. Additionally, all forms filed with 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.  None of the information on or hyperlinked from the Company’s website is incorporated into this Annual Report on Form 10-K.

 

The Company also posts its Committee Charters, Code of Ethics, Code of Conduct and Corporate Governance Guidelines on the Company website.

 

 

Item 1A.  Risk Factors

 

An investment in our common stock is subject to risks inherent to our business.  The material risks and uncertainties that Management believes may affect our business are described below.  Before making an investment decision, you should carefully consider the risks and uncertainties described below together with all of the other information included or incorporated by reference in this Annual Report on Form 10-K.  The risks and uncertainties described below are not the only ones facing our business.  Additional risks and uncertainties that Management is not aware of or that Management currently deems immaterial may also impair our business operations.  This Annual Report is qualified in its entirety by these risk factors.

 

If any of the following risks actually occur, our financial condition and results of operations could be materially and adversely affected.  If this were to happen, the value of our common stock could decline significantly, and you could lose all or part of your investment.

 

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Risks Associated With Our Business

 

Our Banking subsidiary is operating under a Consent Order with the FDIC and DFI and the Company is operating under a Written Agreement with the Federal Reserve Bank of San Francisco to address, among other things, lending, credit and capital related issues.

 

In light of the challenging operating environment, along with our elevated level of non-performing assets, delinquencies and adversely classified assets, we are subject to increased regulatory scrutiny and additional regulatory restrictions and became subject to certain enforcement actions under a Consent Order issued by the FDIC and DFI to the Bank on March 4, 2010 and Written Agreement with the Federal Reserve Board entered into on March 4, 2010.  These enforcement actions followed the FDIC’s regularly scheduled examination of our banking subsidiary during the fourth quarter of 2009 and are based on discussions the Bank had with its examiners following the examination.  Such enforcement actions place limitations on our business and may adversely affect our ability to implement our business plans.  These enforcement actions require, among other things, the Bank to take certain steps to strengthen its balance sheet, such as reducing the level of classified assets, increasing capital levels and addressing other criticisms of the examination.  These enforcement actions are more fully discussed in “Supervision and Regulation – Regulatory Order and Written Agreement” and Note 22. Regulatory Order and Written Agreement, of the consolidated financial statements, filed in this Form 10-K. If the Company fails to comply with these enforcement actions, it may become subject to further regulatory enforcement actions up to and including the appointment of a conservator or receiver for the Bank.

 

The regulatory agencies have the authority to restrict our operations to those consistent with adequately capitalized institutions.  For example, the regulatory agencies have imposed restrictions that place limitations on our lending activities and our ability to complete acquisitions.  The regulatory agencies also have the power to limit the rates paid by the Bank to attract retail deposits in its local markets.

 

Although We Have Been Able to Reduce the Overall Level of Classified Assets, the Level Still Remains Elevated as Compared to Our Long-term Experience and Exposes Us to Increased Lending Risk. Further, if Our Allowance for Loan Losses is Insufficient to Absorb Losses in Our Loan Portfolio, Our Earnings May Decline

 

If the level of loans the Bank currently categorizes as substandard and doubtful do not perform according to their terms and/or the underlying collateral for such loans is insufficient to cover the Bank’s recorded investment, the allowance for loan losses may not be sufficient to absorb potential losses.  This could result in additional loan losses which may adversely impact our operating results.  Further, although we have made strides in resolving the level of classified assets in the last year, our level of remaining classified assets will still take time to resolve.  While we believe that we are making progress in identifying and resolving classified assets, no assurance can be given that we will continue to make progress, particularly if the local economies in which we operate suffer further deterioration.

 

We believe that the Company’s allowance for loan losses is maintained at a level adequate to absorb probable, estimable losses inherent in our loan portfolio as of the corresponding balance sheet date.  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. If our assumptions are incorrect, our allowance for loan losses may be insufficient to cover losses inherent in our loan portfolio, resulting in additions to our allowance. 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 adverse effect on our financial condition and results of operations.

 

We Are Highly Dependent On Real Estate and Any Further Downturn in the Real Estate Market May Hurt Our Business

 

A significant portion of our loan portfolio is collateralized by real estate.  Although we have seen, what we believe are the early 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, 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 adversely impact our financial condition and results of operations and the market value of our common stock.

 

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 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 negatively impact our financial condition.

 

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We Have a Concentration in Higher Risk Commercial Real Estate Loans

 

We have a high concentration in commercial real estate (“CRE”) loans. CRE loans, as defined by final guidance issued by Bank regulators, 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 55.4% of our lending portfolio can be classified as CRE lending as of December 31, 2011.  CRE loans generally involve a higher degree of credit risk than certain other types of lending due, among other things, to the generally large amounts loaned to individual borrowers.  Losses incurred on loans to a small number of borrowers could have a material 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.

 

Additionally, federal banking regulators recently issued final guidance regarding commercial real estate lending.  This guidance suggests that institutions that are potentially exposed to significant commercial real estate concentration risk will be subject to increased regulatory scrutiny.  Institutions that have experienced rapid growth in commercial real estate lending, have notable exposure to a specific type of commercial real estate lending or are approaching or exceed certain supervisory criteria that measure an institution’s commercial real estate portfolio against its capital levels, may be subject to increased regulatory scrutiny.  We are subject to increased regulatory scrutiny because of our commercial real estate portfolio and, as a result, the Bank developed and implemented a plan to systematically reduce the amount of loans within this category as required in the Consent Order issued to the Bank on March 4, 2010.

 

Liquidity Risk Could Impair Our Ability to Fund Operations and Jeopardize 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 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.  Our ability to acquire deposits or borrow could also be impaired by factors that are not specific to us, such as a severe disruption of the financial markets or negative views and expectations about the prospects for the financial services industry in general.

 

We Depend on Cash Dividends from Our Subsidiary Bank to Meet Our Cash Obligations, but Our Consent Order and Written Agreement Prohibit the Payment of Such Dividends without Prior Regulatory Approval Which May Impair Our Ability to Fulfill Our 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, our preferred stock and other obligations, including any cash dividends. Various statutory provisions restrict the amount of dividends our subsidiary bank can pay to us without regulatory approval.  As outlined in the Consent Order and Written Agreement, previously mentioned, the Bank cannot pay any cash dividends or other payments to the holding company without prior written consent of the regulatory authorities.  Additionally, the Company cannot declare or pay any dividends (including those on outstanding preferred stock issued to the U.S. Treasury under the TARP Capital Purchase Program) or make any distributions of principal, interest or other sums on its trust preferred securities without prior written approval of the Federal Reserve.  If we defer six dividend payments, the U.S. Treasury will have the right to appoint two directors to our Board. As of December 31, 2011, we had deferred 7 payments.  The Treasury has assigned an observer to our Board of Directors, but to date we have not been notified of their intent to appoint directors to our Board.

 

The Recent Recession and Changes in Domestic and Foreign Financial Markets Have Adversely Affected Our Industry and May Have a Material Impact on Our Operating Results and Financial Condition

 

The recent recession has resulted in significant business failures and job losses. Further, dramatic declines in the housing market with decreasing home prices and increasing delinquencies and foreclosures, have negatively impacted the credit performance of mortgage and construction loans and resulted in significant losses to many financial institutions. Concerns over the stability of the financial markets and the economy have resulted in decreased lending by financial institutions to customers and to each other.  This market turmoil and tightening of credit has led to increased commercial and consumer delinquencies, lack of customer confidence, increased market volatility and widespread reduction in general business activity.  The resulting economic pressure on consumers and businesses and volatility in the financial markets may adversely affect our business, financial condition, results of operations and stock price.  Although we believe we have seen the early signs of stabilization in these conditions in our local market, these challenging conditions may not improve or may again begin to deteriorate in the near future and we may face the following risks as a result:

 

·                  Increased regulation of our industry, compliance with which may increase our costs and limit our ability to pursue business opportunities.

 

·                  The process we use to estimate losses inherent in our credit exposure requires difficult, subjective and complex judgments, including forecasts of economic conditions and how these economic conditions might impair the ability of our borrowers to repay loans.  The level of uncertainty concerning economic conditions may adversely affect the accuracy of our estimates which may, in turn, impact the reliability of the process.

 

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·                  The value of the portfolio of investment securities that we hold may be adversely affected.

 

·                  Higher FDIC premiums because market developments have significantly depleted the insurance fund of the FDIC and reduced the ratio of reserves to insured deposits.

 

If current levels of market disruption and volatility continue or worsen, there can be no assurance that we will not experience an adverse effect, which may be material, to our business, financial condition and results of operations.

 

We Cannot Accurately Predict the Effect of the Current Economic Downturn on Our Future Results of Operations or Market Price of Our Stock

 

The national economy and the financial services sector in particular remain challenged with weakness in the broader economy despite high levels of government stimulus. We cannot accurately predict the severity or duration of the current economic downturn, which has adversely impacted the markets we serve. Any further deterioration in the economies of the nation as a whole or in our markets would have an adverse effect which could be material on our business, financial condition, results of operations, prospects and could also cause the market price of our stock to decline.

 

Financial Reform Legislation Will, among Other Things, Tighten Capital Standards, Create A New Consumer Financial Protection Bureau and Result in New Regulations that Are Expected to Increase Our Costs of Operations.

 

On July 21, 2010, President Obama signed the Dodd-Frank Act into law.  This law significantly changes the current bank regulatory structure and affects the lending, deposit, investment, trading and operating activities of financial institutions and their holding companies. The Dodd-Frank Act requires various federal agencies to adopt a broad range of new implementing rules and regulations, and to prepare numerous studies and reports for Congress. The federal agencies are given significant discretion in drafting the implementing rules and regulations, and consequently, many of the details and much of the impact of the Dodd-Frank Act may not be known for many months or years.

 

Among the many requirements in the Dodd-Frank Act for new banking regulations is a requirement for new capital regulations to be adopted within 18 months.  These regulations must be at least as stringent as, and may call for higher levels of capital than, current regulations.  Generally, trust preferred securities will no longer be eligible as Tier 1 capital, but the Company’s currently outstanding trust preferred securities will be grandfathered and its currently outstanding TARP preferred securities will continue to qualify as Tier 1 capital.  In addition, the FDIC, along with other federal bank regulators, is required to seek to make its capital requirements for the banks it regulates, such as the Bank, countercyclical so that capital requirements increase in times of economic expansion and decrease in times of economic contraction.

 

Certain provisions of the Dodd-Frank Act are expected to have a near term impact on us.  For example, one year after the date of its enactment, the Dodd-Frank Act eliminated the federal prohibitions on paying interest on demand deposits, thus allowing businesses to have interest bearing checking accounts. Depending on competitive responses, this significant change to existing law could have an adverse impact on our interest expense.

 

The Dodd-Frank Act also broadened the base for FDIC insurance assessments. Assessments are now based on the average consolidated total assets less tangible equity capital of a financial institution and are generally expected to increase for institutions having total assets in excess of $10 billion. The Dodd-Frank Act also permanently increased the maximum amount of deposit insurance for banks, savings institutions and credit unions to $250,000 per depositor, retroactive to January 1, 2008, and non-interest bearing transaction accounts and IOLTA accounts have unlimited deposit insurance through December 31, 2013.

 

In addition, the Dodd-Frank Act increased the authority of the Federal Reserve Board to examine the Company and its non-bank subsidiaries and gave the Federal Reserve Board the authority to establish rules regarding interchange fees charged for an electronic debit transaction by a payment card issuer that, together with its affiliates, has assets of $10 billion or more, and to enforce a new statutory requirement that such fees be reasonable and proportional to the actual cost of a transaction to the issuer.  By regulation, the Federal Reserve Board has limited the fees for such a transaction to the sum of 21 cents plus five basis points times the value of the transaction, plus up to one cent for fraud prevention costs.  While this rule does not apply to us directly because our asset size is less than $10 billion, such limits place practical limitations in the financial services marketplace on such fees.  The Dodd-Frank Act also restricts proprietary trading by banks, bank holding companies and others, and their acquisition and retention of ownership interests in and sponsorship of hedge funds and private equity funds, subject to an exception allowing a bank to organize and offer hedge funds and private equity funds to customers if certain conditions are met, including, among others, a requirement that the bank limit its ownership interest in any single fund to 3% and its aggregate investment in all funds to 3% of Tier 1 capital, with no director or employee of the bank holding an ownership interest in the fund unless he or she provides services directly to the funds.

 

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The Dodd-Frank Act created a Bureau of Consumer Financial Protection (the “CFPB”) with broad powers to supervise and enforce consumer protection laws. The Bureau has broad rule-making authority for a wide range of consumer protection laws that apply to all banks, including the authority to prohibit “unfair, deceptive or abusive” acts and practices. The Bureau has examination and enforcement authority over all banks with more than $10 billion in assets.  The CFPB is beginning to issue rules and regulations, among them examination procedures for mortgage loan originators.  It is not yet known the extent to which the regulatory activities of the CFPB will impact our results of operations and financial condition.

 

Many aspects of the Dodd-Frank Act are subject to rulemaking and will take effect over several years, making it difficult to anticipate the overall financial impact on the Company.  However, compliance with this law and its implementing regulations has resulted, and will continue to result, in additional operating costs that could have a material adverse effect on our future financial condition and results of operations.  For additional discussion of the Dodd-Frank Act, see “Item 1. Business—Supervision and Regulation-The Dodd-Frank Wall Street Reform and Consumer Protection Act.”

 

The Downgrade of the U.S. Credit Rrating and Europe’s Debt Crisis Could Have a Material Adverse Effect on Our Business, Financial Condition and Liquidity.

 

Standard & Poor’s lowered its long term sovereign credit rating on the United States of America from AAA to AA+ on August 5, 2011. A further downgrade or a downgrade by other rating agencies could have a material adverse impact on financial markets and economic conditions in the United States and worldwide. Any such adverse impact could have a material adverse effect on our liquidity, financial condition and results of operations. Many of our investment securities are issued by U.S. government agencies and U.S. government sponsored entities.

 

In addition, the possibility that certain European Union (“EU”) member states will default on their debt obligations have negatively impacted economic conditions and global markets. The continued uncertainty over the outcome of international and the EU’s financial support programs and the possibility that other EU member states may experience similar financial troubles could further disrupt global markets. The negative impact on economic conditions and global markets could also have a material adverse effect on our liquidity, financial condition and results of operations.

 

FDIC Deposit Insurance Assessments May Increase Substantially Which Would Adversely Affect Our Net Earnings

 

Although changes to the FDIC deposit insurance assessment base rate calculation reduced the level of insurance paid in 2011 to $2.5 million from the $2.7 million paid in 2010.  These levels still remain elevated due to the existence of the Regulatory Order and Written Agreement. Although the Company currently expects the level of deposit insurance premiums to decline over 2012, they remain elevated as compared to pre-recession levels, which will impact future operating results.

 

Declines in the Value of Our Investment Portfolio Securities May Result in Impairment Charges and May Adversely Affect Our Financial Performance and Capital

 

We maintain an investment portfolio that includes, but is not limited to, mortgage-backed securities, municipal securities and corporate bonds. Although we have seen an improvement in the overall market value of our investment portfolio in 2011, 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.  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 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.  For a more detailed discussion of investments the Company holds, including other than temporary impairment recognized during 2010, please see Note 2. Investments, of the consolidated financial statements, filed in this Form 10-K.

 

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Our Business Is Subject To Interest Rate Risk and Changes in Interest Rates May Adversely Affect Our Performance and Financial Condition

 

Our earnings and cash flows are highly dependent upon net interest income.  Net interest income is the difference between interest income earned on interest-earning assets such as loans and securities and interest expense paid on interest-bearing liabilities such as deposits and borrowed funds.  Our net interest income (including net interest spread and margin) and overall earnings are impacted by changes in interest rates and monetary policy.  Changes in interest rates and monetary policy can impact the demand for new loans, the credit profile of our borrowers, the yields earned on loans and securities and rates paid on deposits and borrowings.

 

Management employs the use of an Asset and Liability Management software that is used to measure the Company’s exposure to future changes in interest rates. This model measures the expected cash flows and re-pricing of each financial asset/liability separately in measuring the Company’s interest rate sensitivity.  Based on the results of this model, Management believes the Company’s balance sheet is slightly “liability sensitive.”  This means that until such time as a substantial portion of the Company’s variable rate loan portfolio returns to rates above their floor levels, the Company would expect (all other things being equal) to experience a contraction in its net interest income if rates rise and conversely to experience expansion in net interest income, if rates fall. Although we believe our current level of interest rate sensitivity is reasonable, significant fluctuations in interest rates (such as a sudden and substantial increase in Prime and Overnight Fed Funds rates) as well as increasing competition may require the Bank to increase rates on deposits at a faster pace than the increase in the rate it earns on interest-earning assets.  The impact of any sudden and substantial move in interest rates and/or increased competition may have an adverse effect on our business, financial condition and results of operations, as the Bank’s net interest income (including the net interest spread and margin) may be negatively impacted.

 

Additionally, a sustained decrease in market interest rates could adversely affect our earnings.  When interest rates decline, borrowers tend to prepay existing higher-rate, fixed-rate loans by refinancing to lower interest rates loan.   Under those circumstances, we may not be able to reinvest those prepayments in assets earning interest rates as high as the rates on the prepaid loans.

 

Failure to Successfully Execute Our Strategy May Adversely Affect Our Performance

 

Our financial performance and profitability depends on our ability to execute our corporate growth strategy.  Continued growth, however, may present operating and other problems that could adversely affect our business, financial condition and results of operations.  Accordingly, there can be no assurance that we will be able to execute our growth strategy or maintain the level of profitability that we have recently experienced.

 

Factors that may adversely affect our ability to attain our long-term financial performance goals include those stated elsewhere in this section, as well as: inability to control non-interest expense, including, but not limited to, rising employee compensation costs, regulatory compliance, healthcare cost, limitations imposed on us in the Consent Order and/or Written Agreement, inability to increase non-interest income and continuing ability to expand, through de novo branching or identifying acquisition targets at attractive valuation levels.

 

We Face Strong Competition from Financial Service and Other Companies That Offer Banking Service Which May Adversely Impact Our Business

 

The financial services business in our market areas 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, decrease loan demand, cause the prices we charge for our services to fall, result 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 that historically have involved banks through alternative methods.  For example, consumers can now maintain funds that 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.

 

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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.

 

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 services of one or more of our key personnel could have a material adverse impact on our business because of their skills, knowledge of our market, years of industry experience and the difficulty of promptly finding qualified replacement personnel.

 

Because of Our Participation in the Troubled Asset Relief Program (‘‘TARP’’), We Are Subject to Several Restrictions, Including Restrictions on Compensation Paid to Our Executives

 

Certain standards for executive compensation and corporate governance apply to us for the period during which the U.S. Treasury holds an equity position in us. These standards generally apply to our Chief Executive Officer, Chief Financial Officer and the three next most highly compensated senior executive officers. The standards include, among other things, (1) ensuring that incentive compensation for senior executives does not encourage unnecessary and excessive risks that threaten the value of the financial institution; (2) required claw back of any bonus or incentive compensation paid to a senior executive based on statements of earnings, gains or other criteria that are later proven to be materially inaccurate; (3) prohibition on making golden parachute payments to senior executives; and (4) agreement not to deduct for tax purposes, executive compensation in excess of $500,000 for each senior executive. In particular, the change to the deductibility limit on executive compensation may increase the overall cost of our compensation programs in future periods. Pursuant to the ARRA, more commonly known as the economic stimulus recovery package, further compensation restrictions, including significant limitations on incentive compensation, have been imposed on our senior executive officers and most highly compensated employees. Such restrictions and any future restrictions on executive compensation, which may be adopted, could adversely affect our ability to hire and retain qualified senior executive officers.

 

Our Internal Operations Are Subject to a Number of Risks

 

We are subject to certain operations 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, uninsured or in excess of applicable insurance limits, it could have a significant adverse impact on our business, financial condition or results of operations.

 

·                  Information Systems

 

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.  While we have policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of our information systems, there can be no assurance that any such failures, interruptions or security breaches will not occur or, if they do occur, that they will be adequately addressed.  The occurrence of any failures, interruptions or security breaches of our information systems could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our financial condition and results of operations.

 

·                  Technological Advances

 

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.

 

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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 adverse impact on our business and, in turn, our financial condition and results of operations.

 

·                  Severe Weather, Natural Disasters, Acts of War or Terrorism and Other External Events

 

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.  For example, the Central Coast of California is subject to earthquakes and fires.  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.  While we have not experienced such an occurrence to date, other severe weather or natural disasters, acts of war or terrorism or other adverse external events may occur in the future.  Although management has established disaster recovery policies and procedures, the occurrence of any such event could have a material adverse effect on our business, which, in turn, could have a material adverse effect on our financial condition and results of operations.

 

·                  Reliance on Third Party Service Providers for Key Systems

 

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 an adverse impact on the Company and its customers. Further, if the Company was required to switch service providers due to deterioration in service quality or other factors, there is no guarantee that it could obtain comparable services for a comparable price.

 

We are a Community Bank and our Ability to Maintain our Reputation is Critical to the Success of our Business and the Failure to Do So May Materially 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.  This is done, in part, by recruiting, hiring and retaining employees who share our core values of being an integral part of the communities we serve, delivering superior service to our customers and caring about our customers and associates.  If our reputation is negatively affected by the actions of our employees, or otherwise, our business and, therefore, our operating results may be materially adversely affected.

 

We Are Subject to Government Regulation That May Limit or Restrict Our Activities Which May Adversely Impact Our Operations

 

The financial services industry is regulated extensively.  Federal and state regulation is designed primarily to protect the deposit insurance funds and consumers and not to benefit shareholders.  These regulations can sometimes impose significant limitations on our operations.  New laws and regulations or changes in existing laws and regulations or repeal of existing laws and regulations may adversely impact our business.  We anticipate that continued compliance with various regulatory provisions will impact future operating expenses.  Further, federal monetary policy, particularly as implemented through the Federal Reserve System, significantly affects economic conditions which may impact the Bank.

 

New Legislative and Regulatory Proposals May Affect Our Operations and Growth

 

Proposals to change the laws and regulations governing the operations and taxation of banks and financial institutions and federal insurance premiums paid by banks and financial institutions and companies that control such institutions are frequently raised in the U.S. Congress, state legislatures and before bank regulatory authorities.  The likelihood of any major changes in the future and the impact such changes might have on us or our subsidiaries are impossible to determine.  Similarly, proposals to change the accounting treatment applicable to banks and other depository institutions are frequently raised by the SEC, the federal banking agencies, the IRS and other appropriate authorities.

 

The likelihood and impact of any additional future changes in law or regulation and the impact such changes might have on us or our subsidiaries are impossible to determine at this time.

 

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Risks Associated With Our Stock

 

Our Participation in the U.S. Treasury’s Capital Purchase Program (“CPP”) May Pose Certain Risks to Holders of Our Common Stock

 

Under the terms of the CPP, the Company sold to the U.S. Treasury $21.0 million in preferred stock and a warrant to purchase approximately $3.2 million of the Company’s common stock.  Although the Company believes that its participation in the CPP is in the best interests of our shareholders in that it enhances Company and Bank capital and provides additional funds for future growth, it may pose certain risks to the holders of our common stock such as the following:

 

·                  Under the terms outlined by the U.S. Treasury for participants in the CPP, the Company issued a warrant to the U.S Treasury to purchase shares of its common stock.  The issuance of this warrant may be dilutive to current common stockholders in that it reduces earnings per common share. Additionally, the ownership interest of the existing holders of our common stock will be diluted to the extent the warrant is exercised.  The U.S. Treasury has the right to purchase 611,650 shares of our common stock at a price of $5.15 per share, which would result in an approximate 2.4% ownership interest.

 

·                  Although the U.S. Treasury has agreed not to vote any of the shares of common stock it receives upon exercise of the warrant, a transferee of any portion of the warrant or of any shares of common stock acquired upon exercise of the warrant is not bound by this restriction and therefore has the ability to become a shareholder of the Company and possess voting power.

 

·                  The preferred equity issued to the U.S. Treasury is non-voting; however, the terms of the CPP stipulate that the U.S. Treasury may vote its senior equity in matters deemed by the U.S. Treasury to have an impact on its holdings.

 

·                  The Purchase Agreement between the Company and the U.S Treasury provides that before the earlier of (1) March 20, 2012 and (2) the date on which all of the shares of the preferred stock have been redeemed by us or transferred by the U.S. Treasury to third parties, we may not, without consent of the U.S. Treasury, (a) increase the quarterly cash dividend on our common stock above $0.08 per share, the amount of the last quarterly cash dividend per share declared prior to October 14, 2008 or (b) subject to limited exceptions, redeem, repurchase or otherwise acquire shares of our common stock or preferred stock other than the preferred stock. In addition, we are unable to pay any dividends on our common stock unless we are current in our dividend payments on the preferred stock. These restrictions, together with the potentially dilutive impact of the warrant issued to the U.S. Treasury, may have a negative effect on the value of our common stock.

 

·                  Although the Company does not foresee any material changes to the terms associated with its participation in the CPP, the U.S. Government, as a sovereign body, may at any time change the terms of our participation in the CPP and or significantly influence Company policy.

 

For more information about the Company’s participation in the CPP, see Note 21. Preferred Stock, of the consolidated financial statements, filed in this Form 10-K.

 

Our Outstanding Preferred Stock Impacts Net Income Available to Our Common Stockholders and Earnings per Common Share and May be Dilutive to Common Stockholders

 

Accrued dividends and the accretion on our outstanding preferred stock reduce net income available to common stockholders and our earnings per common share.  Additionally, our Series C Preferred Stock may be dilutive to common stockholders to the extent the Company is profitable and must consider the dilutive nature of these securities in its 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.

 

Our Stock Trades Less Frequently Than Others

 

Although our common stock is listed for trading on the NASDAQ Capital Market, the trading volume in our common stock is less than that of other larger financial service companies.  A public trading market having the desired characteristics of depth, liquidity and orderliness depends on the presence in the marketplace of willing buyers and sellers of our common stock at any given time.  This presence depends on the individual decisions of investors and general economic and market conditions over which we have no control.  Given the lower trading volume of our common stock, significant sales of our common stock, or the expectation of these sales, could cause our stock price to fall.

 

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Table of Contents

 

Our Stock Price is Affected by a Variety of Factors

 

Stock price volatility may make it more difficult for investors to resell their common stock when they want and at prices they find attractive.  Our stock price can fluctuate significantly in response to a variety of factors discussed in this section, including, among other things: actual or anticipated variations in quarterly results of operations; recommendations by securities analysts; operating and stock price performance of other companies that investors deem comparable to our company; news reports relating to trends, concerns and other issues in the financial services industry; and perceptions in the marketplace regarding our company and/or its competitors and the industry in which we operate.

 

These factors may adversely affect the trading price of our common stock, regardless of our actual operating performance, and could prevent shareholders from selling their common stock at or above the price they paid.  In addition, the stock markets, from time to time, experience extreme price and volume fluctuations that may be unrelated or disproportionate to the operating performance of companies.  These broad fluctuations may adversely affect the market price of our common stock, regardless of our trading performance.

 

Any Future Issuance of Preferred or Common Stock Adversely Affect the Market Price of Our Common Stock

 

We are not restricted from issuing additional shares of common stock or securities that are convertible into or exchangeable for, or that represent the right to receive, common stock.  We frequently evaluate opportunities to access the capital markets, taking into account our regulatory capital ratios, financial condition and other relevant considerations.  In March of 2010, the Company raised gross proceeds of approximately $60.0 million though a private placement, as more fully disclosed in Note 21. Preferred Stock, of the consolidated financial statements, filed in this Form 10-K.  Any future issuances of equity may result in additional common shares outstanding and/or reduce the amount of income available to common shareholders.

 

In addition, we face significant regulatory and other governmental risk as a financial institution and as a participant in the CPP and it is possible that capital requirements and directives may, in the future, require us to change the amount or composition of our current capital including common equity.  As a result we may determine we need, or our regulators may require us to raise additional capital.  There may also be market perceptions regarding the capital we raised in 2010 or the need to raise additional capital, which may have an adverse effect on the price of our common stock.

 

Holders of Our Junior Subordinated Debentures Have Rights That Are Senior to Those of Our Common Shareholders

 

We have supported our continued growth through two issuances of trust preferred securities from two separate special purpose trusts, one of which was dissolved in 2010.  At December 31, 2011, we had $8.0 million of trust preferred securities outstanding.  Payments of the principal and interest on the trust preferred securities of these special purpose trusts are fully and unconditionally guaranteed by us.  Further, the accompanying junior subordinated debentures we issued to the special purpose trusts are senior to our shares of common stock.  As a result, we must make payments on the junior subordinated debentures before any dividends can be paid on our common stock and, in the event of our bankruptcy, dissolution or liquidation, the holders of the junior subordinated debentures must be satisfied before any distributions can be made on our common stock.  We have the right to defer distributions on our junior subordinated debentures and the related trust preferred securities for up to five years during which time no cash dividends may be paid on our common stock.

 

Our Common Stock is Not an Insured Deposit

 

Our common stock is not a bank deposit and is not insured against loss by the FDIC, any other deposit insurance fund or by any other public or private entity.  Investment in our common stock is inherently risky for the reasons described in this “Risk Factors” section and elsewhere in this report and is subject to market forces that affect the price of common stock in any company.  As a result, if you acquire our common stock, you may lose some or all of your investment.

 

Our Articles of Incorporation and By-Laws, As Well As Certain Banking Laws, May Have an Anti-Takeover Effect

 

Provisions of our articles of incorporation, bylaws and federal banking laws, including regulatory approval requirements, could make it more difficult for a third party to acquire us, even if doing so would be perceived to be beneficial to our shareholders.  The combination of these provisions may hinder a non-negotiated merger or other business combination, which, in turn, could adversely affect the market price of our common stock.

 

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Table of Contents

 

Item 1B.  Unresolved Staff Comments

 

None.

 

 

Item 2.  Properties

 

The Company’s headquarters are located in a three story administrative facility from where all administrative functions are based.  This facility is located at 1222 Vine Street in Paso Robles, California.  The Bank operates branches within the counties of San Luis Obispo and Santa Barbara.  The Bank currently owns one of the branches that it occupies and leases the remaining branches from various parties.

 

In June of 2007, the Company sold four of its properties to First States Group, L.P. (“First States”), an unaffiliated party, in a sale-leaseback transaction for approximately $12.8 million.  In connection with the sale, the Bank entered into four separate lease agreements with First States Investors, LLC to lease back three branches and one administrative facility.  The three branches are located in Paso Robles, Arroyo Grande and Santa Maria, California.  The administrative facility is located in Paso Robles, California.  Each of the four leases contains an annual rent escalation clause equal to the lower of CPI-U (Consumer Price Index for all Urban Consumers) or 2.5 percent.  Each of the four leases provide for an initial term of 15 years with the option to renew for two 10 year terms.

 

The Company believes its facilities are adequate for its present needs.  The Company believes that the insurance coverage on all properties is adequate.  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:

 

Alpert, et al v. Cuesta Title Company, et al.  San Luis Obispo County Sup. Ct. case no. CV 098220.  Plaintiffs have sued a title company, title insurer, Hurst Financial and related individuals on a variety of claims related to Hurst Financial’s lending practices.  The Bank, which made a commercial loan to a developer which also borrowed from Hurst Financial, was named in two causes of action alleging (1) negligence and (2) aiding and abetting Hurst Financial’s allegedly illegal lending practices.  The Bank did not lend to any of the plaintiffs or to Hurst Financial, nor did the Bank have any contact whatsoever with the plaintiffs in relation to their transactions with Hurst Financial.  The Bank has foreclosed upon and now owns one of the properties Hurst Financial purportedly financed for the developer using funds raised from the plaintiffs.  The Bank believes the action against it is without merit.  The matter has been tendered to the Bank’s insurance carrier, and the Bank is actively defending the case, which is now in the discovery phase.  The Bank has successfully demurred to the cause of action for negligence.  As such, the Bank anticipates a favorable outcome to the case and does not expect the litigation to have any significant financial impact to the Bank.

 

Gardality v. Heritage Oaks Bank, et al.  San Diego County Sup. Ct. case no. 37-2010-00055218-CU-NC. Plaintiff sued the Bank and 157 other defendants.  The pleading indicates the plaintiff’s claim is connected to funds he borrowed from Estate Financial, Inc. (“EFI”) as the developer of a real estate project.  EFI was a customer of the Bank and is now a debtor in a bankruptcy proceeding.  The complaint was poorly written and legally deficient to the point where it is impossible to determine the nature or validity of the claim.  The Bank had no contact with the plaintiff prior to service of the complaint and believes that plaintiff’s action against it is without merit.  The matter was tendered to the Bank’s insurance carrier and the Bank actively defended the case.

 

The plaintiff dismissed the defective complaint against the Bank at the Bank’s request, and has not filed a new complaint under the original case number. However, on February 3, 2011, the Bank learned that Mr. Gardality filed a cross-complaint in San Luis Obispo County with similar allegations, San Luis Obispo County Sup. Ct. case no. CV 100365, which is a case filed against Mr. Gardality by the bankruptcy Trustee for EFI. The Bank appeared in that matter and challenged the sufficiency of the pleadings. The Court ruled in favor of the Bank on May 18, 2011 and dismissed the cross-complaint, awarding attorney’s fees to the Bank. Mr. Gardality appealed the dismissal of his claim and his appeal has been denied.  At this time there is no litigation pending with Mr. Gardality and the Bank does not expect his claim to have any material financial impact to the Bank.

 

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Table of Contents

 

Joao-Bock Transaction Systems, LLC v. Bank of Stockton, et al. USDC, Central District, Los Angeles case no. CV11 03526 DSF. Plaintiff sued the Bank and 15 other California banks claiming patent infringement relating to plaintiff’s claimed patent of certain on-line banking systems.  The plaintiff has a history of filing infringement claims against banks relating to on-line banking software and systems. The Bank outsources its on-line banking systems from third party vendors, and has tendered the matter to those providers, as well as to its insurance carriers, for a defense.  As of December 31, 2011, one of the vendors has agreed to defend the infringement claim, and the Bank is negotiating with the other vendor. The vendor’s counsel is defending the claim in cooperation with the Bank. Based on preliminary contact and negotiations with the plaintiff, the Bank does not expect the litigation to have any material financial impact to the bank.

 

On February, 21, 2012, the Bank and Company were served with a complaint, Santa Barbara County Superior Court case no. 1390870, by Corona Fruits & Veggies, Inc., and related entities 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 focus of the claims is that the Bank promised to extend agricultural and equipment financing to plaintiffs and ultimately failed to do so, causing plaintiffs’ damages.  The Bank has not had time to fully analyze the claims or determine to what extent, if any, all or part of the claims are potentially covered by insurance; however, the Bank denies that it acted improperly in any respect toward plaintiffs or that it breached an enforceable loan commitment and intends to vigorously defend the matter.  The amount of potential loss to the Bank from this claim, if any, is unknown at this time.

 

Except as indicated above, neither the Company nor the Bank is involved in any legal proceedings other than routine legal proceedings occurring in the ordinary course of business.  The majority of such proceedings have been initiated by the Bank in the process of collecting on delinquent loans.  To the extent any such matters are defense matters, they are each covered by one or more policies of insurance carried by the Bank and do not carry an exposure to loss in excess of the coverage available. Such routine legal proceedings, in the aggregate, are believed by Management to be immaterial to the financial condition, results of operations and cash flows of the Company as of December 31, 2011.

 

 

Item 4.  Mine Safety Disclosures

 

Not Applicable.

 

 

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.”  The following table summarizes those trades of the Company’s Common Stock on NASDAQ, setting forth the approximate high and low closing sales prices for each quarterly period ended since January 1, 2010:

 

 

Closing Prices

Quarters Ended

 

High

 

Low

 

December 31, 2011

 

$

3.70

 

$

3.03

 

September 30, 2011

 

3.86

 

3.02

 

June 30, 2011

 

3.95

 

3.22

 

March 31, 2011

 

3.75

 

3.18

 

 

 

 

 

 

 

December 31, 2010

 

$

3.69

 

$

3.05

 

September 30, 2010

 

3.80

 

3.07

 

June 30, 2010

 

4.25

 

3.20

 

March 31, 2010

 

5.26

 

3.45

 

 

Holders

 

As of February 13, 2012, there were 1,997 holders of the Company’s Common Stock.  There are no other classes of common equity securities outstanding.

 

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Table of Contents

 

Dividends

 

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 1-1/4 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 1-1/4 times its current liabilities.  See also Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations, for limitations on dividends resulting from the issuance of junior subordinated debentures. 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 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 period.  However, a bank may, with the approval of the DFI, make a distribution to its shareholders in an amount not exceeding the greatest of (x) its retained earnings; (y) its net income for its last fiscal year; or (z) its net income for its current fiscal year.  In the event that the DFI 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 DFI 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. (See, “Item 1 - Description of Business - Prompt Corrective Action and Other Enforcement Mechanisms”).

 

Additionally, 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.

 

However, under the Consent Order issued by the FDIC and DFI in March 2010, the Bank may not pay cash dividends or make other payments to the Company without prior written consent of the FDIC and DFI.  Additionally, under the Written Agreement the Company entered into with the Federal Reserve Bank of San Francisco in March 2010, the Company may not receive any dividends or other forms of payment from the Bank or pay dividends to its shareholders without the prior approval of the Federal Reserve Bank of San Francisco and the Director of the Division of Banking Supervision and Regulation of the Board of Governors of the Federal Reserve System.  As a result of these requirements of the Order and Written Agreement, the Company has deferred payment of interest on its subordinated debt securities and dividends on its Series A Preferred Stock since the second quarter of 2010.

 

Further, under the terms of the Company’s participation in the U.S. Treasury’s TARP CPP, the Company must obtain approval by the U.S. Treasury for a period of three years following the initial date of the U.S. Treasury’s investment for any proposed increases in the payment of cash dividends on its common stock.  Additionally, the Company may not pay dividends on its common stock because it is not current with all dividends on its Series A Senior Preferred Stock issued to the U.S. Treasury.

 

No dividends have been paid to holders of the Company’s common stock during each of the preceding three years.

 

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Table of Contents

 

Securities Authorized for Issuance under Equity Compensation Plans

 

The table below summarizes information as of December 31, 2011 relating to equity compensation plans of the Company pursuant to which grants of options, restricted stock or other rights to acquire shares may be granted from time to time.  These plans are discussed more fully in Note 15. Share-Based Compensation Plans, of the consolidated financial statements, filed in this Form 10-K.

 

 

 

 

Number of

 

 

 

 

 

 

 

Securities To Be

 

Weighted Average

 

Number of Securities

 

 

 

Issued Upon Exercise

 

Exercise Price of

 

Remaining Available

 

Plan Category

 

of Outstanding Options

 

Outstanding Options

 

For Future Issuance

 

Equity compensation plans

 

 

 

 

 

 

 

approved by security holders:

 

636,406  

(1)

$

5.40

 

1,826,516  

(2)

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, 2011, there were 91,513 shares of restricted stock issued and outstanding.  See also Note 15. Share Based Compensation Plans, of the Consolidated Financial Statements on this Form 10-K for more information on the Company’s equity compensation plans.

 

(2) Includes securities available for issuance of stock options and restricted stock.

 

Purchases of Equity Securities

 

The Company is not currently authorized to make repurchases of its common stock, nor did it make repurchases of its common stock during 2011, 2010 or 2009.

 

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Table of Contents

 

Item 6.  Selected Financial Data

 

The table below provides selected financial data for the five years ended December 31, 2011, 2010, 2009, 2008 and 2007:

 

 

 

 

At or For The Years Ended December 31,

 

(dollar amounts in thousands, except per share data)

 

2011

 

2010

 

2009

 

2008

 

2007

 

Consolidated Income Data:

 

 

 

 

 

 

 

 

 

 

 

Interest income

 

$

48,227

 

$

50,794

 

$

49,559

 

$

50,150

 

$

45,174

 

Interest expense

 

5,023

 

8,047

 

10,049

 

12,564

 

14,751

 

Net interest income

 

43,204

 

42,747

 

39,510

 

37,586

 

30,423

 

Provision for loan losses

 

6,063

 

31,531

 

24,066

 

12,215

 

660

 

Net interest income after provision for loan losses

 

37,141

 

11,216

 

15,444

 

25,371

 

29,763

 

Non interest income

 

9,730

 

10,747

 

7,415

 

6,666

 

5,632

 

Non interest expense

 

37,318

 

41,283

 

35,733

 

29,894

 

24,191

 

(Loss)/income before income taxes

 

9,553

 

(19,320

)

(12,874

)

2,143

 

11,204

 

Provision for income taxes

 

1,828

 

(1,760

)

(5,825

)

497

 

4,287

 

Net (loss)/income

 

$

7,725

 

$

(17,560

)

$

(7,049

)

$

1,646

 

$

6,917

 

Dividends and accretion on preferred stock

 

1,358

 

5,008

 

964

 

-

 

-

 

Net (loss) / income available to common shareholders

 

$

6,367

 

$

(22,568

)

$

(8,013

)

$

1,646

 

$

6,917

 

Share Data:

 

 

 

 

 

 

 

 

 

 

 

(Loss) / earnings per common share - basic

 

$

0.25

 

$

(1.30

)

$

(1.04

)

$

0.22

 

$

0.99

 

(Loss) / earnings per common share - diluted

 

$

0.24

 

$

(1.30

)

$

(1.04

)

$

0.21

 

$

0.96

 

Dividend payout ratio (1)

 

0.00%

 

0.00%

 

0.00%

 

37.68%

 

35.55%

 

Common book value per share

 

$

4.17

 

$

3.85

 

$

8.07

 

$

9.03

 

$

9.04

 

Actual shares outstanding at end of period (2)

 

25,145,717

 

25,082,344

 

7,771,952

 

7,753,078

 

7,683,829

 

Weighted average shares outstanding - basic

 

25,048,477

 

17,312,306

 

7,697,234

 

7,641,726

 

6,984,174

 

Weighted average shares outstanding - diluted

 

26,254,745

 

17,312,306

 

7,697,234

 

7,753,013

 

7,228,804

 

Consolidated Balance Sheet Data:

 

 

 

 

 

 

 

 

 

 

 

Total cash and cash equivalents

 

$

34,892

 

$

22,951

 

$

40,738

 

$

24,571

 

$

46,419

 

Total investments and other securities

 

$

236,982

 

$

223,857

 

$

121,180

 

$

50,762

 

$

47,556

 

Total gross loans

 

$

646,286

 

$

677,303

 

$

728,679

 

$

680,147

 

$

613,217

 

Allowance for loan losses

 

$

(19,314

)

$

(24,940

)

$

(14,372

)

$

(10,412

)

$

(6,143

)

Total assets

 

$

987,138

 

$

982,612

 

$

945,177

 

$

805,588

 

$

745,554

 

Total deposits

 

$

786,208

 

$

798,206

 

$

775,465

 

$

603,521

 

$

644,808

 

Federal Home Loan Bank borrowings

 

$

51,500

 

$

45,000

 

$

65,000

 

$

109,000

 

$

8,000

 

Junior subordinated debt

 

$

8,248

 

$

8,248

 

$

13,403

 

$

13,403

 

$

13,403

 

Total stockholders’ equity

 

$

129,554

 

$

121,256

 

$

83,751

 

$

70,032

 

$

69,450

 

Selected Other Balance Sheet Data:

 

 

 

 

 

 

 

 

 

 

 

Average assets

 

$

976,988

 

$

995,223

 

$

887,628

 

$

779,575

 

$

605,736

 

Average earning assets

 

$

916,356

 

$

935,991

 

$

829,329

 

$

722,061

 

$

555,871

 

Average stockholders’ equity

 

$

124,824

 

$

121,865

 

$

86,949

 

$

71,748

 

$

55,927

 

Selected Financial Ratios:

 

 

 

 

 

 

 

 

 

 

 

Return on average assets

 

0.79%

 

-1.76%

 

-0.79%

 

0.21%

 

1.14%

 

Return on average stockholders’ equity

 

6.19%

 

-14.41%

 

-8.11%

 

2.29%

 

12.37%

 

Net interest margin (3)

 

4.71%

 

4.57%

 

4.76%

 

5.21%

 

5.47%

 

Efficiency ratio (4)

 

67.98%

 

69.08%

 

69.86%

 

65.57%

 

66.14%

 

Capital Ratios:

 

 

 

 

 

 

 

 

 

 

 

Average stockholders’ equity to average assets

 

12.78%

 

12.24%

 

9.80%

 

9.20%

 

9.23%

 

Leverage Ratio

 

12.06%

 

10.83%

 

8.24%

 

8.90%

 

9.60%

 

Tier 1 Risk-Based Capital ratio

 

14.81%

 

13.94%

 

9.59%

 

9.37%

 

10.08%

 

Total Risk-Based Capital ratio

 

16.07%

 

15.21%

 

10.85%

 

10.62%

 

11.04%

 

Selected Asset Quality Ratios:

 

 

 

 

 

 

 

 

 

 

 

Non-performing loans to total gross loans (5)

 

1.91%

 

4.85%

 

5.26%

 

2.75%

 

0.06%

 

Non-performing assets to total assets (6)

 

1.35%

 

4.02%

 

4.15%

 

2.48%

 

0.05%

 

Allowance for loan losses to total gross loans

 

2.99%

 

3.68%

 

1.97%

 

1.53%

 

1.00%

 

Allowance for loan losses to non-performing loans

 

156.16%

 

75.99%

 

37.50%

 

55.75%

 

1817.46%

 

Net charge-offs (recoveries) to average loans

 

1.75%

 

2.96%

 

2.83%

 

1.21%

 

0.00%

 

 

(1) For the years 2008 and 2007 cash dividends totaling $0.08 and $0.32 per share, respectively, were paid. No cash dividends were paid in 2011, 2010 and 2009.

(2) Actual shares have been adjusted to fully reflect stock dividends and stock splits.

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

(4) Efficiency ratio is defined as non interest expense, before foreclosed property expense and amortization of intangibles, as a percent of the combined net interest income plus non interest income, exclusive of gains and losses on security sales and nonrecurring items, including other than temporary impairment losses, gains and losses on sale of OREO and gains and losses on sale of fixed assets.

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

(6) Non-performing assets are defined as assets that are past due 90 days or more and assets placed in non-accrual status plus other real estate owned.

 

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Table of Contents

 

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

 

The following is an analysis of the financial condition and results of operations of the Company as of and for the years ended December 31, 2011, 2010 and 2009.  The analysis should be read in connection with the consolidated financial statements and notes thereto appearing elsewhere in this report.

 

Overview

 

Executive Summary of Operating Results

 

For the year ended December 31, 2011, the Company reported net income of approximately $7.7 million or $0.24 per share on a fully diluted basis.  This compares to a net loss of $17.6 million or $1.30 per common share for 2010 and a net loss of $7.0 million or $1.04 per common share for 2009.

 

The improvement in 2011 earnings is largely due to lower loan loss provision expense as compared to the prior two years, as well as the reversal of a portion of the $7.1 million valuation allowance on the Company’s deferred tax assets that was established in the latter half of 2010.  The provision for loan loss decreased to $6.1 million from the provisions recorded in 2010 and 2009 of $31.5 million and $24.1 million, respectively. The lower provisioning requirements in 2011 were driven by overall improvements in the credit quality of the loan portfolio and lower net charge-offs, whereas 2010 and 2009 were two of the most challenging years in the Company’s history. Of the $6.1 million of provisions recorded in 2011, $5.4 million was attributable to loan sales that were executed to reduce the level of classified and non-performing assets in 2011. Absent the provisions driven by the loan sales, the provision required to cover the net impact of both improved credits and newly identified credit downgrades during 2011 would have been $0.7 million. The reduced level of provisioning reflects improving trends in credit quality as evidenced by the decline in our historical loss rates, in particular over 2011. The Company’s allowance for loan losses declined to 2.99% of gross loans receivable from 3.68% at the end of 2010. The decline was due to: an improvement in the overall credit profile of the Company, including reduced levels of classified and non-performing loans; Management aggressively addressing credit problems during 2011 through work-out processes and the sale of pools of classified and non-performing loans.  The allowance for loan losses increased as a percentage of non-performing loans to 156% at December 31, 2011 from 76% at December 31, 2010, again reflecting the steps that the Company took to reduce the level of non-performing assets in 2011.

 

The other key contributor to the improvement in earnings in 2011 was the reversal of $1.5 million of deferred tax asset valuation allowance in 2011 as compared to the $7.1 million of deferred tax asset valuation allowance established in 2010.  The partial reversal of allowance in 2011 reflected the impacts of numerous factors, such as improvements in earnings and credit quality that provided adequate positive evidence that $1.5 million of deferred tax asset for which a valuation allowance had been previously established were now more likely than not recognizable as future tax benefits.  See Note 10. Income Taxes, of the notes to the consolidated financial statements, filed in this Form 10-K for a more detailed discussion of the accounting for the Company’s deferred tax valuation allowance.

 

Operating results for 2011 were also favorably impacted by decreases in non-interest expense levels, which were $4.0 million lower than 2010. The primary reduction in non-interest expense was due to a $2.5 million reduction in the level of write-downs on foreclosed assets. The balance of the expense reduction was attributable to a combination of reductions in salary and benefit costs and regulatory assessment costs. The favorable impacts from reductions in non-interest expense were partially offset by declines in non-interest income of $1.0 million.  The decline in non-interest income was largely due to a one-time gain on the extinguishment of debt, totaling $1.7 million, which was recognized in the second quarter of 2010 related to retirement of junior subordinated debentures, and the net impact in 2011 of a $0.6 million increase in losses recognized on the sale of foreclosed asset, partially offset by a $1.2 million increase in gains realized on the sale of investment securities. Please see “Non-Interest Income”, and “Non-Interest Expense” under Results of Operations, below, for additional information related to these components of operating income.

 

The Company believes that the operating results for 2011 better reflect the core earnings of the Company relative to the earnings in 2010 and 2009, which were adversely impacted by the credit issues brought on by the recent financial crisis and resulting national recession.  These trends are not only a result of what appears to be the first signs of some degree of stabilization in the local economies in which the Company operates, but also from improvements realized in asset quality through a combination of sales of classified assets and improvement in credit quality during the year.

 

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The improvements in asset quality since December 31, 2010 are evidenced by:

 

·

the $27.9 million decline in classified assets,

·

the $22.2 million decline in impaired loans,

·

the improvement in the coverage of the allowance for loan loss as a percentage of non-performing loans to 156% from 76% at December 31, 2010,

·

the decline in special mention risk graded loan balances from $55.0 million at December 31, 2010 to $39.3 million at December 31, 2011,

·

the decline in OREO balances outstanding from $6.7 million at December 31, 2010 to $0.9 million at December 31, 2011.

 

While the Company is cautiously optimistic about the current positive trends in credit quality that we have experienced in 2011, it is unclear as to how the uncertainties in the global economy could impact the local economy, if at all.

 

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 in this Form 10-K. The following discussions should be read in conjunction with the Consolidated Financial Statements, including the notes thereto, appearing in Item 8 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 the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  Actual results could differ from those estimates.

 

Estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan losses, the valuation of real estate acquired in connection with foreclosures or in satisfaction of loans, the carrying value of the Company’s deferred tax assets and estimates used in the determination of the fair value of certain financial instruments.

 

Allowance for Loan Losses and Valuation of Foreclosed Real Estate

 

In connection with the determination of the allowance for loan losses and the value of foreclosed real estate, Management obtains independent appraisals for significant properties.  While Management uses available information to recognize losses on loans and foreclosed real estate and collateral, future additions to the allowance may be necessary based on changes in local economic conditions.  In addition, regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for loan losses and foreclosed real estate.  Such agencies may require the Company to recognize additions to the allowance based on their judgments about information available to them at the time of their examination.  Because of these factors, it is reasonably possible that the allowance for loan losses and foreclosed real estate may change in future periods.  See also Note 4. Allowance for Loan Losses, of the consolidated financial statements filed in 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 may be established.  During 2010, the Company established a valuation allowance against a portion of its deferred tax assets. Based on the Company’s ongoing assessment of the realizability of its deferred tax assets, it reduced the level of valuation allowance in 2011.  See also Note 10. Income Taxes, of the consolidated financial statements filed in this Form 10-K.

 

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Table of Contents

 

Fair Value of Financial Instruments

 

The degree of judgment utilized in measuring the fair value of financial instruments generally correlates to the level of pricing observability.  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 not yet established and the characteristics specific to the transaction.  See also Note 18. Fair Value of Assets and Liabilities, of the consolidated financial statements filed in this Form 10-K.

 

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 paid on deposits and borrowings, and the interest earned on loans and investments.  The net interest margin 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.

 

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Table of Contents

 

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, 2011, 2010 and 2009.  The average balance of non-accruing loans has been included in loan totals.

 

 

 

For The Year Ended,

 

For The Year Ended,

 

For The Year Ended,

 

 

 

December 31, 2011

 

December 31, 2010

 

December 31, 2009

 

 

 

 

 

Yield/

 

Income/

 

 

 

Yield/

 

Income/

 

 

 

Yield/

 

Income/

 

(dollar amounts in thousands)

 

Balance

 

Rate

 

Expense

 

Balance

 

Rate

 

Expense

 

Balance

 

Rate

 

Expense

 

Interest Earning Assets

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Investments with other banks

 

$

58

 

1.72%

 

$

1

 

$

119

 

1.68%

 

$

2

 

$

119

 

2.52%

 

$

3

 

Interest bearing due from banks

 

16,343

 

0.18%

 

30

 

38,630

 

0.23%

 

90

 

16,950

 

0.29%

 

49

 

Federal funds sold

 

700

 

0.00%

 

-    

 

4,414

 

0.11%

 

5

 

14,555

 

0.14%

 

21

 

Investment securities taxable

 

194,761

 

2.75%

 

5,361

 

156,911

 

3.46%

 

5,422

 

67,197

 

4.55%

 

3,060

 

Investment securities non taxable

 

36,888

 

4.04%

 

1,490

 

26,664

 

4.30%

 

1,146

 

20,589

 

4.35%

 

896

 

Loans (1) (2)

 

667,606

 

6.19%

 

41,345

 

709,253

 

6.22%

 

44,129

 

709,919

 

6.41%

 

45,530

 

Total interest earning assets

 

916,356

 

5.26%

 

48,227

 

935,991

 

5.43%

 

50,794

 

829,329

 

5.98%

 

49,559

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Allowance for loan losses

 

(22,895

)

 

 

 

 

(20,698

)

 

 

 

 

(12,342

)

 

 

 

 

Other assets

 

83,527

 

 

 

 

 

79,930

 

 

 

 

 

70,641

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total assets

 

$

976,988

 

 

 

 

 

$

995,223

 

 

 

 

 

$

887,628

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest Bearing Liabilities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest bearing demand

 

$

64,187

 

0.15%

 

$

95

 

$

70,935

 

0.50%

 

$

352

 

$

66,652

 

0.82%

 

$

548

 

Savings

 

32,153

 

0.14%

 

46

 

27,739

 

0.26%

 

73

 

24,665

 

0.24%

 

60

 

Money market

 

275,278

 

0.50%

 

1,367

 

281,754

 

1.00%

 

2,813

 

222,343

 

1.44%

 

3,207

 

Time deposits

 

214,677

 

1.39%

 

2,974

 

232,450

 

1.81%

 

4,210

 

220,120

 

2.30%

 

5,069

 

Total interest bearing deposits

 

586,295

 

0.76%

 

4,482

 

612,878

 

1.22%

 

7,448

 

533,780

 

1.66%

 

8,884

 

Federal funds purchased

 

-    

 

0.00%

 

-    

 

-    

 

0.00%

 

-

 

188

 

1.06%

 

2

 

Securities sold under agreement to repurchase

 

-    

 

0.00%

 

-    

 

-    

 

0.00%

 

-

 

650

 

0.15%

 

1

 

Federal Home Loan Bank borrowing

 

38,527

 

0.97%

 

372

 

62,041

 

0.54%

 

332

 

76,953

 

0.76%

 

588

 

Federal Reserve Bank borrowing

 

-    

 

0.00%

 

-    

 

-    

 

0.00%

 

-   

 

14

 

0.49%

 

-    

 

Junior subordinated debentures

 

8,248

 

2.05%

 

169

 

10,479

 

2.34%

 

245

 

13,403

 

4.28%

 

574

 

Other secured borrowing

 

3

 

0.00%

 

-    

 

445

 

4.94%

 

22

 

-    

 

0.00%

 

-    

 

Total borrowed funds

 

46,778

 

1.16%

 

541

 

72,965

 

0.82%

 

599

 

91,208

 

1.28%

 

1,165

 

Total interest bearing liabilities

 

633,073

 

0.79%

 

5,023

 

685,843

 

1.17%

 

8,047

 

624,988

 

1.61%

 

10,049

 

Non interest bearing demand

 

208,646

 

 

 

 

 

178,096

 

 

 

 

 

167,226

 

 

 

 

 

Total funding

 

841,719

 

0.60%

 

5,023

 

863,939

 

0.93%

 

8,047

 

792,214

 

1.27%

 

10,049

 

Other liabilities

 

10,445

 

 

 

 

 

9,419

 

 

 

 

 

8,465

 

 

 

 

 

Total liabilities

 

852,164

 

 

 

 

 

873,358

 

 

 

 

 

800,679

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Stockholders’ Equity

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total stockholders’ equity

 

124,824

 

 

 

 

 

121,865

 

 

 

 

 

86,949

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total liabilities and stockholders’ equity

 

$

976,988

 

 

 

 

 

$

995,223

 

 

 

 

 

$

887,628

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net interest margin (3)

 

 

 

4.71%

 

 

 

 

 

4.57%

 

 

 

 

 

4.76%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest rate spread

 

 

 

4.47%

 

$

43,204

 

 

 

4.26%

 

$

42,747

 

 

 

4.37%

 

$

39,510

 

 

(1) Non-accruing loans have been included in total loans.

(2) Loan fees of $354; $656; $918  for the years ending December 31, 2011, 2010, and 2009 respectively have been included in interest income computation.

(3) Net interest margin has been calculated by dividing the net interest income by total average earning assets.

 

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Table of Contents

 

Discussion of 2011 Compared to 2010

 

At December 31, 2011, average earning assets were approximately $19.6 million lower than that reported at December 31, 2010.  This decline was driven by a $41.6 million reduction in the level of net loans outstanding, due in large part to $25.8 million of loan sales completed in 2011 (including the impacts of the $5.9 million of loans transferred to held for sale status at December 31, 2011 and subsequently sold in January 2012), and $22.3 million decline in interest bearing funds due from banks, both of which were partially offset by an increase in investment securities, which increased by $48.1 million over 2010.  The decline in the overall average earning assets and the change in mix between loans and investment securities were the primary factors contributing to the decline in interest income and yield in 2011, as higher yielding loans that were sold or paid down in 2011, were replaced by lower yielding investment securities.

 

We continued to experience tepid loan demand through most of 2011, which when combined with increased competition for quality lending opportunities has contributed to the contraction in the loan portfolio in 2011, as customer pay-down activity and the sale of classified and non-performing loans has outpaced new loan production.  However, we began to see an increase in loan demand at year end which we anticipate will continue in 2012. Yields on the loan portfolio in 2011 were essentially flat compared to 2010, as the impacts of originating and renewing loans in the current historically low interest rate environment, which placed some level of downward pressure on rates, were substantially offset by a 62% reduction in the level of non-performing loans. Total forgone interest on impaired loans (including interest reversed when a loan is initially placed on non-accrual and all interest income lost prospectively) was approximately $1.7 million for 2011, impacting the yield on earning assets by approximately 25 basis points, a decline of $1.3 million and 7 basis points from 2010.

 

At December 31, 2011, average interest bearing liabilities decreased $52.8 million as compared to December 31, 2010.  The decline was largely caused by a reduction in the level of federal home loan bank (“FHLB”) borrowings, which declined $23.5 million and time deposits, which declined $17.8 million.  Time deposits and FHLB borrowings tend to be the higher cost elements of our interest bearing liabilities, therefore the decline in such balances led to a significant decline in the amount of interest expense and the cost associated with our interest bearing liabilities.  Interest expense declined $3.0 million from 2010 to $5.0 million in 2011 and the average rate declined 38 basis points to .79%.

 

As a result of the interplay of the above factors, we realized an increase in both net interest income and net interest margin in 2011 as compared to 2010.

 

Discussion of 2010 Compared to 2009

 

At December 31, 2010, average interest earning assets were approximately $106.7 million higher than that reported for the year ended December 31, 2009.  Higher average balances of investment securities stemming from the $56.0 million in net proceeds the Company received from its March 2010 private placement, coupled with an increase in average core deposit balances led to the year over year increase in average interest-earning assets.  Although the increase in investment balances ultimately contributed to a year over year increase in interest income, the lower yields earned on these investments, due in large part to the current lower interest rate environment, contributed to a decline in earning asset yields in 2010.

 

During 2010, the Company transferred $54.4 million in loans to non-accrual status, which resulted in interest reversals of $0.6 million, contributing to the year over year decline in interest and fees earned on loans as compared to 2009.  Furthermore, average impaired loan balances in 2010 were approximately $11.4 million higher than that reported for 2009, which placed additional pressure on loan portfolio yields in 2010.  Total forgone interest on impaired loans (including interest reversed when a loan is initially placed on non-accrual and all interest income lost prospectively) totaled approximately $3.0 million for 2010, impacting the yield on earning assets by approximately 32 basis points.  For 2009 forgone interest totaled $1.3 million and impacted the yield on earning assets by 16 basis points.

 

Average interest bearing liabilities increased $60.9 million in 2010 from the $685.8 million reported at December 31, 2009.  The year over year increase can be attributed to higher average balances of core interest bearing deposits, including increases in money market and time deposit accounts, which resulted from promotional activities and added focus on attracting and retaining core relationships.  The yield on interest-bearing liabilities was 1.17% for the year ended December 31, 2010, representing a decline of 44 basis points.  In an effort to augment the decline in earning asset yields and reduce pressure on the net interest margin, the Company lowered offering rates significantly during the latter half of 2010.  As a result, the Company significantly reduced the cost of money market and time deposits during 2010.  Additionally, the Company restructured and paid down higher cost FHLB borrowings during 2010, contributing to the decline in the cost of interest bearing liabilities.  Further, in June 2010 the Company eliminated $5.2 million in junior subordinated debentures from the balance sheet, associated with the repurchase of trust preferred securities issued by Heritage Oaks Capital Trust III.  These borrowings previously accrued interest at a rate of 6.89% per annum.

 

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Table of Contents

 

The lower overall yield on the loan portfolio, coupled with an increase in lower yielding investment securities in 2010 resulted in lower earning asset yields, which more than offset savings realized by reducing the cost of our deposit base, leading to a year over year decline in the net interest margin in 2010 as compared to 2009.

 

The following table sets forth the dollar difference in interest earned and paid for each major category of interest-earning assets and interest-bearing liabilities and the amount of such change attributable to changes in average balances (volume) or changes in interest rates for the three years ended December 31, 2011, 2010 and 2009:

 

 

 

For The Year Ended,

 

For The Year Ended,

 

For The Year Ended,

 

 

 

December 31, 2011

 

December 31, 2010

 

December 31, 2009

 

(dollar amounts in thousands)

 

Volume

 

Rate

 

Total

 

Volume

 

Rate

 

Total

 

Volume

 

Rate

 

Total

 

Interest income:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Investments with other banks

 

$

(1

)

$

-    

 

$

(1

)

$

-    

 

$

(1

)

$

(1

)

$

(3

)

$

(2

)

$

(5

)

Interest bearing due from

 

(58

)

(2

)

(60

)

51

 

(10

)

41

 

49

 

-    

 

49

 

Federal funds sold

 

(6

)

1

 

(5

)

(18

)

2

 

(16

)

81

 

(200

)

(119

)

Investment securities taxable

 

1,164

 

(1,225

)

(61

)

3,251

 

(889

)

2,362

 

1,178

 

(341

)

837

 

Investment securities non-taxable (1)

 

632

 

(111

)

521

 

396

 

(17

)

379

 

232

 

3

 

235

 

Taxable equivalent adjustment (1)

 

(215

)

38

 

(177

)

(135

)

6

 

(129

)

(79

)

(1

)

(80

)

Loans

 

(2,587

)

(197

)

(2,784

)

(43

)

(1,358

)

(1,401

)

3,680

 

(5,188

)

(1,508

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net (decrease) / increase

 

(1,071

)

(1,496

)

(2,567

)

3,502

 

(2,267

)

1,235

 

5,138

 

(5,729

)

(591

)

Interest expense:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Savings, NOW, money market

 

(76

)

(1,654

)

(1,730

)

711

 

(1,288

)

(577

)

292

 

(852

)

(560

)

Time deposits

 

(340

)

(896

)

(1,236

)

270

 

(1,129

)

(859

)

1,679

 

(1,938

)

(259

)

Other borrowings

 

(170

)

188

 

18

 

(102

)

(133

)

(235

)

(38

)

(1,352

)

(1,390

)

Federal funds purchased

 

-    

 

-    

 

-    

 

(1

)

(1

)

(2

)

(52

)

(33

)

(85

)

Long term borrowings

 

(56

)

(20

)

(76

)

(143

)

(186

)

(329

)

-    

 

(221

)

(221

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net (decrease) / increase

 

(642

)

(2,382

)

(3,024

)

735

 

(2,737

)

(2,002

)

1,881

 

(4,396

)

(2,515

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total net increase / (decrease)

 

$

(429

)

$

886

 

$

457

 

$

2,767

 

$

470

 

$

3,237

 

$

3,257

 

$

(1,333

)

$

1,924

 

 

(1) Adjusted to a fully taxable equivalent basis using a tax rate of 34%.

 

Provision for Loan Losses

 

As more fully discussed in Note 4. Allowance for Loan Losses, of the consolidated financial statements, filed in this Form 10-K, the allowance for loan losses has been established by Management in order to provide for those loans, which for a variety of reasons, may not be repaid in their entirety.  The allowance is maintained at a level considered by Management to be adequate to provide for probable losses during the holding period of the loan and is based on methodologies applied on a consistent basis with the prior year.  Management’s review of the adequacy of the allowance 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 losses is based on estimates, and ultimate losses will likely vary from current estimates. The Company recognizes that credit losses will be experienced and 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 quality of the collateral for such loan.  The allowance for loan losses represents the Company’s best estimate of the allowance necessary to provide for probable estimable losses in the portfolio as of the balance sheet date. As of December 31, 2011, the Company’s allowance for loan losses represented 2.99% of total gross loans and 156% of loans identified as non-performing.  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.

 

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Discussion of 2011 Compared to 2010

 

The Company’s provision for loan losses was $6.1 million for the year ended December 31, 2011.  This represents a decrease of $25.5 million as compared to that reported in 2010.  The decrease in the provisions for loan losses can be attributed to: 1) a deceleration in the amount of required provisions due to efforts taken to date to identify and address potential credit issues, 2) a decrease in the amount of classified and non-performing loans through structured problem loan sales executed in 2011 and the overall improving quality of the loan portfolio, as evidenced by the improvements in the loss history over the last year, 3) enhanced procedures around the issuance of new credit over the last couple of years and 4) early signs that the local economies, in which it operates, may be stabilizing after a prolonged period of recession and stagnant recovery, based on recent reports on improved unemployment levels and modest upward trends in commercial real estate leasing activity.

 

Discussion of 2010 Compared to 2009

 

Provisions for loan losses in 2010 were $7.5 million higher than that reported for 2009, which is reflective of additional credit losses the Company incurred during 2010 as well as continued weakness in economic conditions.  See the discussion of the Allowance for Loan and Leases Losses later in this Management’s Discussion and Analysis for further details on the 2010 provision for loan losses.

 

Non-Interest Income

 

The table below sets forth changes for 2011, 2010 and 2009 in non-interest income:

 

 

 

For The Years Ended

 

Variances

 

 

 

December 31,

 

2011

 

2010

 

(dollar amounts in thousands)

 

2011

 

2010

 

2009

 

dollar

 

percentage

 

dollar

 

percentage

 

Fees and service charges

 

$

2,453

 

$

2,428

 

$

2,965

 

$

25

 

1.0%

 

$

(537

)

-18.1%

 

Mortgage gain on sale and origination fees

 

2,645

 

3,271

 

2,470

 

(626

)

-19.1%

 

801

 

32.4%

 

Debit/credit card fee income

 

1,632

 

1,447

 

1,156

 

185

 

12.8%

 

291

 

25.2%

 

Earnings on bank owned life insurance

 

596

 

585

 

504

 

11

 

1.9%

 

81

 

16.1%

 

Other than temporary impairment (OTTI) losses on investment securities:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total impairment loss on investment securities

 

-    

 

(1,214

)

(1,956

)

1,214

 

-100.0%

 

742

 

-37.9%

 

Non credit related losses recognized in other comprehensive income

 

-    

 

1,007

 

1,584

 

(1,007

)

-100.0%

 

(577

)

-36.4%

 

Net impairment losses on investment securities

 

-    

 

(207

)

(372

)

207

 

-100.0%

 

165

 

-44.4%

 

Gain / (loss) on sale of investment securities

 

1,983

 

783

 

333

 

1,200

 

153.3%

 

450

 

135.1%

 

(Loss) / gain on sale of other real estate owned

 

(543

)

24

 

(280

)

(567

)

-2362.5%

 

304

 

-108.6%

 

Gain on extinguishment of debt

 

-    

 

1,700

 

-    

 

(1,700

)

-100.0%

 

1,700

 

0.0%

 

Other income

 

964

 

716

 

639

 

248

 

34.6%

 

77

 

12.1%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

9,730

 

$

10,747

 

$

7,415

 

$

(1,017

)

-9.5%

 

$

3,332

 

44.9%

 

 

Discussion of 2011 Compared to 2010

 

The decrease in non-interest income in 2011 as compared to 2010 was largely due to the $1.7 million one-time gain recognized on the extinguishment of $5.2 million of subordinated debt in 2010, as the Company reduced this higher cost debt in an effort to improve overall net interest income, as noted above.  See also Note 9. Borrowings, of the consolidated financial statements, filed in this Form 10-K for additional discussion concerning the extinguishment of these borrowings.

 

In addition, we experienced a $0.6 million decline in gains and fees attributable to mortgage sales, reflecting lower demand for new and refinance mortgages over most of the year. Although the volume of mortgages funded in 2011 was lower than 2010, with the decline in mortgage rates in the second half of the 2011, which fell to new historical levels, and incremental staff being added to the mortgage team, mortgage funding levels increased in the second half of 2011 as compared to the first half of the year.  Lastly, we experienced an increase in the level of loss on the sale of other real estate owned, as we dramatically reduced the level of foreclosed assets through the sales of such properties, as part of our strategy to reduce non-earning assets in 2011. Partially offsetting these declines in non-interest income was a $1.2 million increase in gains on sales of investment securities, as the investment portfolio in whole returned to a net unrealized gain position and securities were sold, as part of our strategy to change the overall mix of the portfolio in an effort to improve the total return on invested funds, yielded higher gains.

 

Discussion of 2010 Compared to 2009

 

The majority of the of the increase in non-interest income in 2010 as compared to 2009 was attributable to a $1.7 million one-time gain realized on the extinguishment of $5.2 million of subordinated debt.  In addition, we realized a $0.8 million increase in gain and fee income from the sale of mortgages, as the historically low interest environment resulted in renewed activity in the refinance markets for home mortgages. This in conjunction with further expansion of the mortgage origination team led to increased volume in 2010 and consequently higher fee income.

 

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Table of Contents

 

The other factors that contributed to the variance in non-interest income in 2010 as compared to 2009 included an increase in debit/credit card transaction and interchange fee income of $0.3 million or 25.2% in 2010.  The Company attributes this growth to an increase in related transactions as well as additional core deposit relationships the Bank obtained during 2010.  The increase in gain on sale of investment securities of $0.5 million was largely consistent with improvements in the overall performance of the investment portfolio and the investment market in general. Lastly, we realized a nominal gain on the sale of other real estate owned in 2010 as compared to the $0.3 million loss in 2009. Partially offsetting these favorable changes was a decline in service charges and fee income of $0.5 million or 18.1% in 2010. Management believes the decline within this category can be attributed to better cash management practices by business customers in an effort to control costs in the difficult economic environment.

 

Non-Interest Expenses

 

The table below sets forth changes in non-interest expense for 2011, 2010 and 2009:

 

 

 

For the Years Ended

 

Variances

 

 

 

December 31,

 

2011

 

2010

 

(dollar amounts in thousands)

 

2011

 

2010

 

2009

 

dollar

 

percentage

 

dollar

 

percentage

 

Salaries and employee benefits

 

$

17,630

 

$

19,293

 

$

16,719

 

$

(1,663

)

-8.6%

 

$

2,574

 

15.4%

 

Equipment

 

1,739

 

1,653

 

1,445

 

86

 

5.2%

 

208

 

14.4%

 

Occupancy

 

3,771

 

3,805

 

3,472

 

(34

)

-0.9%

 

333

 

9.6%

 

Promotional

 

668

 

690

 

644

 

(22

)

-3.2%

 

46

 

7.1%

 

Data processing

 

2,975

 

2,676

 

2,743

 

299

 

11.2%

 

(67

)

-2.4%

 

OREO related costs

 

670

 

689

 

427

 

(19

)

-2.8%

 

262

 

61.4%

 

Write-downs of foreclosed assets

 

1,198

 

3,686

 

1,514

 

(2,488

)

-67.5%

 

2,172

 

143.5%

 

Regulatory assessment costs

 

2,360

 

2,657

 

1,984

 

(297

)

-11.2%

 

673

 

33.9%

 

Audit and tax advisory costs

 

779

 

571

 

625

 

208

 

36.4%

 

(54

)

-8.6%

 

Directors fees

 

483

 

551

 

355

 

(68

)

-12.3%

 

196

 

55.2%

 

Outside services

 

1,524

 

1,712

 

1,801

 

(188

)

-11.0%

 

(89

)

-4.9%

 

Telephone / communications costs

 

358

 

369

 

275

 

(11

)

-3.0%

 

94

 

34.2%

 

Amortization of intangible assets

 

445

 

514

 

1,049

 

(69

)

-13.4%

 

(535

)

-51.0%

 

Stationery and supplies

 

368

 

460

 

431

 

(92

)

-20.0%

 

29

 

6.7%

 

Other general operating costs

 

2,350

 

1,957

 

2,249

 

393

 

20.1%

 

(292

)

-13.0%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

37,318

 

$

41,283

 

$

35,733

 

$

(3,965

)

-9.6%

 

$

5,550

 

15.5%

 

 

Salaries and Employee Benefits

 

Salaries and employee benefits are the largest component of the Company’s non-interest expenses. For the years ended December 31, 2011, 2010 and 2009 the total number of full time equivalent employees were 256, 281 and 265, respectively.

 

Discussion of 2011 Compared to 2010

 

The $1.7 million reduction in salaries and employee benefits in 2011 was largely due to: a $0.4 million reduction in commission expense in part due to decline in the level of mortgages underwritten in 2011, as well as, the implementation of new compensation plans put in place in 2011; a $0.1 million reduction in bonus compensation due to the elimination of bonuses in 2011 pending the lifting of the Order and Written Agreement; a reduction of $0.4 million due to the establishment of an accrual for compensated absences during the third quarter of 2010; and reductions in other benefit costs of $0.4 million due to changes in plan benefits, refunds received from the benefit providers as part of their commitment to limit medical benefit costs and the percentage of employer contribution for those benefits.

 

Discussion of 2010 Compared to 2009

 

The $2.6 million year over year increase can be attributed to further expansion of the Company’s management team and Special Assets department in an effort to address the requirements of the Order and Written Agreement.  Additionally, during 2010 the Company incurred a one-time charge of $0.4 million to update its accrual for compensated absences, contributing further to the year over year increase.

 

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Table of Contents

 

Occupancy and Equipment

 

Discussion of 2011 Compared to 2010

 

Occupancy costs in 2011, declined modestly largely due to the closure of one of our smallest branches in 2011 as part of our goal to improve operating efficiency and due to refunds of previously paid property taxes based on approved petitions to reduce the assessed value of the properties the Company owns and leases.

 

Discussion of 2010 Compared to 2009

 

The $0.5 million increase within this category can be attributed to: an increase in depreciation expense associated with various leasehold improvements and equipment purchases, higher property tax costs, increased licensing costs associated with various process improvement initiatives throughout the organization, and a decline in sublease rental income resulting from the relocation on one branch office during late 2009.

 

FDIC and Other Regulatory Fees

 

Discussion of 2011 Compared to 2010

 

The decrease in regulatory assessment costs in 2011 of $0.3 million was largely due to a revision to the assessment calculation that went into effect during 2011.  However, the rates remain elevated due in part to the FDIC’s overall increase in rates to help replenish the Deposit Insurance Fund and increased assessments due to the Regulatory Order.

 

Discussion of 2010 Compared to 2009

 

For the year ended December 31, 2010, regulatory assessment costs increased $0.7 million over that reported for 2009.    The Bank’s deposit insurance assessment rates increased during 2010 in part because of the Regulatory Order and due to an increase by the FDIC in assessment rates.

 

Amortization of Intangible Assets

 

Amortization consists primarily of core deposit intangible amortization for the Hacienda acquisition in October 2003 and the Business First National Bank acquisition in October 2007. The level of amortization is determined pursuant to an analysis prepared by a third party at the time of acquisition to determine the fair value of deposits acquired in accordance with U.S. GAAP and which is updated, if needed by changes in projected run-off rates of acquired core deposits.

 

Discussion of 2011 Compared to 2010

 

The decrease in amortization in 2011 of $0.1 million was largely due to modest declines in the level of amortization from the Business First Bank core deposit intangible.

 

Discussion of 2010 Compared to 2009

 

The decrease in amortization in 2010 of $0.5 million was largely due to the Hacienda portion of the core deposit intangible becoming fully amortized in 2009.

 

Director Fees

 

Discussion of 2011 Compared to 2010

 

The decrease in fees in 2011 of $0.1 million was due to a decline in the level of fees paid to the chairman of the board of directors.

 

Discussion of 2010 Compared to 2009

 

The increase in fees in 2010 was primarily due to increased oversight by the Bank and Company’s board pursuant to the terms of the Consent Order, which resulted in increased fees paid to the chairman of the board, and to an increase in the total number of Board Members.

 

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Table of Contents

 

Write-downs of Foreclosed Assets

 

Discussion of 2011 Compared to 2010

 

The decrease in OREO valuation adjustments in 2011 of $2.5 million was due to the fact that much of the write-down on OREO inventory that existed at December 31, 2010 occurred in 2010.  In 2011, most of the OREO inventory was liquidated in conjunction with the Company’s strategy to reduce non-performing assets, which when combined with lower   levels of new additions to OREO in 2011, resulted in  a decline in the level of valuation allowance provisioning in 2011. See also Note 5. Other Real Estate Owned, of the consolidated financial statements, filed in this Form 10-K.

 

Discussion of 2010 Compared to 2009

 

2010 marked the peak of foreclosure activity and therefore the level of foreclosed asset holdings dramatically increased in 2010.  In conjunction with this increased foreclosure activity, the Company continued to refine the value of the foreclosed assets throughout the year, as new appraisal information became available on the value of the collateral, resulting in increased levels of write-downs during the 2010.

 

Provision for Income Taxes

 

The amount of the tax provision is determined by applying the Company’s statutory income tax rates to pre-tax book income, adjusted for permanent differences between pre-tax book income and actual taxable income. Such permanent differences include, but are not limited to, tax-exempt municipal interest income and earnings on bank-owned life insurance.  For 2011, the Company recorded a tax provision of $1.8 million.  For the years ended December 31, 2010 and 2009 the Company recorded an income tax benefit of $1.8 million and $5.8 million, respectively.

 

The Company’s effective tax rate for the years ended December 31, 2011, 2010 and 2009 was 19.1%, (9.1)% and (45.2)%, respectively. During 2010 the Company established a valuation allowance for a portion of its deferred tax assets of $7.1 million as of December 31, 2010.  The establishment of this valuation allowance resulted in a reduction in the income tax benefit the Company recorded in 2010, which would have been (45.9)% before the impact of the valuation allowance adjustment.  In 2011, the Company reassessed the level of valuation allowance required against its deferred tax assets and determined that based on the return to profitability over all four quarters of 2011, as well as the Company’s ability to forecast positive earnings for the foreseeable future that $1.5 million of the valuation allowance could be reversed.  As a result, the income tax provision for 2011 was reduced by $1.5 million, thereby lowering the effective tax rate for 2011. Exclusive of the reversal of $1.5 million of deferred tax asset valuation allowance, the effective tax rate would have been 34.8%.  The effective tax rate for the year ended December 31, 2009 was impacted significantly by the substantial provisions the Bank made to the allowance for loan losses during those years, significantly reducing pre-tax income.  See also Note 10. Income Taxes, of the consolidated financial statements, filed in this Form 10-K for a more detailed discussion concerning the valuation allowance the Company established for a portion of its deferred tax assets.

 

Financial Condition

 

The Company saw an improvement in its overall financial condition in 2011.  A discussion of each of the key elements of our financial condition follows:

 

Loans

 

Impact of Market Condition on Lending

 

Despite the recent signs of some stabilization in the local economies, in which it operates, loan demand remained tepid for the much of 2011, which was the primary factor in the contraction in the loan portfolio during 2011 and 2010.  It should be noted that near year-end 2011 loan demand appeared to be increasing.  We anticipate this trend to continue into 2012. The secondary factor that contributed to the 2011 decline in net loans was $25.8 million of problem loan sales, which occurred during the year.  Although the Company believes that it may be starting to see some signs of stabilization in the local economies in which it operates, the Company realizes that a renewed decline in the national, state and local economies may further impact local borrowers, as well as the values of real estate within our market footprint used to secure certain loans. As such, Management continues to closely monitor credit trends and leading indicators for additional signs of deterioration. The Bank employs stringent lending standards and remains very selective with regard to loan originations, including commercial real estate, real estate construction, land and commercial loans that it chooses to originate, in an effort to effectively manage risk in this difficult credit environment. The Company has devoted considerable resources to monitoring credit in order to take appropriate 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 safekeeping of customers’ deposits. The Company’s policies concerning the extension of credit require risk analyses 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 the Company operates, which can have a direct impact on the value of real estate securing collateral dependent loans. Weak economic conditions have also impacted certain borrowers the Company has extended credit to, making it difficult for those borrowers to continue to make timely repayment on their 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 losses that have an adverse impact on the Company’s operating results.

 

See also Note 3. Loans, of the consolidated financial statements, filed in this Form 10-K, for a more detailed discussion concerning credit quality, including the Company’s related policy.

 

Summary of Loan Portfolio

 

At December 31, 2011, total gross loan balances were $646.3 million.  This represents a decline of approximately $31.0 million or 4.6% from the $677.3 million reported at December 31, 2010.  The current year decline in total gross loans was most significantly impacted by $25.8 million in problem loan sales.  Exclusive of the loan sales, loan pay-downs, charge-offs and transfers to foreclosed collateral associated with the work through of certain problem credits, were largely offset by new loans issued during the year.

 

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Table of Contents

 

The table below sets forth the composition of the loan portfolio as of December 31, 2011, 2010, 2009, 2008 and 2007:

 

 

 

2011

 

 

 

2010

 

 

 

2009

 

 

 

2008

 

 

 

2007

 

 

 

(dollar amounts in thousands)

 

Amount

 

Percent

 

Amount

 

Percent

 

Amount

 

Percent

 

Amount

 

Percent

 

Amount

 

Percent

 

Real Estate Secured

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Multi-family residential

 

$

15,915

 

2.5%

 

$

17,637

 

2.6%

 

$

20,631

 

2.8%

 

$

16,206

 

2.4%

 

$

12,779

 

2.1%

 

Residential 1 to 4 family

 

20,839

 

3.2%

 

21,804

 

3.2%

 

25,483

 

3.5%

 

23,910

 

3.5%

 

24,326

 

4.0%

 

Home equity line of credit

 

31,047

 

4.8%

 

30,801

 

4.5%

 

29,780

 

4.1%

 

26,409

 

3.9%

 

17,470

 

2.8%

 

Commercial

 

357,499

 

55.4%

 

348,583

 

51.6%

 

337,940

 

46.5%

 

285,631

 

41.8%

 

274,266

 

44.7%

 

Farmland

 

8,155

 

1.3%

 

15,136

 

2.2%

 

13,079

 

1.8%

 

10,723