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



FORM 10-Q

(MARK ONE)    

ý

 

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

For the quarterly period ended March 31, 2013

OR

o

 

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

For the transition period from                        to                       

Commission file number 000-23877

Heritage Commerce Corp
(Exact name of Registrant as Specified in its Charter)

California
(State or Other Jurisdiction of
Incorporation or Organization)
  77-0469558
(I.R.S. Employer Identification No.)

150 Almaden Boulevard, San Jose, California
(Address of Principal Executive Offices)

 

95113
(Zip Code)

(408) 947-6900
(Registrant's Telephone Number, Including Area Code)

N/A
(Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report)

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

        Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, 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 ý    NO o

        Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o   Accelerated filer ý   Non-accelerated filer o
(Do not check if a
smaller reporting company)
  Smaller reporting company o

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

        The Registrant had 26,333,368 shares of Common Stock outstanding on April 18, 2013.

   


Table of Contents


HERITAGE COMMERCE CORP
QUARTERLY REPORT ON FORM 10-Q
TABLE OF CONTENTS

 
   
  Page No.

Cautionary Note on Forward-Looking Statements

  3


Part I. FINANCIAL INFORMATION


 

 


Item 1.


 


Consolidated Financial Statements (unaudited):


 


5



 


Consolidated Balance Sheets


 


5



 


Consolidated Statements of Income


 


6



 


Consolidated Statements of Comprehensive Income


 


7



 


Consolidated Statement of Changes in Shareholders' Equity


 


8



 


Consolidated Statements of Cash Flows


 


9



 


Notes to Consolidated Financial Statements


 


10


Item 2.


 


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


 


36


Item 3.


 


Quantitative and Qualitative Disclosures About Market Risk


 


65


Item 4.


 


Controls and Procedures


 


65


PART II. OTHER INFORMATION


 

 


Item 1.


 


Legal Proceedings


 


67


Item 1A.


 


Risk Factors


 


67


Item 2.


 


Unregistered Sales of Equity Securities and Use of Proceeds


 


67


Item 3.


 


Defaults Upon Senior Securities


 


67


Item 4.


 


Mine Safety Disclosures


 


67


Item 5.


 


Other Information


 


67


Item 6.


 


Exhibits


 


68


SIGNATURES


 


69


EXHIBIT INDEX


 


70

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Cautionary Note Regarding Forward-Looking Statements

        This Report on Form 10-Q contains various statements that may constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and are intended to be covered by the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Any statements about our expectations, beliefs, plans, objectives, assumptions or future events or performance are not historical facts and may be forward-looking. These forward-looking statements often can be, but are not always, identified by the use of words such as "assume," "expect," "intend," "plan," "project," "believe," "estimate," "predict," "anticipate," "may," "might," "should," "could," "goal," "potential" and similar expressions. We base these forward-looking statements on our current expectations and projections about future events, our assumptions regarding these events and our knowledge of facts at the time the statements are made. These statements include statements relating to our projected growth, anticipated future financial performance, and management's long-term performance goals, as well as statements relating to the anticipated effects on results of operations and financial condition.

        These forward-looking statements are subject to various risks and uncertainties that may be outside our control and our actual results could differ materially from our projected results. In addition, our past results of operations do not necessarily indicate our future results. The forward-looking statements could be affected by many factors, including but not limited to:

    Competition for loans and deposits and failure to attract or retain deposits and loans;

    Local, regional, and national economic conditions and events and the impact they may have on us and our customers, and our assessment of that impact on our estimates including, the allowance for loan losses;

    Risks associated with concentrations in real estate related loans;

    Changes in the level of nonperforming assets and charge-offs and other credit quality measures, and their impact on the adequacy of the Company's allowance for loan losses and the Company's provision for loan losses;

    The effects of and changes in trade, monetary and fiscal policies and laws, including the interest rate policies of the Federal Open Market Committee of the Federal Reserve Board;

    Stability of funding sources and continued availability of borrowings;

    Our ability to raise capital or incur debt on reasonable terms;

    Regulatory limits on Heritage Bank of Commerce's ability to pay dividends to the Company;

    Continued volatility in credit and equity markets and its effect on the global economy;

    The impact of reputational risk on such matters as business generation and retention, funding and liquidity;

    Oversupply of inventory and continued deterioration in values of California commercial real estate;

    A prolonged slowdown in construction activity;

    The effect of changes in laws and regulations (including laws and regulations concerning taxes, banking, securities, and executive compensation) which we must comply, including but not limited to, the Dodd-Frank Act of 2010;

    The effects of security breaches and computer viruses that may affect our computer systems;

    Changes in consumer spending, borrowings and saving habits;

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    Changes in the competitive environment among financial or bank holding companies and other financial service providers;

    The effect of changes in accounting policies and practices, as may be adopted by the regulatory agencies, as well as the Public Company Accounting Oversight Board, the Financial Accounting Standards Board and other accounting standard setters;

    The costs and effects of legal and regulatory developments, including resolution of legal proceedings or regulatory or other governmental inquiries, and the results of regulatory examinations or reviews;

    The ability to increase market share and control expenses; and

    Our success in managing the risks involved in the foregoing items.

        We are not able to predict all the factors that may affect future results. You should not place undue reliance on any forward looking statement, which speaks only as of the date of this Report on Form 10-Q. Except as required by applicable laws or regulations, we do not undertake any obligation to update or revise any forward looking statement, whether as a result of new information, future events or otherwise.

4


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Part I—FINANCIAL INFORMATION

ITEM 1—CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)


HERITAGE COMMERCE CORP

CONSOLIDATED BALANCE SHEETS (Unaudited)

 
  March 31,
2013
  December 31,
2012
 
 
  (Dollars in thousands)
 

Assets

             

Cash and due from banks

  $ 19,779   $ 16,520  

Interest-bearing deposits in other financial institutions

    57,090     357,045  
           

Total cash and cash equivalents

    76,869     373,565  

Securities available-for-sale, at fair value

    346,800     367,912  

Securities held-to-maturity, at amortized cost (fair value of $65,659 at March 31, 2013 and $50,964 at December 31, 2012)

    68,283     51,472  

Loans held-for-sale—SBA, at lower of cost or fair value, including deferred costs

    4,394     3,409  

Loans, including deferred fees and costs

    801,925     812,313  

Allowance for loan losses

    (19,342 )   (19,027 )
           

Loans, net

    782,583     793,286  

Federal Home Loan Bank and Federal Reserve Bank stock, at cost

    10,764     10,728  

Company owned life insurance

    48,774     48,358  

Premises and equipment, net

    7,632     7,469  

Intangible assets

    1,882     2,000  

Accrued interest receivable and other assets

    35,583     35,113  
           

Total assets

  $ 1,383,564   $ 1,693,312  
           

Liabilities and Shareholders' Equity

             

Liabilities:

             

Deposits:

             

Demand, noninterest-bearing

  $ 397,198   $ 727,684  

Demand, interest-bearing

    169,681     155,951  

Savings and money market

    286,784     272,047  

Time deposits—under $100

    23,835     25,157  

Time deposits—$100 and over

    189,779     190,502  

Time deposits—brokered

    83,763     97,807  

CDARS—money market and time deposits

    15,850     10,220  
           

Total deposits

    1,166,890     1,479,368  

Subordinated debt

    9,279     9,279  

Accrued interest payable and other liabilities

    36,560     34,924  
           

Total liabilities

    1,212,729     1,523,571  

Shareholders' equity:

             

Preferred stock, no par value; 10,000,000 shares authorized

             

Series C convertible perpetual preferred stock, 21,004 shares issued and outstanding at March 31, 2013 and December 31, 2012 (liquidation preference of $21,004 at March 31, 2013 and December 31, 2012)           

    19,519     19,519  

Common stock, no par value; 60,000,000 shares authorized; 26,333,368 shares issued and outstanding at March 31, 2013 and 26,322,147 shares issued and outstanding at December 31, 2012

    131,998     131,820  

Retained earnings

    17,901     15,721  

Accumulated other comprehensive income

    1,417     2,681  
           

Total shareholders' equity

    170,835     169,741  
           

Total liabilities and shareholders' equity

  $ 1,383,564   $ 1,693,312  
           

   

See notes to consolidated financial statements

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HERITAGE COMMERCE CORP

CONSOLIDATED STATEMENTS OF INCOME (Unaudited)

 
  Three Months Ended
March 31,
 
 
  2013   2012  
 
  (Dollars in thousands,
except per share data)

 

Interest income:

             

Loans, including fees

  $ 10,089     10,316  

Securities, taxable

    2,462     3,097  

Securities, non-taxable

    248      

Interest-bearing deposits in other financial institutions

    68     36  
           

Total interest income

    12,867     13,449  
           

Interest expense:

             

Deposits

    625     716  

Subordinated debt

    88     474  

Short-term borrowings

    1      
           

Total interest expense

    714     1,190  
           

Net interest income before provision for loan losses

    12,153     12,259  

Provision for loan losses

        100  
           

Net interest income after provision for loan losses

    12,153     12,159  
           

Noninterest income:

             

Service charges and fees on deposit accounts

    577     590  

Increase in cash surrender value of life insurance

    416     429  

Servicing income

    365     460  

Gain on sales of SBA loans

    136     36  

Gain on sales of securities

    31     27  

Other

    138     181  
           

Total noninterest income

    1,663     1,723  
           

Noninterest expense:

             

Salaries and employee benefits

    6,011     5,667  

Occupancy and equipment

    1,068     996  

Professional fees

    982     1,211  

Low income housing investment losses

    311     269  

Software subscriptions

    291     290  

FDIC deposit insurance premiums

    259     225  

Insurance expense

    254     224  

Data processing

    252     245  

Correspondent bank charges

    164     143  

Foreclosed assets, net

    (155 )   115  

Other

    1,344     1,471  
           

Total noninterest expense

    10,781     10,856  
           

Income before income taxes

    3,035     3,026  

Income tax expense

    855     951  
           

Net income

    2,180     2,075  

Dividends and discount accretion on preferred stock

        (1,206 )
           

Net income available to common shareholders

  $ 2,180   $ 869  
           

Earnings per common share:

             

Basic

  $ 0.07   $ 0.03  

Diluted

  $ 0.07   $ 0.03  

   

See notes to consolidated financial statements

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HERITAGE COMMERCE CORP

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)

 
  For the
Three Months Ended
March 31,
 
 
  2013   2012  
 
  (Dollars in thousands)
 

Net income

  $ 2,180   $ 2,075  

Other comprehensive income (loss):

             

Change in net unrealized holding gains on available-for-sale securities and I/O strips          

    (2,164 )   372  

Deferred income taxes

    909     (156 )

Change in net unamortized unrealized gain on securities available-for-sale that were reclassified to securities held-to-maturity

    (14 )    

Deferred income taxes

    6      

Reclassification adjustment for (gains) realized in income

    (31 )   (27 )

Deferred income taxes

    13     11  
           

Change in unrealized gains (loss) on securities and I/O strips, net of deferred income taxes

    (1,281 )   200  
           

Change in net pension and other benefit plan liability adjustment

    29     57  

Deferred income taxes

    (12 )   (24 )
           

Change in pension and other benefit plan liability, net of deferred income taxes

    17     33  
           

Other comprehensive income (loss)

    (1,264 )   233  
           

Total comprehensive income

  $ 916   $ 2,308  
           

   

See notes to consolidated financial statements

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HERITAGE COMMERCE CORP

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (Unaudited)

 
  Three Months Ended March 31, 2013 and 2012  
 
  Preferred Stock   Common Stock    
  Accumulated
Other
Comprehensive
Income
   
 
 
  Retained
Earnings
  Total
Shareholders'
Equity
 
 
  Shares   Amount   Discount   Shares   Amount  
 
  (Dollars in thousands)
 

Balance, January 1, 2012

    61,004   $ 59,365   $ (833 )   26,295,001   $ 131,172   $ 7,172   $ 955   $ 197,831  

Net income

                        2,075         2,075  

Other comprehensive income

                            233     233  

Repurchase of Series A preferred stock

    (40,000 )   (40,000 )                       (40,000 )

Series A preferred stock capitalized offering costs

        154                 (154 )        

Forfeitures of restricted stock awards

                (8,500 )                

Amortization of restricted stock awards, net of forfeitures and taxes

                    28             28  

Cash dividends paid on Series A preferred stock

                        (373 )       (373 )

Accretion of discount on Series A preferred stock

            833             (833 )        

Stock option expense, net of forfeitures and taxes

                    102             102  
                                   

Balance, March 31, 2012

    21,004   $ 19,519   $     26,286,501   $ 131,302   $ 7,887   $ 1,188   $ 159,896  
                                   

Balance, January 1, 2013

    21,004   $ 19,519   $     26,322,147   $ 131,820   $ 15,721   $ 2,681   $ 169,741  

Net income

                        2,180         2,180  

Other comprehensive loss

                            (1,264 )   (1,264 )

Issuance of restricted stock awards

                10,000                  

Amortization of restricted stock awards, net of forfeitures and taxes

                    45             45  

Stock option expense, net of forfeitures and taxes

                    129             129  

Stock options exercised

                1,221     4             4  
                                   

Balance, March 31, 2013

    21,004   $ 19,519   $     26,333,368   $ 131,998   $ 17,901   $ 1,417   $ 170,835  
                                   

   

See notes to consolidated financial statements

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HERITAGE COMMERCE CORP

CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

 
  Three Months Ended
March 31,
 
 
  2013   2012  
 
  (Dollars in thousands)
 

CASH FLOWS FROM OPERATING ACTIVITIES:

             

Net income

  $ 2,180   $ 2,075  

Adjustments to reconcile net income to net cash provided by operating activities:

             

Amortization of discounts and premiums on securities

    756     533  

Gain on sales of securities available-for-sale

    (31 )   (27 )

Gain on sales of SBA loans

    (136 )   (36 )

Proceeds from sale of SBA loans originated for sale

    1,774     632  

Net change in SBA loans originated for sale

    (2,643 )   (4,621 )

Provision for loan losses

        100  

Increase in cash surrender value of life insurance

    (416 )   (429 )

Depreciation and amortization

    177     195  

Amortization of intangible assets

    118     123  

Gains on sale of foreclosed assets, net

    (198 )   (31 )

Stock option expense, net

    129     102  

Amortization of restricted stock awards, net

    45     28  

Effect of changes in:

             

Accrued interest receivable and other assets

    (88 )   818  

Accrued interest payable and other liabilities

    1,806     (609 )
           

Net cash provided by (used in) operating activities

    3,473     (1,147 )
           

CASH FLOWS FROM INVESTING ACTIVITIES:

             

Purchase of securities available-for-sale

    (8,334 )   (19,943 )

Purchase of securities held-to-maturity

    (18,433 )    

Maturities/paydowns/calls of securities available-for-sale

    23,056     18,858  

Maturities/paydowns/calls of securities held-to-maturity

    1,429      

Proceeds from sale of securities available-for-sale

    3,530     2,280  

Net change in loans

    10,690     5,239  

Change in Federal Home Loan Bank and Federal Reserve Bank stock

    (36 )   (3 )

Purchase of premises and equipment

    (340 )   (98 )

Proceeds from sale of foreclosed assets

    743     188  

Proceeds from sale of other loans transferred to held-for-sale

        220  

Purchases of company owned life insurance

        (250 )
           

Net cash provided by investing activities

    12,305     6,491  
           

CASH FLOWS FROM FINANCING ACTIVITIES:

             

Net change in deposits

    (312,478 )   30,822  

Repayment of preferred stock

        (40,000 )

Payment of cash dividends—preferred stock

        (373 )

Exercise of stock options

    4      
           

Net cash used in financing activities

    (312,474 )   (9,551 )
           

Net decrease in cash and cash equivalents

    (296,696 )   (4,207 )

Cash and cash equivalents, beginning of period

    373,565     72,872  
           

Cash and cash equivalents, end of period

  $ 76,869   $ 68,665  
           

Supplemental disclosures of cash flow information:

             

Interest paid

  $ 709   $ 1,557  

Income taxes paid

    1,025     800  

Supplemental schedule of non-cash investing activity:

             

Due to broker for securities purchased

  $ 3,351   $ 11,921  

Loans transferred to foreclosed assets

    33     1,973  

Transfer of loans held-for-sale to loan portfolio

    20      

   

See notes to consolidated financial statements

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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2013

(Unaudited)

1) Basis of Presentation

        The unaudited consolidated financial statements of Heritage Commerce Corp (the "Company" or "HCC") and its wholly owned subsidiary, Heritage Bank of Commerce (the "Bank" or "HBC"), have been prepared pursuant to the rules and regulations for reporting on Form 10-Q. Accordingly, certain information and notes required by accounting principles generally accepted in the United States of America ("GAAP") for annual financial statements are not included herein. The interim statements should be read in conjunction with the consolidated financial statements and notes that were included in the Company's Form 10-K for the year ended December 31, 2012. The Company has also established the following unconsolidated subsidiary grantor trusts: Heritage Capital Trust I; Heritage Statutory Trust I; Heritage Statutory Trust II; and Heritage Commerce Corp Statutory Trust III, which are Delaware Statutory business trusts formed for the exclusive purpose of issuing and selling trust preferred securities. During the third quarter of 2012 the Company dissolved the Heritage Statutory Trust I and the Heritage Capital Trust I.

        HBC is a commercial bank serving customers located in Santa Clara, Alameda, and Contra Costa counties of California. No customer accounts for more than 10 percent of revenue for HBC or the Company. Management evaluates the Company's performance as a whole and does not allocate resources based on the performance of different lending or transaction activities. Accordingly, the Company and its subsidiary operate as one business segment.

        In management's opinion, all adjustments necessary for a fair presentation of these consolidated financial statements have been included and are of a normal and recurring nature. All intercompany transactions and balances have been eliminated.

        The preparation of financial statements in conformity with 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 consolidated financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ significantly from these estimates.

        The results for the three months ended March 31, 2013 are not necessarily indicative of the results expected for any subsequent period or for the entire year ending December 31, 2013.

Reclassifications

        Certain reclassifications of prior year balances have been made to conform to the current year presentation. These reclassifications had no impact on the Company's consolidated financial position, results of operations or net change in cash and cash equivalents.

Adoption of New Accounting Standards

        In February 2013, the FASB issued an accounting standards update with the primary objective of improving the reporting of reclassifications out of accumulated other comprehensive income ("AOCI"). For significant reclassifications that are required to be presented in their entirety in net income in the same reporting period by U.S. GAAP, the update requires an entity to report the effect of these reclassifications out of AOCI on the respective line items of net income either on the face of the

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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

March 31, 2013

(Unaudited)

1) Basis of Presentation (Continued)

statement that reports net income or in the financial statement notes. For AOCI items that that are not reclassified to net income in their entirety, presentation in the financial statement notes is required. This update is effective for public companies for fiscal years and interim periods within those years beginning after December 15, 2012, or the first quarter of 2013 for calendar year-end companies, and is required to be applied prospectively. The effect of adopting this standard did not have a material effect on the Company's operating results or financial condition, but the additional disclosures are included in Note 3.

2) Earnings Per Share

        Basic earnings per common share is computed by dividing net income, less dividends and discount accretion on preferred stock, by the weighted average common shares outstanding. On June 21, 2010, the Company issued to various institutional investors 21,004 shares of Series C Convertible Perpetual Preferred Stock ("Series C Preferred Stock"). The Series C Preferred Stock is convertible into 5,601,000 shares of common stock when transferred in accordance with its terms. The Series C Preferred Stock participate in the earnings of the Company and, therefore, the shares issued on the conversion of the Series C Preferred Stock are considered outstanding under the two-class method of computing basic earnings per common share during periods of earnings. Diluted earnings per share reflect potential dilution from outstanding stock options and common stock warrants, using the treasury stock method. The common stock warrant was antidilutive at March 31, 2013 and 2012. A reconciliation of these factors used in computing basic and diluted earnings per common share is as follows:

 
  For the Three Months Ended
March 31,
 
 
  2013   2012  
 
  (Dollars in thousands)
 

Net income available to common shareholders

  $ 2,180   $ 869  

Less: net income allocated to Series C Preferred Stock

    382     153  
           

Net income allocated to common shareholders

  $ 1,798   $ 716  
           

Weighted average common shares outstanding for basic earnings per common share

    26,329,343     26,289,334  

Dilutive effect of stock options oustanding, using the the treasury stock method

    49,114     27,220  
           

Shares used in computing diluted earnings per common share

    26,378,457     26,316,554  
           

Basic earnings per share

 
$

0.07
 
$

0.03
 

Diluted earnings per share

  $ 0.07   $ 0.03  

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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

March 31, 2013

(Unaudited)

3) Accumulated Other Comprehensive Income ("AOCI")

        The following table reflects the changes in AOCI by component for the periods indicated:

 
  For the Three Months Ended March 31, 2013 and 2012  
 
  Unrealized
Gains on
Available-
for-Sale
Securities
and I/O
Strips(1)
  Unamortized
Unrealized
Gain on
Available-
for-Sale
Securities
Reclassified
to Held-to-
Maturity(1)
  Defined
Benefit
Pension
Plan
Items(1)
  Total(1)  
 
  (Dollars in thousands)
 

Beginning balance January 1, 2013, net of taxes

  $ 7,887   $ 497   $ (5,703 ) $ 2,681  

Other comprehensive (loss) before reclassification, net of taxes

   
(1,255

)
 
   
(24

)
 
(1,279

)

Amounts reclassified from other comprehensive income (loss), net of taxes

    (18 )   (8 )   41     15  
                   

Net current period other comprensive income (loss), net of taxes

    (1,273 )   (8 )   17     (1,264 )
                   

Ending balance March 31, 2013, net of taxes

  $ 6,614   $ 489   $ (5,686 ) $ 1,417  
                   

Beginning balance January 1, 2012, net of taxes

  $ 6,210   $   $ (5,255 ) $ 955  

Other comprehensive income (loss) before reclassification, net of taxes

   
216
   
   
(8

)
 
208
 

Amounts reclassified from other comprehensive income (loss), net of taxes

    (16 )       41     25  
                   

Net current period other comprensive income, net of taxes

    200         33     233  
                   

Ending balance March 31, 2012, net of taxes

  $ 6,410   $   $ (5,222 ) $ 1,188  
                   

(1)
Amounts in parenthesis indicate debits.

12


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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

March 31, 2013

(Unaudited)

3) Accumulated Other Comprehensive Income ("AOCI") (Continued)

 
  Amounts
Reclassified
from AOCI(1)
For the Three
Months Ended
March 31,
   
 
  Affected Line Item Where
Net Income is Presented
Details About AOCI Components
  2013   2012
 
  (Dollars in
thousands)

   

Unrealized gains on available-for-sale securities and I/O strips

  $ 31   $ 27   Realized gains on sale of securities

    (13 )   (11 ) Income tax expense
             

    18     16   Net of tax
             

Amortization of unrealized gain on securities available-for-sale that were reclassified to securities held-to-maturity

    14       Interest income on taxable securities

    (6 )     Income tax expense
             

    8       Net of tax
             

Amortization of defined benefit pension plan items(2)

               

Prior service cost

        (7 )  

Actuarial losses

    (71 )   (63 )  
             

    (71 )   (70 ) Income before income tax

    30     29   Income tax expense
             

    (41 )   (41 ) Net of tax
             

Total reclassification for the period

  $ (15 ) $ (25 )  
             

(1)
Amounts in parenthesis indicate debits.

(2)
This AOCI component is included in the computation of net periodic benefit cost (see Note 7—Benefit Plans).

13


Table of Contents


HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

March 31, 2013

(Unaudited)

4) Securities

        The amortized cost and estimated fair value of securities at March 31, 2013 and December 31, 2012 were as follows:

March 31, 2013
  Amortized
Cost
  Gross
Unrealized
Gains
  Gross
Unrealized
Losses
  Estimated
Fair
Value
 
 
  (Dollars in thousands)
 

Securities available-for-sale:

                         

Agency mortgage-backed securities

  $ 262,710   $ 8,444   $ (77 ) $ 271,077  

Corporate bonds

    53,681     1,269     (58 )   54,892  

Trust preferred securities

    20,789     150     (108 )   20,831  
                   

Total

  $ 337,180   $ 9,863   $ (243 ) $ 346,800  
                   

Securities held-to-maturity:

                         

Agency mortgage-backed securities

  $ 15,185   $ 6   $ (298 ) $ 14,893  

Municipals—tax exempt

    53,098     1     (2,333 )   50,766  
                   

Total

  $ 68,283   $ 7   $ (2,631 ) $ 65,659  
                   

 

December 31, 2012
  Amortized
Cost
  Gross
Unrealized
Gains
  Gross
Unrealized
Losses
  Estimated
Fair
Value
 
 
  (Dollars in thousands)
 

Securities available-for-sale:

                         

Agency mortgage-backed securities

  $ 281,598   $ 9,668   $ (22 ) $ 291,244  

Corporate bonds

    53,739     1,849         55,588  

Trust preferred securities

    20,769     375     (64 )   21,080  
                   

Total

  $ 356,106   $ 11,892   $ (86 ) $ 367,912  
                   

Securities held-to-maturity:

                         

Agency mortgage-backed securities

  $ 16,659   $ 2   $ (177 ) $ 16,484  

Municipals—tax exempt

    34,813     80     (413 )   34,480  
                   

Total

  $ 51,472   $ 82   $ (590 ) $ 50,964  
                   

        There were no holdings of securities of any one issuer, other than the U.S. Government and its sponsored entities, in an amount greater than 10% of shareholders' equity. At March 31, 2013, the Company held 320 securities (169 available-for-sale and 151 held-to-maturity), of which 143 had fair values below amortized cost. No securities had been carried with an unrealized loss for over 12 months. Unrealized losses were due to higher interest rates. The issuers are of high credit quality and all principal amounts are expected to be paid when securities mature. The fair value is expected to recover as the securities approach their maturity date and/or market rates decline. The Company does not intend to sell any securities with an unrealized loss and does not believe that it is more likely than not that the Company will be required to sell a security in an unrealized loss position prior to recovery in

14


Table of Contents


HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

March 31, 2013

(Unaudited)

4) Securities (Continued)

value. The Company does not consider these securities to be other-than-temporarily impaired at March 31, 2013.

        At December 31, 2012, the Company held 269 securities (168 available-for-sale and 101 held-to-maturity), of which 70 had fair values below amortized cost. No securities had been carried with an unrealized loss for over 12 months. The Company does not consider these securities to be other-than-temporarily impaired at December 31, 2012.

        The amortized cost and estimated fair values of securities as March 31, 2013, by contractual maturity, are shown below. The expected maturities will differ from contractual maturities if borrowers have the right to call or pre-pay obligations with or without call or pre-payment penalties. Securities not due at a single maturity date are shown separately.

 
  Available-for-sale  
 
  Amortized Cost   Estimated Fair Value  
 
  (Dollars in thousands)
 

Due after one through five years

  $ 924   $ 963  

Due after five through ten years

    52,757     53,929  

Due after ten years

    20,789     20,831  

Agency mortgage-backed securities

  $ 262,710     271,077  
           

Total

  $ 337,180   $ 346,800  
           

 

 
  Held-to-maturity  
 
  Amortized Cost   Estimated Fair Value  
 
  (Dollars in thousands)
 

Due after five through ten years

  $ 1,085   $ 1,060  

Due after ten years

    52,013     49,706  

Agency mortgage-backed securities

    15,185     14,893  
           

Total

  $ 68,283   $ 65,659  
           

15


Table of Contents


HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

March 31, 2013

(Unaudited)

5) Loans

        Loans were as follows:

 
  March 31,
2013
  December 31,
2012
 
 
  (Dollars in thousands)
 

Loans held-for-investment:

             

Commercial

  $ 356,688   $ 375,469  

Real estate:

             

Commercial and residential

    361,340     354,934  

Land and construction

    24,611     22,352  

Home equity

    45,347     43,865  

Consumer

    14,036     15,714  
           

Loans

    802,022     812,334  

Deferred loan origination (fees) costs, net

    (97 )   (21 )
           

Loans, including deferred fees and costs

    801,925     812,313  

Allowance for loan losses

    (19,342 )   (19,027 )
           

Loans, net

  $ 782,583   $ 793,286  
           

        Changes in the allowance for loan losses were as follows for the periods indicated:

 
  Three Months Ended March 31, 2013  
 
  Commercial   Real Estate   Consumer   Total  
 
  (Dollars in thousands)
 

Balance, beginning of period

  $ 12,866   $ 6,034   $ 127   $ 19,027  

Charge-offs

    (840 )           (840 )

Recoveries

    1,150     5         1,155  
                   

Net recoveries

    310     5         315  

Provision (credit) for loan losses

    (721 )   731     (10 )    
                   

Balance, end of period

  $ 12,455   $ 6,770   $ 117   $ 19,342  
                   

 

 
  Three Months Ended March 31, 2012  
 
  Commercial   Real Estate   Consumer   Total  
 
  (Dollars in thousands)
 

Balance, beginning of period

  $ 13,215   $ 7,338   $ 147   $ 20,700  

Charge-offs

    (910 )   (45 )       (955 )

Recoveries

    461             461  
                   

Net charge-offs

    (449 )   (45 )       (494 )

Provision (credit) for loan losses

    968     (884 )   16     100  
                   

Balance, end of period

  $ 13,734   $ 6,409   $ 163   $ 20,306  
                   

16


Table of Contents


HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

March 31, 2013

(Unaudited)

5) Loans (Continued)

        The following table presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment, based on the impairment method at the following period-ends:

 
  March 31, 2013  
 
  Commercial   Real Estate   Consumer   Total  
 
  (Dollars in thousands)
 

Allowance for loan losses:

                         

Ending allowance balance attributable to loans:

                         

Individually evaluated for impairment

  $ 2,031   $ 977   $ 18   $ 3,026  

Collectively evaluated for impairment

    10,424     5,793     99     16,316  
                   

Total allowance balance

  $ 12,455   $ 6,770   $ 117   $ 19,342  
                   

Loans:

                         

Individually evaluated for impairment

  $ 8,128   $ 10,112   $ 141   $ 18,381  

Collectively evaluated for impairment

    348,560     421,186     13,895     783,641  
                   

Total loan balance

  $ 356,688   $ 431,298   $ 14,036   $ 802,022  
                   

 

 
  December 31, 2012  
 
  Commercial   Real Estate   Consumer   Total  
 
  (Dollars in thousands)
 

Allowance for loan losses:

                         

Ending allowance balance attributable to loans:

                         

Individually evaluated for impairment

  $ 1,963   $ 760   $ 17   $ 2,740  

Collectively evaluated for impairment

    10,903     5,274     110     16,287  
                   

Total allowance balance

  $ 12,866   $ 6,034   $ 127   $ 19,027  
                   

Loans:

                         

Individually evaluated for impairment

  $ 10,161   $ 9,336   $ 147   $ 19,644  

Collectively evaluated for impairment

    365,308     411,815     15,567     792,690  
                   

Total loan balance

  $ 375,469   $ 421,151   $ 15,714   $ 812,334  
                   

17


Table of Contents


HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

March 31, 2013

(Unaudited)

5) Loans (Continued)

        The following table presents loans held-for-investment individually evaluated for impairment by class of loans as of March 31, 2013 and December 31, 2012. The recorded investment included in the following table represents loan principal net of any partial charge-offs recognized on the loans. The unpaid principal balance represents the recorded balance prior to any partial charge-offs.

 
  March 31, 2013   December 31, 2012  
 
  Unpaid
Principal
Balance
  Recorded
Investment
  Allowance
for Loan
Losses
Allocated
  Unpaid
Principal
Balance
  Recorded
Investment
  Allowance
for Loan
Losses
Allocated
 
 
  (Dollars in thousands)
 

With no related allowance recorded:

                                     

Commercial

  $ 3,939   $ 3,939   $   $ 7,829   $ 6,978   $  

Real estate:

                                     

Commercial and residential

    3,622     3,622         2,755     2,741      

Land and construction

    2,177     2,177         2,310     2,223      

Home Equity

    2,137     2,137         2,141     2,141      
                           

Total with no related allowance recorded

    11,875     11,875         15,035     14,083      

With an allowance recorded:

                                     

Commercial

    4,272     4,189     2,031     3,678     3,182     1,963  

Real estate:

                                     

Commercial and residential

    1,882     1,882     683     3,183     1,937     465  

Home Equity

    294     294     294     295     295     295  

Consumer

    141     141     18     147     147     17  
                           

Total with an allowance recorded

    6,589     6,506     3,026     7,303     5,561     2,740  
                           

Total

  $ 18,464   $ 18,381   $ 3,026   $ 22,338   $ 19,644   $ 2,740  
                           

        The following tables present interest recognized and cash-basis interest earned on impaired loans for the periods indicated:

 
  Three Months Ended March 31, 2013  
 
   
  Real Estate    
   
 
 
  Commercial   Commercial and
Residential
  Land and
Construction
  Home
Equity
  Consumer   Total  
 
  (Dollars in thousands)
 

Average of impaired loans during the period

  $ 9,145   $ 5,090   $ 2,200   $ 2,434   $ 144   $ 19,013  

Interest income during impairment

  $   $   $   $   $   $  

Cash-basis interest earned

  $   $   $   $   $   $  

18


Table of Contents


HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

March 31, 2013

(Unaudited)

5) Loans (Continued)


 
  Three Months Ended March 31, 2012  
 
   
  Real Estate    
   
 
 
  Commercial   Commercial and
Residential
  Land and
Construction
  Home
Equity
  Consumer   Total  
 
  (Dollars in thousands)
 

Average of impaired loans during the period

  $ 11,450   $ 2,773   $ 3,002   $ 16   $ 11   $ 17,252  

Interest income during impairment

  $   $ 1   $ 14   $   $   $ 15  

Cash-basis interest earned

  $   $ 1   $ 14   $   $   $ 15  

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

 
  March 31,    
 
 
  December 31,
2012
 
 
  2013   2012  
 
  (Dollars in thousands)
 

Nonaccrual loans—held-for-sale

  $   $ 184   $  

Nonaccrual loans—held-for-investment

    16,115     14,005     17,335  

Restructured and loans over 90 days past due and still accruing

    549     2,155     859  
               

Total nonperforming loans

  $ 16,664   $ 16,344   $ 18,194  
               

Other restructured loans

  $ 1,717   $ 431   $ 1,450  

Impaired loans, excluding loans held-for-sale

  $ 18,381   $ 16,591   $ 19,644  

        The following table presents the nonperforming loans by class as of March 31, 2013 and December 31, 2012:

 
  March 31, 2013   December 31, 2012  
 
  Nonaccrual   Restructured and
Loans Over
90 Days
Past Due and
Still Accruing
  Total   Nonaccrual   Restructured and
Loans Over
90 Days
Past Due and
Still Accruing
  Total  
 
  (Dollars in thousands)
 

Commercial

  $ 5,863   $ 549   $ 6,412   $ 7,852   $ 859   $ 8,711  

Real estate:

                                     

Commercial and residential

    5,503         5,503     4,676         4,676  

Land and construction

    2,177         2,177     2,223         2,223  

Home equity

    2,431         2,431     2,437         2,437  

Consumer

    141         141     147         147  
                           

Total

  $ 16,115   $ 549   $ 16,664   $ 17,335   $ 859   $ 18,194  
                           

19


Table of Contents


HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

March 31, 2013

(Unaudited)

5) Loans (Continued)

        The following table presents the aging of past due loans as of March 31, 2013 by class of loans:

 
  March 31, 2013  
 
  30 - 59
Days
Past Due
  60 - 89
Days
Past Due
  90 Days or
Greater
Past Due
  Total
Past Due
  Loans Not
Past Due
  Total  
 
  (Dollars in thousands)
 

Commercial

  $ 1,445   $ 646   $ 4,368   $ 6,459   $ 350,229   $ 356,688  

Real estate:

                                     

Commercial and residential

            3,485     3,485     357,855     361,340  

Land and construction

            69     69     24,542     24,611  

Home equity

    87         2,043     2,130     43,217     45,347  

Consumer

    103               103     13,933     14,036  
                           

Total

  $ 1,635   $ 646   $ 9,965   $ 12,246   $ 789,776   $ 802,022  
                           

        The following table presents the aging of past due loans as of December 31, 2012 by class of loans:

 
  December 31, 2012  
 
  30 - 59
Days
Past Due
  60 - 89
Days
Past Due
  90 Days or
Greater
Past Due
  Total
Past Due
  Loans Not
Past Due
  Total  
 
  (Dollars in thousands)
 

Commercial

  $ 1,699   $ 355   $ 5,120   $ 7,174   $ 368,295   $ 375,469  

Real estate:

                                     

Commercial and residential

    1,603         3,290     4,893     350,041     354,934  

Land and construction

            78     78     22,274     22,352  

Home equity

    742         2,045     2,787     41,078     43,865  

Consumer

                    15,714     15,714  
                           

Total

  $ 4,044   $ 355   $ 10,533   $ 14,932   $ 797,402   $ 812,334  
                           

        Past due loans 30 days or greater totaled $12,246,000 and $14,932,000 at March 31, 2013 and December 31, 2012, respectively, of which $11,267,000 and $12,020,000 were on nonaccrual. At March 31, 2013, there were also $4,848,000 loans less than 30 days past due included in nonaccrual loans held-for-investment. At December 31, 2012, there were also $5,315,000 loans less than 30 days past due included in nonaccrual loans held-for-investment. Management's classification of a loan as "nonaccrual" is an indication that there is reasonable doubt as to the full recovery of principal or interest on the loan. At that point, the Company stops accruing interest income, and reverses any uncollected interest that had been accrued as income. The Company begins recognizing interest income only as cash interest payments are received and it has been determined the collection of all outstanding principal is not in doubt. The loans may or may not be collateralized, and collection efforts are pursued.

20


Table of Contents


HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

March 31, 2013

(Unaudited)

5) Loans (Continued)

Credit Quality Indicators

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

        The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. The Company analyzes loans individually by classifying the loans as to credit risk. This analysis is performed on a quarterly basis. Nonclassified loans generally include those loans that are expected to be repaid in accordance with contractual loans terms. Classified loans are those loans that are assigned a substandard, substandard-nonaccrual, or doubtful risk rating using the following definitions:

        Substandard.    Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.

        Substandard-Nonaccrual.    Loans classified as substandard-nonaccrual are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected. In addition, the Company no longer accrues interest on the loan because of the underlying weaknesses.

        Doubtful.    Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.

        Loss.    Loans classified as loss are considered uncollectable or of so little value that their continuance as assets is not warranted. This classification does not necessarily mean that a loan has no recovery or salvage value; but rather, there is much doubt about whether, how much, or when the recovery would occur. Loans classified as loss are immediately charged off against the allowance for loan losses. Therefore, there is no balance to report at March 31, 2013 or December 31, 2012.

21


Table of Contents


HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

March 31, 2013

(Unaudited)

5) Loans (Continued)

        The following table provides a summary of the loan portfolio by loan type and credit quality classification at March 31, 2013 and December 31, 2012:

 
  March 31, 2013   December 31, 2012  
 
  Nonclassified   Classified   Total   Nonclassified   Classified   Total  
 
  (Dollars in thousands)
 

Commercial

  $ 340,372   $ 16,316   $ 356,688   $ 355,440   $ 20,029   $ 375,469  

Real estate:

                                     

Commercial and residential

    351,911     9,429     361,340     345,045     9,889     354,934  

Land and construction

    22,433     2,178     24,611     18,858     3,494     22,352  

Home equity

    42,591     2,756     45,347     41,187     2,678     43,865  

Consumer

    13,656     380     14,036     15,321     393     15,714  
                           

Total

  $ 770,963   $ 31,059   $ 802,022   $ 775,851   $ 36,483   $ 812,334  
                           

        In order to determine whether a borrower is experiencing financial difficulty, an evaluation is performed of the probability that the borrower will be in payment default on any of its debt in the foreseeable future without the modification. This evaluation is performed under the Company's underwriting policy.

        The recorded investment of troubled debt restructurings at March 31, 2013 was $3,662,000, which included $1,396,000 of nonaccrual loans and $2,266,000 of accruing loans. The book balance of troubled debt restructurings at December 31, 2012 was $4,107,000, which included $1,798,000 of nonaccrual loans and $2,309,000 of accruing loans. Approximately $920,000 and $1,152,000 in specific reserves were established with respect to these loans as of March 31, 2013 and December 31, 2012, respectively. As of March 31, 2013 and December 31, 2012, the Company had no additional amounts committed on any loan classified as a troubled debt restructuring.

        There were no loans modified as troubled debt restructuring during the three months ended March 31, 2013. The following table presents loans by class modified as troubled debt restructurings during the three month period ended March 31, 2012:

 
  During the Three Months Ended
March 31, 2012
 
Troubled Debt Restructurings:
  Number
of
Contracts
  Pre-modification
Outstanding
Recorded
Investment
  Post-modification
Outstanding
Recorded
Investment
 
 
  (Dollars in thousands)
 

Commercial

    2   $ 412   $ 412  
               

Total

    2   $ 412   $ 412  
               

        The troubled debt restructurings described above increased the allowance for loan losses by $27,000 through the allocation of specific reserves, and resulted in no net charge-offs during the three month period ended March 31, 2012.

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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

March 31, 2013

(Unaudited)

5) Loans (Continued)

        A loan is considered to be in payment default when it is 30 days contractually past due under the modified terms. There were no defaults on troubled debt restructurings, within twelve months following the modification, during the three month ended March 31, 2013 or 2012.

        A loan that is a troubled debt restructuring on nonaccrual status may return to accruing status after a period of at least six months of consecutive payments in accordance with the modified terms.

6) Income Taxes

        Some items of income and expense are recognized in different years for tax purposes than when applying generally accepted accounting principles, leading to timing differences between the Company's actual tax liability and the amount accrued for this liability based on book income. These temporary differences comprise the "deferred" portion of the Company's tax expense or benefit, which is accumulated on the Company's books as a deferred tax asset or deferred tax liability until such time as they reverse.

        Realization of the Company's deferred tax assets is primarily dependent upon the Company generating sufficient taxable income to obtain benefit from the reversal of net deductible temporary differences and utilization of tax credit carryforwards and the net operating loss carryforwards for Federal and California state income tax purposes. The amount of deferred tax assets considered realizable is subject to adjustment in future periods based on estimates of future taxable income. Under generally accepted accounting principles, a valuation allowance is required to be recognized if it is "more likely than not" that a deferred tax asset will not be realized. The determination of the realizability of the deferred tax assets is highly subjective and dependent upon judgment concerning management's evaluation of both positive and negative evidence, including forecasts of future income, cumulative losses, applicable tax planning strategies, and assessments of current and future economic and business conditions.

        The Company had net deferred tax assets of $20,237,000, and $19,264,000, at March 31, 2013, and December 31, 2012, respectively. After consideration of the matters in the preceding paragraph, the Company determined that it is more likely than not that the net deferred tax asset at March 31, 2013 and December 31, 2012 will be fully realized in future years.

7) Benefit Plans

Supplemental Retirement Plan

        The Company has a supplemental retirement plan (the "Plan") covering current and former key executives and directors. The Plan is a nonqualified defined benefit plan. Benefits are unsecured as

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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

March 31, 2013

(Unaudited)

7) Benefit Plans (Continued)

there are no Plan assets. The following table presents the amount of periodic cost recognized for the periods indicated:

 
  Three Months
Ended
March 31,
 
 
  2013   2012  
 
  (Dollars in
thousands)

 

Components of net periodic benefit cost:

             

Service cost

  $ 304   $ 294  

Interest cost

    196     193  

Amortization of prior service cost

        7  

Amortization of net actuarial loss

    71     63  
           

Net periodic benefit cost

  $ 571   $ 557  
           

Split-Dollar Life Insurance Benefit Plan

        The Company maintains life insurance policies for current and former directors and officers that are subject to split-dollar life insurance agreements. The following table sets forth the funded status of the split-dollar life insurance benefits for the periods indicated:

 
  March 31, 2013   December 31, 2012  
 
  (Dollars in thousands)
 

Change in projected benefit obligation

             

Projected benefit obligation at beginning of year

  $ 4,717   $ 4,525  

Interest cost

    44     185  

Actuarial gain

    3     7  
           

Projected benefit obligation at end of period

  $ 4,764   $ 4,717  
           

        Amounts recognized in accumulated other comprehensive income at March 31, 2013 and December 31, 2012 consist of the following:

 
  March 31, 2013   December 31, 2012  
 
  (Dollars in thousands)
 

Net actuarial loss

  $ 669   $ 624  

Prior transition obligation

    1,665     1,685  
           

Accumulated other comprehensive loss

  $ 2,334   $ 2,309  
           

24


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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

March 31, 2013

(Unaudited)

8) Preferred Stock

Series A Preferred Stock

        On November 21, 2008, the Company issued 40,000 shares of Series A Fixed Rate Cumulative Perpetual Preferred Stock ("Series A Preferred Stock") to the U.S. Treasury under the terms of the U.S. Treasury Capital Purchase Program for $40,000,000 with a liquidation preference of $1,000 per share. On March 7, 2012, in accordance with approvals received from the U.S. Treasury and the Federal Reserve Board, the Company repurchased all of the Series A Preferred Stock and paid all of the related accrued and unpaid dividends. HCC used available cash and proceeds from a $30,000,000 distribution approved by the California Department of Financial Institutions from HBC to HCC. The repurchase of the Series A Preferred Stock accelerated the accretion of the remaining issuance discount on the Series A Preferred Stock. Total dividends and discount accretion on Preferred Stock, including accelerated accretion of approximately $765,000, reduced net income available to common shareholders by $1,206,000 in the first quarter of 2012. The Company did not repurchase the related warrant that was issued to the U.S. Treasury, and the warrant remains outstanding as of the date of this report.

Series C Preferred Stock

        On June 21, 2010, the Company issued to various institutional investors 21,004 shares of Series C Convertible Perpetual Preferred Stock ("Series C Preferred Stock"). The Series C Preferred Stock is mandatorily convertible into common stock at a conversion price of $3.75 per share upon a subsequent transfer of the Series C Preferred Stock to third parties not affiliated with the holder in a widely dispersed offering. The Series C Preferred Stock is non-voting except in the case of certain transactions that would affect the rights of the holders of the Series C Preferred Stock or applicable law. Holders of Series C Preferred Stock will receive dividends if and only to the extent dividends are paid to holders of common stock. The Series C Preferred Stock is not redeemable by the Company or by the holders and has a liquidation preference of $1,000 per share. The Series C Preferred Stock ranks senior to the Company's common stock.

9) Fair Value

        Accounting guidance establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:

        Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

        Level 2: Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities in active markets; quoted prices for identical assets or liabilities in markets that are not active; or other inputs that are observable or can be corroborated by observable market data (for example, interest rates and yield curves observable at commonly quoted intervals, prepayment speeds, credit risks, and default rates).

        Level 3: Significant unobservable inputs that reflect a reporting entity's own assumptions about the assumptions that market participants would use in pricing an asset or liability.

25


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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

March 31, 2013

(Unaudited)

9) Fair Value (Continued)

Financial Assets and Liabilities Measured on a Recurring Basis

        The fair values of securities available for sale are determined by obtaining quoted prices on nationally recognized securities exchanges (Level 1 inputs) or matrix pricing, which is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities, but rather by relying on the securities' relationship to other benchmark quoted securities (Level 2 inputs).

        The fair value of interest-only ("I/O") strip receivable assets is based on a valuation model used by a third party. The Company is able to compare the valuation model inputs and results to widely available published industry data for reasonableness (Level 2 inputs).

 
   
  Fair Value Measurements Using  
 
  Balance   Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
  Significant
Other
Observable
Inputs
(Level 2)
  Significant
Unobservable
Inputs
(Level 3)
 
 
  (Dollars in thousands)
 

Assets at March 31, 2013:

                         

Available-for-sale securities:

                         

Agency mortgage-backed securities          

  $ 271,077       $ 271,077      

Corporate bonds

    54,892         54,892      

Trust preferred securities

    20,831         20,831      

I/O strip receivables

    1,777         1,777      

Assets at December 31, 2012:

                         

Available-for-sale securities:

                         

Agency mortgage-backed securities          

  $ 291,244       $ 291,244      

Corporate bonds

    55,588         55,588      

Trust preferred securities

    21,080         21,080      

I/O strip receivables

    1,786           1,786      

        There were no transfers between Level 1 and Level 2 during the period for assets measured at fair value on a recurring basis.

Assets and Liabilities Measured on a Non-Recurring Basis

        The fair value of loans held-for-sale is generally based on obtaining bids and broker indications on the estimated value of these loans held-for-sale, resulting in a Level 2 classification.

        The fair value of impaired loans with specific allocations of the allowance for loan losses is generally based on recent real estate appraisals. The appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.

26


Table of Contents


HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

March 31, 2013

(Unaudited)

9) Fair Value (Continued)

        Foreclosed assets are valued at the time the loan is foreclosed upon and the asset is transferred to foreclosed assets. The fair value is based primarily on third party appraisals, less costs to sell. The appraisals may utilize a single valuation approach or a combination of approaches including the comparable sales and income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are typically significant and result in a Level 3 classification of the inputs for determining fair value.

 
   
  Fair Value Measurements Using  
 
  Balance   Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
  Significant
Other
Observable
Inputs
(Level 2)
  Significant
Unobservable
Inputs
(Level 3)
 
 
  (Dollars in thousands)
 

Assets at March 31, 2013:

                         

Impaired loans—held-for-investment:

                         

Commercial

  $ 2,982           $ 2,982  

Real estate:

                         

Commercial and residential

    3,217             3,217  

Land and construction

    1,685             1,685  

Consumer

    122             122  
                       

  $ 8,006           $ 8,006  
                       

Foreclosed assets:

                         

Commercial

  $ 81           $ 81  

Land and construction

    657             657  
                       

  $ 738           $ 738  
                       

Assets at December 31, 2012:

                         

Impaired loans—held-for-investment:

                         

Commercial

  $ 3,645           $ 3,645  

Real estate:

                         

Commercial and residential

    3,674             3,674  

Land and construction

    1,723             1,723  

Consumer

    130             130  
                       

  $ 9,172           $ 9,172  
                       

Foreclosed assets:

                         

Commercial

  $ 83           $ 83  

Land and construction

    1,187             1,187  
                       

  $ 1,270           $ 1,270  
                       

27


Table of Contents


HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

March 31, 2013

(Unaudited)

9) Fair Value (Continued)

        The following table shows the detail of the impaired loans held-for-investment and the impaired loans held-for-investment carried at fair value for the periods indicated:

 
  March 31, 2013   December 31, 2012  
 
  (Dollars in thousands)
 

Impaired loans held-for-investment:

             

Book value of impaired loans held-for-investment carried at fair value

  $ 11,032   $ 11,912  

Book value of impaired loans held-for-investment carried at cost

    7,349     7,732  
           

Total impaired loans held-for-investment

  $ 18,381   $ 19,644  
           

Impaired loans held-for-investment carried at fair value:

             

Book value of impaired loans held-for-investment carried at fair value

  $ 11,032   $ 11,912  

Specific valuation allowance

    (3,026 )   (2,740 )
           

Impaired loans held-for-investment carried at fair value, net

  $ 8,006   $ 9,172  
           

        Impaired loans held-for-investment which are measured primarily for impairment using the fair value of the collateral were $18,381,000 at March 31, 2013, after partial charge-offs of $83,000 in the first three months of 2013. In addition, these loans had a specific valuation allowance of $3,026,000 at March 31, 2013. Impaired loans held-for-investment totaling $11,032,000 at March 31, 2013 were carried at fair value as a result of the aforementioned partial charge-offs and specific valuation allowances at period-end. The remaining $7,349,000 of impaired loans were carried at cost at March 31, 2013, as the fair value of the collateral exceeded the cost basis of each respective loan. Partial charge-offs and changes in specific valuation allowances during the first three months of 2013 on impaired loans held-for-investment carried at fair value at March 31, 2013 resulted in an additional provision for loan losses of $757,000.

        Foreclosed assets measured at fair value less costs to sell, had a carrying amount of $738,000, with no valuation allowance at March 31, 2013.

        Impaired loans held-for-investment of $19,644,000 at December 31, 2012, after partial charge-offs of $2,694,000 in 2012, were analyzed for additional impairment primarily using the fair value of collateral. In addition, these loans had a specific valuation allowance of $2,740,000 at December 31, 2012. Impaired loans held-for-investment totaling $11,912,000 at December 31, 2012 were carried at fair value as a result of the aforementioned partial charge-offs and specific valuation allowances at year-end. The remaining $7,732,000 of impaired loans were carried at cost at December 31, 2012, as the fair value of the collateral exceeded the cost basis of each respective loan. Partial charge-offs and changes in specific valuation allowances during 2012 on impaired loans held-for-investment carried at fair value at December 31, 2012 resulted in an additional provision for loan losses of $3,856,000.

28


Table of Contents


HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

March 31, 2013

(Unaudited)

9) Fair Value (Continued)

        At December 31, 2012, foreclosed assets had a carrying amount of $1,270,000, with no valuation allowance at December 31, 2012.

        The following table presents quantitative information about level 3 fair value measurements for financial instruments measured at fair value on a non-recurring basis at the periods indicated:

 
  March 31, 2013
 
  Fair Value   Valuation
Techniques
  Unobservable Inputs   Range
(Weighted
Average)
 
  (Dollars in thousands)

Impaired loans—held-for-investment:

                 

Commercial

  $ 2,982   Market Approach   Discount adjustment for differences between comparable sales   0% to 3% (2%)

Real estate:

                 

Commercial and residential

    3,217   Market Approach   Discount adjustment for differences between comparable sales   0% to 13% (1%)

Land and construction

    1,685   Market Approach   Discount adjustment for differences between comparable sales   1% to 4% (2%)

Foreclosed assets:

                 

Land and construction

    657   Market Approach   Discount adjustment for differences between comparable sales   1% to 16% (7%)

 

 
  December 31, 2012
 
  Fair Value   Valuation
Techniques
  Unobservable Inputs   Range
(Weighted
Average)
 
  (Dollars in thousands)

Impaired loans—held-for-investment:

                 

Commercial

  $ 3,645   Market Approach   Discount adjustment for differences between comparable sales   0% to 4% (1%)

Real estate:

                 

Commercial and residential

    3,674   Market Approach   Discount adjustment for differences between comparable sales   0% to 13% (1%)

Land and construction

    1,723   Market Approach   Discount adjustment for differences between comparable sales   1% to 4% (2%)

Foreclosed assets:

                 

Land and construction

    1,187   Market Approach   Discount adjustment for differences between comparable sales   0% to 23% (6%)

29


Table of Contents


HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

March 31, 2013

(Unaudited)

9) Fair Value (Continued)

        The Company obtains third party appraisals on its impaired loans held-for-investment and foreclosed assets to determine fair value. Generally, the third party appraisals apply the "market approach," which is a valuation technique that uses prices and other relevant information generated by market transactions involving identical or comparable (that is, similar) assets, liabilities, or a group of assets and liabilities, such as a business. Adjustments are then made based on the type of property, age of appraisal, current status of property and other related factors to estimate the current value of collateral.

        The carrying amounts and estimated fair values of financial instruments at March 31, 2013 are as follows:

 
   
  Estimated Fair Value  
 
  Carrying
Amounts
  Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
  Significant
Other
Observable
Inputs
(Level 2)
  Significant
Unobservable
Inputs
(Level 3)
  Total  
 
  (Dollars in thousands)
 

Assets:

                               

Cash and cash equivalents

  $ 76,869   $ 76,869   $   $   $ 76,869  

Securities available-for-sale

    346,800         346,800         346,800  

Securities held-to-maturity

    68,283         65,659         65,659  

Loans (including loans held-for-sale), net

    786,977         4,394     783,126     787,520  

FHLB and FRB stock

    10,764                 N/A  

Accrued interest receivable

    4,309         1,919     2,390     4,309  

Loan servicing rights and I/O strips receivables

    2,447         4,680         4,680  

Liabilities:

                               

Time deposits

  $ 302,476   $   $ 303,282   $   $ 303,282  

Other deposits

    864,414         864,414         864,414  

Subordinated debt

    9,279             5,400     5,400  

Accrued interest payable

    281         281         281  

30


Table of Contents


HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

March 31, 2013

(Unaudited)

9) Fair Value (Continued)

        The carrying amounts and estimated fair values of the Company's financial instruments at December 31, 2012:

 
   
  Estimated Fair Value  
 
  Carrying
Amounts
  Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
  Significant
Other
Observable
Inputs
(Level 2)
  Significant
Unobservable
Inputs
(Level 3)
  Total  
 
  (Dollars in thousands)
 

Assets:

                               

Cash and cash equivalents

  $ 373,565   $ 373,565   $   $   $ 373,565  

Securities available-for-sale

    367,912         367,912         367,912  

Securities held-to-maturity

    51,472         50,964         50,964  

Loans (including loans held-for-sale), net

    796,695         3,409     793,911     797,320  

FHLB and FRB stock

    10,728                 N/A  

Accrued interest receivable

    3,773         1,514     2,259     3,773  

Loan servicing rights and I/O strips receivables

    2,495         4,715         4,715  

Liabilities:

                               

Time deposits

  $ 318,664   $   $ 319,476   $   $ 319,476  

Other deposits

    1,160,704         1,160,704         1,160,704  

Subordinated debt

    9,279             5,400     5,400  

Accrued interest payable

    277         277         277  

        The methods and assumptions, not previously discussed, used to estimate the fair value are described as follows:

Cash and Cash Equivalents

        The carrying amounts of cash on hand, noninterest and interest bearing due from bank accounts, and Fed funds sold approximate fair values and are classified as Level 1.

Loans

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

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

31


Table of Contents


HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

March 31, 2013

(Unaudited)

9) Fair Value (Continued)

FHLB and FRB Stock

        It was not practical to determine the fair value of FHLB and FRB stock due to restrictions placed on their transferability.

Accrued Interest Receivable/Payable

        The carrying amounts of accrued interest approximate fair value resulting in a Level 2 or Level 3 classification.

Deposits

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

Subordinated Debt

        The fair values of the subordinated debentures are estimated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements resulting in a Level 3 classification.

Off-balance Sheet Instruments

        Fair values for off-balance sheet, credit-related financial instruments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties' credit standing. The fair value of commitments is not material.

Limitations

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

32


Table of Contents


HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

March 31, 2013

(Unaudited)

10) Equity Plan

        The Company has an Amended and Restated 2004 Equity Plan (the "Equity Plan") for directors, officers, and key employees. The Equity Plan provides for the grant of incentive and non-qualified stock options and restricted stock. The Equity Plan provides that the option price for both incentive and non-qualified stock options will be determined by the Board of Directors at no less than the fair value at the date of grant. Options granted vest on a schedule determined by the Board of Directors at the time of grant. Generally, options vest over four years. All options expire no later than ten years from the date of grant. As of March 31, 2013, there are 349,071 shares available for future grants under the Equity Plan.

        Stock option activity under the Equity Plan is as follows:

Total Stock Options
  Number
of Shares
  Weighted
Average
Exercise
Price
  Weighted
Average
Remaining
Contractual
Life (Years)
  Aggregate
Intrinsic
Value
 

Outstanding at January 1, 2013

    1,314,347   $ 12.90              

Granted

    15,000   $ 6.51              

Exercised

    (1,221 ) $ 3.57              

Forfeited or expired

    (4,159 ) $ 4.96              
                         

Outstanding at March 31, 2013

    1,323,967   $ 12.80     5.6   $ 794,000  
                     

Vested or expected to vest

    1,257,769           5.6   $ 755,000  
                     

Exercisable at March 31, 2013

    1,011,067           4.6   $ 484,000  
                     

        As of March 31, 2013, there was $1,066,000 of total unrecognized compensation cost related to nonvested stock options granted under the Equity Plan. That cost is expected to be recognized over a weighted-average period of approximately 2.79 years.

        Restricted stock activity under the Equity Plan is as follows:

Total Restricted Stock Award
  Number
of Shares
  Weighted
Average
Grant Date
Fair Value
 

Nonvested shares at January 1, 2013

    88,000   $ 5.74  

Granted

    10,000   $ 6.51  

Vested

      $  

Forfeited

      $  
             

Nonvested shares at March 31, 2013

    98,000   $ 5.82  
             

        As of March 31, 2013, there was $266,000 of total unrecognized compensation cost related to nonvested restricted stock awards granted under the Equity Plan. The cost is expected to be recognized over a weighted-average period of approximately 11 months.

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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

March 31, 2013

(Unaudited)

11) Subordinated Debt

        The Company has supported its growth through the issuance of trust preferred securities from special purpose trusts and accompanying sales of subordinated debt to these trusts. The subordinated debt that we issued to the trusts is senior to our shares of common stock and Series C Preferred Stock. As a result, we must make payments on the subordinated debt before any dividends can be paid on our common stock and Series C Preferred Stock. Under the terms of the subordinated debt, we may defer interest payments for up to five years. Interest payments on the subordinated notes payable to the Company's subsidiary grantor Trusts are deductible for tax purposes. The subordinated debt is not registered with the Securities and Exchange Commission. For regulatory reporting purposes, the subordinated debt qualifies for Tier 1 capital treatment. Under the Dodd-Frank Wall Street Reform and Consumer Protection Act, certain trust preferred securities will no longer be eligible to be included as Tier 1 capital for regulatory purposes. The trust preferred securities continued to be eligible for Tier 1 capital under Dodd-Frank for bank holding companies with less than $15,000,000,000 of assets; however, under proposed rules implementing Basel III trust preferred securities would lose eligibility for Tier 1 capital over a ten year period. Therefore, our trust preferred securities will continue to be eligible to be treated as Tier 1 capital, subject to other rules and limitations.

        During the third quarter of 2012, the Company redeemed its 10.875% fixed-rate subordinated debentures in the amount of $7,000,000 issued to Heritage Capital Trust I (and the related premium cost of $304,500) and the Company's 10.600% fixed-rate subordinated debentures in the amount of $7,000,000 issued to Heritage Statutory Trust I (and the related premium cost of $296,800). The related trust securities issued by Capital Trust I and Statutory Trust I were also redeemed in connection with the subordinated debt redemption and the trusts were dissolved. A $15,000,000 distribution from the Bank to the HCC provided the cash for the redemption. The Company incurred a charge of $601,300 in 2012 for the early payoff premium on the redemption of the subordinated debt.

        The table below summarizes the Company's subordinated debt as of the periods indicated:

 
  March 31,
2013
  December 31,
2012
 
 
  (Dollars in thousands)
 

Subordinated debentures due to Heritage Statutory Trust II with interest payable quarterly based on 3-month Libor plus 3.58% (3.86% at March 31, 2013), redeemable with a premium beginning July 31, 2006 and with no premium beginning July 31, 2011, due July 31, 2031

  $ 5,155   $ 5,155  

Subordinated debentures due to Heritage Statutory Trust III with interest payable quarterly based on 3-month Libor plus 3.40% (3.68% at March 31, 2013), redeemable with a premium beginning September 26, 2007 and due September 26, 2032

    4,124     4,124  
           

Total

  $ 9,279   $ 9,279  
           

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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

March 31, 2013

(Unaudited)

12) Loss Contingencies

        The Company's policy is to accrue for legal costs associated with both asserted and unasserted claims when it probable that such costs will be incurred and such costs can be reasonably estimated. The Company had previously accrued for such costs associated with an unasserted claim arising from an apparent transfer of funds for personal use by an authorized signatory of a customer. During the first quarter of 2013, a legal claim was asserted on this matter and the Company accrued an additional $266,000 for additional legal costs that are expected to be incurred to defend this matter. The litigation is in the very early stages and the Company intends to vigorously defend the litigation. At this time it is not possible to determine the amount of the loss, if any, arising from the claim in excess of the legal expenses expected to be incurred in defense of the litigation.

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ITEM 2—MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

        The following discussion provides information about the results of operations, financial condition, liquidity, and capital resources of Heritage Commerce Corp (the "Company" or "HCC") and its wholly owned subsidiary, Heritage Bank of Commerce (sometimes referred to as the "Bank" or "HBC"). This information is intended to facilitate the understanding and assessment of significant changes and trends related to our financial condition and the results of operations. This discussion and analysis should be read in conjunction with our consolidated financial statements and the accompanying notes presented elsewhere in this report. Unless we state otherwise or the context indicates otherwise, references to the "Company," "Heritage," "we," "us," and "our," in this Report on Form 10-Q refer to Heritage Commerce Corp and Heritage Bank of Commerce.

CRITICAL ACCOUNTING POLICIES

        Critical accounting policies are discussed in our Form 10-K for the year ended December 31, 2012. There are no changes to these policies as of March 31, 2013.

EXECUTIVE SUMMARY

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

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

Performance Overview

        For the three months ended March 31, 2013, net income was $2.2 million, compared to $2.1 million for the three months ended March 31, 2012. Net income available to common shareholders was $2.2 million, or $0.07 per average diluted common share for the three months ended March 31, 2013. After accrued dividends and discount accretion on preferred stock of $1.2 million, net income available to shareholders was $869,000, or $0.03 per average common share for the three months ended March 31, 2012. Beginning in the second quarter of 2012, there were no dividends or discount accretion on preferred stock, following the redemption of the Company's $40 million of Series A Fixed Rate Cumulative Perpetual Preferred Stock ("Series A Preferred Stock") issued to the U.S. Treasury Department under the TARP Capital Purchase Program. The Company's annualized return on average assets was 0.61% and annualized return on average equity was 5.20% for the three months ended March 31, 2013, compared to 0.64% and 4.43%, respectively, for the three months ended March 31, 2012.

        Late in the fourth quarter of 2012, the Company received short-term demand deposits in the amount of $467.5 million from one customer for specific transactions. Of this amount, $195.6 million was subsequently withdrawn, for a net outstanding balance of $271.9 million at December 31, 2012. The outstanding balance of the short-term demand deposits was $24.3 million at March 31, 2013. Because of the short-term nature of these funds, the excess liquidity was placed in low-interest earning deposits at the Federal Reserve Bank.

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        The following are major factors that impacted the Company's results of operations:

    The net interest margin was 3.71% for the first quarter of 2013, compared to 4.06% for the first quarter of 2012. The decline in the net interest margin for the first quarter of 2013 was primarily due to the increased short-term deposits at the Federal Reserve Bank as a result of the aforementioned short-term demand deposits of one customer. The net interest margin for the first quarter of 2013 was also impacted by a decline in loan and security yields, partially offset by a lower cost of funds. Excluding the impact to the net interest margin as a result of the large short-term demand deposits from one customer, and favorable benefit on the repayment of interest income from paid-off nonaccrual loans, the net interest margin was 3.78% for the first quarter of 2013.

    Net interest income was $12.2 million for the first quarter of 2013, compared to $12.3 million for the first quarter of 2012, primarily due to a lower net interest margin.

    The Company did not record a provision for loan losses in the first quarter of 2013 because of the loan recoveries and the reduced credit risk from the reduction in nonperforming assets and classified assets at March 31, 2013. The loan loss provision for the first quarter of 2012 was $100,000.

    Noninterest income was $1.7 million for both the first quarter of 2013 and the first quarter of 2012.

    Noninterest expense for the first quarter of 2013 was $10.8 million, compared to $10.9 million for the first quarter of 2012.

    Income tax expense for the first quarter ended March 31, 2013 was $855,000, compared to $951,000 for the first quarter of 2012.

    The efficiency ratio was 78.03% for the first quarter of 2013, compared to 77.64% for the first quarter of 2012.

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

    Cash, Federal funds sold, interest-bearing deposits in other financial institutions and securities available-for-sale decreased 7% to $423.7 million at March 31, 2013, from $454.5 million at March 31, 2012, and decreased 43% from $741.5 million at December 31, 2012. Excluding the short-term deposits at the Federal Reserve Bank offsetting the short-term demand deposits from one customer of $24.3 million at March 31, 2013 and $271.9 million at December 31, 2012, total cash, Federal funds sold, interest-bearing deposits in other financial institutions and securities available-for-sale decreased 12% to $399.3 million at March 31, 2013, from $454.5 million at March 31, 2012, and decreased 15% from $469.6 million at December 31, 2012.

    Securities held-to-maturity, at amortized cost, were $68.3 million at Mach 31, 2013, compared to no securities held-to-maturity at March 31, 2012. Securities held-to-maturity, at amortized cost, were $51.5 million at December 31, 2012.

    Total loans, excluding loans held-for-sale, increased $45.0 million, or 6%, to $801.9 million at March 31, 2013, compared to $756.9 million at March 31, 2012, and decreased $10.4 million, or 1%, from $812.3 million at December 31, 2012.

    Nonperforming assets were $17.4 million, or 1.26% of total assets at March 31, 2013, compared to $19.5 million or 1.49% of total assets at March 31, 2012, and $19.5 million, or 1.15% of total assets at December 31, 2012. Nonperforming assets were 1.28% of total assets at March 31, 2013, compared to 1.37% of total assets at December 31, 2012, excluding the short-term deposits

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      of $24.3 million and $271.9 million, respectively, at the Federal Reserve Bank offsetting the short-term demand deposits from one customer.

    Classified assets, net of Small Business Administration ("SBA") guarantees, decreased 42% to $31.2 million at March 31, 2013 from $54.2 million at March 31, 2012, and decreased 15% from $36.8 million at December 31, 2012.

    Net recoveries totaled $315,000 for the first quarter of 2013, compared to net charge-offs of $494,000 for the first quarter of 2012, and net charge-offs of $766,000 for the fourth quarter of 2012.

    The allowance for loan losses at March 31, 2013 was $19.3 million, or 2.41% of total loans, representing 116.07% of nonperforming loans (there were no nonaccrual loans in loans held-for-sale at March 31, 2013). The allowance for loan losses at March 31, 2012 was $20.3 million, or 2.68% of total loans, representing 125.66% of nonperforming loans excluding nonaccrual loans in loans held-for-sale. The allowance for loan losses at December 31, 2012 was $19.0 million, or 2.34% of total loans, representing 104.58% of nonperforming loans (there were no nonaccrual loans in loans held-for-sale at December 31, 2012).

    Total deposits, excluding brokered deposits and short-term demand deposits from one customer of $24.3 million at March 31, 2013 and $271.9 million at December 31, 2012, were $1.06 billion at March 31, 2013, compared to $995.5 million at March 31, 2012, and $1.11 billion at December 31, 2012.

    The ratio of noncore funding (which consists of time deposits—$100,000 and over, CDARS deposits, brokered deposits, securities under agreement to repurchase and short-term borrowings) to total assets was 20.92% at March 31, 2013, compared to 19.89% at March 31, 2012, and 17.63% at December 31, 2012. The ratio of noncore funding to total assets was 21.29% at March 31, 2013 and 21.00% at December 31, 2012, excluding the short-term deposits of $24.3million and $271.9 million, respectively, at the Federal Reserve Bank offsetting the short-term demand deposits from one customer.

    The loan to deposit ratio was 68.72% at March 31, 2013, compared to 70.07% at March 31, 2012, and 54.91% at December 31, 2012. The loan to deposit ratio was 70.19% at March 31, 2013 and 67.27% at December 31, 2012, excluding the $24.3 million and $271.9 million, respectively, of short-term demand deposits from one customer.

    Capital ratios exceed regulatory requirements for a well-capitalized financial institution, both on a consolidated basis and at the bank level at March 31, 2013:

Capital Ratios
  Heritage
Commerce Corp
  Heritage
Bank of Commerce
  Well-Capitalized
Financial Institution
Regulatory Guidelines
 

Total Risk-Based

    16.7 %   15.9 %   10.0 %

Tier 1 Risk-Based

    15.5 %   14.6 %   6.0 %

Leverage

    11.5 %   10.9 %   5.0 %

Deposits

        The composition and cost of the Company's deposit base are important in analyzing the Company's net interest margin and balance sheet liquidity characteristics. Except for brokered and State of California time deposits, the Company's depositors are generally located in its primary market area. Depending on loan demand and other funding requirements, the Company also obtains deposits from wholesale sources including deposit brokers. The Company had $83.8 million in brokered deposits at March 31, 2013, compared to $84.7 million at March 31, 2012, and $97.8 million at December 31,

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2012. Deposits from title insurance companies, escrow accounts and real estate exchange facilitators decreased to $20.2 million at March 31, 2013, compared to $30.6 million at March 31 2012, and $21.4 million at December 31, 2012. Certificates of deposit from the State of California totaled $85.0 million at March 31, 2013, compared to $50.0 million at March 31, 2012, and $85.0 million at December 31, 2012. Total deposits at March 31, 2013 were $1.17 billion, compared to $1.08 billion at March 31, 2012 and $1.48 billion at December 31, 2012. Core deposits (excluding all time deposits, CDARS deposits, and the short-term demand deposits from one customer of $24.3 million at March 31, 2013 and $271.9 million at December 31, 2012) increased to $829.3 million at March 31, 2013, an increase of $36.7 million, or 5% from $792.6 million at March 31, 2012, and decreased $54.5 million, or 6%, from $883.8 million at December 31, 2012. The Company has a policy to monitor all deposits that may be sensitive to interest rate changes to help assure that liquidity risk does not become excessive due to concentrations.

        HBC is a member of the Certificate of Deposit Account Registry Service ("CDARS") program. The CDARS program allows customers with deposits in excess of FDIC insured limits to obtain coverage on time deposits through a network of banks within the CDARS program. Deposits gathered through this program are considered brokered deposits under regulatory guidelines. Deposits in the CDARS program totaled $15.9 million at March 31, 2013, compared to $6.2 million at March 31, 2012, and $10.2 million at December 31, 2012.

Liquidity

        Our liquidity position refers to our ability to maintain cash flows sufficient to fund operations and to meet obligations and other commitments in a timely fashion. At March 31, 2013, we had $76.9 million in cash and cash equivalents and approximately $328.9 million in available borrowing capacity from various sources including the Federal Home Loan Bank ("FHLB"), the Federal Reserve Bank of San Francisco ("FRB"), and Federal funds facilities with several financial institutions. The Company also had $276.9 million in unpledged securities available at March 31, 2013. Our loan to deposit ratio decreased to 68.72% at March 31, 2013, compared to 70.07% at March 31, 2012, and 54.91% at December 31, 2012. The loan to deposit ratio was 70.19% at March 31, 2013 and 67.27% at December 31, 2012, excluding the $24.3 million and $271.9 million, respectively, of short-term demand deposits from one customer.

Lending

        Our lending business originates principally through our branch offices located in our primary markets. The Company also has an additional SBA loan production office in Santa Rosa, California. Total loans, excluding loans held-for-sale, increased 6% to $801.9 million at March 31, 2013, from $756.9 million at March 31, 2012, and decreased 1% from $812.3 million at December 31, 2012. The loan portfolio remains well diversified with commercial and industrial ("C&I") loans accounting for 44% of the total loan portfolio at March 31, 2013. Commercial and residential real estate loans accounted for 45% of the total loan portfolio at March 31, 2013, of which 51% were owner-occupied by businesses. Consumer and home equity loans accounted for 8% of the total loan portfolio, and land and construction loans accounted for the remaining 3% of the total loan portfolio at March 31, 2013. The yield on the loan portfolio was 5.13% for the first quarter of 2013, compared to 5.41% for the first quarter of 2012.

Net Interest Income

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

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        The Company through its asset and liability policies and practices seeks to maximize net interest income without exposing the Company to an excessive level of interest rate risk. Interest rate risk is managed by monitoring the pricing, maturity and repricing options of all classes of interest bearing assets and liabilities. This is discussed in more detail under "Liquidity and Asset/Liability Management." In addition, we believe there are measures and initiatives we can take to improve the net interest margin, including increasing loan rates, adding floors on floating rate loans, reducing nonperforming assets, managing deposit interest rates, and reducing higher cost deposits.

        The net interest margin is also adversely impacted by the reversal of interest on nonaccrual loans and the reinvestment of loan payoffs into lower yielding investment securities and other short-term investments.

Management of Credit Risk

        We continue to proactively identify, quantify, and manage our problem loans. Early identification of problem loans and potential future losses helps enable us to resolve credit issues with potentially less risk and ultimate losses. We maintain an allowance for loan losses in an amount that we believe is adequate to absorb probable incurred losses in the portfolio. While we strive to carefully manage and monitor credit quality and to identify loans that may be deteriorating, circumstances can change at any time for loans included in the portfolio that may result in future losses, that as of the date of the financial statements have not yet been identified as potential problem loans. Through established credit practices, we adjust the allowance for loan losses accordingly. However, because future events are uncertain, there may be loans that deteriorate some of which could occur in an accelerated time frame. As a result, future additions to the allowance for loan losses may be necessary. Because the loan portfolio contains a number of commercial loans, commercial real estate, construction and land development loans with relatively large balances, deterioration in the credit quality of one or more of these loans may require a significant increase to the allowance for loan losses. Future additions to the allowance may also be required based on changes in the financial condition of borrowers. Additionally, Federal and state banking regulators, as an integral part of their supervisory function, periodically review our allowance for loan losses. These regulatory agencies may require us to recognize further loan loss provisions or charge-offs based upon their judgments, which may be different from ours. Any increase in the allowance for loan losses would have an adverse effect, which may be material, on our financial condition and results of operation.

        Further discussion of the management of credit risk appears under "Provision for Loan Losses" and "Allowance for Loan Losses."

Noninterest Income

        While net interest income remains the largest single component of total revenues, noninterest income is an important component. A portion of the Company's noninterest income is associated with its SBA lending activity, consisting of gains on the sale of loans sold in the secondary market and servicing income from loans sold with servicing retained. Other sources of noninterest income include loan servicing fees, service charges and fees, cash surrender value from company owned life insurance policies, and gains on the sale of securities.

Noninterest Expense

        Management considers the control of operating expenses to be a critical element of the Company's performance. The Company has undertaken several initiatives to reduce its noninterest expense and improve its efficiency. Noninterest expense for the first quarter of 2013 decreased to $10.8 million, compared to $10.9 million for the same period in 2012.

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Capital Management

        As part of its asset and liability management process, the Company continually assesses its capital position to take into consideration growth, expected earnings, risk profile and potential corporate activities that it may choose to pursue.

        On November 21, 2008, the Company issued to the U.S. Treasury under its Capital Purchase Program 40,000 shares of Series A Preferred Stock for $40.0 million and issued a warrant to purchase 462,963 shares of common stock at an exercise price of $12.96.

        On June 21, 2010, the Company issued Series C Convertible Perpetual Preferred Stock ("Series C Preferred Stock") to a limited number of institutional investors. The Series C Preferred Stock remains outstanding until its conversion to common stock upon the transfer of the Series C Preferred Stock in accordance with its terms. Holders of Series C Preferred Stock will receive dividends if and only to the extent dividends are paid to holders of common stock.

        On March 7, 2012, in accordance with approvals received from the U.S. Treasury and the Federal Reserve, the Company repurchased all shares of the Series A Preferred Stock and paid the related accrued and unpaid dividends. The repurchase of the Series A Preferred Stock will save $2.0 million in annual dividends. At the time the Company repurchased the Series A Preferred Stock, it did not repurchase the related warrant. The warrant was outstanding as of the date of this report.

        We have supported our growth through the issuance of trust preferred securities from special purpose trusts and accompanying sales of subordinated debt to these trusts. The subordinated debt that we issued to the trusts is senior to our shares of common stock and Series C Preferred Stock. As a result, we must make payments on the subordinated debt before any dividends can be paid on our common stock and Series C Preferred Stock. Under the terms of the subordinated debt, we may defer interest payments for up to five years. During the third quarter of 2012, the Company completed the redemption of $14 million fixed-rate subordinated debt, and had $9.3 million of variable-rate subordinated debt outstanding at March 31, 2013. The Company is current with respect to interest accrued on trust preferred subordinated debt securities as of March 31, 2013 and was current as of December 31, 2012.

RESULTS OF OPERATIONS

        The Company earns income from two primary sources. The first is net interest income, which is interest income generated by earning assets less interest expense on interest-bearing liabilities. The second is noninterest income, which primarily consists of gains on the sale of loans, loan servicing fees, customer service charges and fees, the increase in cash surrender value of life insurance, and gains on the sale of securities. The majority of the Company's noninterest expenses are operating costs that relate to providing a full range of banking services to our customers.

Net Interest Income and Net Interest Margin

        The level of net interest income depends on several factors in combination, including yields on earning assets, the cost of interest-bearing liabilities, the relative volumes of earning assets and interest-bearing liabilities, and the mix of products which comprise the Company's earning assets, deposits, and other interest-bearing liabilities. To maintain its net interest margin the Company must manage the relationship between interest earned and paid.

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

Distribution, Rate and Yield

 
  For the Three Months Ended
March 31, 2013
  For the Three Months Ended
March 31, 2012
 
NET INTEREST INCOME AND NET INTEREST MARGIN
  Average
Balance
  Interest
Income/
Expense
  Average
Yield/
Rate
  Average
Balance
  Interest
Income/
Expense
  Average
Yield/
Rate
 
 
  (Dollars in thousands)
 

Assets:

                                     

Loans, gross(1)

  $ 798,131   $ 10,089     5.13 % $ 767,288   $ 10,316     5.41 %

Securities—taxable

    385,707     2,462     2.59 %   389,919     3,097     3.19 %

Securities—tax exempt(2)

    40,552     382     3.82 %            

Federal funds sold and interest-bearing deposits in other financial institutions

    116,947     68     0.24 %   55,991     36     0.26 %
                               

Total interest earning assets

    1,341,337     13,001     3.93 %   1,213,198     13,449     4.46 %
                                   

Cash and due from banks

    23,555                 20,987              

Premises and equipment, net

    7,521                 7,978              

Intangible assets

    1,954                 2,441              

Other assets

    68,561                 67,381              
                                   

Total assets

  $ 1,442,928               $ 1,311,985              
                                   

Liabilities and shareholders' equity:

                                     

Deposits:

                                     

Demand, noninterest-bearing

  $ 461,108               $ 347,291              

Demand, interest-bearing

   
164,402
   
59
   
0.15

%
 
142,650
   
52
   
0.15

%

Savings and money market

    283,229     120     0.17 %   288,202     166     0.23 %

Time deposits—under $100

    24,596     23     0.38 %   28,223     38     0.54 %

Time deposits—$100 and over

    190,273     203     0.43 %   169,694     256     0.61 %

Time deposits—brokered

    92,063     219     0.96 %   6,262     3     0.19 %

CDARS—money market and time deposits

    11,475     1     0.04 %   84,730     201     0.95 %
                               

Total interest-bearing deposits

    766,038     625     0.33 %   719,761     716     0.40 %
                               

Total deposits

    1,227,146     625     0.21 %   1,067,052     716     0.27 %

Subordinated debt

   
9,279
   
88
   
3.85

%
 
23,702
   
474
   
8.04

%

Short-term borrowings

    85     1     4.77 %   39         N/A  
                               

Total interest-bearing liabilities

    775,402     714     0.37 %   743,502     1,190     0.64 %
                               

Total interest-bearing liabilities and demand, noninterest-bearing / cost of funds

    1,236,510     714     0.23 %   1,090,793     1,190     0.44 %

Other liabilities

    36,535                 32,671              
                                   

Total liabilities

    1,273,045                 1,123,464              

Shareholders' equity

    169,883                 188,521              
                                   

Total liabilities and shareholders' equity

  $ 1,442,928               $ 1,311,985              
                                   

                                     
                                   

Net interest income(2) / margin

          12,287     3.71 %         12,259     4.06 %

Less tax equivalent adjustment(2)

          (134 )                      
                                   

Net interest income

        $ 12,153               $ 12,259        
                                   

(1)
Includes loans held-for-sale. Yield amounts earned on loans include loan fees and costs. Nonaccrual loans are included in average balance.

(2)
Reflects tax equivalent adjustment for tax exempt income based on a 35% tax rate.

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Volume and Rate Variances

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

 
  Three Months Ended March 31,
2013 vs. 2012
Increase (Decrease) Due to
Change In:
 
 
  Average
Volume
  Average
Rate
  Net
Change
 
 
  (Dollars in thousands)
 

Income from interest earning assets:

                   

Loans, gross

  $ 383   $ (610 ) $ (227 )

Securities—taxable

    (28 )   (607 )   (635 )

Securities—tax exempt

    382         382  

Federal funds sold and interest-bearing deposits in other financial institutions

    35     (3 )   32  
               

Total interest income from interest earnings assets

    772     (1,220 )   (448 )
               

Expense on interest-bearing liabilities:

                   

Demand, interest-bearing

    6     1     7  

Savings and money market

    (1 )   (45 )   (46 )

Time deposits—under $100

    (3 )   (12 )   (15 )

Time deposits—$100 and over

    23     (76 )   (53 )

Time deposits—brokered

    204     12     216  

CDARS—money market and time deposits

    (7 )   (193 )   (200 )

Subordinated debt

    (137 )   (249 )   (386 )

Short-term borrowings

    1         1  
               

Total interest expense on interest-bearing liabilities

    86     (562 )   (476 )
               

Net interest income

  $ 686   $ (658 ) $ 28  
               

        The Company's net interest margin expressed as a percentage of average earning assets was 3.71% for the first quarter of 2013, compared to 4.06% for the first quarter of 2012. The decline in the net interest margin for the first quarter of 2013 was primarily due to the increased short-term deposits at the Federal Reserve Bank as a result of the aforementioned short-term demand deposits of one customer. The net interest margin for the first quarter of 2013 was also impacted by a decline in loan and securities yields, partially offset by a lower cost of funds. Excluding the impact to the net interest margin as a result of the large short-term demand deposits from one customer, and favorable benefit on the repayment of interest income from paid-off nonaccrual loans, the net interest margin was 3.78% for the first quarter of 2013.

        A substantial portion of the Company's earning assets are variable-rate loans that re-price when the Company's prime lending rate is changed, compared to a large base of core deposits that are generally slower to re-price. This causes the Company's balance sheet to be asset-sensitive, which means that all else being equal, the Company's net interest margin will be lower during periods when short-term interest rates are falling and higher when rates are rising.

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Provision for Loan Losses

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

        The Company did not record a provision for loan losses in the first quarter of 2013 because of the net loan recoveries during the period and the reduced credit risk from the reduction in nonperforming assets and classified assets. The provision for loan losses for the first quarter of 2012 was $100,000.

        The allowance for loan losses totaled $19.3 million, or 2.41% of total loans at March 31, 2013, compared to $20.3 million, or 2.68% of total loans at March 31, 2012, and $19.0 million, or 2.34% of total loans at December 31, 2012. The decrease in the allowance for loan losses at March 31, 2013, compared to March 31, 2012, was primarily due to improved risk grading and credit metrics on non-impaired real estate loans, as well as a decline in historical charge-off levels. Net recoveries totaled $315,000 for the first quarter of 2013, compared to net charge-offs of $494,000 for the first quarter of 2012, and net charge-offs of $766,000 for the fourth quarter of 2012. Provisions for loan losses are charged to operations to bring the allowance for loan losses to a level deemed appropriate by the Company based on the factors discussed under "Allowance for Loan Losses".

Noninterest Income

        The following table sets forth the various components of the Company's noninterest income for the periods indicated:

 
  For the Three
Months Ended
March 31,
  Increase
(decrease)
2013 versus 2012
 
 
  2013   2012   Amount   Percent  
 
  (Dollars in thousands)
 

Service charges and fees on deposit accounts

  $ 577   $ 590   $ (13 )   -2 %

Increase in cash surrender value of life insurance

    416     429     (13 )   -3 %

Servicing income

    365     460     (95 )   -21 %

Gain on sales of SBA loans

    136     36     100     278 %

Gain on sales of securities

    31     27     4     15 %

Other

    138     181     (43 )   -24 %
                     

Total noninterest income

  $ 1,663   $ 1,723   $ (60 )   -3 %
                     

        Noninterest income for the first quarter of 2013 remained relatively flat at $1.7 million, compared to the same period in 2012.

        Historically, a significant percentage of the Company's noninterest income has been associated with its SBA lending activity, as gains on the sale of loans sold in the secondary market and servicing income from loans sold with servicing rights retained. For the quarter ended March 31, 2013, SBA loan sales resulted in a $136,000 gain, compared to a $36,000 gain on sales of SBA loans for the quarter ended March 31, 2012. The servicing assets that result from the sales of SBA loans with servicing

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retained, are amortized over the expected term of the loans using a method approximating the interest method. Servicing income generally declines as the respective loans are repaid.

Noninterest Expense

        The following table sets forth the various components of the Company's noninterest expense for the periods indicated:

 
  For the Three
Months Ended
March 31,
  Increase
(decrease)
2013 versus 2012
 
 
  2013   2012   Amount   Percent  
 
  (Dollars in thousands)
 

Salaries and employee benefits

  $ 6,011   $ 5,667   $ 344     6 %

Occupancy and equipment

    1,068     996     72     7 %

Professional fees

    982     1,211     (229 )   -19 %

Low income housing investment losses

    311     269     42     16 %

Software subscriptions

    291     290     1     0 %

FDIC deposit insurance premiums

    259     225     34     15 %

Insurance expense

    254     224     30     13 %

Data processing

    252     245     7     3 %

Correspondent bank charges

    164     143     21     15 %

Foreclosed assets, net

    (155 )   115     (270 )   -235 %

Other

    1,344     1,471     (127 )   -9 %
                     

Total noninterest expense

  $ 10,781   $ 10,856   $ (75 )   -1 %
                     

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

Noninterest Expense by Category

 
  For The Three Months Ended March 31,  
 
  2013   Percent
of Total
  2012   Percent
of Total
 
 
  (Dollars in thousands)
 

Salaries and employee benefits

  $ 6,011     56 % $ 5,667     52 %

Occupancy and equipment

    1,068     10 %   996     9 %

Professional fees

    982     9 %   1,211     11 %

Low income housing investment losses

    311     3 %   269     3 %

Software subscriptions

    291     3 %   290     3 %

FDIC deposit insurance premiums

    259     2 %   225     2 %

Insurance expense

    254     2 %   224     2 %

Data processing

    252     2 %   245     2 %

Correspondent bank charges

    164     2 %   143     1 %

Foreclosed assets, net

    (155 )   -1 %   115     1 %

Other

    1,344     12 %   1,471     14 %
                   

Total noninterest expense

  $ 10,781     100 % $ 10,856     100 %
                   

        Noninterest expense in the first quarter of 2013 was $10.8 million, a decrease from $10.9 million for the first quarter of 2012. The decrease in noninterest expense for the first quarter of 2013 was primarily due to a gain on the disposition of foreclosed assets and lower professional fees, partially

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offset by higher health insurance premiums and other salaries and employee benefits costs. Full-time equivalent employees were 188 at March 31, 2013 and 189 at March 31, 2012.

Income Tax Expense

        The Company computes its provision for income taxes on a monthly basis. The effective tax rate is determined by applying the Company's statutory income tax rates to pre-tax book income as adjusted for permanent differences between pre-tax book income and actual taxable income. These permanent differences include, but are not limited to, increases in the cash surrender value of life insurance policies, California Enterprise Zone deductions, certain expenses that are not allowed as tax deductions, and tax credits.

        The Company's Federal and state income tax expense for the quarter ended March 31, 2013 was $855,000, compared to $951,000 for the quarter ended March 31, 2012. The following table shows the Company's effective income tax rates for the periods indicated:

 
  For the Three
Months Ended
March 31,
 
 
  2013   2012  

Effective income tax rate

    28.2 %   31.4 %

        The difference in the effective tax rate compared to the combined Federal and state statutory tax rate of 42% is primarily the result of the Company's investment in life insurance policies whose earnings are not subject to taxes, tax credits related to investments in low income housing limited partnerships, and tax exempt municipal securities. The Company has net investments of $2.2 million in low-income housing limited partnerships as of March 31, 2013.

        Some items of income and expense are recognized in different years for tax purposes than when applying generally accepted accounting principles leading to timing differences between the Company's actual tax liability, and the amount accrued for this liability based on book income. These temporary differences comprise the "deferred" portion of the Company's tax expense or benefit, which is accumulated on the Company's books as a deferred tax asset or deferred tax liability until such time as they reverse.

        Realization of the Company's deferred tax assets is primarily dependent upon the Company generating sufficient future taxable income to obtain benefit from the reversal of net deductible temporary differences and utilization of tax credit carryforwards and the net operating loss carryforwards for Federal and California state income tax purposes. The amount of deferred tax assets considered realizable is subject to adjustment in future periods based on estimates of future taxable income. Under generally accepted accounting principles a valuation allowance is required to be recognized if it is "more likely than not" that a deferred tax asset will not be realized. The determination of the realizability of the deferred tax assets is highly subjective and dependent upon judgment concerning management's evaluation of both positive and negative evidence, including forecasts of future income, cumulative losses, applicable tax planning strategies, and assessments of current and future economic and business conditions.

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        The Company had net deferred tax assets of $20.2 million and $19.3 million at March 31, 2013, and December 31, 2012, respectively. After consideration of the matters in the preceding paragraph, the Company determined that it is more likely than not that the net deferred tax asset at March 31, 2013 and December 31, 2012 will be fully realized in future years.

FINANCIAL CONDITION

        As of March 31, 2013, total assets increased to $1.38 billion, compared to $1.31 billion at March 31, 2012, and decreased from $1.69 billion at December 31, 2012. Excluding the short-term deposits at the Federal Reserve Bank offsetting the short-term demand deposits from one customer of $24.3 million at March 31, 2013 and $271.9 million at December 31, 2012, total assets were $1.36 billion and $1.42 billion, respectively. Securities available-for-sale (at fair value) were $346.8 million at March 31, 2013, a decrease of 10% from $385.8 million at March 31, 2012, and a decrease of 6% from $367.9 million at December 31, 2012. Securities held-to-maturity (at amortized cost) were $68.3 million at March 31, 2013, compared to no securities held-to-maturity at March 31, 2012, and $51.5 million at December 31, 2012. The total loan portfolio, excluding loans held-for-sale, was $801.9 million at March 31, 2013, an increase of 6% from $756.9 million at March 31, 2012, and a decrease of 1% from $812.3 million at December 31, 2012.

        Total deposits, excluding the short-term demand deposits from one customer of $24.3 million at March 31, 2013 and $271.9 million at December 31, 2012, increased 6% to $1.14 billion at March 31, 2013, from $1.08 billion at March 31, 2012 and decreased 5% from $1.21 billion at December 31, 2012. Subordinated debt decreased to $9.3 million at March 31, 2013 and December 31, 2012, compared to $23.7 million at March 31, 2012, as a result of the redemption of $14 million fixed-rate subordinated debt during the third quarter of 2012.

Securities Portfolio

        The following table reflects the balances for each category of securities at the dates indicated:

 
  March 31,    
 
 
  December 31,
2012
 
 
  2013   2012  
 
  (Dollars in thousands)
 

Securities available-for-sale (at fair value):

                   

Agency mortgage-backed securities

  $ 271,077   $ 340,181   $ 291,244  

Corporate bonds

    54,892     10,636     55,588  

Trust preferred securities

    20,831     35,009     21,080  
               

Total

  $ 346,800   $ 385,826   $ 367,912  
               

Securities held-to-maturity (at amortized cost):

                   

Agency mortgage-backed securities

  $ 15,185   $   $ 16,659  

Municipals—Tax Exempt

    53,098         34,813  
               

  $ 68,283   $   $ 51,472  
               

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        The following table summarizes the weighted average life and weighted average yields of securities at March 31, 2013:

 
  March 31, 2013
Weighted Average Life
 
 
  After One
and Within
Five Years
  After Five
and Within
Ten Years
  After
Ten Years
  Total  
 
  Amount   Yield   Amount   Yield   Amount   Yield   Amount   Yield  
 
  (Dollars in thousands)
 

Securities available-for-sale (at fair value):

                                                 

Agency mortgage-backed securities

  $ 216,999     2.48 % $ 49,911     2.31 % $ 4,167     2.51 % $ 271,077     2.45 %

Corporate bonds

    963     2.45 %   53,929     3.26 %           54,892     3.25 %

Trust preferred securities

                    20,831     4.92 %   20,831     4.92 %
                                           

  $ 217,962     2.48 % $ 103,840     2.80 % $ 24,998     4.52 % $ 346,800     2.72 %
                                           

 

 
  March 31, 2013
Weighted Average Life
 
 
  After One
and Within
Five Years
  After Five
and Within
Ten Years
  After
Ten Years
  Total  
 
  Amount   Yield   Amount   Yield   Amount   Yield   Amount   Yield  
 
  (Dollars in thousands)
 

Securities held-to-maturity (at amortized cost):

                                                 

Agency mortgage-backed securities

  $ 12,307     2.51 % $       $ 2,878     2.81 % $ 15,185     2.56 %

Municipals—Tax Exempt

            8,180     3.81 %   44,918     3.76 %   53,098     3.77 %
                                           

  $ 12,307     2.51 % $ 8,180     3.81 % $ 47,796     3.71 % $ 68,283     3.50 %
                                           

        The securities portfolio is the second largest component of the Company's interest-earning assets, and the structure and composition of this portfolio is important to an analysis of the financial condition of the Company. The portfolio serves the following purposes: (i) it provides a source of pledged assets for securing certain deposits and borrowed funds, as may be required by law or by specific agreement with a depositor or lender; (ii) it provides liquidity to even out cash flows from the loan and deposit activities of customers; (iii) it can be used as an interest rate risk management tool, since it provides a large base of assets, the maturity and interest rate characteristics of which can be changed more readily than the loan portfolio to better match changes in the deposit base and other funding sources of the Company; and (iv) it is an alternative interest-earning use of funds when loan demand is weak or when deposits grow more rapidly than loans.

        The Company's portfolio may include: (i) U.S. Treasury securities and U.S. Government sponsored entities' debt securities for liquidity and pledging; (ii) mortgage-backed securities, which in many instances can also be used for pledging, and which generally enhance the yield of the portfolio; (iii) municipal obligations, which provide tax free income and limited pledging potential; (iv) collateralized mortgage obligations, which generally enhance the yield of the portfolio; and (v) single entity issue trust preferred securities, which generally enhance the yield on the portfolio.

        The Company classifies its securities as either available-for-sale or held-to-maturity at the time of purchase. Prior to the third quarter of 2012, the Company's securities were all classified under existing accounting rules as "available-for-sale" to allow flexibility for the management of the portfolio. Accounting guidance requires available-for-sale securities to be marked to fair value with an offset to accumulated other comprehensive income (loss), a component of shareholders' equity. Monthly adjustments are made to reflect changes in the fair value of the Company's available-for-sale securities. The investment securities available-for-sale portfolio totaled $346.8 million at March 31, 2013, a decrease of 10% from $385.8 million at March 31, 2012, and a decrease of 6% from $367.9 million at December 31, 2012. At March 31, 2013, the investment securities available-for-sale portfolio was

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comprised of $271.1 million of agency mortgage-backed securities (all issued by U.S. Government sponsored entities), $54.9 million of corporate bonds, and $20.8 million of single entity issue trust preferred securities.

        The investment securities held-to-maturity portfolio, at amortized cost, totaled $68.3 million at March 31, 2013, compared to no investment securities held-to-maturity at March 31, 2012, and $51.5 million at December 31, 2012. At March 31, 2013, the investment securities held-to-maturity portfolio was comprised of $53.1 million of tax-exempt municipal bonds, and $15.2 million of agency mortgage-backed securities. During the third quarter of 2012, the Company evaluated its available-for-sale portfolio and reclassified at fair value approximately $16.4 million of the mortgage-backed securities with higher price volatility and longer maturities to the held-to-maturity category. The Company transferred these securities to mitigate possible negative impacts on its regulatory capital under the proposed Basel III capital guidelines as the Company has the intent and ability to hold these securities to maturity. The related unrealized after-tax gains of $489,000 at March 31, 2013 remained in accumulated other comprehensive income and will be amortized over the remaining life of the securities as an adjustment of yield, offsetting the related amortization of the premium or accretion of the discount on the transferred securities. No gains or losses were recognized at the time of reclassification. Management considers the held-to-maturity classification of these investment securities to be appropriate based on the Company's positive intent and ability to hold these securities to maturity.

        The Company has not used interest rate swaps or other derivative instruments to hedge fixed rate loans or securities to otherwise mitigate interest rate risk.

Loans

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

        Gross loans, excluding loans held-for-sale, represented 58% of total assets at March 31, 2013 and March 31, 2012, and 48% of total assets at December 31, 2012. Gross loans, excluding loans held-for-sale, represented 59% and 57% of total assets, excluding the short-term deposits at the Federal Reserve Bank offsetting the short-term demand deposits from one customer at March 31, 2013 and December 31, 2012, respectively. The ratio of loans to deposits decreased to 68.75% at March 31, 2013 from 70.07% at March 31, 2012 and 54.91% at December 31, 2012. The loan to deposit ratio was 70.19% and 67.27%, excluding the short-term demand deposits from one customer at March 31, 2013 and December 31, 2012, respectively.

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Loan Distribution

        The Loan Distribution table that follows sets forth the Company's gross loans, excluding loans held-for-sale, outstanding and the percentage distribution in each category at the dates indicated: