0001047469-14-004752.txt : 20140508 0001047469-14-004752.hdr.sgml : 20140508 20140508170153 ACCESSION NUMBER: 0001047469-14-004752 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 12 CONFORMED PERIOD OF REPORT: 20140331 FILED AS OF DATE: 20140508 DATE AS OF CHANGE: 20140508 FILER: COMPANY DATA: COMPANY CONFORMED NAME: HERITAGE COMMERCE CORP CENTRAL INDEX KEY: 0001053352 STANDARD INDUSTRIAL CLASSIFICATION: STATE COMMERCIAL BANKS [6022] IRS NUMBER: 770469558 STATE OF INCORPORATION: CA FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 000-23877 FILM NUMBER: 14825821 BUSINESS ADDRESS: STREET 1: 150 ALMADEN BOULEVARD CITY: SAN JOSE STATE: CA ZIP: 95113 BUSINESS PHONE: 4089476900 MAIL ADDRESS: STREET 1: 150 ALMADEN BOULEVARD CITY: SAN JOSE STATE: CA ZIP: 95113 10-Q 1 a2220023z10-q.htm 10-Q

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Table of Contents

 

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, 2014

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 26,370,510 shares of Common Stock outstanding on April 18, 2014.

   


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 Statements 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

  38

       

Item 3.

 

Quantitative and Qualitative Disclosures About Market Risk

  68

       

Item 4.

 

Controls and Procedures

  68

       

PART II. OTHER INFORMATION

   

       

Item 1.

 

Legal Proceedings

  68

       

Item 1A.

 

Risk Factors

  68

       

Item 2.

 

Unregistered Sales of Equity Securities and Use of Proceeds

  68

       

Item 3.

 

Defaults Upon Senior Securities

  68

       

Item 4.

 

Mine Safety Disclosures

  69

       

Item 5.

 

Other Information

  69

       

Item 6.

 

Exhibits

  70

       

SIGNATURES

  71

       

EXHIBIT INDEX

  72

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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:

    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;

    Delay in the pace of economic recovery and stagnant or decreasing employment levels;

    Changes in the financial performance or condition of the Company's customers, or changes in the performance or creditworthiness of our customers' suppliers or other counterparties, which could lead to decreased loan utilization rates, delinquencies, or defaults, which could negatively affect our customers' ability to meet certain credit obligations;

    Volatility in credit or equity markets and its effect on the global economy;

    Changes in consumer spending, borrowing or saving habits;

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

    The ability to increase market share and control expenses;

    Risks associated with concentrations in real estate related loans;

    Other-than-temporary impairment charges to our securities portfolio;

    An oversupply of inventory and deterioration in values of California commercial real estate;

    A prolonged slowdown in construction activity;

    Changes in the level of nonperforming assets, charge-offs, or 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;

    Changes in inflation, interest rates, and market liquidity which may impact interest margins and impact funding sources;

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

3


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

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

    The impact of cyber security attacks or other disruptions to the Company's information systems and any resulting compromise of data or disruptions in service;

    The effect of the enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and the rules and regulations to be promulgated by supervisory and oversight agencies implementing the legislation taking into account that the precise timing, extent and nature of such rules and regulations and the impact on the Company are uncertain;

    The impact of revised capital requirements under Basel III;

    Significant changes in applicable laws and regulations, including those concerning taxes, banking and securities;

    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, 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; and

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

        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,
2014
  December 31,
2013
 
 
  (Dollars in thousands)
 

Assets

             

Cash and due from banks

  $ 30,666   $ 20,158  

Interest-bearing deposits in other financial institutions

    54,333     92,447  
           

Total cash and cash equivalents

    84,999     112,605  

Securities available-for-sale, at fair value

    262,375     280,100  

Securities held-to-maturity, at amortized cost (fair value of $89,840 at March 31, 2014 and $86,032 at December 31, 2013)

    95,548     95,921  

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

    2,894     3,148  

Loans, net of deferred fees

    941,759     914,913  

Allowance for loan losses

    (18,817 )   (19,164 )
           

Loans, net

    922,942     895,749  

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

    10,557     10,435  

Company owned life insurance

    50,055     50,012  

Premises and equipment, net

    7,186     7,240  

Intangible assets

    1,412     1,527  

Accrued interest receivable and other assets

    32,142     34,895  
           

Total assets

  $ 1,470,110   $ 1,491,632  
           
           

Liabilities and Shareholders' Equity

             

Liabilities:

             

Deposits:

             

Demand, noninterest-bearing

  $ 440,864   $ 431,085  

Demand, interest-bearing

    198,141     195,451  

Savings and money market

    352,977     347,052  

Time deposits—under $100

    20,669     21,646  

Time deposits—$100 and over

    195,769     195,005  

Time deposits—brokered

    40,440     55,524  

CDARS—money market and time deposits

    13,135     40,458  
           

Total deposits

    1,261,995     1,286,221  

Accrued interest payable and other liabilities

    31,298     32,015  
           

Total liabilities

    1,293,293     1,318,236  

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, 2014 and December 31, 2013 (liquidation preference of $21,004 at March 31, 2014 and December 31, 2013)

    19,519     19,519  

Common stock, no par value; 60,000,000 shares authorized; 26,370,510 shares issued and outstanding at March 31, 2014 and 26,350,938 shares issued and outstanding at December 31, 2013

    132,631     132,561  

Retained earnings

    27,143     25,345  

Accumulated other comprehensive loss

    (2,476 )   (4,029 )
           

Total shareholders' equity

    176,817     173,396  
           

Total liabilities and shareholders' equity

  $ 1,470,110   $ 1,491,632  
           
           

   

See notes to consolidated financial statements

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HERITAGE COMMERCE CORP

CONSOLIDATED STATEMENTS OF INCOME (Unaudited)

 
  Three Months Ended March 31,  
 
  2014   2013  
 
  (Dollars in thousands, except per share data)
 

Interest income:

             

Loans, including fees

  $ 11,139   $ 10,089  

Securities, taxable

    2,170     2,462  

Securities, non-taxable

    506     248  

Interest-bearing deposits in other financial institutions

    40     68  
           

Total interest income

    13,855     12,867  
           

Interest expense:

             

Deposits

    521     625  

Subordinated debt

        88  

Short-term borrowings

        1  
           

Total interest expense

    521     714  
           

Net interest income before provision for loan losses

    13,334     12,153  

Provision (credit) for loan losses

    (10 )    
           

Net interest income after provision for loan losses

    13,344     12,153  
           

Noninterest income:

             

Service charges and fees on deposit accounts

    620     577  

Increase in cash surrender value of life insurance

    398     416  

Servicing income

    348     365  

Gain on sales of SBA loans

    157     136  

Gain on sales of securities

    50     31  

Other

    444     138  
           

Total noninterest income

    2,017     1,663  
           

Noninterest expense:

             

Salaries and employee benefits

    6,243     6,011  

Occupancy and equipment

    945     1,068  

Professional fees

    586     982  

Insurance expense

    269     254  

Software subscriptions

    247     291  

FDIC deposit insurance premiums

    234     259  

Data processing

    230     252  

Low income housing investment losses

    188     311  

Correspondent bank charges

    182     164  

Foreclosed assets, net

    (18 )   (155 )

Other

    1,628     1,344  
           

Total noninterest expense

    10,734     10,781  
           

Income before income taxes

    4,627     3,035  

Income tax expense

    1,551     855  
           

Net income

    3,076     2,180  

Dividends on preferred stock

    (224 )    
           

Net income available to common shareholders

  $ 2,852   $ 2,180  
           
           

Earnings per common share:

             

Basic

  $ 0.10   $ 0.07  

Diluted

  $ 0.10   $ 0.07  

   

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,
 
 
  2014   2013  
 
  (Dollars in thousands)
 

Net income

  $ 3,076   $ 2,180  

Other comprehensive income (loss):

             

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

    2,750     (2,164 )

Deferred income taxes

    (1,155 )   909  

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

    (14 )   (14 )

Deferred income taxes

    6     6  

Reclassification adjustment for gains realized in income

    (50 )   (31 )

Deferred income taxes

    21     13  
           

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

    1,558     (1,281 )
           

Change in net pension and other benefit plan liability adjustment

    (9 )   29  

Deferred income taxes

    4     (12 )
           

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

    (5 )   17  
           

Other comprehensive income (loss)

    1,553     (1,264 )
           

Total comprehensive income

  $ 4,629   $ 916  
           
           

   

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, 2014 and 2013  
 
   
   
   
   
   
  Accumulated
Other
Comprehensive
Income /
(Loss)
   
 
 
  Preferred Stock   Common Stock    
   
 
 
  Retained
Earnings
  Total
Shareholders'
Equity
 
 
  Shares   Amount   Shares   Amount  
 
  (Dollars in thousands, except share data)
 

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  
                               
                               

Balance, December 31, 2013

   
21,004
 
$

19,519
   
26,350,938
 
$

132,561
 
$

25,345
 
$

(4,029

)

$

173,396
 

Net income

                    3,076         3,076  

Other comprehensive income

                        1,553     1,553  

Issuance of restricted stock awards, net

            15,000                  

Amortization of restricted stock awards, net of forfeitures and taxes

                (136 )           (136 )

Cash dividend declared $0.04 per share

                    (1,278 )       (1,278 )

Stock option expense, net of forfeitures and taxes

                187             187  

Stock options exercised

            4,572     19             19  
                               

Balance, March 31, 2014

    21,004   $ 19,519     26,370,510   $ 132,631   $ 27,143   $ (2,476 ) $ 176,817  
                               
                               

   

See notes to consolidated financial statements

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HERITAGE COMMERCE CORP

CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

 
  Three Months Ended
March 31,
 
 
  2014   2013  
 
  (Dollars in thousands)
 

CASH FLOWS FROM OPERATING ACTIVITIES:

             

Net income

  $ 3,076   $ 2,180  

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

             

Amortization of discounts and premiums on securities

    256     756  

Gain on sales of securities available-for-sale

    (50 )   (31 )

Gain on sales of SBA loans

    (157 )   (136 )

Proceeds from sale of SBA loans originated for sale

    2,433     1,774  

Net change in SBA loans originated for sale

    (2,022 )   (2,643 )

Provision (credit) for loan losses

    (10 )    

Increase in cash surrender value of life insurance

    (398 )   (416 )

Depreciation and amortization

    177     177  

Amortization of intangible assets

    115     118  

Gains on sale of foreclosed assets, net

        (198 )

Stock option expense, net

    187     129  

Amortization of restricted stock awards, net

    (136 )   45  

Gain on redemption of company owned life insurance

    (51 )    

Effect of changes in:

             

Accrued interest receivable and other assets

    1,623     (88 )

Accrued interest payable and other liabilities

    237     1,806  
           

Net cash provided by operating activities

    5,280     3,473  
           

CASH FLOWS FROM INVESTING ACTIVITIES:

             

Purchase of securities available-for-sale

    (34,775 )   (8,334 )

Purchase of securities held-to-maturity

    (959 )   (18,433 )

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

    5,013     23,056  

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

    331     1,429  

Proceeds from sale of securities available-for-sale

    50,011     3,530  

Net change in loans

    (27,183 )   10,690  

Change in Federal Home Loan Bank and Federal Reserve Bank stock

    (122 )   (36 )

Purchase of premises and equipment

    (123 )   (340 )

Proceeds from sale of foreclosed assets

        743  

Proceeds from redemption of company owned life insurance

    406      
           

Net cash (used in) provided by investing activities

    (7,401 )   12,305  
           

CASH FLOWS FROM FINANCING ACTIVITIES:

             

Net change in deposits

    (24,226 )   (312,478 )

Payment of cash dividends

    (1,278 )    

Exercise of stock options

    19     4  
           

Net cash used in financing activities

    (25,485 )   (312,474 )
           

Net decrease in cash and cash equivalents

    (27,606 )   (296,696 )

Cash and cash equivalents, beginning of period

    112,605     373,565  
           

Cash and cash equivalents, end of period

  $ 84,999   $ 76,869  
           
           

Supplemental disclosures of cash flow information:

             

Interest paid

  $ 518   $ 709  

Income taxes paid

    500     1,025  

Supplemental schedule of non-cash investing activity:

   
 
   
 
 

Due to broker for securities purchased

  $   $ 3,351  

Loans transferred to foreclosed assets

        33  

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, 2014

(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, 2013. The Company 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 were 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. During the third quarter of 2013 the Company dissolved the Heritage Statutory Trust II and the Heritage Commerce Corp Statutory Trust III.

        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, 2014 are not necessarily indicative of the results expected for any subsequent period or for the entire year ending December 31, 2014.

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 January 2014, the FASB amended existing guidance clarifying that an in substance repossession or foreclosure occurs, and a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan, upon either (1) the creditor obtaining legal title to the residential real estate property upon completion of a foreclosure or (2) the borrower

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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

March 31, 2014

(Unaudited)

1) Basis of Presentation (Continued)

conveying all interest in the residential real estate property to the creditor to satisfy that loan through completion of a deed in lieu of foreclosure or through a similar legal agreement. Additionally, the amendments require interim and annual disclosure of both (1) the amount of foreclosed residential real estate property held by the creditor and (2) the recorded investment in consumer mortgage loans collateralized by residential real estate property that are in the process of foreclosure according to local requirements of the applicable jurisdiction. The amendments in this update are effective for public business entities for annual periods, and interim periods within those annual periods, beginning after December 15, 2014. For entities other than public business entities, the amendments in this update are effective for annual periods beginning after December 15, 2014, and interim periods within annual periods beginning after December 15, 2015. We are currently evaluating the impact of adopting the new guidance on the consolidated financial statements, but it is not expected to have a material impact.

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. The Series C Preferred Stock participates 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 for the three months ended March 31, 2013. The Company repurchased the warrant for $140,000 in the second quarter of 2013. 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,  
 
  2014   2013  
 
  (Dollars in thousands, except per share amounts)
 

Net income available to common shareholders

  $ 2,852   $ 2,180  

Less: undistributed earnings allocated to Series C Preferred Stock

    315     382  
           

Distributed and undistributed earnings allocated to common shareholders

  $ 2,537   $ 1,798  
           
           

Weighted average common shares outstanding for basic earnings per common share

    26,359,825     26,329,343  

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

    123,263     49,114  
           

Shares used in computing diluted earnings per common share

    26,483,088     26,378,457  
           
           

Basic earnings per share

  $ 0.10   $ 0.07  

Diluted earnings per share

  $ 0.10   $ 0.07  

11


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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

March 31, 2014

(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, 2014 and 2013  
 
  Unrealized
Gains
(Losses) 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, 2014, net of taxes

  $ (430 ) $ 466   $ (4,065 ) $ (4,029 )

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

   
1,595
   
   
(10

)
 
1,585
 

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

    (29 )   (8 )   5     (32 )
                   

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

    1,566     (8 )   (5 )   1,553  
                   

Ending balance March 31, 2014, net of taxes

  $ 1,136   $ 458   $ (4,070 ) $ (2,476 )
                   
                   

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

)
 
   
(11

)
 
(1,266

)

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

    (18 )   (8 )   28     2  
                   

Net current period other comprehensive 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  
                   
                   

(1)
Amounts in parenthesis indicate debits.

12


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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

March 31, 2014

(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
  2014   2013
 
  (Dollars in thousands)
   

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

  $ 50   $ 31   Realized gains on sale of securities

    (21 )   (13 ) Income tax expense
             

    29     18   Net of tax
             

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

    14     14   Interest income on taxable securities

    (6 )   (6 ) Income tax expense
             

    8     8   Net of tax
             

Amortization of defined benefit pension plan items(2)

               

Prior transition obligation

    26     22    

Actuarial losses

    (35 )   (71 )  
             

    (9 )   (49 ) Income before income tax

    4     21   Income tax expense
             

    (5 )   (28 ) Net of tax
             

Total reclassification for the period

  $ 32   $ (2 )  
             
             

(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


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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

March 31, 2014

(Unaudited)

4) Securities

        The amortized cost and estimated fair value of securities at March 31, 2014 and December 31, 2013 were as follows:

March 31, 2014
  Amortized
Cost
  Gross
Unrealized
Gains
  Gross
Unrealized
Losses
  Estimated
Fair
Value
 
 
  (Dollars in thousands)
 

Securities available-for-sale:

                         

Agency mortgage-backed securities

  $ 160,905   $ 2,254   $ (1,927 ) $ 161,232  

Asset-backed securities

    27,355     40     (112 )   27,283  

Corporate bonds

    52,952     552     (470 )   53,034  

Trust preferred securities

    20,869         (43 )   20,826  
                   

Total

  $ 262,081   $ 2,846   $ (2,552 ) $ 262,375  
                   
                   

Securities held-to-maturity:

                         

Agency mortgage-backed securities

  $ 15,586   $   $ (345 ) $ 15,241  

Municipals—tax exempt

    79,962     343     (5,706 )   74,599  
                   

Total

  $ 95,548   $ 343   $ (6,051 ) $ 89,840  
                   
                   

 

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

Securities available-for-sale:

                         

Agency mortgage-backed securities

  $ 208,644   $ 2,465   $ (3,465 ) $ 207,644  

Corporate bonds

    53,002     527     (1,483 )   52,046  

Trust preferred securities

    20,849         (439 )   20,410  
                   

Total

  $ 282,495   $ 2,992   $ (5,387 ) $ 280,100  
                   
                   

Securities held-to-maturity:

                         

Agency mortgage-backed securities

  $ 15,932   $   $ (470 ) $ 15,462  

Municipals—tax exempt

    79,989     54     (9,473 )   70,570  
                   

Total

  $ 95,921   $ 54   $ (9,943 ) $ 86,032  
                   
                   

14


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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

March 31, 2014

(Unaudited)

4) Securities (Continued)

        Securities with unrealized losses at March 31, 2014 and December 31, 2013, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position are as follows:

 
  Less Than 12 Months   12 Months or More   Total  
March 31, 2014
  Fair
Value
  Unrealized
Losses
  Fair
Value
  Unrealized
Losses
  Fair
Value
  Unrealized
Losses
 
 
  (Dollars in thousands)
 

Securities available-for-sale:

                                     

Agency mortgage-backed securities

  $ 66,006   $ (1,783 ) $ 2,632   $ (144 ) $ 68,638   $ (1,927 )

Asset-backed securities

    17,525     (112 )           17,525     (112 )

Corporate bonds

    34,974     (372 )   1,922     (98 )   36,896     (470 )

Trust preferred securities

    5,826     (43 )           5,826     (43 )
                           

Total

  $ 124,331   $ (2,310 ) $ 4,554   $ (242 ) $ 128,885   $ (2,552 )
                           
                           

Securities held-to-maturity:

                                     

Agency mortgage-backed securities

  $ 5,539   $ (43 ) $ 9,326   $ (302 ) $ 14,865   $ (345 )

Municipals—Tax Exempt

    21,562     (1,297 )   39,602     (4,409 )   61,164     (5,706 )
                           

Total

  $ 27,101   $ (1,340 ) $ 48,928   $ (4,711 ) $ 76,029   $ (6,051 )
                           
                           

 

 
  Less Than 12 Months   12 Months or More   Total  
December 31, 2013
  Fair
Value
  Unrealized
Losses
  Fair
Value
  Unrealized
Losses
  Fair
Value
  Unrealized
Losses
 
 
  (Dollars in thousands)
 

Securities available-for-sale:

                                     

Agency mortgage-backed securities

  $ 87,798   $ (2,869 ) $ 8,920   $ (596 ) $ 96,718   $ (3,465 )

Corporate bonds

    38,092     (1,322 )   1,860     (161 )   39,952     (1,483 )

Trust preferred securities

    20,410     (439 )           20,410     (439 )
                           

Total

  $ 146,300   $ (4,630 ) $ 10,780   $ (757 ) $ 157,080   $ (5,387 )
                           
                           

Securities held-to-maturity:

                                     

Agency mortgage-backed securities

  $ 5,978   $ (101 ) $ 9,134   $ (369 ) $ 15,112   $ (470 )

Municipals—Tax Exempt

    38,177     (4,421 )   25,520     (5,052 )   63,697     (9,473 )
                           

Total

  $ 44,155   $ (4,522 ) $ 34,654   $ (5,421 ) $ 78,809   $ (9,943 )
                           
                           

        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, 2014, the Company held 370 securities (141 available for sale and 229 held-to-maturity), of which 235 had fair values below amortized cost. At March 31, 2014, there were $2,632,000 of agency mortgage-backed securities available-for-sale, $1,922,000 of corporate bonds available-for-sale, $9,326,000 of agency mortgage-backed securities held-to-maturity and $39,602,000 of municipals bonds held-to-maturity carried with an unrealized loss for over 12 months. The total unrealized loss for securities over 12 months was $4,953,000 at March 31, 2014. The unrealized losses were due to higher interest rates.

15


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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

March 31, 2014

(Unaudited)

4) Securities (Continued)

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 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 value. The Company does not consider these securities to be other than temporarily impaired at March 31, 2014.

        At December 31, 2013, the Company held 392 securities (163 available-for-sale and 229 held to maturity), of which 275 had fair values below amortized cost. At December 31, 2013, there were $8,920,000 of agency mortgage-backed securities available-for-sale, $1,860,000 of corporate bonds available-for-sale, $9,134,000 of agency mortgage-backed securities held-to-maturity, and $25,520,000 of municipal bonds held-to-maturity carried with an unrealized loss for over 12 months. The total unrealized loss for securities over 12 months was $6,178,000 at December 31, 2013. The unrealized losses were due to higher interest rates. The issuers were of high credit quality and all principal amounts were expected to be paid when securities mature. The fair value was expected to recover as the securities approach their maturity date and/or market rates decline. The Company did not believe that it is more likely than not that the Company would be required to sell a security in an unrealized loss position prior to recovery in value. The Company did not consider these securities to be other than temporarily impaired at December 31, 2013.

        The proceeds from sales of securities and the resulting gains and losses are listed below:

 
  Three Months Ended
March 31,
 
 
  2014   2013  
 
  (Dollars in thousands)
 

Proceeds

  $ 50,011   $ 3,530  

Gross gains

  $ 720   $ 31  

Gross losses

  $ (670 )    

        The amortized cost and estimated fair values of securities as of March 31, 2014, are shown by contractual maturity 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

  $ 6,276   $ 6,630  

Due after five through ten years

    46,676     46,404  

Due after ten years

    20,869     20,826  

Asset-backed securities and agency mortgage-backed securities

    188,260     188,515  
           

Total

  $ 262,081   $ 262,375  
           
           

16


Table of Contents


HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

March 31, 2014

(Unaudited)

4) Securities (Continued)


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

Due after five through ten years

  $ 3,643   $ 3,610  

Due after ten years

    76,319     70,989  

Agency mortgage-backed securities

    15,586     15,241  
           

Total

  $ 95,548   $ 89,840  
           
           

5) Loans

        Loans were as follows:

 
  March 31,
2014
  December 31,
2013
 
 
  (Dollars in thousands)
 

Loans held-for-investment:

             

Commercial

  $ 390,650   $ 393,074  

Real estate:

             

Commercial and residential

    436,562     423,288  

Land and construction

    42,889     31,443  

Home equity

    56,289     51,815  

Consumer

    15,829     15,677  
           

Loans

    942,219     915,297  

Deferred loan origination fees, net

    (460 )   (384 )
           

Loans, net of deferred fees

    941,759     914,913  

Allowance for loan losses

    (18,817 )   (19,164 )
           

Loans, net

  $ 922,942   $ 895,749  
           
           

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

 
  Three Months Ended March 31, 2014  
 
  Commercial   Real Estate   Consumer   Total  
 
  (Dollars in thousands)
 

Balance, beginning of period

  $ 12,533   $ 6,548   $ 83   $ 19,164  

Charge-offs

    (408 )           (408 )

Recoveries

    44     27         71  
                   

Net (charge-offs) recoveries

    (364 )   27         (337 )

Provision (credit) for loan losses

    (323 )   319     (6 )   (10 )
                   

Balance, end of period

  $ 11,846   $ 6,894   $ 77   $ 18,817  
                   
                   

17


Table of Contents


HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

March 31, 2014

(Unaudited)

5) Loans (Continued)


 
  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  
                   
                   

        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, 2014  
 
  Commercial   Real Estate   Consumer   Total  
 
  (Dollars in thousands)
 

Allowance for loan losses:

                         

Ending allowance balance attributable to loans:

                         

Individually evaluated for impairment

  $ 1,694   $ 667   $ 18   $ 2,379  

Collectively evaluated for impairment

    10,152     6,227     59     16,438  
                   

Total allowance balance

  $ 11,846   $ 6,894   $ 77   $ 18,817  
                   
                   

Loans:

                         

Individually evaluated for impairment

  $ 5,157   $ 5,552   $ 115   $ 10,824  

Collectively evaluated for impairment

    385,493     530,188     15,714     931,395  
                   

Total loan balance

  $ 390,650   $ 535,740   $ 15,829   $ 942,219  
                   
                   

 

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

Allowance for loan losses:

                         

Ending allowance balance attributable to loans:

                         

Individually evaluated for impairment

  $ 1,694   $ 741   $ 21   $ 2,456  

Collectively evaluated for impairment

    10,839     5,807     62     16,708  
                   

Total allowance balance

  $ 12,533   $ 6,548   $ 83   $ 19,164  
                   
                   

Loans:

                         

Individually evaluated for impairment

  $ 4,906   $ 6,790   $ 122   $ 11,818  

Collectively evaluated for impairment

    388,168     499,756     15,555     903,479  
                   

Total loan balance

  $ 393,074   $ 506,546   $ 15,677   $ 915,297  
                   
                   

18


Table of Contents


HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

March 31, 2014

(Unaudited)

5) Loans (Continued)

        The following table presents loans held-for-investment individually evaluated for impairment by class of loans as of March 31, 2014 and December 31, 2013. 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, 2014   December 31, 2013  
 
  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

  $ 2,821   $ 2,556   $   $ 1,999   $ 1,915   $  

Real estate:

                                     

Commercial and residential

    1,714     1,714         2,831     2,831      

Land and construction

    1,718     1,718         1,761     1,761      

Home Equity

    373     373         377     377      
                           

Total with no related allowance recorded

    6,626     6,361         6,968     6,884      

With an allowance recorded:

                                     

Commercial

    2,601     2,601     1,694     3,225     2,991     1,694  

Real estate:

                                     

Commercial and residential

    1,513     1,513     433     1,531     1,531     451  

Home Equity

    234     234     234     290     290     290  

Consumer

    115     115     18     122     122     21  
                           

Total with an allowance recorded

    4,463     4,463     2,379     5,168     4,934     2,456  
                           

Total

  $ 11,089   $ 10,824   $ 2,379   $ 12,136   $ 11,818   $ 2,456  
                           
                           

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

 
  Three Months Ended March 31, 2014  
 
   
  Real Estate    
   
 
 
  Commercial   Commercial and
Residential
  Land and
Construction
  Home
Equity
  Consumer   Total  
 
  (Dollars in thousands)
 

Average of impaired loans during the period

  $ 5,032   $ 3,795   $ 1,739   $ 637   $ 118   $ 11,321  

Interest income during impairment

  $ 10   $   $   $   $   $ 10  

Cash-basis interest earned

  $   $   $   $   $   $  

19


Table of Contents


HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

March 31, 2014

(Unaudited)

5) Loans (Continued)


 
  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

  $   $   $   $   $   $  

        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,
2013
 
 
  2014   2013  
 
  (Dollars in thousands)
 

Nonaccrual loans—held-for-investment

  $ 9,546   $ 16,115   $ 11,326  

Restructured and loans over 90 days past due and still accruing

    1,278     549     492  
               

Total nonperforming loans

  $ 10,824   $ 16,664   $ 11,818  
               
               

Other restructured loans

  $   $ 1,717   $  

Impaired loans, excluding loans held-for-sale

  $ 10,824   $ 18,381   $ 11,818  

        The following table presents the nonperforming loans by class for the periods indicated:

 
  March 31, 2014   December 31, 2013  
 
  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

  $ 3,879   $ 1,278   $ 5,157   $ 4,414   $ 492   $ 4,906  

Real estate:

                                     

Commercial and residential

    3,227         3,227     4,363         4,363  

Land and construction

    1,718         1,718     1,761         1,761  

Home equity

    607         607     666         666  

Consumer

    115         115     122         122  
                           

Total

  $ 9,546   $ 1,278   $ 10,824   $ 11,326   $ 492   $ 11,818  
                           
                           

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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

March 31, 2014

(Unaudited)

5) Loans (Continued)

        The following tables present the aging of past due loans by class for the periods indicated:

 
  March 31, 2014  
 
  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

  $ 890   $ 1,153   $ 2,451   $ 4,494   $ 386,156   $ 390,650  

Real estate:

                                     

Commercial and residential

    873         1,065     1,938     434,624     436,562  

Land and construction

                    42,889     42,889  

Home equity

            234     234     56,055     56,289  

Consumer

    14     25     83     122     15,707     15,829  
                           

Total

  $ 1,777   $ 1,178   $ 3,833   $ 6,788   $ 935,431   $ 942,219  
                           
                           

 

 
  December 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

  $ 3,314   $ 428   $ 2,865   $ 6,607   $ 386,467   $ 393,074  

Real estate:

                                     

Commercial and residential

    1,559         1,065     2,624     420,664     423,288  

Land and construction

                    31,443     31,443  

Home equity

    28         290     318     51,497     51,815  

Consumer

            89     89     15,588     15,677  
                           

Total

  $ 4,901   $ 428   $ 4,309   $ 9,638   $ 905,659   $ 915,297  
                           
                           

        Past due loans 30 days or greater totaled $6,788,000 and $9,638,000 at March 31, 2014 and December 31, 2013, respectively, of which $3,050,000 and $5,900,000 were on nonaccrual. At March 31, 2014, there were also $6,496,000 loans less than 30 days past due included in nonaccrual loans held-for-investment. At December 31, 2013, there were also $5,426,000 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.

Credit Quality Indicators

        Concentrations of credit risk arise when a number of customers 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

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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

March 31, 2014

(Unaudited)

5) Loans (Continued)

Company's loan portfolio is concentrated in commercial (primarily manufacturing, wholesale, and service) and real estate lending, with the balance in consumer loans. While no specific industry concentration is considered significant, the Company's lending operations are located in the Company's market areas that are dependent on the technology and real estate industries and their supporting companies. Thus, the Company's borrowers could be adversely impacted by a downturn in these sectors of the economy which could reduce the demand for loans and adversely impact the borrowers' ability to repay their loans.

        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, and it is probable that the Company will not receive payment of the full contractual principal and interest. 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, 2014 or December 31, 2013.

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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

March 31, 2014

(Unaudited)

5) Loans (Continued)

        The following table provides a summary of the loan portfolio by loan type and credit quality classification at period end:

 
  March 31, 2014   December 31, 2013  
 
  Nonclassified   Classified*   Total   Nonclassified   Classified*   Total  
 
  (Dollars in thousands)
 

Commercial

  $ 379,566   $ 11,084   $ 390,650   $ 380,806   $ 12,268   $ 393,074  

Real estate:

                                     

Commercial and residential

    432,370     4,192     436,562     416,992     6,296     423,288  

Land and construction

    41,171     1,718     42,889     29,682     1,761     31,443  

Home equity

    53,367     2,922     56,289     48,818     2,997     51,815  

Consumer

    15,499     330     15,829     15,336     341     15,677  
                           

Total

  $ 921,973   $ 20,246   $ 942,219   $ 891,634   $ 23,663   $ 915,297  
                           
                           

*
Classified loans in the table above are gross of Small Business Administration ("SBA") guarantees.

        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, 2014 was $3,593,000, which included $3,135,000 of nonaccrual loans and $458,000 of accruing loans. The book balance of troubled debt restructurings at December 31, 2013 was $3,722,000, which included $3,230,000 of nonaccrual loans and $492,000 of accruing loans. Approximately $1,092,000 and $1,186,000 in specific reserves were established with respect to these loans as of March 31, 2014 and December 31, 2013, respectively. As of March 31, 2014 and December 31, 2013, the Company had no additional amounts committed on any loan classified as a troubled debt restructuring.

        There were no new loans modified as troubled debt restructurings during the three month periods ended March 31, 2014 and March 31, 2013.

        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 periods ended March 31, 2014 and 2013.

        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

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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

March 31, 2014

(Unaudited)

6) Income Taxes (Continued)

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 $21,403,000, and $23,326,000, at March 31, 2014, and December 31, 2013, 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, 2014 and December 31, 2013 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 there are no Plan assets. The following table presents the amount of periodic cost recognized for the periods indicated:

 
  Three Months Ended
March 31,
 
 
  2014   2013  
 
  (Dollars in thousands)
 

Components of net periodic benefit cost:

             

Service cost

  $ 179   $ 304  

Interest cost

    228     196  

Amortization of net actuarial loss

    35     71  
           

Net periodic benefit cost

  $ 442   $ 571  
           
           

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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

March 31, 2014

(Unaudited)

7) Benefit Plans (Continued)

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, 2014   December 31, 2013  
 
  (Dollars in thousands)
 

Change in projected benefit obligation

             

Projected benefit obligation at beginning of year

  $ 4,353   $ 4,717  

Interest cost

    49     177  

Actuarial gain

        (541 )
           

Projected benefit obligation at end of period

  $ 4,402   $ 4,353  
           
           

 

 
  March 31, 2014   December 31, 2013  
 
  (Dollars in thousands)
 

Net actuarial loss

  $ 304   $ 256  

Prior transition obligation

    1,575     1,597  
           

Accumulated other comprehensive loss

  $ 1,879   $ 1,853  
           
           

 

 
  March 31, 2014   March 31, 2013  
 
  (Dollars in thousands)
 

Amortization of prior transition obligation

  $ (26 ) $ (22 )

Interest cost

    49     44  
           

Net periodic benefit cost

  $ 23   $ 22  
           
           

8) Equity

Common Stock Warrant

        The common stock warrant issued to the U.S. Treasury as part of the Company's participation in the U.S. Treasury Capital Purchase Program was repurchased by the Company in the second quarter of 2013.

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 21,004 shares of Series C Preferred Stock are convertible into 5,601,000 shares of common stock. 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. The

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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

March 31, 2014

(Unaudited)

8) Equity (Continued)

holders of Series C Preferred Stock receive dividends on an as converted basis when dividends are also declared for 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.

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).

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Table of Contents


HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

March 31, 2014

(Unaudited)

9) Fair Value (Continued)

        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, 2014:

                         

Available-for-sale securities:

                         

Agency mortgage-backed securities          

  $ 161,232       $ 161,232      

Asset-backed securities

  $ 27,283         $ 27,283        

Corporate bonds

  $ 53,034       $ 53,034      

Trust preferred securities

  $ 20,826       $ 20,826      

I/O strip receivables

  $ 1,664       $ 1,664      

Assets at December 31, 2013:

   
 
   
 
   
 
   
 
 

Available-for-sale securities:

                         

Agency mortgage-backed securities          

  $ 207,644       $ 207,644      

Corporate bonds

  $ 52,046       $ 52,046      

Trust preferred securities

  $ 20,410       $ 20,410      

I/O strip receivables

  $ 1,647       $ 1,647      

        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 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.

        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

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Table of Contents


HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

March 31, 2014

(Unaudited)

9) Fair Value (Continued)

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, 2014:

                         

Impaired loans—held-for-investment:

                         

Commercial

  $ 1,918           $ 1,918  

Real estate:

                         

Commercial and residential

    1,729             1,729  

Land and construction

    1,255             1,255  

Consumer

    97             97  
                       

  $ 4,999           $ 4,999  
                       
                       

Assets at December 31, 2013:

                         

Impaired loans—held-for-investment:          

                         

Impaired loans—held-for-investment:

                         

Commercial

  $ 1,780           $ 1,780  

Real estate:

                         

Commercial and residential

    2,846             2,846  

Land and construction

    1,290             1,290  

Consumer

    100             100  
                       

  $ 6,016           $ 6,016  
                       
                       

Foreclosed assets:

                         

Land and construction

  $ 575           $ 575  
                       

  $ 575               $ 575  
                       
                       

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Table of Contents


HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

March 31, 2014

(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, 2014   December 31, 2013  
 
  (Dollars in thousands)
 

Impaired loans held-for-investment:

             

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

  $ 7,378   $ 8,472  

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

    3,446     3,346