2.	Significant Accounting Policies, Recent Accounting Pronouncements, Commitments and Contingencies

The accompanying unaudited interim consolidated financial statements have been prepared in accordance with the instructions to Form 10-Q and, therefore, do not include all footnotes that would be required for a full presentation of our financial position, results of operations, changes in cash flows and comprehensive income (loss) in accordance with generally accepted accounting principles in the United States (“GAAP”). However, these interim financial statements reflect all adjustments (consisting of normal recurring adjustments and accruals) which, in the opinion of management, are necessary for a fair presentation of our consolidated financial position and results of operations for the interim periods presented. These interim consolidated financial statements also reflect any events which may have occurred between July 1, 2013 and the date on which this Quarterly Report on Form 10-Q was filed with the Securities and Exchange Commission (the “SEC”) and which required any adjustments to or disclosure in these financial statements.

These unaudited consolidated financial statements have been prepared on a basis consistent with prior periods and should be read in conjunction with our audited consolidated financial statements as of and for the year ended December 31, 2012, and the notes thereto, included in our Annual Report on Form 10-K for the year ended December 31, 2012 (our “2012 10-K”), as filed with the SEC under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)

Our consolidated financial position at June 30, 2013, and the consolidated results of operations for the six months then ended, are not necessarily indicative of what our financial position will be at December 31, 2013, or of the results of our operations that may be expected for any other interim period or for the full year ending December 31, 2013.

Use of Estimates

The preparation of financial statements in conformity with GAAP requires us to make certain estimates and assumptions that could affect the reported amounts of certain of our assets, liabilities, and contingencies at the date of the financial statements and the reported amounts of our revenues and expenses during the reporting periods. For the fiscal periods covered by this Report, those estimates related primarily to our determinations of the allowance for loan losses, the fair values of securities available for sale and mortgage loans held for sale, repurchase reserves on mortgage loans held for sale, and the determination of reserves pertaining to deferred tax assets. If circumstances or financial trends on which those estimates were based were to change in the future or there were to occur any currently unanticipated events affecting the amounts of those estimates, our future financial position or results of operations could differ, possibly materially, from those expected at the current time.

Recently Adopted Accounting Pronouncements

In February 2013, the FASB issued Accounting Standards Update (“ASU”) 2013-02, “Reporting of Amounts Reclassified out of Accumulated Other Comprehensive Income”, ASU No. 2013-02, which requires an entity to report the effect of significant reclassifications out of accumulated other comprehensive income on the respective lines in the entity’s net income if the amount being reclassified is required under GAAP to be reclassified in its entirety to net income. The ASU is effective for fiscal years, and interim periods within those years, beginning after December 15, 2012. The adoption of ASU No. 2013-02 did not have a material impact on our consolidated financial condition or results of operations.

Commitments and Contingencies

Commitments

To meet the financing needs of our customers in the normal course of business, we are a party to financial instruments with off-balance sheet risk. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated financial statements. At June 30, 2013, loan commitments and letters of credit totaled $118 million and $2 million, respectively. The contractual amount of a credit-related financial instrument such as a commitment to extend credit, a credit-card arrangement or a letter of credit represents the amounts of potential accounting loss should the commitment be fully drawn upon, the customer were to default, and the value of any existing collateral securing the customer’s payment obligation becomes worthless.

As a result, we use the same credit policies in making commitments to extend credit and conditional obligations as we do for on-balance sheet instruments. Commitments generally have fixed expiration dates; however, since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. We evaluate each customer’s creditworthiness on a case-by-case basis, using the same credit underwriting standards that are employed in making commercial loans. The amount of collateral obtained, if any, upon an extension of credit is based on our evaluation of the credit worthiness of the customer. Collateral held varies, but may include accounts receivable, inventory, property, plant and equipment, real estate and income-producing commercial properties.

During the first quarter of 2012, we began selling a portion of our mortgage loan production directly to secondary market investors on a “mandatory commitment” basis, agreeing to sell a specified dollar amount of mortgage loans at an agreed-upon price within a specified timeframe in order to avail ourselves of more favorable pricing on mortgage loan sales to investors. In order to mitigate interest rate risk on loans subject to such mandatory commitments, when we locked the interest rate for the borrowers on those loans prior to funding, we locked the price to sell the loans to investors in a mandatory commitment and entered into a mortgage backed to-be-announced (“TBA”) security. The mandatory commitment and the TBA security act as a hedge against market interest rate movements between the time the interest rate is locked and the loan is funded and sold in the secondary market. TBA securities are deemed to be derivatives and involve off-balance sheet financial risk. The contractual or notional amounts of the TBA securities are tied to the Bank’s loan origination volume and we bear a financial risk from such securities. The unrealized gains from the interest rate contracts and TBA security hedges were $584,000 and $393,000 for the three and six months ended June 30, 2013, respectively. These gains or losses depend upon the value of the underlying financial instruments and are affected by market changes in interest rates.

TBA securities pose credit risk for us if and to the extent that the institutional counterparties are unable to meet the terms of the agreements. We control counterparty credit risk by using multiple counterparties and limiting them to major financial institutions with investment grade credit ratings. In addition, we regularly monitor the potential risk of loss with any one party resulting from this type of credit risk.

Legal Proceedings

Mark Zigner vs. Pacific Mercantile Bank, et al., filed in January, 2010, in the California Superior Court for the County of Orange (Case No.0337433). This lawsuit was filed by plaintiff asserting that a set-off by the Bank of funds in plaintiff’s deposit accounts in the Bank’s efforts to recover borrowings owed to it by plaintiff was wrongful.

As previously reported, at the conclusion of a jury trial in February 2012, the plaintiff was awarded $250,000 of compensatory damages and $950,000 in punitive damages against the Bank. In addition, the trial court entered an award to plaintiff of his attorney’s fees and costs, in the amount of $762,000. Promptly thereafter, the Bank filed an appeal of the trial court’s rulings and the jury verdict, asserting that those rulings and the jury’s verdict were erroneous.

Due to the inherent uncertainties with respect to the ultimate outcome of appeals and the opportunity to put an end to what was becoming a lengthy and costly appellate process, on May 13, 2013, we entered into a settlement with the plaintiff pursuant to which plaintiff released all claims that he had or might have had against the Bank in exchange for the payment by the Bank to plaintiff of $1,316,377, and to plaintiff’s lien claimant of $33,623, totaling $1,350,000, which was less than the contingency reserve previously established by the Bank for this suit. As a result, the settlement had no material effect on the Company’s results of operations for the three or the six months ended June 30, 2013.

Other Claims. We also are subject to legal actions that arise from time to time in the ordinary course of our business. Currently there are no such pending legal proceedings that we believe their resolution will be material to our financial condition or results of operations.

Regulatory Matters

On August 31, 2010, the Company and the Bank entered into a Written Agreement (the “FRBSF Agreement”) with FRBSF. On the same date, the Bank consented to the issuance of a regulatory order by the DFI (“DFI Order”). The principal purposes of the FRBSF Written Agreement and DFI Order, which constitute formal supervisory actions by the FRBSF and the DFI, were to require us to adopt and implement formal plans and take certain actions, as well as to continue to implement other measures that we previously adopted, to address the adverse consequences that the economic recession has had on the performance of our loan portfolio and our operating results, to improve our operating results, and to increase our capital to strengthen our ability to weather any further adverse economic conditions that might arise in the future.

The FRBSF Agreement and DFI Order contain substantially similar provisions. They required the Boards of Directors of the Company and the Bank to prepare and submit written plans to the FRBSF and the DFI to address the following matters: (i) strengthening board oversight of the management operations of the Bank; (ii) strengthening credit risk management practices; (iii) improving credit administration policies and procedures; (iv) improving the Bank’s position with respect to problem assets; (v) maintaining adequate reserves for loan losses in accordance with applicable supervisory guidelines; (vi) improving the capital position of the Bank and, in the case of the FRBSF Agreement, the capital position of the Company; (vii) improving the Bank’s earnings through the formulation, adoption and implementation of a new strategic plan, and (viii) submitting a satisfactory funding contingency plan for the Bank that would identify available sources of liquidity and a plan for dealing with possible future adverse economic and market conditions. The Bank is also prohibited from paying dividends to the Company without the prior approval of the DFI, and the Company may not declare or pay cash dividends, repurchase any of its shares, make payments on its trust preferred securities or incur or guarantee any debt, without the prior approval of the FRBSF.

The Company and the Bank already have made substantial progress with respect to several of these requirements, including a requirement, achieved in August 2011, that the Bank raise additional capital to increase its ratio of adjusted tangible shareholders’ equity to its tangible assets to 9.0%. Additionally, both the Board and management are committed to achieving all of the requirements on a timely basis. However, a failure by the Company or the Bank to meet any of those remaining requirements could be deemed, by the FRBSF or the DFI, to be conducting business in an unsafe manner which could subject the Company or the Bank to further regulatory enforcement action.