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Item 8. Consolidated Financial Statements and Supplementary Data

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



FORM 10-K



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

For the fiscal year ended December 31, 2015.

Commission file number: 000-25020

GRAPHIC

(Exact name of registrant as specified in its charter)

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

1222 Vine Street,
Paso Robles, California 93446
(Address of principal executive offices) (Zip Code)

(805) 369-5200
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:

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

Securities registered pursuant to Section 12(g) of the Act: None

Indicate by check mark if the registrant is a well-known, seasoned issuer, as defined in Rule 405 of the Securities Act.
Yes o No ý

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

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

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K o

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

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

The aggregate market value of the common equity held by non-affiliates of the registrant at June 30, 2015 was $187.5 million based on the closing sales price of a share of Common Stock of $7.87 as of June 30, 2015.

As of February 23, 2016, the registrant had 34,165,694 shares of Common Stock outstanding.


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Documents Incorporated By Reference

The information required in Part III, Items 10 through 14 are incorporated herein by reference to the registrant's definitive proxy statement for the 2016 annual meeting of shareholders.

Heritage Oaks Bancorp
and Subsidiaries

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  Page
Part I        
Item 1.   Business   4
Item 1A.   Risk Factors   16
Item 1B.   Unresolved Staff Comments   25
Item 2.   Properties   26
Item 3.   Legal Proceedings   26
Item 4.   Mine Safety Disclosures   26
Part II        
Item 5.   Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities   27
Item 6.   Selected Financial Data   31
Item 7.   Management's Discussion and Analysis of Financial Condition and Results of Operations   32
Item 7A.   Quantitative and Qualitative Disclosures About Market Risk   68
Item 8.   Financial Statements and Supplementary Data   72
Item 9.   Changes in and Disagreements with Accountants on Accounting and Financial Disclosure   149
Item 9A.   Controls and Procedures   149
Item 9B.   Other Information   149
Part III        
Item 10.   Directors, Executive Officers and Corporate Governance   150
Item 11.   Executive Compensation   150
Item 12.   Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters   150
Item 13.   Certain Relationships and Related Transactions, and Director Independence   150
Item 14.   Principal Accounting Fees and Services   150
Part IV        
Item 15.   Exhibits, Financial Statement Schedules   151
Signatures   152
Exhibit Index   153
Certifications   156

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Part I

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

This Annual Report on Form 10-K may contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. You can find many (but not all) of these statements by looking for words such as "approximates," "believes," "expects," "anticipates," "estimates," "intends," "plans," "would," "may" and other similar expressions in this Annual Report on Form 10-K. With respect to any such forward-looking statements, the Company claims the protection of the safe harbor provided for in the Private Securities Litigation Reform Act of 1995. The Company cautions investors that any forward-looking statements presented in this Annual Report on Form 10-K, or those that the Company may make orally or in writing from time to time, are based on the beliefs of, on assumptions made by, and information available to, Company management at the time such statements are first made. Actual outcomes will be affected by known and unknown risks, trends, uncertainties and factors that are beyond the Company's control or ability to predict. Although the Company believes that management's beliefs and assumptions are reasonable, they are not guarantees of future performance and some will inevitably prove to be incorrect. As a result, the Company's actual future results can be expected to differ from management's expectations, and those differences may be material and adverse to the Company's business, results of operations and financial condition. Accordingly, investors should use caution in relying on forward-looking statements to anticipate future results or trends.

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

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

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

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

      Our ability to attract and retain qualified employees.

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

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

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

      The likelihood that any expansionary activities will be impeded by our regulatory agencies while current or future enforcement actions remain outstanding.

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

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

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

Item 1.    Business

Organizational Structure and History

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

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

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

Banking Activities

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

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Business Strategy

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

Deliver Superior Customer Service

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

Enhance Product Delivery to Our Customers

We believe that our customers should have a positive experience at every point of contact with us. The primary point of contact with our customers continues to be our retail offices. We continue to implement user-friendly technologies for our customers who want to interact with us through electronic channels such as the internet, phone, or other mobile devices. We currently offer online banking, bill pay, and cash management; remote deposit capture; Automated Clearing House ("ACH") and positive payments; automatic payroll deposits; eDelivery; prepaid gift and payroll cards; some advanced function ATMs; and mobile banking. We expect to continue to expand our electronic delivery channels as customer preferences change and newer devices and technologies are developed. We believe the combination of high touch service in retail locations and user-friendly electronic banking services enhances our customer experience. It also provides us additional delivery channels to attract more customers.

Maintain Strong Brand Awareness

We expend a considerable amount of resources maintaining and enhancing our retail brand. We believe that our brand should reflect the superior customer service we offer as a community bank and our commitment to the communities where we operate. Maintaining strong brand awareness requires a consistent brand design; effective use of marketing and merchandising; participation and sponsorship in community based events; and usage of multiple media sources. We hold service marks issued by the U.S. Patent and Trademark Office for the "Acorn" design; the "Oakley" design; and the tag lines "Deeply Rooted in Your Hometown" and "Heritage Oaks Bank – Expect More." We have also filed an "intent to use" servicemark application and we are currently establishing "proof of use" for the tag line "Heritage Oaks Bank – We're central to the coast," and we anticipate that we will obtain full registration of this service mark in 2016. We continually evaluate the effectiveness of our brand and from time to time will take steps to improve our overall brand awareness in the markets we serve.

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Increase Market Share in Existing Markets and Expand into New Markets

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

The Company believes the combination with MISN created a more valuable retail and business community banking franchise, with a low cost core deposit base, strong capital ratios, attractive net interest margins, lower operating costs, and better overall returns for the shareholders of the combined institution. It also created a banking platform that is well positioned for future growth. In connection with the combination, during 2014 the Company added two experienced banking professionals from Mission Community Bancorp, Howard N. Gould and Stephen P. Yost, to its Board of Directors.

Community Service

We strongly believe in enhancing the economic vitality and welfare of the communities where we work and live. In 2015, Bank employees provided approximately 2,400 hours in direct volunteer support of local community activities, projects, and events. The Bank also provided in-kind support throughout the year including providing meeting rooms at retail branch and administrative locations, and giving surplus furniture and used computers to local partners. Bank employees also serve on boards of local non-profit and charitable organizations. Finally, we donated over $0.4 million during 2015 to local organizations to support community related activities.

Products and Services

We offer a full array of financial products and services to targeted businesses and consumers. We regularly monitor our customers' financial needs to determine whether we should design or offer new products and services. We also regularly monitor the pricing and profitability of these financial products and services to ensure that we are able to achieve a reasonable rate of return for the risks we assume in offering such products and services. The Bank offers to its commercial clients commercial loans secured by real estate, other commercial loans and lines of credit, agricultural loans, construction financing, other real estate loans and small business administration loans. The Bank also offers interest rate swap products to commercial clients who meet certain suitability requirements. For consumers, the Bank offers residential mortgages, home equity lines of credit and other consumer loans. The Bank employs relationship managers focused on the development and origination of new loan and banking relationships across the markets it serves. Deposits are obtained primarily through retail deposit gathering efforts as well as through commercial account relationships. Deposit products offered include personal and business checking and savings accounts, time deposit accounts, individual retirement accounts ("IRAs"), health savings accounts ("HSAs"), and money market accounts. The Bank also offers online banking, mobile banking, wire transfers, safe deposit boxes, cashier's checks, traveler's checks, bank-by-mail, remote deposit capture, night depository services and other customary banking services.

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Competition, Market and Economic Conditions

The banking and financial services industry in California generally, and in the Company's service area specifically, is highly competitive. In our primary market areas, money center banks and large regional banks generally hold dominant market share positions. By virtue of their larger capital bases, these institutions have significantly larger lending limits than we do and generally have more expansive branch networks. Competition also includes other community-focused commercial banks. In addition, credit unions also present a significant competitive challenge for us. Credit unions currently have an exemption from income taxes and as a result can offer higher deposit rates and lower loan rates than we can on a comparable basis.

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

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

The economy in the Company's primary market area (San Luis Obispo, Santa Barbara and Ventura Counties) is based primarily on agriculture, hospitality, light industry, oil and retail trade. Additionally, the local economy in San Luis Obispo County and to a lesser degree Santa Barbara County is dependent on the level of employment generated by state and local government agencies. Services supporting these industries have also developed in the areas of medical, financial and educational services. The populations of San Luis Obispo County, the City of Santa Maria (in Northern Santa Barbara County), and the City of Santa Barbara totaled approximately 279,000, 103,000, and 91,000 respectively, according to the most recent data provided by the U.S. Census Bureau.

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

Beginning in 2012 and continuing through 2015, the business climate has shown steady signs of improvement including improved real estate prices and a decline in the unemployment rates. The most recent labor market information published by the California Employment Development Department shows the unemployment rate within California to be approximately 5.7%, compared to over 12% at the peak of the recent economic crisis in 2010.

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

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

Management remains cautiously optimistic that there will be continued slow but steady improvement in economic conditions in 2016 in our primary markets. However, there have been growing concerns regarding both the global economy and the national economy due primarily to excessive government debt, public perceptions of unsound fiscal policies, and a significant decline in the price of oil, and equity markets. There are also growing concerns that the prolonged drought, which has affected most of California, could have adverse impacts on the Central Coast of California's critical agriculture market, and therefore our loan portfolio, in the future should drought conditions not ease. Should either of these uncertainties materialize they could eventually affect our local economy, and ultimately negatively impact the financial condition of borrowers to whom the Company has extended credit. In turn, the Company may suffer higher credit losses as a result.

Employees

At December 31, 2015, the Company employed 283 full-time equivalent employees. The Company's employees are not represented by a union or covered by a collective bargaining agreement. Management believes that its employee relations are positive.

Supervision and Regulation

General

The Company is a legal entity separate and distinct from the Bank. As a bank holding company, the Company is registered with and subject to examination by the Federal Reserve Board as a bank holding company and is also subject to certain provisions of the California Financial Code as applicable to bank holding companies. As a California state-chartered bank whose accounts are insured by the FDIC, the Bank is subject to regulation, supervision and regular examination by the California Department of Business Oversight (the "DBO") and the FDIC. Such supervision and regulation covers substantially all of its business activities, including, among others, capital standards, general investment authority, deposit taking and borrowing authority, mergers, establishment of branch offices and permitted subsidiary investments and activities. In addition, while the Bank is not a member of the Federal Reserve system, the Bank is subject to certain regulations of the Federal Reserve Board. The federal and state regulatory systems are intended primarily for the protection of depositors, the FDIC deposit insurance fund (the "DIF") and the banking system as a whole, rather than for the protection of shareholders or other investors.

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Legislation and Regulatory Developments

From time to time, federal and state legislation is enacted that may have the effect of materially increasing the cost of doing business, limiting or expanding permissible activities, or affecting the competitive balance between banks and other financial services providers. The implementation and impact of legislation and regulations enacted since 2008 in response to the U.S. economic downturn and financial industry instability continued in 2015 as modest recovery returned to many institutions in the banking sector. Many institutions, including the Company, have repaid and repurchased U.S. Treasury investments under the Troubled Asset Relief Program ("TARP"). The federal banking agencies continue to implement the remaining requirements in the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank Act") as well as promulgating other regulations and guidelines intended to assure the financial strength and safety and soundness of banks and the stability of the U.S. banking system.

Following on the implementation in 2014 and effectiveness in 2015 of new capital rules ("the New Capital Rules") and the so called Volcker Rule restrictions on certain proprietary trading and investment activities, developments in 2015 included:

(i)    the extension of the Volcker Rule conformance period until July 21, 2016 and a possible additional extension until 2017 for banking institutions to conform existing investments, including certain collateralized loan obligations, and relationships, with certain exceptions, with "covered funds," including hedge funds, private equity funds and certain other private funds. The Company and the Bank held no investment positions or fund relationships at December 31, 2015 which were subject to the final rule and have controls in place to ensure compliance with the Volcker Rule going forward.

(ii)   the implementation of an additional "capital conservation buffer" of 0.625% in 2016 for minimum risk-weighted asset ratios under the New Capital Rules. See "Capital Adequacy Requirements" and "Management's Discussion and Analysis of Financial Condition and Results of Operations."

(iii)  the effectiveness in October, 2015 of the final TILA-RESPA Integrated Disclosure ("TRID") rules promulgated by the CFPB, as required by the Dodd-Frank Act, which require new mortgage disclosures and training of staff for most mortgage loan applications. The Bank is in compliance with the TRID requirements – See "CFPB."

(iv)  the release by the Interagency Federal Financial Institutions Examinations Council (FFIEC) of a cybersecurity assessment tool for voluntary use by banks which provides guidelines to measure a bank's individual risk profile and "Cybersecurity maturity." The Bank completed a cybersecurity risk assessment in early 2015, prior to the availability of the FFIEC risk assessment tool. The Bank subsequently performed a revision in the fourth quarter of 2015 to bring the risk assessment in line with the FFIEC's published tool.

(v)   the enactment in 2015 of the Cybersecurity Information Sharing Act authorizing the Department of Homeland Security to enhance the coordination and information sharing about cybersecurity threats between banks and government agencies consistent with customers' rights of privacy; and

(vi)  the adoption of the Fixing America's Surface Transportation Act (the "FAST Act"), highway legislation which contains financial services provisions, including (a) expanding the extended 18 months examination cycle for banks with up to $1 billion in assets; (b) deleting the annual privacy notice for banks which have not changed their policy or practices of sharing of information with third parties and (c) limiting the percentage payment of dividends on reserve bank stock held by banks with more than $10 billion in assets. The Bank, as a nonmember state bank, holds no reserve bank stock.

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Regulatory Enforcement Authority

In the exercise of their supervisory and examination authority, the federal and state bank regulatory agencies have recently emphasized corporate governance, capital planning and stress testing, liquidity management, enterprise risk management and other board responsibilities, anti-money laundering compliance; information technology adequacy; cyber security preparedness; vendor management and fair lending and other consumer compliance obligations.

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

The Bank is currently subject to a Consent Order ("the BSA Consent Order") dated November 5, 2014 issued by the FDIC and the DBO relating to identified deficiencies in the Bank's centralized Bank Secrecy Act and anti-money laundering compliance program. Management and the Board have been working diligently to comply with the BSA Consent Order and believe they have allocated sufficient resources to address the corrective actions required by the FDIC and DBO. Compliance and resolution of the BSA Consent Order will ultimately be determined by the FDIC and DBO.

Bank Holding Company and Bank Regulation

Bank holding companies and their subsidiaries are subject to significant regulation and restrictions by federal and state laws and regulatory agencies. federal and state laws, regulations and restrictions, which may affect the cost of doing business, limit permissible activities and expansion or impact the competitive balance between banks and other financial services providers, are intended primarily for the protection of depositors and the DIF, and secondarily for the stability of the U.S. banking system. They are not intended for the benefit of shareholders of financial institutions. The following paragraphs summarize certain of the laws and regulations that apply to the Company and to the Bank. These descriptions of statutes and regulations and their possible effects do not purport to be complete descriptions of all of the provisions of those statutes and regulations and their possible effects on us, nor do they purport to identify every statute and regulation that may apply to us.

The wide range of requirements and restrictions contained in both federal and state banking laws include:

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

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

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

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

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

      The Community Reinvestment Act (the "CRA").  The CRA requires that banks help meet the credit needs in their communities, including the availability of credit to low and moderate income individuals. If the Company or the Bank fails to adequately serve their communities, penalties may be imposed, including denials of applications for branches, to add subsidiaries and affiliates, or to merge with or purchase other financial institutions. In its last reported examination by the FDIC in 2015, the Bank received a CRA rating of "Satisfactory."

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

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

      Limitations on transactions with affiliates.

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

      Requirements for opening of branches intra- and interstate.

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

      Provisions of the federal and state laws dealing with privacy for nonpublic personal information of customers.

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Capital Adequacy Requirements

Bank holding companies and banks are subject to similar regulatory capital requirements administered by their state and federal supervisory banking agencies. The basic capital rule changes in the New Capital Rules adopted by the federal bank regulatory agencies were fully effective on January 1, 2015, but many elements are being phased in over multiple years. The risk-based capital guidelines for bank holding companies and banks and, additionally for banks, prompt corrective action regulations (see "Prompt Corrective Action Provisions"), require capital ratios that vary based on the perceived degree of risk associated with a banking organization's operations for both transactions reported on the balance sheet as assets, such as loans, and those recorded as off-balance sheet items, such as commitments, letters of credit and recourse arrangements. The risk-based capital ratio is determined by classifying assets and certain off-balance sheet financial instruments into weighted categories, with higher levels of capital being required for those categories perceived as representing greater risks and dividing its qualifying capital by its total risk-adjusted assets and off-balance sheet items. Capital amounts and classifications are also subject to qualitative judgments by regulators about components, risk weighting, and other factors. Bank holding companies and banks engaged in significant trading activity may also be subject to the market risk capital guidelines and be required to incorporate additional market and interest rate risk components into their risk-based capital standards. To the extent that the new rules are not fully phased in, the prior capital rules continue to apply.

The New Capital Rules revised the previous risk-based and leverage capital requirements for banking organizations to meet requirements of the Dodd-Frank Act and to implement the international Basel Committee on Banking Supervision Basel III agreements. Many of the requirements in the New Capital Rules and other regulations and rules are applicable only to larger or internationally active institutions and not to all banking organizations, including institutions currently with less than $10 billion of assets, which includes the Company and the Bank. These include required annual stress tests for institutions with $10 billion or more of assets with reporting requirements and Enhanced Prudential Standards, both of which will apply to the Company and the Bank following the Merger, Comprehensive Capital Analysis and Review requirements; capital plan and Resolution Plan or living will submissions, an additional countercyclical capital buffer, a supplementary leverage ratio and the Liquidity Coverage Ratio rule requiring sufficient high-quality liquid assets which may apply to institutions with $50 billion or more or $250 billion or more assets or which may be identified as Global Systematically Important Banking Institutions (G-SIBs).

Under the risk-based capital guidelines in place prior to the effectiveness of the New Capital Rules, which trace back to the 1988 Basel I accord, there were three fundamental capital ratios: a total risk-based capital ratio, a Tier 1 risk-based capital ratio and a Tier 1 leverage ratio. To be deemed "well capitalized," a bank must have a total risk-based capital ratio, a Tier 1 risk-based capital ratio and a Tier 1 leverage ratio of at least ten percent, six percent and five percent, respectively. Under the prior capital rules there was no Tier 1 leverage requirement for a holding company to be deemed well-capitalized.

The following are the New Capital Rules applicable to the Company and the Bank beginning January 1, 2015:

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

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

      a minimum non-risk-based leverage ratio is set at 4.00%;

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      changes in the permitted composition of Tier 1 capital to exclude trust preferred securities subject to certain grandfathering exceptions for organizations like the Company which were under $15 billion in assets as of December 31, 2009, mortgage servicing rights, limitations on the amount of deferred tax assets, and to include unrealized gains and losses on available for sale debt and equity securities unless the organization opts out of including such unrealized gains and losses. The Company and the Bank made this opt out election;

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

      an additional capital conservation buffer of 2.5% of risk weighted assets above the regulatory minimum capital ratios, which will be phased in until 2019 beginning at 0.625% of risk-weighted assets for 2016 and must be met to avoid limitations on the ability of the Bank to pay dividends, repurchase shares or pay discretionary bonuses.

Including the capital conservation buffer of 2.5%, the New Capital Rules would result in the following minimum ratios to be considered well capitalized: (i) a Tier 1 capital ratio of 8.5%, (ii) a common equity Tier 1 capital ratio of 7.0%, and (iii) a total capital ratio of 10.5%. At December 31, 2015, the respective capital ratios of the Bank exceeded the minimum percentage requirements to be deemed "well-capitalized" for regulatory purposes.

While the New Capital Rules set higher regulatory capital standards for the Company and the Bank, bank regulators may also continue their past policies of expecting banks to maintain additional capital beyond the new minimum requirements. The implementation of the New Capital Rules or more stringent requirements to maintain higher levels of capital or to maintain higher levels of liquid assets could adversely impact the Company's net income and return on equity, restrict the ability to pay dividends or executive bonuses and require the raising of additional capital. Please also see "Capital" under Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations for disclosure concerning the Company's and Bank's regulatory capital ratios.

Prompt Corrective Action Provisions

The Federal Deposit Insurance Act requires the federal bank regulatory agencies to take "prompt corrective action" with respect to a depository institution if that institution does not meet certain capital adequacy standards, including requiring the prompt submission of an acceptable capital restoration plan. Depending on the bank's capital ratios, the agencies' regulations define five categories in which an insured depository institution will be placed: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized. The prompt corrective action standards were also changed as the New Capital Rules ratios became effective. Under the new standards, in order to be considered well-capitalized, the bank will be required to meet the new common equity Tier 1 ratio of 6.5%, an increased Tier 1 ratio of 8% (increased from 6%), an unchanged total capital ratio of 10% and an unchanged leverage ratio of 5%.

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At each successive lower capital category, an insured bank is subject to more restrictions, including restrictions on a bank's activities, operational practices or the ability to pay dividends. Based upon its capital levels, a bank that is classified as well capitalized, adequately capitalized, or undercapitalized may be treated as though it were in the next lower capital category if the appropriate federal banking agency, after notice and opportunity for hearing, determines that an unsafe or unsound condition, or an unsafe or unsound practice, warrants such treatment. The federal banking agencies also may require banks and bank holding companies subject to enforcement actions to maintain capital ratios in excess of the minimum ratios otherwise required to be deemed well capitalized. Failure to meet statutorily mandated capital guidelines or more restrictive ratios separately established for a financial institution could subject a bank or bank holding company to a variety of enforcement remedies, including issuance of a capital directive, the termination of deposit insurance by the FDIC, a prohibition on accepting or renewing brokered deposits, limitations on the rates of interest that the institution may pay on its deposits and other restrictions on its business.

Dividends

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

The Bank is a legal entity that is separate and distinct from its holding company. The Company is dependent on the performance of the Bank for funds which may be received as dividends from the Bank for use in the operation of the Company and the ability of the Company to pay dividends to shareholders. Future cash dividends by the Bank will also depend upon management's assessment of future capital requirements, contractual restrictions, and other factors. The phase in of the Basel III Capital Rules restricts dividend payments by the Bank if the additional capital conservation buffer is not achieved.

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

Deposit Insurance

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

The amount of FDIC assessments paid by each DIF member institution is based on its asset size and its relative risk of default as measured by regulatory capital ratios and other supervisory factors. We are generally unable to control the amount of premiums that we are required to pay for FDIC insurance, which can be affected by the cost of bank failures to the FDIC among other factors. Any future increases in FDIC insurance premiums may have a material and adverse effect on our earnings and could have a material adverse effect on the value of, or market for, our common stock.

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The Dodd-Frank Act revised the FDIC's DIF management authority by setting requirements for the Designated Reserve Ratio (the DIF balance divided by estimated insured deposits) and redefining the assessment base which is used to calculate banks' quarterly assessments. In October 2015, the FDIC published for comment a proposed rule that would enable the FDIC to reach a 1.35% DIF reserve ratio by September 30, 2020, as required by the Dodd-Frank Act, by imposing a surcharge on the quarterly assessments of depository institutions with total consolidated assets of $10 billion or more, which could have potential impact on the Bank's deposit insurance assessments in future years as the Bank grows.

Operations and Consumer Compliance Laws

The Bank must comply with numerous federal and state anti-money laundering and consumer protection statutes and implementing regulations, including, but not limited to, the USA PATRIOT Act of 2001, the Bank Secrecy Act, the Foreign Account Tax Compliance Act, the CRA, the Fair Debt Collection Practices Act, the Fair Credit Reporting Act, the Equal Credit Opportunity Act, the Truth in Lending Act, the Fair Housing Act, the Home Mortgage Disclosure Act, the Real Estate Settlement Procedures Act, the National Flood Insurance Act, the California Homeowner Bill of Rights and various federal and state privacy protection laws, including the Telephone Consumer Protection Act, CAN-SPAM Act. Noncompliance with any of these laws could subject the Bank to compliance enforcement actions as well as lawsuits and could also result in administrative penalties, including, fines and reimbursements. The Company and the Bank are also subject to federal and state laws prohibiting unfair or fraudulent business practices, untrue or misleading advertising and unfair competition.

These laws and regulations mandate certain disclosure and reporting requirements and regulate the manner in which financial institutions must deal with customers when taking deposits, making loans, servicing, collecting and foreclosure of loans, and providing other services. Failure to comply with these laws and regulations can subject the Bank to various penalties, including but not limited to enforcement actions, injunctions, fines or criminal penalties, punitive damages to consumers, and the loss of certain contractual rights.

CFPB

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

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In 2014, the CFPB adopted revisions to Regulation Z, which implement the Truth in Lending Act, pursuant to the Dodd Frank Act, and apply to all consumer mortgages (except home equity lines of credit, timeshare plans, reverse mortgages, or temporary loans). The revisions mandate specific underwriting criteria for home loans in order for creditors to make a reasonable, good faith determination of a consumer's ability to repay and establish certain protections from liability under this requirement for "qualified mortgages" meeting certain standards. In particular, it will prevent banks from making "no doc" and "low doc" home loans, as the rules require that banks determine a consumer's ability to pay based in part on verified and documented information. Because we do not originate "no doc" or "low doc" loans, and because it is our intention to originate loans that meet the definitions for a "qualified mortgage" under final regulations adopted by the CFPB, we do not believe this regulation will have a significant impact on our operations. The Bank primarily makes qualified mortgages and is in compliance with the TRID requirements.

Securities Laws and Corporate Governance

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

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

Where You Can Find More Information

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

Item 1A.    Risk Factors

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

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

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

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

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

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

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

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

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We have a concentration in commercial real estate loans.

We have a high concentration in commercial real estate ("CRE") loans. CRE loans are defined as construction, land development, other land loans such as farmland, loans secured by multi-family (5 or more units) residential properties and loans secured by non-farm, non-residential properties. Following this definition, approximately 65.3% of our gross loans can be classified as CRE lending as of December 31, 2015. CRE loans generally involve a higher degree of credit risk than certain other types of lending due to, among other things, the generally large amounts loaned to individual borrowers. Losses incurred on loans to a small number of these borrowers could have a material and adverse impact on our operating results and financial condition. In addition, commercial real estate loans generally depend on the cash flow from the property to service the debt. Cash flow may be adversely affected by general economic conditions, which may result in non-performance by certain borrowers.

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

The Bank is currently subject to a Consent Order ("the BSA Consent Order") dated November 5, 2014 issued by the FDIC and the DBO relating to identified deficiencies in the Bank's centralized Bank Secrecy Act and anti money laundering compliance program. Management and the Board have been working diligently to comply with the BSA Consent Order and believe they have allocated sufficient resources to address the corrective actions required by the FDIC and DBO. Compliance and resolution of the BSA Consent Order will ultimately be determined by the FDIC and DBO. Certain activities, including expansionary activities, that otherwise require regulatory approval will likely be impeded while the BSA Consent Order remains outstanding. Our failure to comply with the BSA Consent Order and to successfully implement an enhanced BSA/AML compliance program may result in additional regulatory action, including civil money penalties against the Bank and its officers and directors or enforcement of the BSA Consent Order through court proceedings, which could have a material and adverse effect on our business, results of operations, financial condition, cash flows and stock price.

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

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

The federal banking agencies continue to implement the remaining requirements in the Dodd-Frank Act as well as promulgating other regulations and guidelines intended to assure the financial strength and safety and soundness of banks and the stability of the U.S. banking system. The full compliance burden and impact of the Dodd Frank Act on the Company's and the Bank's business, financial condition, and results of operations and profitability remain uncertain.

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

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

Our business is also impacted by federal monetary policy, particularly as implemented through the Federal Reserve Board. Federal monetary policy significantly affects our credit conditions, primarily through open market operations in United States government securities, the discount rate for member bank borrowing, and bank reserve requirements. Changes in trade and monetary and fiscal policies and laws, including the interest rate policies of the Federal Reserve Board could have a material and adverse impact on our business, financial condition and results of operations.

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

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

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

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

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

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

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

The financial services business in our market area is highly competitive. It is becoming increasingly competitive due to changes in regulation, technological advances and the accelerating pace of consolidation among financial services providers. We face competition in attracting and retaining core business relationships. Increasing levels of competition in the banking and financial services business may reduce our market share, decrease loan demand, cause the prices we charge for our services to fall, resulting in a decline in the rates we charge on loans and/or cause higher rates to be paid on deposits. Therefore, our results may differ in future periods depending upon the nature and level of competition.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Our controls and procedures could fail or be circumvented.

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

The occurrence of fraudulent activity, breaches of our information security or cybersecurity-related incidents could have a material adverse effect on our business, financial condition and results of operations.

Information technology systems are critical to our business. We use various technology systems to manage our customer relationships, general ledger, securities, deposits, and loans. As a financial institution, we are susceptible to fraudulent activity, information security breaches and cybersecurity-related incidents that may be committed against us or our clients, which may result in financial losses or increased costs to us or our clients, disclosure or misuse of our information or our clients' information, misappropriation of assets, privacy breaches against our clients, litigation, or damage to our reputation. These risks may increase in the future as we continue to increase our mobile-payment and other internet-based product offerings and expand our internal usage of web-based products and applications.

Such fraudulent activity may take many forms, including check fraud, electronic fraud, wire fraud, phishing, social engineering and other dishonest acts. Information security breaches and cybersecurity-related incidents may include fraudulent or unauthorized access to systems used by us or our clients, denial or degradation of service attacks, and malware or other cyberattacks. In recent periods, there continues to be a rise in electronic fraudulent activity, security breaches and cyber-attacks within the financial services industry, especially in the commercial banking sector due to cyber criminals targeting commercial bank accounts. Consistent with industry trends, we have also experienced an increase in attempted electronic fraudulent activity, security breaches and cybersecurity-related incidents in recent periods. Moreover, in the past year, several large corporations, including retail companies, have suffered major data breaches, where in some cases, exposing sensitive financial and other personal information of their clients and subjecting them to potential fraudulent activity. Some of our clients may have been affected by these breaches, which increase their risks of identity theft, credit card fraud and other fraudulent activity that could involve their accounts with the Bank.

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Table of Contents

Information pertaining to us and our clients is maintained, and transactions are executed, on our networks and systems, those of our clients and certain of our third party partners, such as our online banking or reporting systems. The secure maintenance and transmission of confidential information, as well as execution of transactions over these systems, are essential to protect us and our clients against fraud and security breaches and to maintain our clients' confidence. Increases in criminal activity levels and sophistication, advances in computer capabilities, new discoveries, vulnerabilities in third-party technologies (including browsers and operating systems) or other developments could result in a compromise or breach of the technology, processes and controls that we use to prevent fraudulent transactions and to protect data about us, our clients and underlying transactions, as well as the technology used by our clients to access our systems. Although we have developed, and continue to invest in, systems and processes that are designed to detect and prevent security breaches and cyber-attacks and periodically test our security, the inability to anticipate, or failure to adequately mitigate, breaches of security could result in: losses to us or our clients; our loss of business and/or clients; damage to our reputation; the incurrence of additional expenses; disruption to our business, and/or our ability to grow our online services or other businesses; additional regulatory scrutiny or penalties; or exposure to civil litigation or possible financial liability, any of which could have a material adverse effect on our business, financial condition and results of operations.

The potential for fraud when regularly dealing with credit cards, debit cards, prepaid cards, and ACH transactions is significant.

Issuers of credit, debit and prepaid cards and other industry participants, as well as depository institutions participating in the ACH network have suffered significant losses in recent years with respect to the theft of personal, financial and confidential data that has been illegally exploited for personal gain. In addition, we operate a number of electronic, check and other payment connections that are vulnerable to individuals engaging in fraudulent activities that seek to compromise payments and related financial systems illegally. The theft of such information is regularly reported and affects not only individuals but businesses as well. In recent years, losses from such fraud have been substantial. Although fraud has not had a material impact on the profitability of the Bank, it is possible that such activity could adversely impact it in the future.

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

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

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

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

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Necessary changes in technology could be costly.

The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology-driven products and services. The effective use of technology increases efficiency and enables financial institutions to better serve customers and to reduce costs. Our future success depends, in part, upon our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands, as well as to create additional efficiencies in our operations. Many of our competitors have substantially greater resources to invest in technological improvements.

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

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

The Company uses a third party software service provider to perform all of its transaction data processing. The Company also outsources other customer service applications, such as on-line banking, ACH and wire transfers, to third party vendors. If these service providers were to experience technical difficulties or incur any extended outages in services, it could have a material and adverse impact on the Company and its customers. Because such service providers service us and other banks, their systems could be affected by denial of service attacks directed at their other bank customers. In addition, third parties may seek to penetrate our vendors' IT systems, obtain information about us or our customers or access our customers' accounts, and exploit that information to wrongfully withdraw or transfer our customers' funds, which could have material and adverse impacts on our customers and the Company. Further, if the Company was required to switch service providers due to deterioration in service quality or other factors, there is no guarantee that it could obtain comparable services at a comparable price.

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

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

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

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

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

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

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

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

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

As a holding company, dividends from our subsidiary bank provide a substantial portion of our cash flow used to service the interest payments on our trust preferred securities and any cash dividends to our shareholders. Various statutory provisions restrict the amount of dividends the Bank can pay to us without regulatory approval. If the Bank is unable to generate the profits necessary to service the interest payments, or we are unable to obtain regulatory approval to make dividends from the Bank to the Company, our business, operating results and financial condition may be materially and adversely affected.

The soundness of other financial institutions could adversely affect us.

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

Item 1B.    Unresolved Staff Comments

None.

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Item 2.    Properties

The Company's headquarters are located at 1222 Vine Street in Paso Robles, California. As of December 31, 2015, the Bank operates 12 branches within the Counties of San Luis Obispo and Santa Barbara. The Bank currently owns its headquarters and eight of its branches and leases the remaining branches and administrative facilities from various parties. The Bank also leases one location in Ventura County where it operates a loan production office. The Company believes its facilities are adequate for its present needs. The Company believes that the insurance coverage on all properties is adequate for its present needs. Most of the leases contain multiple renewal options and provisions for rental increases, principally for changes in the cost of living index, property taxes and maintenance.

Item 3.    Legal Proceedings

In addition to routine litigation incidental to the business of the Company and/or the Bank, the Company is party to the following litigation.

In re Ennis Commercial Properties, LLC (Debtor) / Ennis Commercial Properties LLC et al. (Plaintiffs) v. Heritage Oaks Bancorp, United States Bankruptcy Court, Eastern District of California – Fresno Division. Case No. 10-12709-A-11. In January 2015, the Plan of Liquidation Administrator ("Administrator" or "Plaintiff") appointed by the Bankruptcy Court regarding the bankruptcy of Ennis Commercial Properties, LLC ("Ennis Commercial") filed a complaint against Heritage Oaks Bancorp ("the Company"). The complaint generally involves actions taken in 2008 by parties not related to the Company in connection with the transfer by Ennis Commercial of deeds of trust on a property ("Transfers") in connection with a loan and loan modification to entities affiliated with Ennis Commercial. One of the deeds of trust was granted by Ennis Commercial in connection with a loan between an unrelated third-party bank and an entity affiliated with Ennis Commercial. In 2006, prior to the events in 2008, one of the Company's predecessors had entered into a Loan Participation Agreement with the unrelated third-party bank in connection with that loan. Subsequent to the Transfers, Ennis Commercial and various affiliated/related entities filed for bankruptcy protection. On or about June 27, 2013, the Bankruptcy Court entered an order confirming Ennis Commercial's Plan of Liquidation, with an effective date of July 12, 2013. The secured loans at issue were originated and modified by unaffiliated third party banks. According to the complaint, the Administrator named the Company as a defendant because it was assigned a third-party bank's claim based on the secured debt against Ennis Commercial's estate on March 14, 2014.

Plaintiff sought to undo the Transfers as fraudulent transfers, and sought $2.7 million in damages, prejudgment interest and attorneys' fees. On November 30, 2015, the parties mediated the matter and reached a mutually agreeable settlement that did not have a material adverse impact on our liquidity, reputation, consolidated financial position, results of operations and/or stock price. The Company recorded expense associated with the settlement during the year ended December 31, 2015. The settlement agreement was signed by all parties and an Order Granting Stipulation to Dismiss Adversary Proceeding with Prejudice was entered on January 15, 2016. This matter will no longer be discussed in the Company's filings.

The outcome of the litigation summarized above and other legal and regulatory matters is inherently uncertain. Were an unfavorable ruling to occur, there exists the possibility of a material adverse impact on our liquidity, reputation, consolidated financial position, results of operations, and/or stock price. Except as indicated above, neither the Company nor the Bank is involved in any legal proceedings other than routine litigation incidental to the business of the Company or the Bank.

Item 4.    Mine Safety Disclosures

Not applicable.

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Part II

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

Market Information

The Company's common stock trades on the NASDAQ Capital Market under the symbol "HEOP." As of February 24, 2016, there were approximately 2,684 holders of record of the Company's common stock. The following table summarizes those trades of the Company's Common Stock on NASDAQ, setting forth the high and low sales prices for each quarterly period ended since January 1, 2014, as well as per share amount of dividends declared on the Company's common stock:

 
  Stock Price    
 
 
  Dividends
Declared
 
 
  High   Low  

Quarters Ended

                   

December 31, 2015

    $ 9.25     $ 7.51     $ 0.06  

September 30, 2015

    $ 8.46     $ 7.36     $ 0.06  

June 30, 2015

    $ 8.80     $ 7.44     $ 0.06  

March 31, 2015

    $ 8.92     $ 7.50     $ 0.05  

December 31, 2014

 
  $

8.51
 
  $

6.95
 
  $

0.05
 

September 30, 2014

    $ 7.94     $ 6.70     $ 0.03  

June 30, 2014

    $ 8.35     $ 6.83     $ -      

March 31, 2014

    $ 8.48     $ 7.27     $ -      

Dividends

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

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

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The principal source of funds from which the Company may pay dividends is the receipt of dividends from the Bank. The availability of dividends from the Bank is limited by various statutes and regulations. The Bank is subject first to corporate restrictions on its ability to pay dividends. Further, the Bank may not pay a dividend if it would be undercapitalized for Bank regulatory purposes after the dividend payment is made. The payment of cash dividends by the Bank is subject to restrictions set forth in the California Financial Code (the "Financial Code"). The Financial Code provides that a bank may not make a cash distribution to its shareholders in excess of the lesser of (a) bank's retained earnings; or (b) bank's net income for its last three fiscal years, less the amount of any distributions made by the bank or by any majority-owned subsidiary of the bank to the shareholders of the bank during such period. However, a bank may, with the approval of the DBO, make a distribution to its shareholders in an amount not exceeding the greatest of (a) its retained earnings; (b) its net income for its last fiscal year; or (c) its net income for its current fiscal year. In the event that the DBO determines that the shareholders' equity of a bank is inadequate or that the making of a distribution by the bank would be unsafe or unsound, the DBO may order the bank to refrain from making a proposed distribution. The FDIC may also restrict the payment of dividends if such payment would be deemed unsafe or unsound or if after the payment of such dividends, the bank would be included in one of the "undercapitalized" categories for capital adequacy purposes pursuant to federal law.

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

Conversion of Series C Preferred Stock

On October 29, 2014, the Company entered into an Exchange Agreement with the holder of its Series C Preferred Stock. Pursuant to the terms of the Exchange Agreement the holder of Series C Preferred Stock would exchange 1,189,538 shares of the Series C Preferred Stock for shares of the Company's common stock on a one-for-one exchange ratio basis. On December 22, 2014, the Company and the holder of its Series C Preferred stock entered into a First Amendment to the Exchange Agreement to allow for an initial exchange of Preferred Stock whereby 840,841 shares of Series C Preferred Stock would be exchanged for 840,841 shares of the Company's common stock. The initial closing took place on December 24, 2014.

On June 4, 2015, the holder of the Company's Series C Convertible Perpetual Preferred Stock ("Series C Preferred Stock") completed the exchange of its remaining 348,697 shares of Series C Preferred Stock for shares of the Company's common stock on a one-for-one exchange ratio basis. As of December 31, 2015, there were no shares of the Company's Series C Preferred Stock issued and outstanding.

On the date the Company made a firm commitment to issue the Series C Preferred Stock, the fair market value of the Company's common stock was higher than the conversion price of $3.25 per share of the Series C Preferred Stock. As a result, the Series C Preferred Stock was issued with a beneficial conversion feature associated with it. In connection with each exchange of Series C Preferred Stock summarized above, the Company recorded charges to retained earnings of $70 thousand and $168 thousand during the years ended December 31, 2015 and 2014, respectively.

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Repurchase of Common Stock

In June 2015, the Company announced it had amended its previously announced plan for the repurchase of up to $5.0 million of its outstanding common stock pursuant to a written plan compliant with Rule 10b5-1 and Rule 10b-18. Repurchase program activity pursuant to the amended plan commenced on July 1, 2015 and will continue in effect until January 31, 2016 or expire earlier upon completion of the repurchase of $5.0 million of the Company's common stock, as well as under certain other circumstances set forth in the repurchase plan agreement. The Company has no obligation to repurchase any shares under this program, and may suspend or discontinue it at any time. All shares repurchased as part of the repurchase program will be cancelled, and therefore no longer available for reissuance.

On January 6, 2016, the Company amended its stock repurchase program to extend the program beyond its expiration date of January 31, 2016. Under the amended plan, repurchase activity may commence on February 1, 2016 and continue until August 2, 2016, the plan's new expiration date, or expire earlier upon the completion of the repurchase of $5.0 million of the Company's common stock, as well as under certain other circumstances as set forth in the amended plan.

As of December 31, 2015, the Company had repurchased 55,428 shares of its common stock under this plan at an average price of $7.47 per share. Repurchases of common stock during 2015 totaled 3,696 shares. The shares were repurchased at an average price of $7.52 per share. The Company made no repurchases of its common stock during the three months ended December 31, 2015.

Securities Authorized for Issuance Under Equity Compensation Plans

The following table provides information at December 31, 2015, with respect to shares of Company common stock that may be issued under the Company's existing equity compensation plans:

 
  Number of
Securities To Be
Issued Upon Exercise
of Outstanding Options
  Weighted Average
Exercise Price of
Outstanding Options
  Number of Securities
Remaining Available
For Future Issuance
 

Plan Category

                   

Equity compensation plans approved by security holders

    932,553  (1)   $ 7.19     2,228,601  (2)

Equity compensation plans not approved by security holders

    N/A     N/A     N/A  
(1)
Outstanding options have been granted from the 2005 Equity Based Compensation Plan, and the 2015 Equity Incentive Plan, which was approved by the Company' shareholders in May 2015. The 2005 Equity Based Compensation Plan expired in March 2015, and no further grants can be made from that plan. Under the 2015 Equity Incentive Plan, the Company is authorized to issue restricted stock awards. Restricted stock awards are not included in the table above. At December 31, 2015, there were 162,394 shares of restricted stock issued and outstanding with a weighted average grant price of $7.30 per share. See also Note 12. Share-based Compensation Plans of the consolidated financial statements, filed on this Form 10-K, for additional information on the Company's equity compensation plans.
(2)
Includes securities available for issuance, including stock options and restricted stock.

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Stock Performance

The following chart compares the cumulative total shareholder return on the Company's common stock over the last five years with the cumulative total return of the Nasdaq Composite Index, and three Company-selected groups of peer institutions (assuming the investment of $100 in each index on December 31, 2010 and reinvestment of all dividends). The Heritage Oaks Peer Group 1 consists of all publicly traded banks & thrifts in the United States with assets of between $750 million and $4 billion in assets as of December 31, 2015. The Heritage Oaks Peer Group 2 consists of all publicly traded banks & thrifts in California with assets of between $750 million and $4 billion at December 31, 2015. The Heritage Oaks Peer Group 3 consists of 14 publicly traded banks located in the Western United States used by the compensation committee in evaluating executive compensation.

The Company believes Heritage Oaks Peer Groups better reflect the Company's asset size. With the addition of Heritage Oaks Peer Group 3, the Company does not expect to utilize Heritage Oaks Peer Group 2 in the future.

CHART

 
  Period Ending  
Index
  12/31/10   12/31/11   12/31/12   12/31/13   12/31/14   12/31/15  

Heritage Oaks Bancorp

    100.00     107.60     176.29     227.96     257.79     253.36  

NASDAQ Composite

    100.00     99.21     116.82     163.75     188.03     201.40  

Heritage Peer Group 1

    100.00     91.97     110.36     141.48     154.74     173.70  

Heritage Peer Group 2

    100.00     98.95     129.54     159.84     189.66     212.97  

Heritage Peer Group 3

    100.00     85.43     111.70     152.20     161.32     182.10  

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Item 6.    Selected Financial Data

The following table provides selected financial data for the past five years. The following should be read in conjunction with the consolidated financial statements and the notes thereto, which are included in this report.

 
  At or For the Years Ended December 31,  
 
  2015   2014   2013   2012   2011  

    (dollars in thousands, except per share data)  

Consolidated Income Data:

                               

Interest income

    $ 68,090     $ 64,088     $ 45,393     $ 46,321     $ 48,227  

Interest expense

    5,831     5,157     3,867     3,818     5,023  

Net interest income

    62,259     58,931     41,526     42,503     43,204  

Provision for loan losses

    -         -         -         7,681     6,063  

Net interest income after provision for loan and lease losses

    62,259     58,931     41,526     34,822     37,141  

Non-interest income

    10,139     9,575     12,875     12,548     9,730  

Non-interest expense

    48,167     54,792     36,563     36,131     37,318  

Income before income tax expense (benefit)             

    24,231     13,714     17,838     11,239     9,553  

Income tax expense (benefit)

    8,882     4,749     6,997     (1,798 )   1,828  

Net income

    15,349     8,965     10,841     13,037     7,725  

Dividends and accretion on preferred stock

    70     168     898     1,470     1,358  

Net income available to common shareholders

    $ 15,279     $ 8,797     $ 9,943     $ 11,567     $ 6,367  

Share Data:

                               

Earnings per common share – basic

    $ 0.45     $ 0.27     $ 0.38     $ 0.44     $ 0.24  

Earnings per common share – diluted

    $ 0.45     $ 0.27     $ 0.37     $ 0.44     $ 0.24  

Dividends declared per common share

    $ 0.23     $ 0.08     $ -         $ -         $ -      

Divdend payout ratio

    51.15%     30.59%     0.00%     0.00%     0.00%  

Common book value per share

    $ 6.01     $ 5.81     $ 4.84     $ 4.78     $ 4.17  

Tangible common book value per share

    $ 5.16     $ 4.92     $ 4.34     $ 4.27     $ 3.67  

Actual shares outstanding at end of period

    34,353,014     33,905,060     25,397,780     25,307,110     25,145,717  

Weighted average shares outstanding – basic

    34,129,930     32,567,137     26,341,592     26,271,000     26,238,015  

Weighted average shares outstanding – diluted

    34,274,902     32,712,983     26,542,689     26,401,870     26,254,745  

Selected Consolidated Balance Sheet Data:

                               

Total cash and cash equivalents

    $ 69,923     $ 35,580     $ 26,238     $ 34,116     $ 34,892  

Total investments and other securities

    $ 450,935     $ 355,580     $ 276,795     $ 287,682     $ 236,982  

Total gross loans held for investment

    $ 1,247,280     $ 1,193,483     $ 827,484     $ 689,608     $ 646,286  

Allowance for loan and lease losses

    $ (17,452 )   $ (16,802 )   $ (17,859 )   $ (18,118 )   $ (19,314 )

Total assets

    $ 1,899,739     $ 1,710,127     $ 1,203,651     $ 1,097,532     $ 987,138  

Total deposits

    $ 1,564,961     $ 1,394,804     $ 973,895     $ 870,870     $ 786,208  

Federal Home Loan Bank borrowings

    $ 103,521     $ 95,558     $ 88,500     $ 66,500     $ 51,500  

Junior subordinated debt

    $ 10,438     $ 13,233     $ 8,248     $ 8,248     $ 8,248  

Total shareholders' equity

    $ 206,434     $ 197,940     $ 126,427     $ 145,529     $ 129,554  

Average assets

    $ 1,815,397     $ 1,609,705     $ 1,119,334     $ 1,024,961     $ 976,988  

Average earning assets

    $ 1,680,843     $ 1,483,393     $ 1,031,578     $ 953,815     $ 916,356  

Average shareholders' equity

    $ 203,321     $ 182,186     $ 137,807     $ 137,392     $ 124,824  

Selected Financial Ratios:

                               

Return on average assets

    0.85%     0.56%     0.97%     1.27%     0.79%  

Return on average equity

    7.55%     4.92%     7.87%     9.49%     6.19%  

Return on average tangible common equity

    8.83%     5.84%     9.04%     11.55%     7.29%  

Net interest margin (1)

    3.70%     3.97%     4.03%     4.46%     4.71%  

Efficiency ratio (2)

    66.15%     78.92%     71.29%     67.88%     67.98%  

Non-interest expense to average assets

    2.65%     3.40%     3.27%     3.53%     3.82%  

Capital Ratios:

                               

Average equity to average assets

    11.20%     11.32%     12.31%     13.40%     12.78%  

Leverage Ratio

    9.90%     10.22%     10.20%     12.32%     12.06%  

Tier 1 Risk-Based Capital ratio

    13.01%     13.13%     12.91%     15.55%     14.81%  

Total Risk-Based Capital ratio

    14.26%     14.38%     14.17%     16.81%     16.07%  

Selected Asset Quality Ratios:

                               

Non-performing loans to total gross loans (3)

    0.63%     0.88%     1.22%     2.51%     1.91%  

Non-performing assets to total assets (4)

    0.43%     0.62%     0.84%     1.58%     1.35%  

Allowance for loan and lease losses to total gross loans

    1.40%     1.41%     2.16%     2.63%     2.99%  

Net (recoveries) charge-offs to average loans

    -0.05%     0.10%     0.03%     1.32%     1.75%  
(1)
Net interest margin represents net interest income as a percentage of average interest-earning assets.
(2)
The efficiency ratio is defined as total non-interest expense as a percentage of the combined: net interest income, non-interest income, excluding gains and losses on the sale of securities, gains and losses on the sale of other real estate owned ("OREO") and other OREO related costs, gains and losses on the sale of fixed assets, and amortization of intangible assets.
(3)
Non-performing loans are defined as loans that are past due 90 days or more, as well as loans placed on non-accrual status.
(4)
Non-performing assets are defined as all non-performing loans, and OREO assets.

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

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

Executive Overview

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

Heritage Oaks Bancorp ("Bancorp") is a California corporation organized in 1994, and is the holding company for Heritage Oaks Bank (the "Bank"), which opened for business in 1983. The Bank, which is the Company's sole operating subsidiary, operates within San Luis Obispo, Santa Barbara and Ventura Counties. As of December 31, 2015, the Bank operated two branch offices each in Paso Robles, and San Luis Obispo; single branch offices in Atascadero, Templeton, Cambria, Morro Bay, Arroyo Grande, Santa Maria, Goleta and Santa Barbara; as well as a single loan production office in Ventura/Oxnard.

The principal business of the Bank consists of attracting deposits and investing these funds primarily in commercial real estate and commercial business loans, loans secured by first mortgages on one-to-four family residences, operating and real estate procurement loans for agricultural businesses, multi-family residential property loans and a variety of consumer loans. The Bank also originates one-to-four family residential mortgages for sale in the secondary market. The Bank offers a variety of deposit accounts for both individuals and businesses with varying rates and terms, which generally include savings accounts, money market deposits, certificates of deposit and checking accounts. The Bank solicits deposits primarily in its market area, and periodically accepts brokered deposits.

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

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On February 28, 2014, the Company completed the acquisition of Mission Community Bancorp and its subsidiary Mission Community Bank (collectively "MISN," or the "MISN Transaction"). The total value of the transaction was $69.0 million, which was comprised of cash of $8.7 million and 7,541,326 shares of Bancorp's common stock valued at $60.3 million, based on the $7.99 closing price of Bancorp's stock on February 28, 2014. The operating results of MISN beginning on March 1, 2014 are included in the Company's results for the year ended December 31, 2015 and 2014. The impact of the MISN Transaction to the Company's total loans and deposits was a 34% increase in total loans and 38% increase in total deposits as of February 28, 2014. Please also refer to Note 2. Business Combination, of the consolidated financial statements filed on this Form 10-K.

Strategic Initiatives

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

      Expand our commercial and agribusiness loan portfolios to diversify both our customer base and the maturities within the loan portfolio, and to benefit from the low cost deposits associated with non-interest bearing demand accounts connected to commercial and agribusiness customers. The Bank successfully recruited and installed an agribusiness team in 2012 which contributed to a significant increase in the Bank's agribusiness lending presence in the Central Coast region of California. We have more recently recruited bankers with experience and knowledge of commercial and industrial lending in the markets we serve, in order to promote growth in this segment of our loan portfolio.

      Enhance the residential lending product mix and loan sale alternatives.  The Bank is currently able to originate and sell qualified loans directly to various investors.

      Invest in infrastructure in order to have the ability to scale efficiently and effectively, in line with our long-term goal of creating a community banking franchise of $3.0 billion to $5.0 billion in total assets.

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Financial Highlights

The Company generated net income available to common shareholders of $15.3 million, or $0.45 per diluted common share, for the year ended December 31, 2015, as compared to net income available to common shareholders of $8.8 million, or $0.27 per diluted common share, for the year ended December 31, 2014 and $9.9 million, or $0.37 per diluted common share, for the year ended December 31, 2013.

      Significant factors impacting the Company's net income for the year ending December 31, 2015 are discussed below. Please also refer to "Results of Operations" for a more detailed discussion concerning our operating results for the years ended December 31, 2015, 2014, and 2013.

      Net Interest Income:  For the year ended December 31, 2015, net interest income was $62.3 million, or $3.3 million and 5.6% higher than the $58.9 million reported for the year ended December 31, 2014. The net interest margin was 3.70% for the year ended December 31, 2015, compared to 3.97% for the year earlier. We continued to experience a decline in the yield on earning assets, including loans and investment securities during 2015, stemming from the prevailing low interest rate environment. However, the impact of a continued low interest rate environment on the yield of earning assets was offset by a $197.5 million increase in average earning asset balances during 2015, resulting in higher net interest income for 2015 as compared to 2014. For the year ended December 31, 2015 interest income and the yield on earning assets was $68.1 million and 4.05%, respectively, compared to $64.1 million and 4.32%, respectively for 2014. For the year ended December 31, 2015 interest expense was $5.8 million and the cost of funds was 0.36%, respectively, compared to interest expense of $5.2 million and the cost of funds of 0.36%, respectively for 2014.

      Non-Interest Expense:  Non-interest expense decreased by $6.6 million to $48.2 million for the year ended December 31, 2015, from $54.8 million for 2014. The decrease in non-interest expense for the year ended December 31, 2015 as compared to 2014 was largely the result of a $9.3 million decrease of merger, restructure, and integration costs related to the MISN Transaction. The decline in merger, restructure, and integration costs were partially offset by a $3.0 million increase in professional services expenses, driven largely by increases in costs for temporary staff and consulting related to our BSA/AML Program remediation efforts, as well as increases in legal, audit and tax services.

      Provision for Loan and Lease Losses:  No provisions for loan and lease losses were recorded for the years ended December 31, 2015, 2014, and 2013. The Company has not required a loan and lease loss provision since 2012 due to stabilization in the level of classified loans, a continued overall improvement in the credit quality of the loan portfolio, and declining levels of specific reserves for impaired loans. As of December 31, 2015, the allowance for loan and leases losses was $17.5 million or 1.40% of total gross loans, compared to $16.8 million or 1.41% of total gross loans at December 31, 2014. The allowance for loan and leases losses increased in 2015 due to net recoveries on previously charged-off loans. The allowance for loan and lease losses for MISN legacy loans was $0.4 million or 0.23% of total MISN legacy loans as of December 31, 2015.

      Non-interest Income:  Non-interest income increased by $0.5 million to $10.1 million for the year ended December 31, 2015 from $9.6 million for 2014. The year-to-year increase in non-interest income is primarily attributable to gains on the extinguishment of debt totaling $0.6 million, resulting from the redemption of junior subordinated debentures, as well as due to an increase in mortgage banking revenues of $0.4 million. These increases were partially offset by a decrease in fees and service charges income of $0.5 million, attributable to the Company exiting certain depository customers in late 2014, as it determined these customers no longer fit the Company's risk profile.

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Critical Accounting Policies and Estimates

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

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America ("U.S. GAAP") requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ materially and adversely from those estimates. Estimates that are particularly susceptible to significant change relate to the determination of purchase accounting adjustments to the fair value of assets purchased and liabilities assumed through strategic acquisitions, the ALLL, the valuation of real estate acquired through foreclosure, the carrying value of the Company's net deferred tax assets, and estimates used in the determination of the fair value of certain financial instruments.

Fair Value of Assets Purchased and Liabilities Assumed through Strategic Acquisitions

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

Allowance for Loan and Lease Losses ("ALLL")

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

As also discussed in Note 1. Summary of Significant Accounting Policies, of the consolidated financial statements filed on this Form 10-K, during the third quarter of 2015, the Company made a specific enhancement to its methodology for determining the general reserve component of ALLL. This enhancement related specifically to the methodology used to calculate the loss rates for loan risk grades within each loan type in the determination of the general reserve component of the ALLL. The enhanced methodology uses more granular loan level data to calculate loss rates for specific loan grades within each loan type, allowing for more detailed loan migration analysis, and the ability to determine average loss rates for each loan risk grade. Although the total general reserve component of the ALLL for each loan type and portfolio segment is still based on total average historical losses for their respective loan types, management believes the allocation of the ALLL to each loan risk grade, within each loan type and the evaluation of the loss emergence period has become more granular under this methodology enhancement.

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The implementation of the ALLL model enhancements did not result in a required increase or decrease in the balance of the ALLL, or a material impact to the overall allocation of the ALLL. The ALLL model enhancement has allowed the Company to apply more precision in determining loss rates for specific loan grades within each loan type. Sections of the accounting policy for the ALLL, which have been updated to reflect the methodology enhancement, are provided in Note 1. Summary of Significant Accounting Policies, of the consolidated financial statements filed on this Form 10-K.

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

Loans and leases acquired through purchase or through a business combination, such as those acquired in the MISN Transaction, are recorded at their fair value at the acquisition date. Credit discounts are included in the determination of fair value. Therefore, an ALLL is not recorded at the acquisition date. These loans include purchased credit impaired loans ("PCI loans"), which are accounted for under ASC 310-30, and all other loans acquired without impairment indicators, and not accounted for within the scope of ASC 310-30, ("non-PCI loans"). Should the Company's ALLL methodology indicate that the credit discount associated with acquired, non-PCI loans, is no longer sufficient to cover probable losses inherent in those loans, the Company establishes an ALLL for those loans through a charge to provision for loan and lease losses. Acquired loans are evaluated upon acquisition for evidence of deterioration in credit quality since origination such that it is probable at acquisition that the Company will be unable to collect all contractually required payments. Such loans are classified as PCI loans, while all other acquired loans are classified as non-PCI loans.

The Company has elected to account for PCI loans at an individual loan level. The Company estimates the amount and timing of expected cash flows for each loan. The expected cash flow in excess of the loan's carrying value, which is fair value on the date of acquisition, is referred to as the accretable yield, and is recorded as interest income over the remaining expected life of the loan. The excess of the loan's contractual principal and interest over expected cash flows is referred to as the non-accretable difference, and is not recorded in the Company's condensed consolidated financial statements. Quarterly, management performs an evaluation of expected future cash flows for PCI loans. If current expectations of future cash flows are less than management's previous expectations, other than due to decreases in interest rates and prepayment assumptions, an ALLL is recorded with a charge to current period earnings through a provision for loan and lease losses. If there has been a probable and significant increase in expected future cash flows over that which was previously expected, the Company will first reduce any previously established ALLL, and then record an adjustment to interest income through a prospective increase in the accretable yield.

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

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Realizability of Deferred Tax Assets

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

Fair Value of Financial Instruments

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

Accrual for Restructuring Activities

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

Results of Operations

Net Interest Income and Margin

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

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The table below sets forth average balance sheet information, interest income and expense, average yields and rates and net interest income and margin for the years ended December 31, 2015, 2014 and 2013.

 
  For the Year Ended,
December 31, 2015
  For the Year Ended,
December 31, 2014
  For the Year Ended,
December 31, 2013
 
 
  Average
Balance
  Yield/
Rate
  Income/
Expense
  Average
Balance
  Yield/
Rate
  Income/
Expense
  Average
Balance
  Yield/
Rate
  Income/
Expense
 

    (dollars in thousands)  

Interest Earning Assets

                                                       

Interest earning deposits in other banks

    $ 71,693     0.21%     $ 152     $ 52,039     0.17%     $ 89     $ 15,466     0.21%     $ 33  

Investment securities

    395,791     1.85%     7,311     350,120     2.07%     7,238     262,504     2.09%     5,476  

Other investments

    9,739     10.56%     1,028     9,101     6.77%     616     6,590     4.16%     274  

Loans (1) (2)

    1,203,620     4.95%     59,599     1,072,133     5.24%     56,145     747,018     5.30%     39,610  

Total interest earning assets

    1,680,843     4.05%     68,090     1,483,393     4.32%     64,088     1,031,578     4.40%     45,393  

Allowance for loan and lease losses

    (17,143 )               (17,375 )               (17,937 )            

Other assets

    151,697                 143,687                 105,693              

Total assets

    $ 1,815,397                 $ 1,609,705                 $ 1,119,334              

Interest Bearing Liabilities

   
 
   
 
   
 
   
 
   
 
   
 
   
 
   
 
   
 
 

Interest bearing demand

    $ 119,166     0.11%     $ 130     $ 103,781     0.11%     $ 114     $ 78,055     0.10%     $ 81  

Savings

    100,387     0.10%     100     93,593     0.10%     91     40,548     0.10%     40  

Money market

    512,825     0.27%     1,404     418,532     0.30%     1,247     302,998     0.33%     1,000  

Time deposits

    263,553     0.75%     1,981     278,292     0.76%     2,115     200,249     0.87%     1,739  

Total interest bearing deposits

    995,931     0.36%     3,615     894,198     0.40%     3,567     621,850     0.46%     2,860  

Federal Home Loan Bank borrowing

    90,174     1.86%     1,675     76,499     1.43%     1,091     59,063     1.42%     840  

Junior subordinated debentures

    12,164     4.45%     541     12,348     4.04%     499     8,248     2.02%     167  

Fed Funds Purchased

    8     0.90%     -         8     0.76%     -         -         0.00%     -      

Total borrowed funds

    102,346     2.17%     2,216     88,855     1.79%     1,590     67,311     1.50%     1,007  

Total interest bearing liabilities

    1,098,277     0.53%     5,831     983,053     0.52%     5,157     689,161     0.56%     3,867  

Non interest bearing demand               

    504,516                 434,012                 282,060              

Total funding

    1,602,793     0.36%     5,831     1,417,065     0.36%     5,157     971,221     0.40%     3,867  

Other liabilities

    9,283                 10,454                 10,306              

Total liabilities

    1,612,076                 1,427,519                 981,527              

Shareholders' Equity

   
 
   
 
   
 
   
 
   
 
   
 
   
 
   
 
   
 
 

Total shareholders' equity

    203,321                 182,186                 137,807              

Total liabilities and shareholders' equity

    $ 1,815,397                 $ 1,609,705                 $ 1,119,334              

Net interest margin (3)

         
3.70%
 
  $

62,259
         
3.97%
 
  $

58,931
         
4.03%
 
  $

41,526
 

Interest rate spread

          3.52%                 3.80%                 3.84%        

Cost of deposits

          0.24%                 0.27%                 0.32%        

 

(1)
Non-accruing loans have been included in total loans.
(2)
Loan fees have been included in interest income.
(3)
Net interest margin represents net interest income as a percentage of average interest earning assets.

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The volume and rate variances table below sets forth the dollar difference in interest earned and paid for each major category of interest earning assets and interest bearing liabilities for each of the years ended December 31, 2015 and 2014 and the amount of such change attributable to changes in average balances (volume) or changes in average yields and rates:

 
  For the Year Ended
December 31, 2015
 
 
  Volume   Rate   Rate/Volume   Total  

    (dollars in thousands)  

Interest Income

                         

Interest bearing deposits in other banks

    $ 34     $ 21     $ 8     $ 63  

Investment securities

    944     (770 )   (101 )   73  

Other investments

    43     345     24     412  

Loans

    6,886     (3,109 )   (323 )   3,454  

Net increase (decrease)

    7,907     (3,513 )   (392 )   4,002  

Interest Expense

                         

Interest bearing demand

    17     -         (1 )   16  

Savings

    7     -         2     9  

Money market

    281     (84 )   (40 )   157  

Time deposits

    (112 )   (28 )   6     (134 )

Federal Home Loan Bank borrowing

    195     329     60     584  

Long term borrowings

    (7 )   51     (2 )   42  

Net increase

    381     268     25     674  

Total net increase (decrease)

    $ 7,526     $ (3,781 )   $ (417 )   $ 3,328  

 

 
  For the Year Ended
December 31, 2014
 
 
  Volume   Rate   Rate/Volume   Total  

    (dollars in thousands)  

Interest Income

                         

Interest bearing deposits in other banks

    $ 78     $ (6 )   $ (16 )   $ 56  

Investment securities

    1,827     (53 )   (12 )   1,762  

Other investments

    107     169     66     342  

Loans

    17,239     (523 )   (181 )   16,535  

Net increase (decrease)

    19,251     (413 )   (143 )   18,695  

Interest Expense

                         

Interest bearing demand

    27     8     (2 )   33  

Savings

    52     -         (1 )   51  

Money market

    381     (91 )   (43 )   247  

Time deposits

    678     (220 )   (82 )   376  

Federal Home Loan Bank borrowing

    248     -         3     251  

Long term borrowings

    83     167     82     332  

Net increase (decrease)

    1,469     (136 )   (43 )   1,290  

Total net increase (decrease)

    $ 17,782     $ (277 )   $ (100 )   $ 17,405  

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Discussion of 2015 Compared to 2014

For the years ended December 31, 2015 and 2014, net interest income was $62.3 million and $58.9 million, respectively, and the NIM was 3.70% and 3.97%, respectively. The historically low interest rate environment continued to have an adverse impact on earning assets yields, and in particular, the overall yield on the loan portfolio. Lower yielding earning assets was the primary driver behind the decline in the NIM during 2015. Long-term interest rates remained fairly consistent during 2015 as compared to 2014. For example, the 10 year U.S. Treasury yield was at 2.17% on January 1, 2015, and was at 2.27% at December 31, 2015. The result of a low prevailing rate environment on our loan portfolio is that the loans that prepay have been at higher average yields than the yields generated from new loan originations, and renewals, resulting in a lower overall yield on the loan portfolio and contributing to the decline in the yield on earning assets and the NIM. During 2015, the yield of newly originated loans averaged 4.06% as compared to an average yield of 4.37% for the same period in 2014, while the yield on loan payoffs averaged 4.76% in 2015, as compared to 5.22% in 2014. Also contributing to the decline in the NIM were higher average balances of lower yielding assets such as interest earning cash balances, and investment securities during 2015. Higher balances of interest earning cash and investment securities resulted primarily from increases in core deposits, which outpaced loan growth in 2015. Slightly offsetting these negative pressures on our NIM, was an increase in the dividend rate paid by the Federal Home Loan Bank ("FHLB") of San Francisco on our investment in FHLB stock, in conjunction with a special dividend of $0.3 million paid in June 2015. This contributed to the significant increase in the yield on other investments in 2015.

Average loan yields declined by 29 basis points to 4.95% for 2015, when compared to 5.24% for 2014. As previously mentioned, the historically low interest rate environment continued to have an adverse impact on loan yields during 2015, as yields on new loan originations and renewals have been lower than the yields on loans that prepay. During 2015, new loan originations held for investment were $255.7 million at an average yield of 4.06%, while payoffs were $187.6 million at an average yield of 4.76%. During 2014, new loan originations were $237.8 million at yields of 4.37%, while payoffs were $127.2 million at yields of 5.22%. Slightly offsetting the decline in loan yields in 2015 was an increase in prepayment penalty income, as well as interest recoveries on the payoff of non-performing loans, together totaling $0.5 million, and positively impacting loan yields by approximately 4 basis points.

Loan yields and our NIM have benefitted from the discount accretion on the acquired MISN loan portfolio since March 1, 2014 and this discount accretion has muted the impact of the historically low interest rate environment on our loan yields during 2015 and 2014. Total discount accretion from acquired loans was $2.7 million during 2015 and $3.4 million during 2014. Purchase discount accretion from acquired loans increased our loan yields by 23 basis points during 2015 and by 31 basis points in 2014. The primary reason for the decline in purchase discount accretion experienced in 2015, as compared to 2014, was a significant decline in accelerated discount accretion associated with acquired MISN loan prepayment activity. The impact of MISN discount accretion on earning asset yields and the NIM was 16 basis points in 2015, and 23 basis points in 2014. We anticipate that the amount of purchase discount accretion from loans acquired through the MISN Transaction will continue to decline, absent any unscheduled loan pay-offs, and due to the decline in the amount of scheduled discount accretion attributable to the maturity of acquired MISN loans.

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The low interest rate environment and relative flatness of interest yield curves during the last couple of years have had a compounding impact on securities' yields as new investments are typically providing lower yields. Additionally, during 2015 we reallocated a portion of the securities portfolio into bonds with lower regulatory capital risk weightings, which yield less than the higher risk weighted bonds they replaced. This was done in an effort to achieve a more favorable risk weighting profile under the new Basel III regulatory capital guidelines, which were implemented on January 1, 2015. These factors have contributed to a 22 basis point decrease in the average yield on investment securities during 2015 to 1.85%, compared to 2.07% for 2014.

Our earnings are directly influenced by changes in interest rates. The Company is currently in a net asset sensitive position, and a large percentage of our interest sensitive assets and liabilities re-price with changes in interest rates. A significant portion of the variable rate component of the Company's loan portfolio has had their interest rates set to their respective contractual interest rate floors. To the extent that interest rates rise, the Company will not experience the benefit of rising interest rates until such rates rise above contractual interest rate floors. See Item 7A. Qualitative and Quantitative Disclosures About Market Risk, included on this Form 10-K for further discussion of the Company's sensitivity to interest rate movements based on our current net asset sensitive profile, as well as the impacts of interest rate floors on the variable rate component of our loan portfolio.

Average interest earning assets for 2015 increased by $197.5 million, or 13.3%, compared to 2014. The increase in average earning assets was primarily driven by growth in the loan portfolio, as well as an increase in the investments portfolio and interest earning cash balances. Growth in average earning assets during 2015 was funded primarily through increases in average core deposit balances.

The average balance of interest bearing liabilities was $115.2 million, or 11.7%, higher for 2015 as compared to 2014. Growth in average interest bearing liabilities for 2015 was primarily the result of successful core deposit gathering activities, and to a lesser extent, an increase in FHLB borrowings.

The rate paid on interest bearing deposits declined by 4 basis points in 2015 to 0.36% as compared to 0.40% for 2014. This decline is in part due to the historically low interest rate environment that has existed for the last several years, but is also due to our efforts to systematically lower our cost of deposits over this same time period. Although these efforts have contributed to a moderate decline in average time deposits (for legacy Heritage Oaks balances), the overall deposit mix and cost of our deposit portfolio has improved as a result of these efforts. We have also benefitted from the lower cost of the deposits acquired through the MISN Transaction in 2015 and 2014. In addition to the favorable effects realized from these changes in our interest bearing deposits, average non-interest bearing demand deposit balances increased by $70.5 million or 16.2% to $504.5 million, for 2015 as compared to $434.0 million for 2014. Non-interest bearing deposits increased at a greater rate than the 11.4% increase in our average interest bearing deposits, which also contributed to a more favorable composition of our funding base, helping to keep the cost of funding unchanged during 2015 at 0.36%, despite an increase in the cost of borrowed funds. Non-interest bearing demand deposit balances have reduced our funding costs by 17 basis points for 2015. During 2015, the Company called higher cost brokered time deposits, as well as prepaid certain higher cost FHLB borrowings. These activities were in response to an increase in liquidity stemming from deposit gathering activities and loan prepayments during 2015. Although these activities are expected to contribute to a reduction in interest expense going forward, they resulted in a $0.2 million increase in interest expense during 2015, and contributed to the 43 basis point increase in the cost of FHLB borrowings in 2015 to 1.86%, from 1.43% in 2014. The impact of these brokered deposit and FHLB borrowing prepayment activities to the total cost of funds was approximately 1 basis point for 2015. The cost of interest bearing liabilities was 0.53% in 2015, compared to 0.52% in 2014.

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Discussion of 2014 Compared to 2013

For the years ended December 31, 2014 and 2013, net interest income was $58.9 million and $41.5 million, respectively, and our NIM was 3.97% and 4.03%, respectively. During 2014, the impact of the historically low interest rate environment had an adverse impact on earning asset yields and on new and renewing loans. To a lesser extent, the change in the earning asset mix also had a negative impact on our NIM for 2014 due to a shift from higher yielding to lower yielding assets. However, the impact of accretion from the loans acquired through the MISN Transaction mitigated the impact of the decline in earning asset yields, and helped to stabilize the NIM in 2014 as compared to the prior year. The MISN loan discount accretion contributed 23 basis points to the yield on earning assets and NIM for 2014. The yield on earning assets fell 8 basis points to 4.32% in 2014 compared to 2013, however, after removing the impact of MISN loan purchase discount accretion, our earning asset yield and NIM would have been 4.09% and 3.74%, respectively, for 2014. During 2014, we also experienced an increase in interest income driven by increases in both the yield and average balance of FHLB stock, included in other investments, which helped to mitigate the decline in loan yields, and the impact of the change in our asset mix in 2014, as compared to 2013.

For the year ended December 31, 2014, average interest-earning assets were $451.8 million, or 43.8%, higher than the amount reported for the year ended December 31, 2013. Growth in average earning assets for 2014 was largely driven by acquired loans and securities in the MISN Transaction, and secondarily by organic loan growth. Our earning asset mix for 2014, as compared to 2013 negatively impacted the yield on earning assets, contributing to a decline in overall earning asset yields. For example, the percent composition of lower yielding interest earning cash balances increased, while the percent composition of higher yielding investment securities decreased during 2014. This change in earning asset mix was anticipated however, due to the Company's strategy, to retain excess liquidity during the period after the close of the MISN Transaction, in order to mitigate the possible impact of any potential run-off of MISN customer deposit balances may have had on the Company's liquidity profile.

For the year ended December 31, 2014, the yield on the loan portfolio declined 6 basis points to 5.24%, from 5.30% for 2013. The decline in our loan yields during 2014 was largely attributable to the decline in interest rates on new loans issued and loans renewed, which decline was driven both by the historically low interest rate environment in 2014, and by increased competition in the Company's primary market area. However, as previously discussed, the accretion income from the loans acquired in the MISN Transaction significantly offset the negative impact of the decline related to new and renewed loan yields. The acquired loan discount accretion contributed 31 basis points to our loan yields during 2014.

The average balance of investment securities increased in 2014, primarily related to securities acquired in the MISN Transaction. During 2014 we did not fundamentally change our interest rate risk strategy and therefore we maintained the composition and overall yield in our securities portfolio. We did, however realign the profile of the investment securities acquired in the MISN Transaction with our balance sheet management strategy. In doing so we sold and replaced the majority of the MISN securities portfolio.

The average balance of interest bearing liabilities increased by $293.9 million for the year ended December 31, 2014, compared to the level reported for 2013. The increase in the average balance of interest bearing liabilities can be attributed primarily to the deposits, FHLB borrowings and junior subordinated debentures assumed in the MISN Transaction. The MISN deposit portfolio also improved our liability mix and funding costs due to the higher level of non-interest bearing demand deposits, as a proportion of total deposits, MISN had on its balance sheet at the time of acquisition, relative to the proportion of the legacy Heritage Oaks deposit portfolio. The impact of MISN acquired deposits helped to increase our percentage of average non-interest bearing deposits to average deposits to 32.7% for 2014 from 31.2% for 2013.

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The rate paid on interest bearing deposits declined by 6 basis points, to 0.40%, for 2014 as compared to 2013. This decline is in part due to the historically low interest rate environment that has existed for the last few years, but is also due to the more favorable funding cost profile of MISN acquired deposits and, to a lesser extent, our efforts to systematically lower our cost of deposits over this same time period. In addition to the favorable effects realized from these changes in our interest bearing deposits, our average non-interest bearing demand deposit balances have increased by $152.0 million, to $434.0 million, for 2014, largely due to the MISN Transaction. These increases in non-interest bearing demand deposit balances have served to reduce our total funding cost by 4 basis points to 0.36% for 2014.

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

Provision for Loan and Lease Losses

The ALLL is maintained at a level considered by management to be appropriate to provide for probable credit losses inherent in the loan portfolio as of the balance sheet date. Management's review of the appropriateness of the ALLL includes, among other things, an analysis of past loan loss experience and an evaluation of the loan portfolio under current economic conditions. See also Note 1. Summary of Significant Accounting Policies, and Note 5. Loans and Allowance for Loan and Lease Losses, of the consolidated financial statements filed on this Form 10-K, for additional information concerning the ALLL.

The ALLL is based on estimates, and actual losses may vary from current estimates. Such variances could be material and could have an adverse effect on the Company's performance. The Company recognizes that the risk of loss will vary with, among other things: general economic conditions; the type of loan being made; the creditworthiness of the borrower over the term of the loan; and, in the case of a collateralized loan, the quality of the underlying collateral for such loans. For additional information see the "Allowance for Loan and Lease Losses" discussion in the Financial Condition section of this Discussion and Analysis.

Discussion of 2015 Compared to 2014

A provision for loan and lease losses was not recorded for the years ended December 31, 2015 or 2014. The lack of need for additional provisions for loan and lease losses was supported by net recoveries of $0.7 million for the year ended December 31, 2015. During the year ended December 31, 2014 the Company recorded net charge-offs of $1.1 million, however, positive adjustments to the general reserve component of the ALLL driven by a reduction in our historical losses allowed for a reduction of the balance of the ALLL and did not require any provision for loan and lease losses during 2014. The lack of provision for loan and lease losses is reflective of the continuing improvements in the overall credit quality of the loan portfolio, the improvement in historical losses over the last two years relative to historical periods, the improvement in property values that serve as collateral for a large portion of our loans, as well as the limited amount of new loans moving into non-accrual status, and therefore requiring specific reserves, all of which were largely offset by increased ALLL requirements due to the growth in the loan portfolio, and qualitative factor adjustments. As of December 31, 2015 the ALLL represented 1.40% of total gross loans. The ALLL attributable to loans acquired in the MISN Transaction was $0.4 million at December 31, 2015, a reduction of $0.6 million as compared to $1.0 million at December 31, 2014. The reduction in the ALLL for acquired MISN loans is attributable in large part to the paydown and payoff of certain MISN loans throughout 2015.

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Discussion of 2014 Compared to 2013

A provision for loan and lease losses was not recorded for years ended December 31, 2014 or 2013. The lack of need for additional provisions for the year ended December 31, 2014 was reflective of improvements in the overall credit quality of the loan portfolio, the overall improvement in the net charge-off history over the last two years relative to historical periods, the improvement in property values that serve as collateral for a large portion of our loans, as well as the limited amount of new loans moving into non-accrual status, and therefore requiring specific reserves. Loans acquired through the MISN Transaction required $1.0 million of provisions for loan and lease losses through December 31, 2014, however, other components of our ALLL such as the general, and specific reserve components, had offsetting provision recaptures. When such provision recaptures were aggregated with the required provision for MISN acquired loans and leases, and provisions to address increases in our qualitative factors, and unallocated portion of our ALLL, the result of these component provisions, and provision recaptures resulted in a net $0 provision for loan and lease losses for 2014. Improved credit quality in conjunction with improvements in the amount of net charge-offs were primary drivers behind the lack of need for provisions in 2013. The ALLL represented 1.41% and 2.16% of total gross loans as of December 31, 2014 and 2013, respectively.

Non-Interest Income

The table below sets forth changes in non-interest income for 2015, 2014, and 2013:

 
   
   
   
  Variances  
 
  For the Years Ended
December 31,
 
 
  2014   2013  
 
  2015   2014   2013   Dollar   Percent   Dollar   Percent  

    (dollars in thousands)  

Fees and service charges

    $ 4,849     $ 5,312     $ 4,529     $ (463 )   -8.7%     $ 783     17.3%  

Net gain on sale of mortgage loans

    1,602     1,330     2,282     272     20.5%     (952 )   -41.7%  

Gain on sale of investment securities

    641     646     3,926     (5 )   -0.8%     (3,280 )   -83.5%  

Gain on extinguishment of debt

    552     -         -         552     -         -         -      

Other mortgage fee income

    452     290     642     162     55.9%     (352 )   -54.8%  

Other income

    2,043     1,997     1,496     46     2.3%     501     33.5%  

Total

    $ 10,139     $ 9,575     $ 12,875     $ 564     5.9%     $ (3,300 )   -25.6%  

Discussion of 2015 Compared to 2014

Non-interest income increased by $0.6 million, or 5.9%, for the year ended December 31, 2015 compared with the amount reported for 2014. The increase in non-interest income in 2015 was driven by $0.6 million in gains on extinguishment of debt, as well as a $0.4 million increase in mortgage banking revenues, which is attributable to an increase in mortgage loan production during 2015. Increased mortgage loan production in 2015 can be attributed to refinance activity, stemming from a decline in long term interest rates over the last year. We remain cautious regarding our mortgage origination volume given that an upward move in rates could have a further adverse impact on the refinance market. However, if we do experience a rising interest rate environment, we believe that this potentially negative trend would be partially mitigated by an increase in purchase mortgage originations, as buyers have historically tended to accelerate purchase decisions in the face of a rising rate environment.

The gain on the extinguishment of debt during 2015 was primarily associated with a $3.0 million redemption of junior subordinated debentures. These increases were offset by a $0.5 million decline in fees and service charges due to the Company exiting certain depository customers in late 2014, as it determined these customers no longer fit the Company's risk profile.

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Discussion of 2014 Compared to 2013

Non-interest income decreased by $3.3 million, or 25.6%, for the year ended December 31, 2014 compared with the amount reported for 2013. The decline in non-interest income in 2014 was driven by a $3.3 million decrease in the gains realized on sale of investment securities and a $1.3 million decrease in the gain on sale and origination fee income for mortgage loans. The decline in mortgage originations over 2014 was attributable to a rise in long term interest rates during 2014 and a corresponding decline in refinance activity for much of the year.

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

Non-Interest Expenses

The table below sets forth changes in non-interest expense for 2015, 2014 and 2013:

 
   
   
   
  Variances  
 
  For the Years Ended
December 31,
 
 
  2014   2013  
 
  2015   2014   2013   Dollar   Percent   Dollar   Percent  

    (dollars in thousands)  

Salaries and employee benefits

    $ 23,814     $ 23,476     $ 18,977     $ 338     1.4%     $ 4,499     23.7%  

Professional services

    7,790     4,801     2,833     2,989     62.3%     1,968     69.5%  

Occupancy and equipment

    6,682     6,576     4,891     106     1.6%     1,685     34.5%  

Information technology

    2,298     3,025     2,582     (727 )   -24.0%     443     17.2%  

Regulatory assessments

    1,212     1,164     1,007     48     4.1%     157     15.6%  

Amortization of intangible assets

    1,049     1,057     400     (8 )   -0.8%     657     164.3%  

Loan department expense

    1,021     934     758     87     9.3%     176     23.2%  

Sales and marketing

    1,017     843     584     174     20.6%     259     44.3%  

Communication costs

    562     638     371     (76 )   -11.9%     267     72.0%  

Merger, restructure and integration

    (77 )   9,190     1,051     (9,267 )   -100.8%     8,139     774.4%  

Other expense

    2,799     3,088     3,109     (289 )   -9.4%     (21 )   -0.7%  

Total

    $ 48,167     $ 54,792     $ 36,563     $ (6,625 )   -12.1%     $ 18,229     49.9%  

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The table below provides a breakdown of professional services expenses for 2015, 2014 and 2013:

 
   
   
   
  Variances  
 
  For the Years Ended
December 31,
 
 
  2014   2013  
 
  2015   2014   2013   Dollar   Percent   Dollar   Percent  

    (dollars in thousands)  

Professional Services

                                           

BSA/AML related costs

    $ 2,296     $ 616     $ -         $ 1,680     272.7%     $ 616     -      

Information technology services and consulting

    1,397     855     174     542     63.4%     681     391.4%  

Audit and tax costs

    1,160     942     617     218     23.1%     325     52.7%  

Legal costs

    1,133     538     200     595     110.6%     338     169.0%  

All other costs

    1,804     1,850     1,842     (46 )   -2.5%     8     0.4%  

Total professional services

    $ 7,790     $ 4,801     $ 2,833     $ 2,989     62.3%     $ 1,968     69.5%  

Discussion of 2015 Compared to 2014

Total non-interest expense decreased by approximately $6.6 million in 2015 as compared to 2014, and was primarily driven by a $9.3 million decrease in merger, restructure and integration costs related to the MISN Transaction in 2014. This decline was partially offset by a $3.0 million increase in professional services costs, which was driven in large part by a $1.7 million increase in costs for temporary staff and consulting related to our BSA/AML Program remediation efforts. The increase in professional services costs can also be attributed to a $0.5 million increase in information technology services and consulting costs associated with our transition of information technology network management from employees of the Company to an outside firm in order to achieve a higher level of information security and cyber-security protection, position the bank for more flexible growth opportunities in the area of information technology infrastructure, and the addition of new technology-based products and services. The increase in professional services costs are also attributable to a $0.5 million increase in legal expenses primarily due to $0.6 million of insurance reimbursements for legal fees received in 2014 for costs incurred during 2012, 2013 and 2014.

The $0.7 million decline in information technology costs can be attributed to the elimination of duplicative data processing costs associated with the MISN Transaction, which existed through July 2014 when MISN's bank processing systems were integrated with our own systems. The decline in these costs can also be attributed to renegotiated pricing in the contract between the Company and its core platform vendor. Salaries and benefits costs increased in 2015 by $0.3 million, which was primarily attributable to higher mortgage commissions.

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Discussion of 2014 Compared to 2013

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

The year over year increase in salaries and employee benefits was driven in large part by the addition of MISN operations during the majority of 2014. This resulted in higher employee base salaries, overtime and related payroll taxes of $4.2 million, higher equity compensation plan expense of $0.5 million, and higher employee group insurance expense of $0.4 million. Offsetting these increases was a reduction in mortgage origination commissions expense, which declined by $0.6 million, or 43%, in 2014 compared to 2013, which is consistent with the 44% year over year decline in mortgage gain on loan sales and other fee income.

Professional services expense also increased by $2.0 million during 2014 as compared to 2013. The increase in professional services expense for 2014 was driven by increases in outsourced information technology services of $0.7 million, $0.6 million for temporary staff and consulting related to our BSA/AML Program remediation efforts, a $0.3 million increase in legal expenses, and a $0.3 million increase in audit and tax service provider costs.

Other increases in non-interest expense related to higher communications costs and loan department expenses, which can be attributed to the MISN Transaction in 2014. Communication costs increased $0.3 million due to a larger branch network, initially, following the MISN Transaction. Increases in loan department costs of $0.2 million were driven by increased appraisal expense for classified acquired MISN loans.

Provision for Income Taxes

For the year ended December 31, 2015, the Company recorded income tax expense of approximately $8.9 million, compared to $4.7 million in 2014, and $7.0 million in 2013. The Company's effective income tax rates were 36.7%, 34.6%, and 39.2% for 2015, 2014, and 2013, respectively. The increase in income tax expense and the effective tax rate in 2015 compared to 2014 was attributable to higher pre-tax income resulting primarily from the absence of significant one-time charges incurred during 2014 associated with the MISN Transaction. Additionally, slightly offsetting the impact of higher pretax income on the Company's effective tax rate was the recognition of $0.2 million in California income tax credits in 2015 for the origination of qualified loans. Excluding the impact of this credit the effective tax rate for 2015 would have been 37.5%.

Income tax expense and the effective rate decline in 2014 compared to 2013 primarily as a result of these one-time charges incurred in 2014 attributed to the MISN Transaction. Excluding the impact of these one-time charges, the Company's effective tax rate would have been approximately 37.6% for 2014.

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The determination as to whether a valuation allowance should be established against deferred tax assets is based on the consideration of all available evidence using a "more likely than not" standard. Management evaluates the realizability of deferred tax assets on a quarterly basis. As of December 31, 2015 and 2014, there was no valuation allowance for deferred tax assets. Please see Note 7. Income Taxes, of the consolidated financial statements filed on this Form 10-K, for additional information concerning the Company's deferred tax assets.

Financial Condition

At December 31, 2015, total assets were approximately $1.9 billion, an increase of approximately $189.6 million or 11.1%, when compared to December 31, 2014. The increase in total assets can be attributed to a $95.4 million increase in investment securities, $53.8 million in loan growth, as well as an increase of $31.3 million in interest earning cash balances. Funding for the increase in total assets was provided by a $170.2 million increase in total deposits, and an $8.0 million increase in FHLB borrowings. The increase in total deposits in 2015 is attributed to the Company's continuing focus on new customer acquisition activities, as well as on expanding our existing customer relationships.

Total Cash and Cash Equivalents

Total cash and cash equivalents were $69.9 million and $35.6 million at December 31, 2015, and December 31, 2014, respectively. This line item will vary depending on daily cash settlement activities and the amount of highly liquid assets needed, based on known events, such as the repayment of borrowings or loans expected to be funded in the near future, and actual cash on hand in the branches. The increase in 2015 can be attributed in part to deposit growth outpacing growth in the loan and investment securities portfolios during the year.

Investment Securities and Other Earning Assets

Other earning assets are comprised of interest earning deposits due from the federal reserve bank, federal funds sold (funds the Company lends on a short-term basis to other banks), investments in securities and short-term interest bearing deposits at other financial institutions. These assets are maintained for liquidity needs of the Company, collateralization of public deposits, and diversification of the earning asset mix.

Securities Available for Sale

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

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The following table provides a summary of investment securities by securities type:

 
  December 31, 2015   December 31, 2014  
 
  Amortized
Cost
  Fair Value   Amortized
Cost
  Fair Value  

    (dollars in thousands)  

Obligations of U.S. government agencies

    $ 47,478     $ 47,318     $ 19,562     $ 19,664  

Mortgage backed securities

                         

U.S. government sponsored entities and agencies

    246,561     245,235     216,492     215,398  

Non-agency

    34,645     34,317     11,891     11,901  

State and municipal securities

    105,164     108,406     79,810     82,592  

Asset backed securities

    16,183     15,627     26,216     26,025  

Other investments

    100     32     -         -      

Total available for sale securities

    $ 450,131     $ 450,935     $ 353,971     $ 355,580  

At December 31, 2015, the fair value of the investment portfolio was approximately $450.9 million or $95.4 million greater than that reported at December 31, 2014. The increase in the balance of the portfolio can be attributed primarily to the deployment of excess liquidity, attributable to deposit growth, into higher interest earning investments during 2015.

Securities available for sale are carried at fair value, with related net unrealized gains or losses, net of deferred income taxes, recorded as an adjustment to accumulated other comprehensive income. At December 31, 2015, the securities portfolio had net unrealized gains, net of taxes, of approximately $0.5 million, a decrease of approximately $0.4 million from the net unrealized gain position of $0.9 million reported at December 31, 2014. Fluctuations in the fair value of the investment portfolio can be attributed primarily to volatility in interest rates.

All fixed and adjustable rate mortgage pools contain a certain amount of risk related to the uncertainty of prepayments of the underlying mortgages, which prepayments are directly impacted by interest rate changes. The Company uses computer simulation models to test the average life, duration, market volatility and yield volatility of adjustable rate mortgage pools under various interest rate assumptions to monitor volatility. The majority of the Company's mortgage securities were issued by: The Government National Mortgage Association ("Ginnie Mae"), The Federal National Mortgage Association ("Fannie Mae"), and The Federal Home Loan Mortgage Corporation ("Freddie Mac"). These securities carry the full faith and guarantee of the issuing agencies and the U.S. Federal Government. At December 31, 2015, approximately $245.2 million or 87.7%, of the Company's mortgage related securities were issued by government agencies and government sponsored entities, such as those listed above.

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The following table sets forth the maturity distribution of the investment portfolio and the weighted average yield for each category at December 31, 2015. All investment securities are classified as available for sale:

 
  December 31, 2015  
 
  One Year
or Less
  Over 1
Through 5
Years
  Over 5 Years
Through 10
Years
  Over 10
Years
  Total  

    (dollars in thousands)  

Obligations of U.S. government agencies

    $ 5,434     $ 15,208     $ 18,852     $ 7,824     $ 47,318  

Mortgage backed securities

                               

U.S. government sponsored entities and agencies

    33,210     100,422     67,442     44,161     245,235  

Non-agency

    8,878     9,071     16,368     -         34,317  

State and municipal securities

    3,456     18,659     78,956     7,335     108,406  

Asset backed securities

    -         9,556     3,252     2,819     15,627  

Other investments

    -         -         -         32     32  

Total available for sale securities

    $ 50,978     $ 152,916     $ 184,870     $ 62,171     $ 450,935  

Amortized cost

    $ 51,049     $ 153,444     $ 182,996     $ 62,642     $ 450,131  

Weighted average yield

    1.87%     1.98%     2.64%     3.17%     2.40%  

Federal Home Loan Bank Stock

As a member of FHLB of San Francisco, the Company is required to hold a specified amount of FHLB capital stock based on the asset size of the Bank and the level of outstanding borrowings with the FHLB. As such, the amount of FHLB stock the Company carries can vary from one period to another based on, among other things, the current liquidity needs of the Company. At December 31, 2015 and 2014, the Company held approximately $7.9 million in FHLB stock.

Loans

Summary of Market Conditions

Total gross loans increased $53.8 million during 2015, with growth attributed to increases in residential 1 to 4 family, farmland, commercial and industrial, and agriculture loans. Growth in these categories was offset by declines in commercial real estate, construction and land, and home equity lines of credit, which was driven in part by the level of prepayments and payoffs exceeding loan production in these categories during 2015. The Company continued to focus on organic loan growth in our region with originations of new loans held for investment during 2015 totaling $255.7 million. New loan production was offset by loan prepayments and payoffs of $217.1 million in addition to normal portfolio amortization. Prepayments and payoffs in 2015 can be attributed in part to the decline in long-term interest rates in conjunction with competition from non-banks for commercial real estate loans.

The Company continues to see improvement in the local economy, and loan demand in the markets we serve. We believe that with the Bank's expansion into Santa Barbara and Ventura counties, in conjunction with a focus on commercial and industrial lending, the Bank is well positioned for continued growth.

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Although we continue to see signs of stabilization and improvement in the local economies in which the Company operates, management recognizes that a renewed decline in the global, national, state or local economies and/or continued drought conditions on the Central Coast of California, may negatively impact local borrowers, as well as the values of real estate within our market footprint. As such, management continues to closely monitor credit trends and leading indicators for renewed signs of economic deterioration. The Bank employs stringent lending standards, and seeks to originate loans to borrowers who have strong credit profiles, adequate debt service ability, and ample collateral support for secondary sources of loan repayment. Additionally, purchased loans are evaluated under the same standards as originated loans. Management seeks to continually monitor the credit profiles of borrowers in order to take proactive steps, when and if necessary, to mitigate any material adverse impacts on the Company.

Credit Quality

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

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

Loans Held for Sale

Loans held for sale primarily consist of residential mortgage originations that have already been specifically designated for sale pursuant to correspondent mortgage loan investor agreements. There is minimal interest rate risk associated with these loans as purchase commitments are entered into with investors at the time the Company funds the loans. Settlement from the correspondents is typically within 30 days of funding the mortgage. At December 31, 2015, loans held for sale totaled $9.8 million compared to $2.6 million at December 31, 2014.

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The table below sets forth the composition of the loan portfolio as of December 31, 2015, 2014, 2013, 2012, and 2011:

 
  December 31,  
 
  2015   2014   2013   2012   2011  
 
  Balance   Percent   Balance   Percent   Balance   Percent   Balance   Percent   Balance   Percent  

    (dollars in thousands)  

Real Estate Secured

                                                             

Commercial

    $ 579,244     46.3%     $ 588,472     49.3%     $ 432,203     52.2%     $ 372,592     54.1%     $ 357,499     55.4%  

Residential 1 to 4 family

    165,829     13.3%     127,201     10.7%     88,904     10.7%     41,444     6.0%     20,839     3.2%  

Farmland

    120,566     9.7%     98,373     8.2%     50,414     6.1%     25,642     3.7%     8,155     1.3%  

Multi-family residential

    79,381     6.4%     78,645     6.6%     31,140     3.8%     21,467     3.1%     15,915     2.5%  

Construction and land

    35,669     2.9%     44,660     3.7%     38,222     4.6%     44,380     6.5%     49,185     7.6%  

Home equity lines of credit

    31,387     2.5%     38,252     3.2%     31,178     3.8%     31,863     4.6%     31,047     4.8%  

Total real estate secured

    1,012,076     81.1%     975,603     81.7%     672,061     81.2%     537,388     78.0%     482,640     74.8%  

Commercial

                                                             

Commercial and industrial

    164,808     13.2%     154,787     13.0%     119,121     14.4%     125,340     18.2%     141,065     21.8%  

Agriculture

    64,363     5.2%     55,101     4.6%     32,686     4.0%     21,663     3.1%     15,740     2.4%  

Other

    -         0.0%     14     0.0%     38     0.0%     61     0.0%     89     0.0%  

Total commercial

    229,171     18.4%     209,902     17.6%     151,845     18.4%     147,064     21.3%     156,894     24.2%  

Consumer

    6,033     0.5%     7,978     0.7%     3,578     0.4%     5,156     0.7%     6,752     1.0%  

Total gross loans

    1,247,280     100.0%     1,193,483     100.0%     827,484     100.0%     689,608     100.0%     646,286     100.0%  

Deferred loan fees

    (1,132 )         (1,445 )         (1,281 )         (937 )         (1,111 )      

Allowance for loan and lease losses

    (17,452 )         (16,802 )         (17,859 )         (18,118 )         (19,314 )      

Total net loans

    $ 1,228,696           $ 1,175,236           $ 808,344           $ 670,553           $ 625,861        

Loans held for sale

 
  $

9,755
       
  $

2,586
       
  $

2,386
       
  $

22,549
       
  $

21,947
       

Real Estate Secured

Other Real Estate Loans

The following table provides a break-down of the real estate secured segment of the Company's loan portfolio, exclusive of construction and land loans, as of December 31, 2015:

 
  December 31, 2015    
   
   
   
   
 
 
  Balance   Undisbursed
Commitment
  Total Bank
Exposure
  Percent
Composition
  Percent of
Total Risk
Based Capital
  Number
of Loans
  Single
Largest
Loan (1)
  Owner
Occupied
 

    (dollars in thousands)        

All Other Real Estate Secured

                                                 

Residential 1 to 4 family

    $ 165,829     $ 477     $ 166,306     16.3%     86.5%     350     $ 4,500     $ 116,295  

Commercial

    155,230     486     155,716     15.3%     81.0%     181     9,250     79,966  

Hotels

    130,163     3,301     133,464     13.1%     69.4%     52     15,000     17,264  

Farmland

    120,566     2,604     123,170     12.1%     64.1%     70     17,647     63,077  

Professional

    101,092     253     101,345     9.9%     52.7%     124     11,500     30,480  

Retail

    97,946     434     98,380     9.6%     51.2%     112     7,300     48,107  

Multi-family

    79,381     4,547     83,928     8.2%     43.7%     58     9,000     -      

Healthcare / medical

    33,435     -         33,435     3.3%     17.4%     45     5,600     19,127  

Home equity lines of credit

    31,387     32,072     63,459     6.2%     33.0%     448     1,200     30,859  

Restaurants and other hospitality

    27,316     350     27,666     2.7%     14.4%     26     13,713     9,572  

Other

    34,062     -         34,062     3.3%     17.7%     46     4,999     26,029  

Total

    $ 976,407     $ 44,524     $ 1,020,931     100.0%     531.1%     1,512     $ 17,647     $ 440,776  
(1)
Amount reported reflects the original loan amount for the single largest loan that remains outstanding as of December 31, 2015.

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At December 31, 2015, the other real estate secured segment of the loan portfolio represented approximately $976.4 million, or 78.3%, of total gross loans. When compared to that reported at December 31, 2014, this represents an increase of approximately $45.5 million, or 4.9%. This increase is attributed to new loan production in residential 1 to 4 family and farmland loans, slightly offset by decreases in commercial real estate, construction and land, and home equity lines of credit.

At December 31, 2015, a total of $36.9 million of the real estate secured portfolio was risk graded as special mention, substandard or doubtful, with the largest single component being the commercial real estate segment, which represented $33.6 million. At December 31, 2014, other real estate secured balances graded special mention, substandard or doubtful totaled $36.5 million, of which $27.9 million can be attributed to commercial real estate loans. At December 31, 2015 and 2014, other real estate secured balances, including undisbursed commitments, represented 531% and 536%, respectively, of the Bank's total risk-based capital. At December 31, 2015, approximately $440.8 million, or 45.1%, of the other real estate secured segment of the loan portfolio was considered owner occupied. Loans meeting the regulatory classification of non-owner occupied commercial real estate represented 266.2% of the Bank's total risk-based capital.

Construction and Land Loans

The following provides a break-down of the Bank's construction and land portfolio as of December 31, 2015:

 
  December 31, 2015    
   
   
   
 
 
  Balance   Undisbursed
Commitment
  Total Bank
Exposure
  Percent
Composition
  Percent of
Total Risk
Based Capital
  Number
of Loans
  Single
Largest
Loan (1)
 

    (dollars in thousands)  

Construction and Land

                                           

Commercial

    $ 20,899     $ 16,851     $ 37,750     66.9%     19.6%     27     $ 10,000  

Tract

    8,183     1,384     9,567     16.9%     5.0%     6     10,673  

Multi-family

    3,861     946     4,807     8.5%     2.5%     6     2,500  

Single family residential

    2,314     1,650     3,964     7.0%     2.1%     21     800  

Single family residential – Spec.

    285     -         285     0.5%     0.1%     3     303  

Hospitality

    127     -         127     0.2%     0.1%     1     560  

Total

    $ 35,669     $ 20,831     $ 56,500     100.0%     29.4%     64     $ 10,673  
(1)
Amount reported reflects the original loan amount for the single largest loan that remains outstanding as of December 31, 2015.

At December 31, 2015, the construction and land portfolio represented $35.7 million, or 2.9%, of total gross loans, a decrease of $9.0 million, or 20.1%, from that reported at December 31, 2014. Construction loans are typically granted for a one year period and then refinanced at the completion of the construction project into permanent loans with varying maturities. The ratio of total construction loans, including undisbursed commitments, to the Bank's total risk-based capital was 29% and 36% at December 31, 2015 and 2014, respectively. At December 31, 2015 there were $5.2 million of construction and land balances risk graded special mention, substandard, or doubtful. This compares to $6.9 million risk graded special mention, substandard or doubtful at December 31, 2014.

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Table of Contents

Commercial Loans

The following table provides a break-down of the commercial and industrial segment of the commercial loan portfolio as of December 31, 2015:

 
  December 31, 2015    
   
   
   
 
 
  Balance   Undisbursed
Commitment
  Total Bank
Exposure
  Percent
Composition
  Percent of
Total Risk
Based Capital
  Number
of Loans
  Single
Largest
Loan (1)
 

    (dollars in thousands)  

Commercial and Industrial

                                           

Professional services

    $ 30,756     $ 17,641     $ 48,397     17.8%     25.2%     200     $ 5,000  

Real estate / rental and leasing

    22,190     13,933     36,123     13.3%     18.8%     120     6,522  

Healthcare / medical

    21,249     11,667     32,916     12.1%     17.1%     117     10,410  

Manufacturing

    17,408     11,692     29,100     10.7%     15.1%     123     2,484  

Wholesale and retail

    15,523     7,681     23,204     8.5%     12.1%     137     2,500  

Construction

    13,204     29,562     42,766     15.7%     22.2%     162     5,000  

Restaurants / hospitality

    8,841     5,134     13,975     5.1%     7.3%     89     2,629  

Media and information services

    8,620     605     9,225     3.4%     4.8%     22     5,000  

Agriculture

    6,596     2,344     8,940     3.3%     4.7%     35     2,000  

Transportation and warehousing

    5,184     754     5,938     2.2%     3.1%     64     596  

Financial services

    5,018     2,273     7,291     2.7%     3.8%     35     3,000  

Oil gas and utilities

    847     1,000     1,847     0.7%     1.0%     6     688  

All other

    9,372     2,770     12,142     4.5%     6.3%     229     2,342  

Total

    $ 164,808     $ 107,056     $ 271,864     100.0%     141.5%     1,339     $ 10,410  
(1)
Amount reported reflects the original loan amount for the single largest loan that remains outstanding as of December 31, 2015.

At December 31, 2015, commercial and industrial loans represented approximately $164.8 million, or 13.2%, of total gross loans. This represents an increase of $10.0 million, or 6.5% from December 31, 2014. The ratio of total commercial and industrial loans, including undisbursed commitments, to risk-based capital was 142% at December 31, 2015 and 144% at December 31, 2014.

The Company's credit exposure within the commercial and industrial segment remains diverse with respect to the industries to which credit has been extended. As of December 31, 2015, a total of $11.8 million of the commercial and industrial portfolio was risk graded as special mention, substandard or doubtful. This compares to $16.5 million being risk graded special mention, substandard or doubtful as of December 31, 2014.

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Agriculture

The following table provides a break-down of the agriculture segment of the Company's commercial loan portfolio as of December 31, 2015:

 
  December 31, 2015    
   
   
   
 
 
  Balance   Undisbursed
Commitment
  Total Bank
Exposure
  Percent
Composition
  Percent of
Total Risk
Based Capital
  Number
of Loans
  Single
Largest
Loan (1)
 

    (dollars in thousands)  

Agriculture

                                           

Fruit and nut tree farming

    $ 27,033     $ 13,071     $ 40,104     39.1%     20.9%     36     $ 7,700  

Wholesale merchants

    12,211     2,671     14,882     14.5%     7.7%     10     8,000  

Vegetable and mellon farming

    9,162     5,638     14,800     14.5%     7.7%     18     4,000  

Food and beverage

    5,001     2,947     7,948     7.8%     4.1%     26     1,500  

Animal production

    3,610     4,280     7,890     7.7%     4.1%     40     2,000  

Support activities for agriculture

    2,863     5,899     8,762     8.6%     4.6%     27     1,800  

Other crop farming

    592     3,530     4,122     4.0%     2.1%     6     2,353  

Transportation and warehousing

    24     -         24     0.0%     0.0%     2     25  

All other

    3,867     11     3,878     3.8%     2.0%     11     1,600  

Total

    $ 64,363     $ 38,047     $ 102,410     100.0%     53.2%     176     $ 8,000  
(1)
Amount reported reflects the original loan amount for the single largest loan that remains outstanding as of December 31, 2015.

At December 31, 2015, agriculture balances totaled approximately $64.4 million, or 5.2%, of total gross loans, which represents an increase of $9.3 million, or 16.8%, from December 31, 2014. The ratio of total agriculture loans, including undisbursed commitments, to risk-based capital increased was 53% at December 31, 2015 and 51% at December 31, 2014. As of December 31, 2015, a total of $3.0 million of the agriculture portfolio was risk graded as special mention, substandard or doubtful. This compares to $2.4 million of the agriculture portfolio being risk graded special mention, substandard or doubtful as of December 31, 2014.

Consumer

At December 31, 2015, the consumer loan portfolio totaled $6.0 million, compared to $8.0 million reported at December 31, 2014. Consumer loans include revolving credit plans, installment loans and credit card balances.

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Maturities and Sensitivities of Loans to Changes in Interest Rates

The following table provides a summary of the approximate maturities and sensitivity to changes in interest rates for the loan portfolio as well as information about fixed and variable rate loans:

 
  December 31, 2015  
 
  Due Less
Than 3
Months
  Due 3 To
12 Months
  Due Over
12 Months
Through 3
Years
  Due Over 3
Years
Through 5
Years
  Due Over 5
Years
Through 15
Years
  Due Over
15 Years
  Total  

    (dollars in thousands)  

Real Estate Secured

                                           

Commercial

    $ 31,249     $ 30,434     $ 154,179     $ 132,673     $ 230,709     $ -         $ 579,244  

Residential 1 to 4 family

    5,081     1,410     25,061     35,707     94,482     4,088     165,829  

Farmland

    25,773     1,314     16,617     8,326     68,536     -         120,566  

Multi-family residential

    6,336     3,889     17,451     31,787     19,918     -         79,381  

Construction and land

    24,807     6,420     2,560     488     1,394     -         35,669  

Home equity lines of credit

    31,112     270     -         -         -         5     31,387  

Commercial

                                           

Commercial and industrial

    72,345     18,750     16,229     31,517     25,777     190     164,808  

Agriculture

    56,094     771     2,288     4,434     149     627     64,363  

Other

    -         -         -         -         -         -         -      

Consumer

    873     64     339     491     3,274     992     6,033