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TABLE OF CONTENTS
Item 8. Consolidated Financial Statements and Supplementary Data

Table of Contents

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, 2016.

Commission file number: 000-25020

LOGO

(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, 2016 was approximately $188.2 million based on the closing sales price of a share of Common Stock of $7.94 as of June 30, 2016.

As of February 23, 2017, the registrant had 34,403,157 shares of Common Stock outstanding.


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Heritage Oaks Bancorp
and Subsidiaries

Table of Contents

 
   
  Page
Part I        
Item 1.   Business   4
Item 1A.   Risk Factors   16
Item 1B.   Unresolved Staff Comments   29
Item 2.   Properties   29
Item 3.   Legal Proceedings   30
Item 4.   Mine Safety Disclosures   30
Part II        
Item 5.   Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities   31
Item 6.   Selected Financial Data   34
Item 7.   Management's Discussion and Analysis of Financial Condition and Results of Operations   35
Item 7A.   Quantitative and Qualitative Disclosures About Market Risk   70
Item 8.   Financial Statements and Supplementary Data   73
Item 9.   Changes in and Disagreements with Accountants on Accounting and Financial Disclosure   153
Item 9A.   Controls and Procedures   153
Item 9B.   Other Information   153
Part III        
Item 10.   Directors, Executive Officers and Corporate Governance   154
Item 11.   Executive Compensation   158
Item 12.   Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters   180
Item 13.   Certain Relationships and Related Transactions, and Director Independence   182
Item 14.   Principal Accounting Fees and Services   183
Part IV        
Item 15.   Exhibits and Financial Statement Schedules   185
Signatures   186
Exhibit Index   187
Certifications    

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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:

      Renewed softness in the overall economy, including the California real estate market.

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

      Our ability to complete the announced merger with Pacific Premier Bancorp, Inc. in a timely manner, if at all, and the possibility that the anticipated benefits of the merger with Pacific Premier Bancorp, Inc. are not realized when expected or at all.

      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.

      Any compromise in the secured transmission of personal, financial and/or confidential information over public networks.

      Environmental conditions, including the prolonged drought in California, natural disasters such as earthquakes, floods, 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 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

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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 is registered as a bank holding company for Heritage Oaks Bank (the "Bank"). The Company acquired all of the outstanding common stock of 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"), and 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 in 2014. 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 are dividends received from the Bank, as well as equity or debt it issues. 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.

Recent Developments

Merger Agreement

On December 12, 2016, the Company and Pacific Premier Bancorp, Inc., a Delaware corporation ("PPBI"), entered into an Agreement and Plan of Reorganization (the "Merger Agreement") pursuant to which the Company will be merged with and into PPBI, with PPBI surviving (the "Corporate Merger"), immediately followed by the merger of Heritage Oaks Bank with and into Pacific Premier Bank, the wholly-owned bank subsidiary of PPBI ("Pacific Premier"), with Pacific Premier surviving (the "Bank Merger"). The Corporate Merger and Bank Merger are collectively referred to in this Annual Report on Form 10-K as the "Announced Transaction." The consideration paid to shareholders of the Company will consist of whole shares of PPBI common stock, and cash in lieu of fractional shares of PPBI common stock. Upon consummation of the Corporate Merger, each share of the Company's common stock issued and outstanding immediately prior to the effective time of the merger will be cancelled and converted into the right to receive 0.3471 shares of PPBI common stock.

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The consummation of the Announced Transaction is subject to a number of conditions, which include: (i) the approval of the Merger Agreement by the Company's shareholders and the approval of the issuance of shares of PPBI common stock by PPBI's shareholders; (ii) as of the month-end prior to the closing of the Announced Transaction, Heritage Oaks Bank must have an aggregate outstanding balance of non-maturity deposits equal to at least $1.25 billion; (iii) as of the closing of the Announced Transaction, the Company shall have tangible common equity of not less than $183.0 million, subject to certain assumptions and adjustments that are set forth in the Merger Agreement; (iv) the receipt of all necessary regulatory approvals for the Announced Transaction, without the imposition of conditions or requirements, other than conditions or requirements related to remedial actions, that the PPBI board of directors reasonably determines in good faith would not, individually or in the aggregate, materially reduce the economic benefits of the Announced Transaction; (v) the absence of any regulation, judgment, decree, injunction or other order of a governmental authority which prohibits the consummation of the Announced Transaction or which makes illegal the consummation of the Announced Transaction; (vi) the effective registration of the shares of PPBI common stock to be issued to the Company's shareholders with the Securities and Exchange Commission ("SEC") and the approval of such shares for listing on the Nasdaq Global Market; (vii) all representations and warranties made by PPBI and the Company in the Merger Agreement must remain true and correct, except for certain inaccuracies that would not have, or would not reasonably be expected to have, a material adverse effect; and (viii) PPBI and the Company must have performed their respective obligations under the Merger Agreement in all material respects. The foregoing description of the Merger Agreement does not purport to be complete and is qualified in its entirety by reference to the full text of the Merger Agreement, which has been previously filed with the SEC on Form 8-K dated December 13, 2016.

The representations, warranties and covenants of each party set forth in the Merger Agreement have been made only for purposes of, and were and are solely for the benefit of the parties to, the Merger Agreement, may be subject to limitations agreed upon by the contracting parties, including being qualified by confidential disclosures made for the purposes of allocating contractual risk between the parties to the Merger Agreement instead of establishing these matters as facts, and may be subject to standards of materiality applicable to the contracting parties that differ from those applicable to investors.

Termination of Mortgage Banking Business

In January 2017, the Company's Management and Board of Directors decided to discontinue activities related to the consumer mortgage banking business, effective February 1, 2017. This decision is primarily attributable to current market conditions, such as rising interest rates, and increasing housing prices. The discontinuation of the consumer mortgage banking business did not involve the sale of existing mortgage assets, rather it entailed the termination of certain business activities such as originating and selling consumer mortgage loans. The Company, however, continues to offer home equity lines of credit and home equity loans. The Company ceased accepting new applications on February 1, 2017, and will terminate all consumer mortgage origination related operations on or about April 30, 2017, other than servicing existing consumer mortgage loans within the Company's loan portfolio. In order to ensure that Heritage Oaks Bank customers continue to have access to consumer mortgage products, the Company entered into a referral arrangement with another bank that has a strategic focus on the consumer mortgage business, and which is not a competitor in terms of deposit gathering and their branch geographic footprint. Effective February 1, 2017, many of the Company's consumer mortgage banking team members joined this other bank. The Company will continue to serve the needs of mortgage customers with loans that were in process of origination prior to February 1, 2017, and will continue to service all loans remaining in the Company's portfolio indefinitely. The Company will honor all contractual commitments to both customers and investors that were in process prior to February 1, 2017. Management expects that the majority of existing loan applications that were in process prior to February 1, 2017 will close within 90 days.

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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.

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 "Oakley" design; and the tag line "Heritage Oaks Bank – We're central to the Coast." 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.

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.

Community Service

We strongly believe in enhancing the economic vitality and welfare of the communities where we work and live. In 2016, Bank employees provided approximately 2,500 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 2016 to local organizations and charities 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 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, state and municipal account relationships. Deposit products offered include personal and business checking and savings accounts, time deposit accounts, individual retirement accounts ("IRAs"), health savings accounts ("HSAs"), 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.

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. Although the Company holds a significant presence within its primary market areas, money center banks and large regional banks, by virtue of their larger capital bases, have significantly larger lending limits than we do and generally have more expansive branch networks.

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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 281,000, 106,000, and 92,000 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 2016, 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 5.0%, compared to over 12% at the peak of the economic crisis in 2010.

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.

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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 of any future changes in monetary and fiscal policies on the Company cannot be predicted and the impact could be material and adverse.

Management remains cautiously optimistic that there will be continued slow but steady improvement in economic conditions in 2017 in our primary markets. However, there have been continued 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 continue to persist. If 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, 2016, the Company employed 302 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. The Company is registered with and subject to regulation, supervision and examination by the Federal Reserve Board as a bank holding company. The Company is also subject to certain provisions of the California Financial Code 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 the Bank's 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 bank depositors, the FDIC deposit insurance fund (the "DIF") and the banking system as a whole and not for the benefit of shareholders.

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Legislation and Regulatory Developments

Bank holding companies and their subsidiaries are subject to significant regulation and restrictions by federal and state laws and regulatory agencies. The following paragraph summarizes certain of the laws and regulations that apply to the Company and 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 the Company or the Bank, nor do they purport to identify every statute and regulation that may apply to the Company and the Bank.

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. For example, 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 2016 as federal banking agencies implemented additional requirements under the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank Act"). State and federal bank regulatory agencies continue to adopt 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.

Regulatory Enforcement Authority

If the FDIC determines that a bank's 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.

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.

Until November 29, 2016, the Bank was 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. The FDIC and the DBO terminated the BSA Consent Order on November 29, 2016.

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Capital Adequacy Requirements

Bank holding companies and banks are subject to regulatory capital requirements administered by their state and federal banking agencies. Federal banking agencies adopted new capital rules (the "New Capital Rules") that generally became effective in 2015, but many elements are being phased in over multiple years. The New Capital Rules replace previous risk-based and leverage capital requirements for banking organizations and were adopted to meet requirements of the Dodd-Frank Act and to implement the international Basel Committee on Banking Supervision Basel III agreements. The risk-based capital guidelines for bank holding companies and banks and, additionally for banks, prompt corrective action regulations (see "Item 1. Business – 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.

Many of the requirements in the New Capital Rules and other regulations and rules apply only to larger or internationally active institutions and not to institutions with less than $10 billion of assets, which currently includes the Company and the Bank. These requirements include required annual stress tests for institutions with $10 billion or more of assets with reporting requirements and Enhanced Prudential Standards, 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 Systemically Important Banking Institutions.

The New Capital Rules narrow the definition of regulatory capital and establish higher minimum risk-based capital ratios that require banking organizations to maintain a new minimum "common equity Tier 1" ratio of 4.5%, a Tier 1 capital ratio of 6.0% (increased from 4.0%), a total risk-based capital ratio of 8.0%, and a minimum leverage ratio of 4.0% (calculated as Tier 1 capital to average consolidated assets). The effective date of these requirements for the Company and the Bank was January 1, 2015.

In addition, a capital conservation buffer of 2.5% above each of these levels (that is being phased in over three years, which began at 0.625% on January 1, 2016, increased to 1.25% on January 1, 2017, and which will be increased by 0.625% on each of January 1, 2018 and January 1, 2019) will be required for banking institutions to avoid restrictions on their ability to pay dividends, repurchase stock 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, 2016, the respective capital ratios of the Company and the Bank exceeded the minimum percentage requirements to be deemed "well capitalized" for regulatory purposes.

In addition, the New Capital Rules include 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 had less than $15 billion in assets as of December 31, 2009, limitations on the amount of mortgage servicing rights and deferred tax assets permitted to be included in Tier 1 capital, and the required inclusion of 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.

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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 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%.

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

Under California law, a California corporation such as the Company may make a distribution to its shareholders to the extent that either the corporation's retained earnings meet or exceed the amount of the proposed distribution or the value of the corporation's assets exceed the amount of its liabilities plus the amount of shareholders preferences, if any, and certain other conditions are met. It is the Federal Reserve Board's policy, however, 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.

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The Bank is a legal entity that is separate and distinct from its holding company. The Company depends 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 New Capital Rules restrict dividend payments by the Bank to the Company if the capital conservation buffer is not achieved.

California law limits the ability of the Bank to pay cash dividends to the Company to the lesser of the Bank's retained earnings or net income for its last three fiscal years (less any distributions to shareholders made during such period). If the Bank is unable to pay cash dividends under this test, the Bank may pay cash dividends 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. The Bank is 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 the Bank's earnings and could have a material adverse effect on the value of, or market for, the Company's common stock.

The Dodd-Frank Act revised the FDIC's DIF management authority by setting requirements for the DIF's reserve ratio and redefining the assessment base used to calculate banks' quarterly assessments. In 2016, the FDIC adopted a rule increasing the DIF's minimum reserve ratio to 1.35% by September 30, 2020, as required by the Dodd-Frank Act. As required by the Dodd-Frank Act, the cost of increasing the DIF's reserve ratio from 1.15% to 1.35% will be borne by depository institutions with total consolidated assets of $10 billion or more.

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 Community Reinvestment Act, 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.

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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 created 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. Those with $10 billion or more in assets are subject to examination by the CFPB. Banks with less than $10 billion in assets will continue to be examined for compliance by their primary federal banking agency.

Bank Holding Company and Bank Regulation

The Company and the Bank are subject to a wide range of other requirements and restrictions contained in both federal and state banking laws, including the following:

      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.

      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 neighborhoods and 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."

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      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.

      The Volcker Rule.  The "Volcker Rule," which was adopted as part of the Dodd-Frank Act, prohibits bank holding companies, banks and their affiliated companies from engaging in short-term proprietary trading of certain securities and commodity futures for their own account. The Volcker Rule also limits banking entities' investments in, and other relationships with, hedge funds and private equity funds, although the Federal Reserve Board has extended the conformance period for certain existing investments to July 2017. The Company and the Bank held no investment positions or fund relationships at December 31, 2016 which were subject to the final rule and have controls in place to ensure compliance with the Volcker Rule going forward.

      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.

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 SEC. As a company listed on the NASDAQ Capital Market, the Company is also subject to NASDAQ's 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.

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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.

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, landslides 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.

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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.

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 64.9% of our gross loans can be classified as CRE lending as of December 31, 2016. 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 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.

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.

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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.

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.

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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.

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.

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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 a continued low interest rate environment as well as competitive pressures within our primary market area.

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.

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.

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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, computer viruses, 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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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.

To date, we have not experienced any material losses relating to cyber-attacks or other information security breaches, but there can be no assurance that we will not suffer such attacks or attempted breaches, or incur such losses in the future. Our risk and exposure to these matters remains heightened because of, among other things, the evolving nature and growth of these threats, our plans to continue to implement and increase Internet and mobile banking to meet customer demand, and the current economic and political environment. As cyber and other data security threats continue to evolve, we may be required to expend significant additional resources to continue to modify and enhance our protective measures or to investigate and remediate any security vulnerabilities.

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.

Further, the Company may be affected by data breaches at retailers and other third parties who participate in data interchanges with us and our customers that involve the theft of customer credit and debit card data, which may include the theft of the Company's debit card PIN numbers and commercial card information used to make purchases at such retailers and other third parties. Such data breaches could result in us incurring significant expenses to reissue debit cards and cover losses, which could result in a material adverse effect on the Company's results of operations or financial condition.

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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.

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.

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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, droughts, fires, floods 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.

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.

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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.

Because the market price of PPBI common stock will fluctuate, the Company's shareholders cannot be sure of the exact value of the consideration they will receive in the Corporate Merger.

Upon the effective time of the Corporate Merger, each share of Company common stock will be cancelled and converted into the right to receive the merger consideration, consisting of shares of PPBI common stock pursuant to the terms of the Merger Agreement. The value of the merger consideration to be received by Company shareholders will be based on an exchange ratio, which is fixed at 0.3471 shares of PPBI common stock for each share of Company common stock. Because the price of PPBI common stock could fluctuate during the period of time between the Company special meeting and the time the Company's shareholders actually receive their shares of PPBI common stock as merger consideration, the Company's shareholders will be subject to the risk of a decline in the price of PPBI common stock during this period. The Company does not have the right to terminate the Merger Agreement or to re-solicit the vote of its shareholders solely because of changes in the market prices of PPBI common stock. Stock price changes may result from a variety of factors, including general market and economic conditions, changes in the values and perceptions of financial services stocks generally and PPBI in particular, changes in PPBI's business, operations and prospects and regulatory considerations. Many of these factors are beyond PPBI's control. Accordingly, at the time of the Company special meeting, the Company's shareholders will not know or be able to calculate the exact value of the shares of PPBI common stock they will receive upon completion of the Corporate Merger.

Directors and officers of the Company have some interests in the Announced Transaction that are in addition to or different than the interests of the Company's shareholders.

The Company's directors and officers have interests in the Announced Transaction as individuals that are in addition to, or different from, their interests as shareholders of the Company, which are:

      The Company's directors and officers will receive, upon consummation of the Announced Transaction, options to acquire PPBI common stock in substitution of their Company options; in addition, directors and officers of the Company or its subsidiaries who will be retained by PPBI or its subsidiaries following the consummation of the Announced Transaction, will receive, upon consummation of the Announced Transaction, restricted shares of PPBI common stock in substitution of their Company restricted stock, and restricted stock units of PPBI in substitution of their Company restricted stock units; directors and officers of the Company and its subsidiaries who will not be retained by PPBI or its subsidiaries following the consummation of the Announced Transaction will have the vesting of their Company stock options, Company restricted stock and Company restricted stock units accelerated and (i) the Company restricted stock shall be converted into the right to receive the merger consideration and (ii) the cash-settled Company restricted stock units shall be converted into the right to receive cash; officers of the Company, whether or not retained, holding performance-based Company restricted stock units will receive cash for such awards;

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      The agreement of PPBI to honor indemnification obligations of the Company for a period of six (6) years, as well as to purchase liability insurance for the Company's directors and officers for six (6) years following the merger, subject to the terms of the Merger Agreement;

      Cash payments to certain officers of the Company in the aggregate amount of approximately $4.75 million, on a pre-tax basis, pursuant to the terms of their respective employment-related agreements with the Company;

      The appointment of Simone Lagomarsino, the President and Chief Executive Officer of the Company and Heritage Oaks Bank, Michael Morris, the Chairman of the Board of the Company and Heritage Oaks Bank, and Michael Pfau, the Vice Chairman of the Board of the Company and Heritage Oaks Bank, to serve on the boards of directors of PPBI and Pacific Premier Bank effective upon completion of the merger;

      Robert Osterbauer, Executive Vice President and commercial banking division Manager, North and Agribusiness Lending, with Heritage Oaks Bank, and Brooks Wise, Executive Vice President and commercial banking division Manager, South, with Heritage Oaks Bank, have entered into employment agreements with Pacific Premier Bank, which will each be effective upon the closing of the Corporate Merger, which provide compensation to those individuals for continued provision of services to, or employment with, Pacific Premier Bank following the Bank Merger; and

      Effective as of the closing of the Corporate Merger, PPBI will establish a Community Advisory Board for the Central Coast Region, which shall be comprised of all members of the Company's board of directors as of the closing of the Corporate Merger who are willing to so serve and no additional compensation will paid for service on the Community Advisory Board.

The Company and PPBI boards of directors were aware of these interests and considered them, among other things, in their approval of the Merger Agreement and the transactions contemplated by the Merger Agreement.

The termination fee and the restrictions on solicitation contained in the Merger Agreement may discourage other companies from trying to acquire the Company.

Until the completion of the Corporate Merger, with some limited exceptions, the Company is prohibited from soliciting, initiating, encouraging or participating in any discussion of or otherwise considering any inquiries or proposals that may lead to an acquisition proposal, such as a merger or other business combination transaction, with any person other than PPBI. In addition, the Company has agreed to pay a termination fee to PPBI in specified circumstances. These provisions could discourage other companies from trying to acquire the Company even though those other companies might be willing to offer greater value to the Company's shareholders than PPBI has offered in the Announced Transaction. The payment of the termination fee could also have a material adverse effect on the Company's financial condition.

PPBI may fail to realize the anticipated benefits of the Announced Transaction.

The success of the Announced Transaction will depend on, among other things, PPBI's ability to realize the anticipated revenue enhancements and efficiencies and to combine the businesses of PPBI and the Company in a manner that does not materially disrupt the existing customer relationships of the Company or result in decreased revenues resulting from any loss of customers and that permits growth opportunities to occur. If PPBI is not able to successfully achieve these objectives, the anticipated benefits of the merger may not be realized fully or at all or may take longer to realize than expected.

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PPBI and the Company have operated and, until the completion of the Announced Transaction, will continue to operate, independently. It is possible that the integration process could result in the loss of key employees, the disruption of each company's ongoing businesses or inconsistencies in standards, controls, procedures and policies that adversely affect PPBI's ability to maintain relationships with clients, customers, depositors and employees or to achieve the anticipated benefits of the Announced Transaction. Integration efforts between the two companies could also divert management attention and resources. These integration matters could have an adverse effect on each of PPBI and the Company during the transition period and on the combined company following completion of the merger.

The market price of PPBI common stock after the Announced Transaction may be affected by factors different from those affecting the shares of the Company or PPBI currently.

Upon completion of the Corporate Merger, holders of Company common stock will become holders of PPBI common stock. PPBI's business differs from that of the Company, and, accordingly, the financial condition and results of operations of the combined company and the market price of PPBI common stock after the completion of the Announced Transaction may be affected by factors different from those currently affecting the financial condition and results of operations of the Company or PPBI on a standalone basis.

The fairness opinion received by PPBI's board of directors from its financial advisor, D.A. Davidson, and the fairness opinion received by the Company's board of directors from the Company's financial advisor, Sandler O'Neill, will not be updated to reflect any changes since the date of such opinions.

Changes in the operations and prospects of PPBI or the Company, general market and economic conditions and other factors that may be beyond the control of PPBI and/or the Company may alter the value of PPBI or the Company or the market price for shares of PPBI common stock or Company common stock by the time the Announced Transaction is completed. Neither the fairness opinion delivered by D.A. Davidson to the PPBI board of directors nor the fairness opinion delivered by Sandler O'Neill to the Company board of directors speaks as of any date other than the date of such opinion, which was December 12, 2016 in the case of D.A. Davidson's opinion, and December 11, 2016 in the case of Sandler O'Neill's opinion. The Merger Agreement does not require that either D.A. Davidson's or Sandler O'Neill's fairness opinion be updated as a condition to the completion of the Announced Transaction, and neither PPBI nor the Company intends to request that the respective fairness opinions be updated.

The Announced Transaction is subject to the receipt of approvals or waivers from regulatory authorities that may impose conditions that could have an adverse effect on PPBI.

Before the Announced Transaction can be completed, various approvals or waivers must be obtained from bank regulatory authorities. Regulatory approval or waivers are not guaranteed and even if granted, the bank regulatory authorities may impose conditions on the completion of the Announced Transaction or require changes to the terms of the Merger Agreement. Although PPBI and the Company do not currently expect that any such conditions or changes will be imposed, there can be no assurance that they will not be, and such conditions or changes could have the effect of delaying completion of the merger, imposing additional costs on, or limiting the revenues of PPBI following the merger or causing the Announced Transaction between PPBI and HEOP to terminate.

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The Announced Transaction cannot be completed unless the PPBI shareholders approve the issuance of PPBI common stock in the merger and the Company's shareholders approve the Merger Agreement.

In order for the Announced Transaction to be completed, the PPBI shareholders must approve the issuance of PPBI common stock in the Announced Transaction and the Company shareholders must approve the Merger Agreement and the other transactions contemplated by the Merger Agreement. While a vote of PPBI's shareholders is not required to approve the Announced Transaction, the approval of PPBI's shareholders is required under applicable NASDAQ rules in order for PPBI to be authorized to issue the shares of PPBI common stock to the Company's shareholders as the merger consideration. Approval of the issuance of PPBI common stock to the Company stockholders under NASDAQ rules requires approval of at least a majority of the total votes cast at the PPBI special meeting. The approval of the Merger Agreement by the Company's shareholders requires the affirmative vote of the holders of a majority of the outstanding shares of Company common stock. If either or both of these required votes is not obtained from the shareholders of each of the respective companies, the merger may not be consummated.

The Announced Transaction is subject to certain closing conditions that, if not satisfied or waived, will result in the Announced Transaction not being completed, which may cause the prices of PPBI common stock and the Company's common stock to decline.

Consummation of the Announced Transaction is subject to customary conditions to closing in addition to the receipt of the required regulatory approvals and approval of the Company's shareholders of the Merger Agreement and the approval of PPBI's shareholders of the issuance of PPBI common stock in connection with the Announced Transaction. If any condition to the Announced Transaction is not satisfied or waived, to the extent permitted by law, the Announced Transaction will not be completed. In addition, PPBI and the Company may terminate the Merger Agreement under certain circumstances even if the Merger Agreement is approved by the Company's shareholders and the issuance of PPBI common stock in connection with the Announced Transaction is approved by PPBI's shareholders, including if the merger has not been completed on or before August 30, 2017. If the merger is not completed, the respective trading prices of PPBI common stock and Company common stock on the NASDAQ Global Stock Market may decline to the extent that the current prices reflect a market assumption that the Announced Transaction will be completed. In addition, neither company would realize any of the expected benefits of having completed the Announced Transaction.

The unaudited condensed pro forma combined financial data included in the joint proxy statement/prospectus are presented for illustrative purposes only and may not be an indication of the combined company's financial condition or results of operations following the Announced Transaction.

The unaudited condensed pro forma combined financial data contained in the joint proxy statement/prospectus are presented for illustrative purposes only, are based on various adjustments, assumptions and preliminary estimates and may not be an indication of the combined company's financial condition or results of operations following the Announced Transaction for several reasons. The actual financial condition and results of operations of the combined company following the Merger may not be consistent with, or evident from, these unaudited pro forma condensed combined financial data. In addition, the assumptions used in preparing the unaudited pro forma condensed combined financial data may not prove to be accurate, and other factors may affect the combined company's financial condition or results of operations following the merger. Any potential decline in the combined company's financial condition or results of operations may cause significant variations in the stock price of the combined company.

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The shares of PPBI common stock to be received by Company shareholders as a result of the Announced Transaction will have different rights than shares of the Company's common stock.

Upon completion of the Announced Transaction, the Company's shareholders will become PPBI shareholders and their rights as shareholders will be governed by the PPBI amended and restated certificate of incorporation, the PPBI amended and restated bylaws and Delaware General Corporation Law. The rights associated with Company common stock are different from the rights associated with PPBI common stock.

We will be subject to contractual restrictions and business uncertainties while the merger with PPBI is pending.

Although there is no assurance as to the exact timing, the merger currently is expected to close at the end of the first quarter of 2017 or early in the second quarter of 2017. The Merger Agreement requires us to operate in the ordinary course of business pending the Merger's completion, but restricts us from certain activities, including making acquisitions or opening of new branches, divestitures, issuance of securities and other customary restrictions without PPBI's consent. These restrictions may limit or prevent us from pursuing attractive business opportunities that may arise prior to the completion of the merger, and which we might pursue absent the Merger Agreement.

Uncertainty about the effects of the merger, including branch consolidation and any divestitures that may be required, on our employees and customers may have an adverse effect on us. Certain employees may experience uncertainty about their future roles. These uncertainties may make it more difficult for us to attract, retain and motivate key personnel until the merger is completed, and could cause our customers and others that deal with us to consider changing existing business relationships with us. It is not unusual for competitors to use mergers as an opportunity to seek the merging parties' customers and to hire certain of their staffs. If key employees depart the Corporation or the Bank in light of uncertainty over the merger or our integration efforts with PPBI, our business could be adversely affected.

Termination of the Merger Agreement could negatively affect us.

If, for any reason, the Merger Agreement is terminated, our business may be adversely affected as a result of not pursuing other beneficial opportunities prior to such termination and our management focus on completing the merger. If the Merger Agreement is terminated and our board of directors seeks another merger or business combination, we may not be able to find a party willing to offer equivalent or more attractive consideration than the consideration PPBI has agreed to provide in the merger, especially if the termination fee of $15.0 million becomes payable as a result. See also "Failure to successfully execute our strategic plan may adversely affect our performance."

Item 1B.   Unresolved Staff Comments

None.

Item 2.   Properties

The Company's headquarters are located at 1222 Vine Street in Paso Robles, California. As of December 31, 2016, 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 Company's leases contain multiple renewal options and provisions for rental increases, principally for changes in the cost of living index, property taxes and maintenance.

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Item 3.   Legal Proceedings

Merger litigation

On February 16, 2017, Robert Garfield, a purported shareholder of the Company, filed a complaint seeking class action status in the Superior Court of the State of California, County of San Luis Obispo, against the Company, each of its directors and PPBI, entitled Robert Garfield vs. Heritage Oaks Bancorp, et. al. (Case No. 17cv0097). The complaint alleges, among other things, that the Company's directors breached their fiduciary duties with regard to the proposed merger. Among other things, the complaint seeks class action status, a court order enjoining the Company and its directors from proceeding with or consummating the merger, disclosure of all material information to the Company's shareholders, compensatory or recessionary damages and the payment of attorneys' and experts' fees. The Company believes that it has defenses to all of the claims and requested relief. The Company is unable to state whether the likelihood of an unfavorable outcome of the dispute is probable or remote. The Company is also unable to provide an estimate of the range or amount of potential loss (if the outcome should be unfavorable). The Company intends to defend this lawsuit vigorously.

The outcome of the litigation summarized above and other legal and regulatory matters is inherently uncertain. While the Company does not believe that any such claims, lawsuits or regulations will have a material adverse effect on its financial condition or results of operations, unfavorable rulings could occur. 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 23, 2017, there were approximately 2,860 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, 2015, 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, 2016

    $ 12.64     $ 7.90     $ 0.06  

September 30, 2016

    $ 8.50     $ 7.56     $ 0.06  

June 30, 2016

    $ 8.49     $ 7.50     $ 0.06  

March 31, 2016

    $ 8.03     $ 6.95     $ 0.06  

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  

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.

Repurchase of Common Stock

On July 22, 2016, the Company announced it had amended its previously announced program 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. Under the amended program, repurchase activity was set to commence on August 6, 2016 and continue until February 8, 2017, the program's new expiration date, or expire earlier upon the completion of the repurchase of $5.0 million of the Company's common stock in addition to what has already been purchased under the program, as well as under certain other circumstances as set forth in the amended program. 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.

For the year ended December 31, 2016, the Company repurchased and cancelled 226,170 shares of its common stock at an aggregate cost of $1.6 million, or $7.23 per share. The Company made no repurchases of its common stock during the three months ended December 31, 2016.

In connection with the announcement of the Announced Transaction between the Company and PPBI, as discussed in "Recent Developments" of Item 1. Business included in this Annual Report on Form 10-K, the Company's stock repurchase plan as discussed above, automatically terminated pursuant to its terms.

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Securities Authorized for Issuance Under Equity Compensation Plans

The following table provides information at December 31, 2016, 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

    796,915  (1)   $ 7.19     1,812,124  (2)

Equity compensation plans not approved by security holders

    N/A     N/A     N/A  
(1)
Under the 2015 Equity Incentive Plan, the Company is authorized to issue restricted stock awards and restricted stock units. Outstanding restricted stock awards and restricted stock units are not included in the table above. At December 31, 2016, there were 188,519 shares of restricted stock awards issued and outstanding with a weighted average grant date fair value of $7.59 per share and 115,207 restricted stock units outstanding. Restricted stock units consist of 36,716 performance based restricted stock units with a weighted average grant date fair value of $7.56 per share that settle in shares of the Company's common stock, and 78,491 restricted stock units that settle in cash and are classified and accounted for as a liability. See also Note 13. Share-based Compensation Plans, of the consolidated financial statements filed on this Form 10-K for more information on the Company's equity compensation plans.
(2)
Includes securities available for issuance: including stock options, restricted stock awards, and restricted stock units.

Stock Performance

Please see "Stock Performance" of "Compensation Discussion and Analysis" under Part III, Item 11. Executive Compensation, of this Form 10-K for a comparison of the Company's common stock performance over the last five years.

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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,
 
2016 2015 2014 2013 2012

(dollars in thousands, except per share data)

Consolidated Income Data:

         

Interest income

  $ 71,347   $ 68,090   $ 64,088   $ 45,393   $ 46,321

Interest expense

5,737 5,831 5,157 3,867 3,818

Net interest income

65,610 62,259 58,931 41,526 42,503

(Reversal of) provision for loan and lease losses

(1,500 ) 7,681

Net interest income after (reversal of) provision for loan and lease losses

67,110 62,259 58,931 41,526 34,822

Non-interest income

12,214 10,139 9,575 12,875 12,548

Non-interest expense

51,314 48,167 54,792 36,563 36,131

Income before income tax expense             

28,010 24,231 13,714 17,838 11,239

Income tax expense

11,077 8,882 4,749 6,997 (1,798 )

Net income

  $ 16,933   $ 15,349   $ 8,965   $ 10,841   $ 13,037

Dividends and accretion on preferred stock

70 168 898 1,470

Net income available to common shareholders

  $ 16,933   $ 15,279   $ 8,797   $ 9,943   $ 11,567

Share Data:

         

Earnings per common share – basic

  $ 0.49   $ 0.45   $ 0.27   $ 0.38   $ 0.44

Earnings per common share – diluted

  $ 0.49   $ 0.44   $ 0.27   $ 0.37   $ 0.44

Dividends declared per common share

  $ 0.24   $ 0.23   $ 0.08   $   $

Dividend payout ratio

48.52% 51.15% 30.59% 0.00% 0.00%

Common book value per share

  $ 6.20   $ 6.01   $ 5.81   $ 4.84   $ 4.78

Tangible common book value per share

  $ 5.38   $ 5.16   $ 4.92   $ 4.34   $ 4.27

Actual shares outstanding at end of period

34,345,073 34,353,014 33,905,060 25,397,780 25,307,110

Weighted average shares outstanding – basic

34,051,171 34,129,930 32,567,137 26,341,592 26,271,000

Weighted average shares outstanding – diluted

34,187,521 34,274,902 32,712,983 26,542,689 26,401,870

Selected Consolidated Balance Sheet Data:

         

Total cash and cash equivalents

  $ 50,874   $ 69,923   $ 35,580   $ 26,238   $ 34,116

Total investments and other securities

  $ 458,817   $ 450,935   $ 355,580   $ 276,795   $ 287,682

Total gross loans held for investment

  $ 1,385,462   $ 1,247,280   $ 1,193,483   $ 827,484   $ 689,608

Allowance for loan and lease losses

  $ (17,237 )   $ (17,452 )   $ (16,802 )   $ (17,859 )   $ (18,118 )

Total assets

  $ 2,024,890   $ 1,899,739   $ 1,710,127   $ 1,203,651   $ 1,097,532

Total deposits

  $ 1,683,895   $ 1,564,961   $ 1,394,804   $ 973,895   $ 870,870

Federal Home Loan Bank borrowings

  $ 107,500   $ 103,521   $ 95,558   $ 88,500   $ 66,500

Junior subordinated debentures

  $ 10,612   $ 10,438   $ 13,233   $ 8,248   $ 8,248

Total shareholders' equity

  $ 212,850   $ 206,434   $ 197,940   $ 126,427   $ 145,529

Average assets

  $ 1,952,512   $ 1,815,397   $ 1,609,705   $ 1,119,334   $ 1,024,961

Average earning assets

  $ 1,822,385   $ 1,680,843   $ 1,483,393   $ 1,031,578   $ 953,815

Average shareholders' equity

  $ 212,442   $ 203,321   $ 182,186   $ 137,807   $ 137,392

Selected Financial Ratios:

         

Return on average assets

0.87% 0.85% 0.56% 0.97% 1.27%

Return on average equity

7.97% 7.55% 4.92% 7.87% 9.49%

Return on average tangible common equity

9.22% 8.83% 5.84% 9.04% 11.55%

Net interest margin (1)

3.60% 3.70% 3.97% 4.03% 4.46%

Efficiency ratio (2)

65.09% 66.15% 78.92% 71.29% 67.88%

Non-interest expense to average assets

2.63% 2.65% 3.40% 3.27% 3.53%

Capital Ratios:

         

Average equity to average assets

10.88% 11.20% 11.32% 12.31% 13.40%

Common Equity Tier 1 Capital ratio

12.16% 12.61% N/A N/A N/A

Leverage ratio

9.88% 9.90% 10.22% 10.20% 12.32%

Tier 1 Risk-Based Capital ratio

12.71% 13.01% 13.13% 12.91% 15.55%

Total Risk-Based Capital ratio

13.87% 14.26% 14.38% 14.17% 16.81%

Selected Asset Quality Ratios:

         

Non-performing loans to total gross loans (3)                                  

0.49% 0.63% 0.88% 1.22% 2.51%

Non-performing assets to total assets (4)

0.34% 0.43% 0.62% 0.84% 1.58%

Allowance for loan and lease losses to total gross loans

1.24% 1.40% 1.41% 2.16% 2.63%

Net recoveries (charge-offs) to average loans

0.10% 0.05% –0.10% –0.03% –1.32%
(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"), 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 registered as a bank 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, 2016, 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 those funds primarily in commercial real estate and commercial business loans, operating and real estate procurement loans for agricultural businesses, multi-family residential property loans and a variety of consumer loans. The Bank offers a variety of deposit accounts for both individuals and businesses with varying rates and terms, which generally include checking accounts, savings accounts, money market deposits, and certificates of deposit. 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 Company 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 Company, the sole purpose of which is to issue trust preferred securities. In conjunction with the acquisition of Mission Community Bancorp in February 2014, the Company 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 the Company's common stock valued at $60.3 million. The operating results of MISN are included in the Company's operating results beginning on March 1, 2014. Please also refer to Note 3. Business Combination, of the consolidated financial statements filed on this Form 10-K.

Merger Agreement

On December 12, 2016, the Company and Pacific Premier Bancorp, Inc., a Delaware corporation ("PPBI"), entered into an Agreement and Plan of Reorganization (the "Merger Agreement") pursuant to which the Company will be merged with and into PPBI, with PPBI surviving (the "Corporate Merger"), immediately followed by the merger of Heritage Oaks Bank with and into Pacific Premier Bank, the wholly-owned bank subsidiary of PPBI ("Pacific Premier"), with Pacific Premier surviving (the "Bank Merger"). The Corporate Merger and Bank Merger are collectively referred to in this Annual Report on Form 10-K as the "Announced Transaction." The consideration paid to shareholders of the Company will consist of whole shares of PPBI common stock, and cash in lieu of fractional shares of PPBI common stock. Upon consummation of the Corporate Merger, each share of the Company's common stock issued and outstanding immediately prior to the effective time of the merger will be cancelled and converted into the right to receive 0.3471 shares of PPBI common stock.

The Merger agreement contains customary representations and warranties from the Company to PPBI, which are qualified by the confidential disclosures provided by the Company to PPBI, and customary representations and warranties from PPBI to the Company.

The foregoing description of the Merger Agreement does not purport to be complete and is qualified in its entirety by reference to the full text of the Merger Agreement, which has been previously filed with the SEC on Form 8-K dated December 13, 2016.

Termination of BSA/AML Consent Order

On November 29, 2016, the Bank announced the termination by the Federal Deposit Insurance Corporation ("FDIC") and California Department of Business Oversight ("DBO") of the BSA/AML Consent Order issued by the FDIC and DBO on November 5, 2014 relating to the Bank's Bank Secrecy Act compliance program.

Financial Highlights

The Company generated net income available to common shareholders of $16.9 million, or $0.49 per diluted common share, for the year ended December 31, 2016, as compared to net income available to common shareholders of $15.3 million, or $0.44 per diluted common share, for the year ended December 31, 2015 and $8.8 million, or $0.27 per diluted common share, for the year ended December 31, 2014.

Significant factors impacting the Company's net income for the year ending December 31, 2016 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, 2016, 2015, and 2014.

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      Net Interest Income:  For the year ended December 31, 2016, net interest income was $65.6 million, or $3.3 million and 5.4% higher than the $62.3 million reported for the year ended December 31, 2015. The net interest margin was 3.60% for the year ended December 31, 2016, compared to 3.70% for the previous year. The increase in net interest income was due primarily to a $141.5 million increase in average interest earning assets, driven by a $111.3 million increase in average loan balances. The decline in the net interest margin can be attributed in large part to a decrease in the overall yield on the loan portfolio to 4.66% for the year ended December 31, 2016 from 4.95% for the year ended December 31, 2015, stemming from the prevailing low interest rate environment. For the year ended December 31, 2016 interest income and the yield on earning assets was $71.3 million and 3.92%, respectively, compared to $68.1 million and 4.05%, respectively for 2015. For the year ended December 31, 2016 interest expense was $5.7 million and the cost of funds was 0.33%, respectively, compared to interest expense of $5.8 million and the cost of funds of 0.36%, respectively for 2015.

      Non-Interest Expense:   Non-interest expense increased by $3.1 million to $51.3 million for the year ended December 31, 2016, from $48.2 million for the year ended December 31, 2015. The increase in non-interest expense is primarily attributed to a $2.8 million increase in salaries and benefits costs, as well as a $0.9 million increase in merger related expenses associated with the Announced Acquisition of the Company by PPBI. Increased salaries and benefits costs can be attributed to higher base compensation, incentive plan expense, and mortgage commissions. Increases in non-interest expense were partially offset by a $0.9 million decrease in professional services expenses associated with the absence of higher legal costs recognized in 2015. The efficiency ratio for the year ended December 31, 2016 was 65.09% compared to 66.15% for the year ended December 31, 2015.

      Provision for Loan and Lease Losses:  During the year ended December 31, 2016 the Company recorded a reversal of provision for loan and lease losses of $1.5 million. The reversal of provision for loan and lease losses during the year ended 2016 was attributable to continued improvement in loan credit quality metrics, including an overall decline in the level of non-performing loans, as well as net recoveries totaling $1.3 million during the year ended December 31, 2016. As of December 31, 2016, the allowance for loan and lease losses was $17.2 million, or 1.24% of total gross loans, compared to $17.5 million, or 1.40% of total gross loans at December 31, 2015. The allowance for loan and lease losses for acquired non-PCI and PCI loans was $0.1 million, or 0.10%, of total acquired loans, as of December 31, 2016.

      Non-Interest Income:   Non-interest income increased $2.1 million to $12.2 million for the year ended December 31, 2016 from $10.1 million for the year ended December 31, 2015. The increase in non-interest income can be primarily attributed to $1.2 million in gains on derivative instruments associated with the "back-to-back" interest rate swap program implemented in 2016, as well as a $0.9 million increase in mortgage banking revenues. These and other increases in non-interest income were partially offset by the absence of gains on the extinguishment of debt totaling $0.6 million, primarily attributable to the partial redemption of $3.0 million in junior subordinated debentures which occurred in the third quarter of 2015.

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.

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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 related to the fair value of assets purchased and liabilities assumed through strategic acquisitions, the allowance for loan and lease losses, 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.

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, generally 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 the Company's 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 allocation 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. 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.

The general portfolio allocation 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 a 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.

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Loans and leases acquired through purchase or through a business combination, such as those acquired in the MISN Transaction in 2014, are recorded at their fair value at the acquisition date. Credit discounts are included in the determination of fair value and therefore an ALLL is not recorded at the acquisition date. 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 purchased credit impaired ("PCI") loans while all other acquired loans are classified as non-PCI loans. PCI loans are accounted for under ASC 310-30, while all other acquired loans without evidence of deteriorated credit quality since their origination are not 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 current period earnings through a provision for loan and lease losses.

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 flows 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 cash flows, including principal and interest, over the expected cash flows is referred to as the non-accretable difference, and is not recorded in the Company's 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 established 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.

Due to the many judgments and variables that are part of 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 6. Loans and Allowance for Loan and Lease Losses, of the consolidated financial statements filed on this Form 10-K.

Realizability of Deferred Tax Assets

The Company uses an estimate of its future earnings in determining if it is more likely than not that the carrying value of its deferred tax assets will be realized over the period they are expected to reverse. If based on all available evidence, the Company believes that a portion or all of its deferred tax assets will not be realized, a valuation allowance is established. See also Note 8. 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 4. Fair Value of Assets and Liabilities, of the consolidated financial statements filed on this Form 10-K.

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Table of Contents

Non-GAAP Financial Measures

The tables below provide reconciliations of shareholders' equity (U.S. GAAP) to tangible common equity (non-U.S. GAAP). The Company uses tangible common equity in the determination of the performance measures: tangible common book value per share and return on tangible common equity. The Company believes that the presentation of tangible common book value per share and return on tangible common equity in this report provides useful measures for investors because they are widely used in the financial services industry to compare the relative market value and financial performance of one financial institution against another. Additionally, the Company believes the measure of return on tangible common equity is more representative of the return to the Company's shareholders relative to their investment in the Company.

The calculations of tangible common equity and average tangible common equity are intended to complement other measures defined by U.S. GAAP. Since U.S. GAAP does not include these measures, the Company believes there are no comparable U.S. GAAP financial measures to these calculations. Despite the importance of these measures to the Company, there are no standardized definitions for these measures and, as a result, the Company's calculations may not be comparable with other organizations. Additionally, there may be limits in the usefulness of these measures to investors. As a result, the Company encourages readers to consider all of the information in its consolidated financial statements and the notes thereto in their entirety and not to rely on a single financial measure.

 
December 31,
2016
December 31,
2015

(dollars in thousands, except per share data)

Period End Balances:

   

Total shareholders' equity

  $ 212,850   $ 206,434

Less intangibles:

   

Goodwill

(24,885 ) (24,885 )

Other intangible assets

(3,354 ) (4,298 )

Tangible common equity (non-U.S. GAAP)

  $ 184,611   $ 177,251

Outstanding shares

34,345,073 34,353,014

Tangible book value per share (non-U.S. GAAP) (1)

  $ 5.38   $ 5.16
(1)
Determined by dividing tangible common equity by outstanding shares as of the end of the period.
 
For The Years Ended December 31,
 
2016 2015 2014

(dollars in thousands)

Average Balances:

     

Total shareholders' equity

  $ 212,442   $ 203,321   $ 182,186

Less preferred stock

(446 ) (3,548 )

Less intangibles:

     

Goodwill

(24,885 ) (24,885 ) (22,902 )

Other intangible assets

(3,830 ) (4,873 ) (5,170 )

Tangible common equity (non-U.S. GAAP)

  $ 183,727   $ 173,117   $ 150,566

Return on tangible common equity (non-U.S. GAAP) (1)

9.22% 8.83% 5.84%
(1)
Determined by dividing net income available to common shareholders by average tangible common equity.

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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.

The table below presents average balance sheet information, interest income and expense, average yields / rates and net interest income and margin for the years ended December 31, 2016, 2015 and 2014:

 
  For the Year Ended
December 31, 2016
  For the Year Ended
December 31, 2015
  For the Year Ended
December 31, 2014
 
 
  Average
Balance
  Yield /
Rate
  Income/
Expense
  Average
Balance
  Yield /
Rate
  Income/
Expense
  Average
Balance
  Yield /
Rate
  Income/
Expense
 

    (dollars in thousands)  

Interest Earning Assets

                                                       

Loans (1) (2)

    $ 1,314,935     4.66%     $ 61,275     $ 1,203,620     4.95%     $ 59,599     $ 1,072,133     5.24%     $ 56,145  

Investment securities

    452,629     1.97%     8,904     395,791     1.85%     7,311     350,120     2.07%     7,238  

Interest earning deposits in other banks

    45,082     0.32%     145     71,693     0.21%     152     52,039     0.17%     89  

Other investments

    9,739     10.50%     1,023     9,739     10.56%     1,028     9,101     6.77%     616  

Total earning assets

    1,822,385     3.92%     71,347     1,680,843     4.05%     68,090     1,483,393     4.32%     64,088  

Allowance for loan and lease losses                      

    (17,641 )               (17,143 )               (17,375 )            

Other assets

    147,768                 151,697                 143,687              

Total assets

    $ 1,952,512                 $ 1,815,397                 $ 1,609,705              

Interest Bearing Liabilities

   
 
   
 
   
 
   
 
   
 
   
 
   
 
   
 
   
 
 

Money market

    $ 581,795     0.28%     $ 1,627     $ 512,825     0.27%     $ 1,404     $ 418,532     0.30%     $ 1,247  

Time deposits

    241,368     0.70%     1,701     263,553     0.75%     1,981     278,292     0.76%     2,115  

Interest bearing demand

    128,336     0.11%     136     119,166     0.11%     130     103,781     0.11%     114  

Savings

    112,396     0.10%     112     100,387     0.10%     100     93,593     0.10%     91  

Total interest bearing deposits

    1,063,895     0.34%     3,576     995,931     0.36%     3,615     894,198     0.40%     3,567  

Federal Home Loan Bank borrowing

    109,001     1.49%     1,629     90,174     1.86%     1,675     76,499     1.43%     1,091  

Junior subordinated debentures

    10,522     5.04%     530     12,164     4.45%     541     12,348     4.04%     499  

Other borrowed funds

    55     3.64%     2     8     0.90%         8     0.76%      

Total borrowed funds

    119,578     1.81%     2,161     102,346     2.17%     2,216     88,855     1.79%     1,590  

Total interest bearing liabilities

    1,183,473     0.48%     5,737     1,098,277     0.53%     5,831     983,053     0.52%     5,157  

Non interest bearing demand               

    545,879                 504,516                 434,012              

Total funding

    1,729,352     0.33%     5,737     1,602,793     0.36%     5,831     1,417,065     0.36%     5,157  

Other liabilities

    10,718                 9,283                 10,454              

Total liabilities

    1,740,070                 1,612,076                 1,427,519              

Shareholders' Equity

   
 
   
 
   
 
   
 
   
 
   
 
   
 
   
 
   
 
 

Total shareholders' equity

    212,442                 203,321                 182,186              

Total liabilities and shareholders' equity

    $ 1,952,512                 $ 1,815,397                 $ 1,609,705              

Net interest margin (3)

         
3.60%
 
  $

65,610
         
3.70%
 
  $

62,259
         
3.97%
 
  $

58,931
 

Interest rate spread

          3.44%                 3.52%                 3.80%        

Cost of deposits

          0.22%                 0.24%                 0.27%        

 

(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, 2016 and 2015 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, 2016  
 
  Volume   Rate   Rate/Volume   Total  

    (dollars in thousands)  

Interest Income

                         

Loans

    $ 5,512     $ (3,490 )   $ (346 )   $ 1,676  

Investment securities

    1,050     475     68     1,593  

Interest earning deposits in other banks

    (56 )   79     (30 )   (7 )

Other investments

        (5 )       (5 )

Net increase (decrease)

    6,506     (2,941 )   (308 )   3,257  

Interest Expense

                         

Money market

    189     51     (17 )   223  

Time deposits

    (167 )   (132 )   19     (280 )

Interest bearing demand

    10         (4 )   6  

Savings

    12             12  

Federal Home Loan Bank borrowing

    350     (325 )   (71 )   (46 )

Junior subordinated debentures

    (73 )   72     (10 )   (11 )

Other borrowed funds

            2     2  

Net increase (decrease)

    321     (334 )   (81 )   (94 )

Total net increase (decrease)

    $ 6,185     $ (2,607 )   $ (227 )   $ 3,351  

 

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

    (dollars in thousands)  

Interest Income

                         

Loans

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

Investment securities

    944     (770 )   (101 )   73  

Interest earning deposits in other banks

    34     21     8     63  

Other investments

    43     345     24     412  

Net increase (decrease)

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

Interest Expense

                         

Money market

    281     (84 )   (40 )   157  

Time deposits

    (112 )   (28 )   6     (134 )

Interest bearing demand

    17         (1 )   16  

Savings

    7         2     9  

Federal Home Loan Bank borrowing

    195     329     60     584  

Junior subordinated debentures

    (7 )   51     (2 )   42  

Net increase

    381     268     25     674  

Total net increase (decrease)

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

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Discussion of 2016 Compared to 2015

For the years ended December 31, 2016 and 2015, net interest income was $65.6 million and $62.3 million, respectively, and the NIM was 3.60% and 3.70%, 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 during 2016, which was the primary driver behind the decline in the NIM during 2016. The 10-Year U.S. Treasury yield remained low throughout 2016, eventually falling below 1.40% during July 2016, and only began to rise back above 2.00% during November 2016. The impact of the low prevailing interest rate environment on our loan portfolio is that the loans that prepay or payoff 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 2016, the yield of newly originated loans held for investment averaged 3.88% as compared to an average yield of 4.06% for the same period in 2015, while the yield on loan payoffs averaged 4.62% in 2016, as compared to 4.76% in 2015. During 2016, the Company originated approximately $42.5 million in new loans under its back-to-back interest rate swap program. While these loans are variable rate loans, which reprice with changes in short-term LIBOR rates, they were originated at a weighted average yield of approximately 2.85%, contributing to the lower overall yield on originated loans during 2016. As interest rates rise, it is anticipated yields on these loans will reset higher than their originated yields.

Average loan yields declined by 29 basis points to 4.66% for 2016, when compared to 4.95% for 2015. As previously mentioned, the historically low interest rate environment continued to have an adverse impact on loan yields during 2016 as yields on new loan originations and renewals have been lower than the yields on loans that prepaid during that same period.

Loan yields and the NIM have benefitted from discount accretion on loans acquired through the MISN Transaction in 2014, and this discount accretion has somewhat muted the impact of the historically low interest rate environment on our loan yields during 2016 and 2015. Total discount accretion from acquired loans was $2.2 million and $2.7 million during the years ended December 31, 2016 and 2015, respectively. Purchase discount accretion from acquired loans increased our loan yields by 17 basis points and 23 basis points during the years ended December 31, 2016 and 2015, respectively. The level of purchase discount accretion decreased during 2016 when compared to 2015 due to a slight decline in accelerated accretion resulting from payoffs of certain acquired loans, as well as lower scheduled accretion due to normal portfolio attrition in conjunction with payoffs experienced in prior periods. The impact of discount accretion on earning asset yields and the NIM was 12 basis points and 16 basis points for the years ended December 31, 2016 and 2015, respectively. The Company anticipates the amount of purchase discount accretion from acquired loans will continue to decline, absent any unscheduled loan payoffs, due to the decline in the amount of scheduled discount accretion attributable to the maturity of acquired loans.

The average yield on investment securities increased in 2016 to 1.97% from 1.85% for 2015. The increase in the average yield on investment securities during 2016 was driven in large part by the Federal Open Market Committee's decision to increase the federal funds rate by 0.25% in December 2015. This increase in the federal funds rate had a positive impact on floating rate investments in the securities portfolio, such as floating rate SBA securities, floating rate commercial mortgage backed securities, and floating rate agency mortgage backed securities; all of which realized higher coupon rates in 2016 given their ties to benchmark rates such as prime, LIBOR and short term treasury yields.

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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 loans in our loan portfolio have 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 those rates rise above contractual interest rate floors. See Item 7A. Qualitative and Quantitative Disclosures About Market Risk included in this Annual Report on 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 2016 increased by $141.5 million, or 8.4%, compared to 2015. 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. This growth in average earning assets over the last year was funded primarily through increases in average core deposit balances, and increases in Federal Home Loan Bank of San Francisco ("FHLB") borrowings.

The average balance of interest bearing liabilities was $85.2 million, or 7.8% higher for the year ended December 31, 2016 as compared to the same period in 2015. The growth in average interest bearing liabilities over the last year 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 2 basis points to 0.34% during the year ended December 31, 2016, as compared to the 0.36% for the year ended December 31, 2015. The overall cost of deposits was 0.22% for the year ended December 31, 2016, as compared to 0.24% for the same period in 2015. These declines are due in part to the historically low interest rate environment that has existed for the last several years, in conjunction with the Company's efforts to systematically lower the cost of deposits over this same time period. Although these efforts have contributed to a moderate decline in average time deposits, the overall deposit mix and cost of the deposit portfolio has improved as a result of these efforts. In addition to the favorable effects realized from these changes in our interest bearing deposits, average non-interest bearing demand deposit balances increased by $41.4 million, or 8.2%, to $545.9 million, for the year ended December 31, 2016 as compared to $504.5 million for the same period a year earlier.

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 had an adverse impact on earning assets yields, including, the overall yield on the loan portfolio, which was the primary driver behind the decrease in earning asset yields and the NIM in 2015 as compared to 2014. During 2015, the average yield on newly originated loans was 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 FHLB 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.

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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, the average yield on new loan originations held for investment was 4.06%, while the average yield on payoffs was 4.76%. During 2014, the average yield on new loan originations held for investment was 4.37%, while the average yield on payoffs was 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.

Total discount accretion from loans acquired through the MISN Transaction in 2014 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.

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 the Company 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 contributed to the 22 basis point decrease in the average yield on investment securities during 2015 to 1.85%, compared to 2.07% for 2014.

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.

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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 was in part due to the historically low interest rate environment that has existed for the last several years, but was also due to the Company's efforts to systematically lower the cost of deposits over this same time period. These efforts have contributed to a moderate decline in average time deposits, however, the overall deposit mix and cost of the deposit portfolio has improved as a result of these efforts. Average non-interest bearing demand deposit balances increased by $70.5 million or 16.2% to $504.5 million during 2015 as compared to $434.0 million for 2014. During 2015 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 the Company's funding base, helping to keep the cost of funding unchanged during 2015 at 0.36%. 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% during 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.

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 that may be incurred 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 6. 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 may have an adverse effect on the Company's results of operations. The Company recognizes that the risk of loss will vary with, among other things: general economic conditions; the type of loans being made; the creditworthiness of borrowers over the term of their respective loans, and in the case of collateralized loans, the quality of the underlying collateral for those loans.

During the year ended December 31, 2016, the Company recorded a reversal of provision for loan and lease losses of $1.5 million. The Company did not record a provision for loan and lease losses during the years ended December 31, 2015 and 2014. The reversal of provision for loan and lease losses during 2016 was attributable to continued improvement in loan credit quality metrics, including an overall decline in the level of non-performing loans, the improvement in historical losses over the last three years relative to historical periods, improvement in property values that serve as collateral for a large portion of the Company's loans, as well as the limited amount of new loans moving into non-accrual status, and therefore requiring specific reserves, as well as net recoveries totaling $1.3 million during the year ended December 31, 2016. Although during the years ended December 31, 2015 and 2014 the Company experienced some of the same positive factors that were experienced during 2016, they were largely offset by increased ALLL requirements due to qualitative factor adjustments, such as increases to the qualitative factor for the long-term California drought and its potential impact on the Company's agribusiness loans, as well as net charge-offs recorded in 2014, thereby requiring neither a provision or reversal of allowance for loan and lease losses during those years.

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Please also see the "Allowance for Loan and Lease Losses" discussion in the Financial Condition section of this Management's Discussion and Analysis of Financial Condition and Results of Operations for additional information concerning the allowance for loan and lease losses and the related impact on the provision for loan and lease losses.

Non-Interest Income

The table below provides a summary of the components of non-interest income for the years ended December 31, 2016, 2015, and 2014:

 
   
   
   
  Variances  
 
  For the Years Ended
December 31,
 
 
  2016 vs. 2015   2015 vs. 2014  
 
  2016   2015   2014   Dollar   Percent   Dollar   Percent  

    (dollars in thousands)  

Fees and service charges

    $ 5,165     $ 5,158     $ 5,594     $ 7     0.1%     $ (436 )   –7.8%  

Net gain on sale of mortgage loans

    2,365     1,602     1,330     763     47.6%     272     20.5%  

Gain on derivative instruments

    1,212             1,212              

Earnings on Bank Owned Life Insurance

    1,158     855     774     303     35.4%     81     10.5%  

Gain on sale of investment securities

    891     641     646     250     39.0%     (5 )   –0.8%  

Other mortgage fee income

    631     452     290     179     39.6%     162     55.9%  

Gain on extinguishment of debt

        552         (552 )   –100.0%     552      

Other income

    792     879     941     (87 )   –9.9%     (62 )   –6.6%  

Total

    $ 12,214     $ 10,139     $ 9,575     $ 2,075     20.5%     $ 564     5.9%  

Discussion of 2016 Compared to 2015

Non-interest income for the year ended December 31, 2016 was $12.2 million, representing an increase of $2.1 million, or 20.5%, when compared to the $10.1 million reported for 2015. The increase in non-interest income during 2016 can be attributed in large part to $1.2 million in gains recognized on derivative instruments associated with the "back-to-back" interest rate swap program the Company began actively marketing in 2016. The increase in non-interest income can also be attributed to the following: a $0.9 million increase in mortgage banking revenues attributed to an increase in held for sale mortgage production activity during 2016, a $0.3 million increase in earnings on BOLI attributed to additional purchases of BOLI the Company made during the fourth quarter of 2015, and a $0.3 million increase in gains on the sale of investment securities. These increases were partially offset by the absence of a $0.6 million gain on the extinguishment of debt associated with the partial redemption of $3.0 million in junior subordinated debentures which occurred in the third quarter of 2015.

Discussion of 2015 Compared to 2014

Non-interest income for the year ended December 31, 2015 was $10.1 million, representing an increase of $0.6 million, or 5.9%, when compared to the $9.6 million reported for 2014. The increase in non-interest income during 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 held for sale mortgage production during 2015. The gain on the extinguishment of debt during 2015 was 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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Non-Interest Expenses

The table below sets forth changes in non-interest expense for the years ended December 31, 2016, 2015, and 2014:

 
   
   
   
  Variances  
 
  For the Years Ended
December 31,
 
 
  2016 vs. 2015   2015 vs. 2014  
 
  2016   2015   2014   Dollar   Percent   Dollar   Percent  

    (dollars in thousands)  

Salaries and employee benefits

    $ 26,626     $ 23,814     $ 23,476     $ 2,812     11.8%     $ 338     1.4%  

Professional services

    6,901     7,790     4,801     (889 )   –11.4%     2,989     62.3%  

Occupancy and equipment

    6,530     6,682     6,576     (152 )   –2.3%     106     1.6%  

Information technology

    2,446     2,298     3,025     148     6.4%     (727 )   –24.0%  

Sales and marketing

    1,035     1,017     843     18     1.8%     174     20.6%  

Loan department expense

    1,024     1,030     1,113     (6 )   –0.6%     (83 )   –7.5%  

Regulatory assessments

    1,019     1,212     1,164     (193 )   –15.9%     48     4.1%  

Amortization of intangible assets

    944     1,049     1,057     (105 )   –10.0%     (8 )   –0.8%  

Merger, restructure and integration

    826     (77 )   9,190     903     1172.7%     (9,267 )   –100.8%  

Communication costs

    492     562     638     (70 )   –12.5%     (76 )   –11.9%  

Write-downs on other real estate owned

    217             217              

Other expense

    3,254     2,790     2,909     464     16.6%     (119 )   –4.1%  

Total

    $ 51,314     $ 48,167     $ 54,792     $ 3,147     6.5%     $ (6,625 )   –12.1%  

The table below provides a breakdown of the components of professional services expenses for the years ended December 31, 2016, 2015, and 2014:

 
   
   
   
  Variances  
 
  For the Years Ended
December 31,
 
 
  2016 vs. 2015   2015 vs. 2014  
 
  2016   2015   2014   Dollar   Percent   Dollar   Percent  

    (dollars in thousands)  

Professional Services

                                           

BSA/AML related costs

    $ 2,100     $ 2,355     $ 616     $ (255 )   –10.8%     $ 1,739     282.3%  

Audit and tax costs

    1,333     1,160     942     173     14.9%     218     23.1%  

Information technology services and consulting

    1,273     1,427     855     (154 )   –10.8%     572     66.9%  

Legal costs

    228     1,133     538     (905 )   –79.9%     595     110.6%  

All other costs

    1,967     1,715     1,850     252     14.7%     (135 )   –7.3%  

Total professional services

    $ 6,901     $ 7,790     $ 4,801     $ (889 )   –11.4%     $ 2,989     62.3%  

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Discussion of 2016 Compared to 2015

Non-interest expense for the year ended December 31, 2016 was $51.3 million, representing an increase of $3.1 million or 6.5%, when compared to the $48.2 million reported for 2015. The increase in non-interest expense is primarily attributed to a $2.8 million increase in salaries and benefits costs, as well as a $0.9 million increase in merger related expenses associated with the Announced Transaction with PPBI. Increased salaries and benefits costs can be attributed to higher base compensation, incentive plan expense, and mortgage commissions. Increases in non-interest expense were partially offset by a $0.9 million decrease in professional services expenses associated with the absence of higher legal costs recognized in 2015. Year over year variances in other categories of non-interest expense during 2016 include: a $0.5 million increase in other expense, of which $0.4 million of this increase is attributable to operating losses resulting from the reimbursement of certain customers for losses they incurred due to debit card fraud, which are losses the Bank was responsible for reimbursing in accordance with Regulation E and Visa network operating rules; a $0.2 million write-down of one OREO property attributed to the re-zoning of the property; and a $0.2 million decrease in regulatory assessment costs primarily attributable to a decline in assessment rates associated with the FDIC's Deposit Insurance Fund reserve ratio reaching a predetermined threshold of 1.15%.

Discussion of 2015 Compared to 2014

Non-interest expense for the year ended December 31, 2015 was $48.2 million, representing a decrease of $6.6 million or 12.1%, when compared to the $54.8 million reported for 2014. The decrease in non-interest expense 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, of which $1.7 million of this increase was driven by costs for temporary staff and consulting related to the Company's 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 received in 2014 related to legal costs incurred by the Bank 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 the Company's 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.

Provision for Income Taxes

For the years ended December 31, 2016, 2015 and 2014, the Company recorded income tax expense of $11.1 million, $8.9 million, and $4.7 million, respectively. The Company's effective income tax rates were 39.6%, 36.7%, and 34.6% for 2016, 2015, and 2014, respectively. The increase in income tax expense and the effective tax rate for 2016 as compared to 2015 is attributable to an increase in pre-tax net income, an increase in non-deductible merger related costs, and a proportional decline in the amount of tax-exempt municipal bond interest income relative to pre-tax net income.

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The increase in income tax expense and the effective tax rate in 2015 as 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 pre-tax 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%.

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, 2016 and 2015, there was no valuation allowance for deferred tax assets. Please see Note 8. 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, 2016, total assets were approximately $2.0 billion, an increase of approximately $125.2 million or 6.6%, when compared to December 31, 2015. The increase in total assets can be attributed to a $138.2 million increase in loans held for investment as well as a $7.9 million increase in investment securities, slightly offset by a decrease in cash and cash equivalents of $19.0 million which can be attributed in part to the loan growth during 2016. Funding for the increase in total assets was provided by a $118.9 million increase in total deposits, and a $4.0 million increase in FHLB borrowings. The increase in total deposits during 2016 is attributed to the Company's continued 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 $50.9 million and $69.9 million at December 31, 2016 and 2015, 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 decrease in 2016 can be attributed in part to the use of excess liquidity in the funding of loan growth 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, 2016   December 31, 2015  
 
  Amortized
Cost
  Fair Value   Amortized
Cost
  Fair Value  

    (dollars in thousands)  

Obligations of U.S. government agencies

    $ 61,119     $ 60,643     $ 47,478     $ 47,318  

Mortgage backed securities

                         

U.S. government sponsored entities and agencies

    242,203     239,335     246,561     245,235  

Non-agency

    24,224     24,237     34,645     34,317  

State and municipal securities

    125,911     125,831     105,164     108,406  

Asset backed securities

    8,956     8,771     16,183     15,627  

Other investments

            100     32  

Total available for sale securities

    $ 462,413     $ 458,817     $ 450,131     $ 450,935  

At December 31, 2016, the fair value of the investment portfolio was approximately $458.8 million or $7.9 million higher than that reported at December 31, 2015. The increase in the balance of the portfolio can be attributed to purchases of investment securities during 2016.

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, 2016, the securities portfolio had net unrealized losses, net of taxes, of approximately $2.1 million, a decrease of approximately $2.6 million from the net unrealized gain position of $0.5 million reported at December 31, 2015. Changes in the fair value of the investment portfolio during 2016 is largely attributed to the increase in interest rates during the fourth quarter of 2016.

All fixed and adjustable rate mortgage pools contain a certain amount of risk related to the uncertainty of prepayments of the underlying mortgages, which are directly impacted by changes in interest rates. The Company employs the use of 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. Included in the Company's mortgage-backed securities are home equity conversion mortgages, which typically possess prepayment characteristics that differ from traditional mortgage-backed securities, such that prepayment activity is not as closely correlated with changes in interest rates. 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"). At December 31, 2016, approximately $239.3 million or 90.8%, 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, 2016. All investment securities are classified as available for sale:

 
  December 31, 2016  
 
  One Year
or Less
  Over 1 Year
Through 5
Years
  Over 5 Years
Through 10
Years
  Over 10
Years
  Total  

    (dollars in thousands)  

Obligations of U.S. government agencies

    $ 5,333     $ 19,234     $ 24,765     $ 11,311     $ 60,643  

Mortgage backed securities

                               

U.S. government sponsored entities and agencies

    29,620     92,343     56,954     60,418     239,335  

Non-agency

    6,003     13,086     5,148         24,237  

State and municipal securities

    2,059     19,323     96,815     7,634     125,831  

Asset backed securities

        3,215     2,614     2,942     8,771  

Total available for sale securities

    $ 43,015     $ 147,201     $ 186,296     $ 82,305     $ 458,817  

Amortized cost

    $ 43,127     $ 147,891     $ 187,652     $ 83,743     $ 462,413  

Weighted average yield

    2.21%     2.23%     2.63%     2.88%     2.51%  

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, 2016 and 2015, the Company held approximately $7.9 million of FHLB stock.

Loans

Summary of Market Conditions

Total gross loans held for investment increased $138.2 million during 2016, with growth attributed to increases in commercial real estate, residential 1 to 4 family, farmland, commercial and industrial, and agriculture loans. Growth in these categories was partially offset by declines in construction and land, and home equity lines of credit, multi-family and consumer loans during 2016. The Company continued to focus on organic loan growth in our region with originations of new loans held for investment during 2016 totaling $288.6 million. Utilization on lines of credit contributed $63.1 million to loan growth during 2016. New loan production was partially offset by loan prepayments and payoffs of $156.9 million in addition to scheduled amortization of the portfolio.

Although local economic conditions within the region the Company operates have been relatively favorable over the last several years, 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 defined lending standards, and seeks to originate loans to borrowers that 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.

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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 6. 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, 2016, loans held for sale totaled $10.1 million compared to $9.8 million at December 31, 2015.

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The table below summarizes the composition of the loan portfolio as of December 31, 2016, 2015, 2014, 2013, and 2012:

 
  December 31,  
 
  2016   2015   2014   2013   2012  
 
  Balance   Percent   Balance   Percent   Balance   Percent   Balance   Percent   Balance   Percent  

    (dollars in thousands)  

Real Estate Secured

                                                             

Commercial

    $ 643,691     46.5%     $ 579,244     46.3%     $ 588,472     49.3%     $ 432,203     52.2%     $ 372,592     54.1%  

Residential 1 to 4 family

    205,999     14.9%     165,829     13.3%     127,201     10.7%     88,904     10.7%     41,444     6.0%  

Farmland

    155,771     11.2%     120,566     9.7%     98,373     8.2%     50,414     6.1%     25,642     3.7%  

Multi-family residential

    77,941     5.6%     79,381     6.4%     78,645     6.6%     31,140     3.8%     21,467     3.1%  

Home equity lines of credit

    24,796     1.8%     31,387     2.5%     38,252     3.2%     31,178     3.8%     31,863     4.6%  

Construction and land

    21,866     1.6%     35,669     2.9%     44,660     3.7%     38,222     4.6%     44,380     6.5%  

Total real estate secured

    1,130,064     81.6%     1,012,076     81.1%     975,603     81.7%     672,061     81.2%     537,388     78.0%  

Commercial

                                                             

Commercial and industrial

    182,637     13.2%     164,808     13.2%     154,787     13.0%     119,121     14.4%     125,340     18.2%  

Agriculture

    68,565     4.9%     64,363     5.2%     55,101     4.6%     32,686     4.0%     21,663     3.1%  

Other

        0.0%         0.0%     14     0.0%     38     0.0%     61     0.0%  

Total commercial

    251,202     18.1%     229,171     18.4%     209,902     17.6%     151,845     18.4%     147,064     21.3%  

Consumer

    4,196     0.3%     6,033     0.5%     7,978     0.7%     3,578     0.4%     5,156     0.7%  

Total loans held for investment

    1,385,462     100.0%     1,247,280     100.0%     1,193,483     100.0%     827,484     100.0%     689,608     100.0%  

Net deferred loan fees

    (1,183 )         (1,132 )         (1,445 )         (1,281 )         (937 )      

Allowance for loan and lease losses

    (17,237 )         (17,452 )         (16,802 )         (17,859 )         (18,118 )      

Total net loans held for investment

    $ 1,367,042           $ 1,228,696           $ 1,175,236           $ 808,344           $ 670,553        

Loans held for sale

    $ 10,055           $ 9,755           $ 2,586           $ 2,386           $ 22,549        

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, which is exclusive of construction and land loans, as of December 31, 2016:

 
  December 31, 2016    
   
   
   
   
 
 
  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)        

Other Real Estate Secured

                                                 

Residential 1 to 4 family

    $ 205,999     $ 1,060     $ 207,059     17.8%     101.5%     400     $ 4,500     $ 140,944  

Commercial

    168,398     3,565     171,963     14.8%     84.3%     194     9,250     76,696  

Farmland

    155,771     2,331     158,102     13.6%     77.5%     86     17,647     79,966  

Hotels

    143,081     5,687     148,768     12.8%     72.9%     53     14,772     4,172  

Professional

    118,360     231     118,591     10.2%     58.2%     123     11,500     30,761  

Retail

    90,996     1,140     92,136     7.9%     45.2%     108     5,724     41,759  

Multi-family

    77,941     2,430     80,371     6.9%     39.4%     57     9,000      

Healthcare / medical

    61,778     463     62,241     5.3%     30.5%     54     12,420     36,714  

Restaurants and other hospitality

    27,259     731     27,990     2.4%     13.7%     24     13,713     7,683  

Home equity lines of credit

    24,796     37,991     62,787     5.4%     30.8%     453     1,200     23,691  

Other

    33,819     307     34,126     2.9%     16.7%     42     4,749     26,729  

Total

    $ 1,108,198     $ 55,936     $ 1,164,134     100.0%     570.7%     1,594     $ 17,647     $ 469,115  
(1)
Amount reported reflects the original loan amount for the single largest loan that remains outstanding as of December 31, 2016.

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Table of Contents

At December 31, 2016, the other real estate secured segment of the loan portfolio represented approximately $1.1 billion, or 80.0%, of total gross loans. When compared to that reported at December 31, 2015, this represents an increase of approximately $131.8 million, or 13.5%. This increase is attributed to new loan production of commercial real estate, residential 1 to 4 family and farmland loans, slightly offset by decreases in home equity lines of credit and multi-family loans. At December 31, 2016, a total of $34.0 million of the other real estate secured portfolio, which excludes construction and land loans, was risk graded as special mention, substandard or doubtful, with the largest single component being the commercial real estate segment, which represented $30.3 million. At December 31, 2015, other real estate secured balances graded special mention, substandard or doubtful totaled $36.9 million, of which $33.6 million can be attributed to commercial real estate loans. Other real estate secured balances, including undisbursed commitments as a percentage of the Bank's total risk-based capital was 571% and 531% at December 31, 2016 and 2015, respectively. At December 31, 2016, approximately $469.1 million, or 42.3%, of the other real estate secured segment of the loan portfolio was considered owner occupied, compared to $440.8 million or 45.1% at December 31, 2015. At December 31, 2016, loans meeting the regulatory classification of non-owner occupied commercial real estate represented 268% of the Bank's total risk-based capital.

Construction and Land Loans

The following table provides a break-down of the Bank's construction and land portfolio as of December 31, 2016:

 
  December 31, 2016    
   
   
   
 
 
  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

    $ 12,345     $ 9,087     $ 21,432     45.5%     10.5%     20     $ 6,732  

Tract

    7,475     1,794     9,269     19.7%     4.5%     8     10,673  

Single family residential

    963         963     2.0%     0.5%     10     250  

Single family residential – Spec.

    916     2,915     3,831     8.1%     1.9%     8     1,750  

Multi-family

    167     11,458     11,625     24.7%     5.7%     3     11,458  

Total

    $ 21,866     $ 25,254     $ 47,120     100.0%     23.1%     49     $ 11,458  
(1)
Amount reported reflects the original loan amount for the single largest loan that remains outstanding as of December 31, 2016.

At December 31, 2016, the construction and land portfolio represented $21.9 million, or 1.6%, of total gross loans, a decrease of $13.8 million, or 38.7%, from that reported at December 31, 2015. 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. Total construction loans, including undisbursed commitments, as a percentage of the Bank's total risk-based capital was 23% and 29% at December 31, 2016 and 2015, respectively. At December 31, 2016 there were $3.3 million of construction and land balances risk graded special mention, substandard, or doubtful, compared to $5.2 million risk graded special mention, substandard or doubtful at December 31, 2015.

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Table of Contents

Commercial Loans

Commercial and Industrial

The following table provides a break-down of the commercial and industrial segment of the commercial loan portfolio as of December 31, 2016:

 
  December 31, 2016    
   
   
   
 
 
  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

                                           

Manufacturing

    $ 34,233     $ 14,140     $ 48,373     16.1%     23.7%     133     $ 5,000  

Professional services

    31,811     18,503     50,314     16.8%     24.6%     187     4,936  

Healthcare / medical

    22,111     16,780     38,891     12.9%     19.1%     120     10,162  

Construction

    17,142     31,875     49,017     16.3%     24.0%     144     5,000  

Wholesale and retail

    16,694     11,423     28,117     9.4%     13.8%     128     5,000  

Real estate / rental and leasing

    16,616     14,212     30,828     10.3%     15.1%     101     6,522  

Restaurants / hospitality

    13,544     3,497     17,041     5.7%     8.4%     68     5,000  

Media and information services

    8,132     940     9,072     3.0%     4.4%     20     4,936  

Transportation and warehousing

    4,620     513     5,133     1.7%     2.5%     59     465  

Financial services

    3,605     1,830     5,435     1.8%     2.7%     30     3,000  

Oil gas and utilities

    533     679     1,212     0.4%     0.6%     5     500  

All other

    13,596     3,299     16,894     5.6%     8.3%     241     2,342  

Total

    $ 182,637     $ 117,691     $ 300,327     100.0%     147.2%     1,236     $ 10,162  
(1)
Amount reported reflects the original loan amount for the single largest loan that remains outstanding as of December 31, 2016.

At December 31, 2016, commercial and industrial loans represented approximately $182.6 million, or 13.2%, of total gross loans. This represents an increase of $17.8 million, or 10.8% from December 31, 2015. Total commercial and industrial loans, including undisbursed commitments, as a percentage of the Bank's total risk-based capital was 147% and 142% at December 31, 2016 and 2015, respectively.

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, 2016, a total of $10.7 million of the commercial and industrial portfolio was risk graded as special mention, substandard or doubtful, compared to $11.8 million being risk graded special mention, substandard or doubtful as of December 31, 2015.

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Table of Contents

Agriculture

The following table provides a break-down of the agriculture segment of the Company's commercial loan portfolio as of December 31, 2016:

 
  December 31, 2016    
   
   
   
 
 
   
  Percent of
Total Risk
Based
Capital
   
   
 
 
  Balance   Undisbursed
Commitment
  Total Bank
Exposure
  Percent
Composition
  Number
of Loans
  Single
Largest
Loan (1)
 

    (dollars in thousands)  

Agriculture

                                           

Fruit and nut tree farming

    $ 31,749     $ 15,004     $ 46,753     46.0%     22.9%     43     $ 9,300  

Wholesale merchants

    13,015     2,471     15,486     15.2%     7.6%     9     8,000  

Vegetable and melon farming

    9,546     5,778     15,324     15.1%     7.5%     16     4,000  

Food and beverage

    3,798     2,581     6,379     6.3%     3.1%     19     1,500  

Other crop farming

    3,542     463     4,005     3.9%     2.0%     8     2,353  

Support activities for agriculture

    2,793     3,776     6,569     6.5%     3.2%     24     1,800  

Animal production

    1,718     2,754     4,472     4.4%     2.2%     35     600  

All other

    2,404     229     2,633     2.6%     1.3%     11     1,000  

Total

    $ 68,565     $ 33,056     $ 101,621     100.0%     49.8%     165     $ 9,300  
(1)
Amount reported reflects the original loan amount for the single largest loan that remains outstanding as of December 31, 2016.

At December 31, 2016, agriculture balances totaled approximately $68.6 million, or 4.9%, of total gross loans, which represents an increase of $4.2 million, or 6.5%, from December 31, 2015. Total agriculture loans, including undisbursed commitments, as a percentage of the Bank's total risk-based capital was 50% and 53% at December 31, 2016 and 2015, respectively. As of December 31, 2016, a total of $9.1 million of the agriculture portfolio was risk graded as special mention, substandard or doubtful, compared to $3.0 million of the agriculture portfolio being risk graded special mention, substandard or doubtful as of December 31, 2015.

Consumer

At December 31, 2016, the consumer loan portfolio totaled $4.2 million, compared to $6.0 million reported at December 31, 2015. 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, 2016  
 
  Due Less
Than
3 Months
  Due 3 To
12 Months
  Due After
1 Year
Through
3 Years
  Due After
3 Years
Through
5 Years
  Due After
5 Years
Through
7 Years
  Due After
7 Years
Through
10 Years
  Due After
10 Years
  Total