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



FORM 10-Q

(MARK ONE)    

ý

 

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

For the quarterly period ended September 30, 2013

OR

o

 

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

For the transition period from                        to                       

Commission file number 000-23877

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

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

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

 

95113
(Zip Code)

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

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

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

        Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    YES ý    NO o

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

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

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

        The Registrant had 26,345,329 shares of Common Stock outstanding on October 30, 2013.

   


Table of Contents


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

 
   
  Page No.

Cautionary Note on Forward-Looking Statements

  3


Part I. FINANCIAL INFORMATION


 

 


Item 1.


 


Consolidated Financial Statements (unaudited)


 


5



 


Consolidated Balance Sheets


 


5



 


Consolidated Statements of Income


 


6



 


Consolidated Statements of Comprehensive Income


 


7



 


Consolidated Statements of Changes in Shareholders' Equity


 


8



 


Consolidated Statements of Cash Flows


 


9



 


Notes to Consolidated Financial Statements


 


10


Item 2.


 


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


 


40


Item 3.


 


Quantitative and Qualitative Disclosures About Market Risk


 


77


Item 4.


 


Controls and Procedures


 


77


PART II. OTHER INFORMATION


 

 


Item 1.


 


Legal Proceedings


 


79


Item 1A.


 


Risk Factors


 


79


Item 2.


 


Unregistered Sales of Equity Securities and Use of Proceeds


 


79


Item 3.


 


Defaults Upon Senior Securities


 


79


Item 4.


 


Mine Safety Disclosures


 


79


Item 5.


 


Other Information


 


79


Item 6.


 


Exhibits


 


80


SIGNATURES


 


81


EXHIBIT INDEX


 


82

2


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Cautionary Note Regarding Forward-Looking Statements

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

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

3


Table of Contents

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

4


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Part I—FINANCIAL INFORMATION

ITEM 1—CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)


HERITAGE COMMERCE CORP

CONSOLIDATED BALANCE SHEETS (Unaudited)

 
  September 30,
2013
  December 31,
2012
 
 
  (Dollars in thousands)
 

Assets

             

Cash and due from banks

  $ 32,571   $ 16,520  

Interest-bearing deposits in other financial institutions

    9,327     357,045  
           

Total cash and cash equivalents

    41,898     373,565  

Securities available-for-sale, at fair value

    280,471     367,912  

Securities held-to-maturity, at amortized cost (fair value of $80,505 at September 30, 2013 and $50,964 at December 31, 2012)

    89,732     51,472  

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

    6,975     3,409  

Loans, net of deferred fees

    893,052     812,313  

Allowance for loan losses

    (19,342 )   (19,027 )
           

Loans, net

    873,710     793,286  

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

    10,792     10,728  

Company owned life insurance

    49,598     48,358  

Premises and equipment, net

    7,390     7,469  

Intangible assets

    1,645     2,000  

Accrued interest receivable and other assets

    38,424     35,113  
           

Total assets

  $ 1,400,635   $ 1,693,312  
           

Liabilities and Shareholders' Equity

             

Liabilities:

             

Deposits:

             

Demand, noninterest-bearing

  $ 409,269   $ 727,684  

Demand, interest-bearing

    178,783     155,951  

Savings and money market

    312,991     272,047  

Time deposits—under $100

    22,029     25,157  

Time deposits—$100 and over

    195,321     190,502  

Time deposits—brokered

    62,833     97,807  

CDARS—money market and time deposits

    14,311     10,220  
           

Total deposits

    1,195,537     1,479,368  

Subordinated debt

        9,279  

Accrued interest payable and other liabilities

    34,613     34,924  
           

Total liabilities

    1,230,150     1,523,571  

Shareholders' equity:

             

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

             

Series C convertible perpetual preferred stock, 21,004 shares issued and outstanding at September 30, 2013 and December 31, 2012 (liquidation preference of $21,004 at September 30, 2013 and December 31, 2012)           

    19,519     19,519  

Common stock, no par value; 60,000,000 shares authorized; 26,341,021 shares issued and outstanding at September 30, 2013 and 26,322,147 shares issued and outstanding at December 31, 2012

    132,298     131,820  

Retained earnings

    22,949     15,721  

Accumulated other comprehensive (loss) income

    (4,281 )   2,681  
           

Total shareholders' equity

    170,485     169,741  
           

Total liabilities and shareholders' equity

  $ 1,400,635   $ 1,693,312  
           

   

See notes to consolidated financial statements

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HERITAGE COMMERCE CORP

CONSOLIDATED STATEMENTS OF INCOME (Unaudited)

 
  Three Months Ended
September 30,
  Nine Months Ended
September 30,
 
 
  2013   2012   2013   2012  
 
  (Dollars in thousands, except per share data)
 

Interest income:

                         

Loans, including fees

  $ 10,733   $ 10,146   $ 30,874   $ 30,754  

Securities, taxable

    2,247     2,681     7,107     8,753  

Securities, non-taxable

    436     5     1,042     5  

Interest-bearing deposits in other financial institutions           

    42     30     140     95  
                   

Total interest income

    13,458     12,862     39,163     39,607  
                   

Interest expense:

                         

Deposits

    575     690     1,796     2,144  

Subordinated debt

    51     346     229     1,293  

Short-term borrowings

    1     2     1     3  
                   

Total interest expense

    627     1,038     2,026     3,440  
                   

Net interest income before provision for loan losses

    12,831     11,824     37,137     36,167  

Provision (credit) for loan losses

    (534 )   1,200     (804 )   2,115  
                   

Net interest income after provision for loan losses

    13,365     10,624     37,941     34,052  
                   

Noninterest income:

                         

Service charges and fees on deposit accounts

    645     575     1,840     1,766  

Increase in cash surrender value of life insurance

    414     434     1,240     1,292  

Servicing income

    331     429     1,081     1,336  

Gain on sales of SBA loans

    103     221     373     633  

Gain on sales of securities

        1,105     38     1,164  

Other

    245     184     744     570  
                   

Total noninterest income

    1,738     2,948     5,316     6,761  
                   

Noninterest expense:

                         

Salaries and employee benefits

    5,772     5,336     17,647     16,380  

Occupancy and equipment

    986     1,041     3,082     3,004  

Professional fees

    602     587     1,984     2,268  

Software subscriptions

    381     275     966     878  

Low income housing investment losses

    320     264     930     795  

Data processing

    259     252     838     744  

Insurance expense

    255     198     763     645  

FDIC deposit insurance premiums

    200     248     666     675  

Correspondent bank charges

    170     156     513     455  

Foreclosed assets, net

    8     9     (242 )   229  

Subordinated debt redemption charges

        601     167     601  

Other

    1,427     1,180     4,236     3,783  
                   

Total noninterest expense

    10,380     10,147     31,550     30,457  
                   

Income before income taxes

    4,723     3,425     11,707     10,356  

Income tax expense

    1,510     939     3,521     3,116  
                   

Net income

    3,213     2,486     8,186     7,240  

Dividends and discount accretion on preferred stock

                (1,206 )
                   

Net income available to common shareholders

  $ 3,213   $ 2,486   $ 8,186   $ 6,034  
                   

Earnings per common share:

                         

Basic

  $ 0.10   $ 0.08   $ 0.26   $ 0.19  

Diluted

  $ 0.10   $ 0.08   $ 0.26   $ 0.19  

Dividends per share

 
$

0.03
 
$

 
$

0.03
 
$

 

   

See notes to consolidated financial statements

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HERITAGE COMMERCE CORP

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)

 
  For the
Three Months Ended
September 30,
  For the
Nine Months Ended
September 30,
 
 
  2013   2012   2013   2012  
 
  (Dollars in thousands)
 

Net income

  $ 3,213   $ 2,486   $ 8,186   $ 7,240  

Other comprehensive income (loss):

                         

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

    675     3,045     (12,033 )   6,814  

Deferred income taxes

    (284 )   (1,279 )   5,053     (2,862 )

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

    (14 )   870     (42 )   870  

Deferred income taxes

    6     (365 )   18     (365 )

Reclassification adjustment for gains realized in income

        (1,105 )   (38 )   (1,164 )

Deferred income taxes

        464     16     489  
                   

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

    383     1,630     (7,026 )   3,782  
                   

Change in net pension and other benefit plan liability adjustment

    44     38     109     134  

Deferred income taxes

    (18 )   (16 )   (45 )   (56 )
                   

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

    26     22     64     78  
                   

Other comprehensive income (loss)

    409     1,652     (6,962 )   3,860  
                   

Total comprehensive income

  $ 3,622   $ 4,138   $ 1,224   $ 11,100  
                   

   

See notes to consolidated financial statements

7


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HERITAGE COMMERCE CORP

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (Unaudited)

 
  Nine Months Ended September 30, 2013 and 2012  
 
   
   
   
   
   
   
  Accumulated
Other
Comprehensive
Income/
(Loss)
   
 
 
  Preferred Stock   Common Stock    
   
 
 
  Retained
Earnings
  Total
Shareholders'
Equity
 
 
  Shares   Amount   Discount   Shares   Amount  
 
  (Dollars in thousands, except share data)
 

Balance, January 1, 2012

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

Net income

                        7,240         7,240  

Other comprehensive income

                            3,860     3,860  

Repurchase of Series A preferred stock

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

Series A preferred stock capitalized offering costs

        154                 (154 )        

Issuance (forfeitures) of restricted stock awards, net

                21,500                  

Amortization of restricted stock awards, net of forfeitures and taxes

                    86             86  

Cash dividends accrued on Series A preferred stock

                        (373 )       (373 )

Accretion of discount on Series A preferred stock

            833             (833 )        

Stock option expense, net of fortfeitures and taxes

                    340             340  

Stock options exercised

                3,683     17             17  
                                   

Balance, September 30, 2012

    21,004   $ 19,519   $     26,320,184   $ 131,615   $ 13,052   $ 4,815   $ 169,001  
                                   

Balance, January 1, 2013

   
21,004
 
$

19,519
 
$

   
26,322,147
 
$

131,820
 
$

15,721
 
$

2,681
 
$

169,741
 

Net income

                        8,186         8,186  

Other comprehensive loss

                            (6,962 )   (6,962 )

Issuance of restricted stock awards

                10,000                  

Repurchase of warrant

                    (140 )           (140 )

Amortization of restricted stock awards, net of forfeitures and taxes

                    153             153  

Stock option expense, net of forfeitures and taxes

                    430             430  

Cash dividend declared on common stock, $0.03 per share

                        (958 )       (958 )

Stock options exercised

                8,874     35             35  
                                   

Balance, September 30, 2013

    21,004   $ 19,519   $     26,341,021   $ 132,298   $ 22,949   $ (4,281 ) $ 170,485  
                                   

   

See notes to consolidated financial statements

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HERITAGE COMMERCE CORP

CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

 
  Nine Months Ended
September 30,
 
 
  2013   2012  
 
  (Dollars in thousands)
 

CASH FLOWS FROM OPERATING ACTIVITIES:

             

Net income

  $ 8,186   $ 7,240  

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

             

Amortization of discounts and premiums on securities

    1,894     1,781  

Gain on sales of securities available-for-sale

    (38 )   (1,164 )

Gain on sales of SBA loans

    (373 )   (633 )

Proceeds from sale of SBA loans originated for sale

    5,128     8,792  

Net change in SBA loans originated for sale

    (8,341 )   (8,882 )

Write-downs on other loans held-for-sale

        87  

Provision (credit) for loan losses

    (804 )   2,115  

Increase in cash surrender value of life insurance

    (1,240 )   (1,292 )

Depreciation and amortization

    539     569  

Amortization of intangible assets

    355     368  

Gains on sale of foreclosed assets, net

    (231 )   (135 )

Stock option expense, net

    430     340  

Amortization of restricted stock awards, net

    153     86  

Effect of changes in:

             

Accrued interest receivable and other assets

    999     1,871  

Accrued interest payable and other liabilities

    1,395     481  
           

Net cash provided by operating activities

    8,052     11,624  
           

CASH FLOWS FROM INVESTING ACTIVITIES:

             

Purchase of securities available-for-sale

    (8,334 )   (148,107 )

Purchase of securities held-to-maturity

    (43,324 )   (6,821 )

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

    55,206     82,766  

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

    3,310      

Proceeds from sale of securities available-for-sale

    26,944     26,357  

Net change in loans

    (79,633 )   (40,360 )

Change in Federal Home Loan Bank and Federal Reserve Bank stock

    (64 )   (976 )

Purchase of premises and equipment

    (460 )   (216 )

Proceeds from sale of foreclosed assets

    809     574  

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

        220  

Purchases of company owned life insurance

        (249 )
           

Net cash used in investing activities

    (45,546 )   (86,812 )
           

CASH FLOWS FROM FINANCING ACTIVITIES:

             

Net change in deposits

    (283,831 )   88,605  

Repurchase of warrant

    (140 )    

Repayment of preferred stock

        (40,000 )

Redemption of subordinated debt

    (9,279 )   (14,423 )

Payment of cash dividends—Series A preferred stock

        (373 )

Payment of cash dividends—common stock

    (958 )    

Exercise of stock options

    35     17  
           

Net cash provided by (used in) financing activities

    (294,173 )   33,826  
           

Net decrease in cash and cash equivalents

    (331,667 )   (41,362 )

Cash and cash equivalents, beginning of period

    373,565     72,872  
           

Cash and cash equivalents, end of period

  $ 41,898   $ 31,510  
           

Supplemental disclosures of cash flow information:

             

Interest paid

  $ 2,110   $ 3,927  

Income taxes paid

    3,365     2,230  

Supplemental schedule of non-cash investing activity:

             

Due to broker for securities purchased

  $ 1,901   $ 9,353  

Loans transferred to foreclosed assets

    33     1,973  

Transfer securities from available-for-sale to held-to-maturity

        15,498  

Transfer of loans held-for-sale to loan portfolio

    20     87  

   

See notes to consolidated financial statements

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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2013

(Unaudited)

1) Basis of Presentation

        The unaudited consolidated financial statements of Heritage Commerce Corp (the "Company" or "HCC") and its wholly owned subsidiary, Heritage Bank of Commerce (the "Bank" or "HBC"), have been prepared pursuant to the rules and regulations for reporting on Form 10-Q. Accordingly, certain information and notes required by accounting principles generally accepted in the United States of America ("GAAP") for annual financial statements are not included herein. The interim statements should be read in conjunction with the consolidated financial statements and notes that were included in the Company's Form 10-K for the year ended December 31, 2012. The Company also established the following unconsolidated subsidiary grantor trusts: Heritage Capital Trust I; Heritage Statutory Trust I; Heritage Statutory Trust II; and Heritage Commerce Corp Statutory Trust III, which were Delaware Statutory business trusts formed for the exclusive purpose of issuing and selling trust preferred securities. During the third quarter of 2012 the Company dissolved the Heritage Statutory Trust I and the Heritage Capital Trust I. During the third quarter of 2013 the Company dissolved the Heritage Statutory Trust II and the Heritage Commerce Corp Statutory Trust III.

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

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

        The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ significantly from these estimates.

        The results for the three and nine months ended September 30, 2013 are not necessarily indicative of the results expected for any subsequent period or for the entire year ending December 31, 2013.

Reclassifications

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

Adoption of New Accounting Standards

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

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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

September 30, 2013

(Unaudited)

1) Basis of Presentation (Continued)

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

2) Earnings Per Share

        Basic earnings per common share is computed by dividing net income, less dividends and discount accretion on preferred stock, by the weighted average common shares outstanding. On June 21, 2010, the Company issued to various institutional investors 21,004 shares of Series C Convertible Perpetual Preferred Stock ("Series C Preferred Stock"). The Series C Preferred Stock is convertible into 5,601,000 shares of common stock when transferred in accordance with its terms. The Series C Preferred Stock participate in the earnings of the Company and, therefore, the shares issued on the conversion of the Series C Preferred Stock are considered outstanding under the two-class method of computing basic earnings per common share during periods of earnings. Diluted earnings per share reflect potential dilution from outstanding stock options and common stock warrant, using the treasury stock method. The common stock warrant was antidilutive for the nine months ended September 30, 2013 and for the three months and nine months ended September 30, 2012. The Company repurchased the warrant for $140,000 in the second quarter of 2013. A reconciliation of these factors used in computing basic and diluted earnings per common share is as follows:

 
  For the Three Months Ended September 30,   For the Nine Months Ended September 30,  
 
  2013   2012   2013   2012  
 
  (Dollars in thousands)
 

Net income available to common shareholders

  $ 3,213   $ 2,486   $ 8,186   $ 6,034  

Less: net income allocated to Series C Preferred Stock

    563     436     1,436     1,059  
                   

Net income allocated to common shareholders

  $ 2,650   $ 2,050   $ 6,750   $ 4,975  
                   

Weighted average common shares outstanding for basic earnings per common share

    26,340,080     26,312,263     26,335,222     26,297,359  

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

    46,969     30,776     46,742     27,096  
                   

Shares used in computing diluted earnings per common share

    26,387,049     26,343,039     26,381,965     26,324,455  
                   

Basic earnings per share

  $ 0.10   $ 0.08   $ 0.26   $ 0.19  

Diluted earnings per share

  $ 0.10   $ 0.08   $ 0.26   $ 0.19  

11


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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

September 30, 2013

(Unaudited)

3) Accumulated Other Comprehensive Income ("AOCI")

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

 
  For the Three Months Ended September 30, 2013 and 2012  
 
  Unrealized
Gains
(Losses) on
Available-
for-Sale
Securities
and I/O
Strips(1)
  Unamortized
Unrealized
Gain on
Available-
for-Sale
Securities
Reclassified
to Held-to-
Maturity(1)
  Defined
Benefit
Pension
Plan
Items(1)
  Total(1)  
 
  (Dollars in thousands)
 

Beginning balance July 1, 2013, net of taxes

  $ 494   $ 481   $ (5,665 ) $ (4,690 )

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

   
391
   
   
(16

)
 
375
 

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

        (8 )   42     34  
                   

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

    391     (8 )   26     409  
                   

Ending balance September 30, 2013, net of taxes

  $ 885   $ 473   $ (5,639 ) $ (4,281 )
                   

Beginning balance July 1, 2012, net of taxes

 
$

8,362
 
$

 
$

(5,199

)

$

3,163
 

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

   
1,766
   
   
(19

)
 
1,747
 

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

    (641 )   505     41     (95 )
                   

Net current period other comprensive income, net of taxes

    1,125     505     22     1,652  
                   

Ending balance September 30, 2012, net of taxes

  $ 9,487   $ 505   $ (5,177 ) $ 4,815  
                   

(1)
Amounts in parenthesis indicate debits.

12


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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

September 30, 2013

(Unaudited)

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

 
  For the Nine Months Ended September 30, 2013 and 2012  
 
  Unrealized
Gains
(Losses) on
Available-
for-Sale
Securities
and I/O
Strips(1)
  Unamortized
Unrealized
Gain on
Available-
for-Sale
Securities
Reclassified
to Held-to-
Maturity(1)
  Defined
Benefit
Pension
Plan
Items(1)
  Total(1)  
 
  (Dollars in thousands)
 

Beginning balance January 1, 2013, net of taxes

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

Other comprehensive (loss) before reclassification, net of taxes

   
(6,980

)
 
   
(63

)
 
(7,043

)

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

    (22 )   (24 )   127     81  
                   

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

    (7,002 )   (24 )   64     (6,962 )
                   

Ending balance September 30, 2013, net of taxes

  $ 885   $ 473   $ (5,639 ) $ (4,281 )
                   

Beginning balance January 1, 2012, net of taxes

 
$

6,210
 
$

 
$

(5,255

)

$

955
 

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

   
3,952
   
   
(44

)
 
3,908
 

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

    (675 )   505     122     (48 )
                   

Net current period other comprensive income, net of taxes

    3,277     505     78     3,860  
                   

Ending balance September 30, 2012, net of taxes

  $ 9,487   $ 505   $ (5,177 ) $ 4,815  
                   

(1)
Amounts in parenthesis indicate debits.

13


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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

September 30, 2013

(Unaudited)

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

 
  Amounts
Reclassified
from AOCI(1)
For the Three
Months Ended
September 30,
   
 
  Affected Line Item Where
Net Income is Presented
Details About AOCI Components
  2013   2012
 
  (Dollars in thousands)
   

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

  $   $ 1,105   Realized gains on sale of securities

        (464 ) Income tax expense
             

        641   Net of tax
             

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

    14     (870 ) Interest income on taxable securities

    (6 )   365   Income tax expense
             

    8     (505 ) Net of tax
             

Amortization of defined benefit pension plan items(2)

               

Prior service cost

        (7 )  

Actuarial losses

    (73 )   (63 )  
             

    (73 )   (70 ) Income before income tax

    31     29   Income tax expense
             

    (42 )   (41 ) Net of tax
             

Total reclassification for the period

  $ (34 ) $ 95    
             

(1)
Amounts in parenthesis indicate debits.

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

14


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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

September 30, 2013

(Unaudited)

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

 
  Amounts
Reclassified
from AOCI(1)
For the Nine
Months Ended
September 30,
   
 
  Affected Line Item Where
Net Income is Presented
Details About AOCI Components
  2013   2012
 
  (Dollars in thousands)
   

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

  $ 38   $ 1,164   Realized gains on sale of securities

    (16 )   (489 ) Income tax expense
             

    22     675   Net of tax
             

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

    42     (870 ) Interest income on taxable securities

    (18 )   365   Income tax expense
             

    24     (505 ) Net of tax
             

Amortization of defined benefit pension plan items(2)

               

Prior service cost

        (21 )  

Actuarial losses

    (219 )   (189 )  
             

    (219 )   (210 ) Income before income tax

    92     88   Income tax expense
             

    (127 )   (122 ) Net of tax
             

Total reclassification for the period

  $ (81 ) $ 48    
             

(1)
Amounts in parenthesis indicate debits.

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

15


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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

September 30, 2013

(Unaudited)

4) Securities

        The amortized cost and estimated fair value of securities at September 30, 2013 and December 31, 2012 were as follows:

September 30, 2013
  Amortized
Cost
  Gross
Unrealized
Gains
  Gross
Unrealized
Losses
  Estimated
Fair
Value
 
 
  (Dollars in thousands)
 

Securities available-for-sale:

                         

Agency mortgage-backed securities

  $ 210,728   $ 4,193   $ (2,407 ) $ 212,514  

Corporate bonds

    49,040     446     (1,739 )   47,747  

Trust preferred securities

    20,829     75     (694 )   20,210  
                   

Total

  $ 280,597   $ 4,714   $ (4,840 ) $ 280,471  
                   

Securities held-to-maturity:

                         

Agency mortgage-backed securities

  $ 13,229   $   $ (316 ) $ 12,913  

Municipals—tax exempt

    76,503     82     (8,993 )   67,592  
                   

Total

  $ 89,732   $ 82   $ (9,309 ) $ 80,505  
                   

 

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

Securities available-for-sale:

                         

Agency mortgage-backed securities

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

Corporate bonds

    53,739     1,849         55,588  

Trust preferred securities

    20,769     375     (64 )   21,080  
                   

Total

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

Securities held-to-maturity:

                         

Agency mortgage-backed securities

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

Municipals—tax exempt

    34,813     80     (413 )   34,480  
                   

Total

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

16


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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

September 30, 2013

(Unaudited)

4) Securities (Continued)

        Securities with unrealized losses at September 30, 2013 and December 31, 2012, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, are as follows:

 
  Less Than 12 Months   12 Months or More   Total  
September 30, 2013
  Fair
Value
  Unrealized
Losses
  Fair
Value
  Unrealized
Losses
  Fair
Value
  Unrealized
Losses
 
 
  (Dollars in thousands)
 

Securities available-for-sale:

                                     

Agency mortgage-backed securities

  $ 62,034   $ (2,254 ) $ 2,731   $ (153 ) $ 64,765   $ (2,407 )

Corporate bonds

    35,744     (1,739 )           35,744     (1,739 )

Trust preferred securities

    14,306     (694 )           14,306     (694 )
                           

Total

  $ 112,084   $ (4,687 ) $ 2,731   $ (153 ) $ 114,815   $ (4,840 )
                           

Securities held-to-maturity:

                                     

Agency mortgage-backed securities

  $ 4,380   $ (145 ) $ 8,213   $ (172 ) $ 12,593   $ (317 )

Municipals—Tax Exempt

    59,680     (8,992 )           59,680     (8,992 )
                           

Total

  $ 64,060   $ (9,137 ) $ 8,213   $ (172 ) $ 72,273   $ (9,309 )
                           

 

 
  Less Than 12 Months   12 Months or More   Total  
December 31, 2012
  Fair
Value
  Unrealized
Losses
  Fair
Value
  Unrealized
Losses
  Fair
Value
  Unrealized
Losses
 
 
  (Dollars in thousands)
 

Securities available-for-sale:

                                     

Agency mortgage-backed securities

  $ 6,226   $ (22 ) $   $   $ 6,226   $ (22 )

Trust preferred securities

    5,705     (64 )           5,705     (64 )
                           

Total

  $ 11,931   $ (86 ) $   $   $ 11,931   $ (86 )
                           

Securities held-to-maturity:

                                     

Agency mortgage-backed securities

  $ 15,789   $ (177 ) $   $   $ 15,789   $ (177 )

Municipals—Tax Exempt

    21,985     (413 )           21,985     (413 )
                           

Total

  $ 37,774   $ (590 ) $   $   $ 37,774   $ (590 )
                           

        There were no holdings of securities of any one issuer, other than the U.S. Government and its sponsored entities, in an amount greater than 10% of shareholders' equity. At September 30, 2013, the Company held 380 securities (160 available for sale and 220 held to maturity), of which 237 had fair values below amortized cost. Unrealized losses were due to higher interest rates. At September 30, 2013, there were $2.7 million of agency mortgage-backed securities available-for-sale, and $8.2 million of agency mortgage-backed securities held-to-maturity carried with an unrealized loss for over 12 months. The total unrealized loss for securities over 12 months was $325,000 at September 30, 2013. The issuers are of high credit quality and all principal amounts are expected to be paid when securities mature. The Company does not consider these securities to be other than temporarily impaired at September 30, 2013.

17


Table of Contents


HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

September 30, 2013

(Unaudited)

4) Securities (Continued)

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

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

 
  Three Months Ended
September 30,
  Nine Months Ended
September 30,
 
 
  2013   2012   2013   2012  
 
  (Dollars in thousands)
 

Proceeds

  $   $ 24,077   $ 26,944   $ 26,357  

Gross gains

        1,105     310     1,164  

Gross losses

            (272 )    

        The amortized cost and estimated fair values of securities as of September 30, 2013, by contractual maturity, are shown below. The expected maturities will differ from contractual maturities if borrowers have the right to call or pre-pay obligations with or without call or pre-payment penalties. Securities not due at a single maturity date are shown separately.

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

Due after one through five years

  $ 2,028   $ 2,124  

Due after five through ten years

    47,012     45,623  

Due after ten years

    20,829     20,210  

Agency mortgage-backed securities

    210,728     212,514  
           

Total

  $ 280,597   $ 280,471  
           

 

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

Due after five through ten years

  $ 2,751   $ 2,658  

Due after ten years

    73,752     64,935  

Agency mortgage-backed securities

    13,229     12,912  
           

Total

  $ 89,732   $ 80,505  
           

18


Table of Contents


HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

September 30, 2013

(Unaudited)

5) Loans

        Loans were as follows:

 
  September 30,
2013
  December 31,
2012
 
 
  (Dollars in thousands)
 

Loans held-for-investment:

             

Commercial

  $ 410,933   $ 375,469  

Real estate:

             

Commercial and residential

    387,777     354,934  

Land and construction

    30,780     22,352  

Home equity

    50,100     43,865  

Consumer

    13,712     15,714  
           

Loans

    893,302     812,334  

Deferred loan origination fees, net

    (250 )   (21 )
           

Loans, net of deferred fees

    893,052     812,313  

Allowance for loan losses

    (19,342 )   (19,027 )
           

Loans, net

  $ 873,710   $ 793,286  
           

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

 
  Three Months Ended September 30, 2013  
 
  Commercial   Real Estate   Consumer   Total  
 
  (Dollars in thousands)
 

Balance, beginning of period

  $ 12,811   $ 6,388   $ 143   $ 19,342  

Charge-offs

    (254 )   (40 )       (294 )

Recoveries

    820     7     1     828  
                   

Net (charge-offs)/recoveries

    566     (33 )   1     534  

Provision (credit) for loan losses

    (10 )   (461 )   (63 )   (534 )
                   

Balance, end of period

  $ 13,367   $ 5,894   $ 81   $ 19,342  
                   

 

 
  Three Months Ended September 30, 2012  
 
  Commercial   Real Estate   Consumer   Total  
 
  (Dollars in thousands)
 

Balance, beginning of period

  $ 13,378   $ 6,539   $ 106   $ 20,023  

Charge-offs

    (916 )   (1,334 )       (2,250 )

Recoveries

    149     2         151  
                   

Net (charge-offs)/recoveries

    (767 )   (1,332 )       (2,099 )

Provision (credit) for loan losses

    661     525     14     1,200  
                   

Balance, end of period

  $ 13,272   $ 5,732   $ 120   $ 19,124  
                   

19


Table of Contents


HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

September 30, 2013

(Unaudited)

5) Loans (Continued)


 
  Nine Months Ended September 30, 2013  
 
  Commercial   Real Estate   Consumer   Total  
 
  (Dollars in thousands)
 

Balance, beginning of period

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

Charge-offs

    (1,213 )   (96 )       (1,309 )

Recoveries

    2,158     269     1     2,428  
                   

Net (charge-offs)/recoveries

    945     173     1     1,119  

Provision (credit) for loan losses

    (444 )   (313 )   (47 )   (804 )
                   

Balance, end of period

  $ 13,367   $ 5,894   $ 81   $ 19,342  
                   

 

 
  Nine Months Ended September 30, 2012  
 
  Commercial   Real Estate   Consumer   Total  
 
  (Dollars in thousands)
 

Balance, beginning of period

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

Charge-offs

    (3,106 )   (1,480 )       (4,586 )

Recoveries

    670     225         895  
                   

Net (charge-offs)/recoveries

    (2,436 )   (1,255 )       (3,691 )

Provision (credit) for loan losses

    2,493     (351 )   (27 )   2,115  
                   

Balance, end of period

  $ 13,272   $ 5,732   $ 120   $ 19,124  
                   

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

 
  September 30, 2013  
 
  Commercial   Real Estate   Consumer   Total  
 
  (Dollars in thousands)
 

Allowance for loan losses:

                         

Ending allowance balance attributable to loans:

                         

Individually evaluated for impairment

  $ 2,426   $ 827   $ 25   $ 3,278  

Collectively evaluated for impairment

    10,941     5,067     56     16,064  
                   

Total allowance balance

  $ 13,367   $ 5,894   $ 81   $ 19,342  
                   

Loans:

                         

Individually evaluated for impairment

  $ 5,736   $ 9,259   $ 132   $ 15,127  

Collectively evaluated for impairment

    405,197     459,398     13,580     878,175  
                   

Total loan balance

  $ 410,933   $ 468,657   $ 13,712   $ 893,302  
                   

20


Table of Contents


HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

September 30, 2013

(Unaudited)

5) Loans (Continued)

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

Allowance for loan losses:

                         

Ending allowance balance attributable to loans:

                         

Individually evaluated for impairment

  $ 1,963   $ 760   $ 17   $ 2,740  

Collectively evaluated for impairment

    10,903     5,274     110     16,287  
                   

Total allowance balance

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

Loans:

                         

Individually evaluated for impairment

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

Collectively evaluated for impairment

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

Total loan balance

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

        The following table presents loans held-for-investment individually evaluated for impairment by class of loans as of September 30, 2013 and December 31, 2012. The recorded investment included in the following table represents loan principal net of any partial charge-offs recognized on the loans. The unpaid principal balance represents the recorded balance prior to any partial charge-offs.

 
  September 30, 2013   December 31, 2012  
 
  Unpaid
Principal
Balance
  Recorded
Investment
  Allowance
for Loan
Losses
Allocated
  Unpaid
Principal
Balance
  Recorded
Investment
  Allowance
for Loan
Losses
Allocated
 
 
  (Dollars in thousands)
 

With no related allowance recorded:

                                     

Commercial

  $ 682   $ 598   $   $ 7,829   $ 6,978   $  

Real estate:

                                     

Commercial and residential

    3,452     3,452         2,755     2,741      

Land and construction

    1,794     1,794         2,310     2,223      

Home Equity

    2,059     2,059         2,141     2,141      
                           

Total with no related allowance recorded

    7,987     7,903         15,035     14,083      

With an allowance recorded:

                                     

Commercial

    5,207     5,138     2,426     3,678     3,182     1,963  

Real estate:

                                     

Commercial and residential

    1,543     1,543     463     3,183     1,937     465  

Land and construction

    55     55     8              

Home Equity

    356     356     356     295     295     295  

Consumer

    132     132     25     147     147     17  
                           

Total with an allowance recorded

    7,293     7,224     3,278     7,303     5,561     2,740  
                           

Total

  $ 15,280   $ 15,127   $ 3,278   $ 22,338   $ 19,644   $ 2,740  
                           

21


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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

September 30, 2013

(Unaudited)

5) Loans (Continued)

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

 
  Three Months Ended September 30, 2013  
 
   
  Real Estate    
   
 
 
  Commercial   Commercial and
Residential
  Land and
Construction
  Home
Equity
  Consumer   Total  
 
  (Dollars in thousands)
 

Average of impaired loans during the period

  $ 5,539   $ 5,032   $ 1,989   $ 2,393   $ 133   $ 15,086  

Interest income during impairment

  $   $   $   $   $   $  

Cash-basis interest earned

  $   $   $   $   $   $  

 

 
  Three Months Ended September 30, 2012  
 
   
  Real Estate    
   
 
 
  Commercial   Commercial and
Residential
  Land and
Construction
  Home
Equity
  Consumer   Total  
 
  (Dollars in thousands)
 

Average of impaired loans during the period

  $ 11,138   $ 3,329   $ 2,228   $ 546   $ 156   $ 17,397  

Interest income during impairment

  $   $   $   $   $   $  

Cash-basis interest earned

  $   $   $   $   $   $  

 

 
  Nine Months Ended September 30, 2013  
 
   
  Real Estate    
   
 
 
  Commercial   Commercial and
Residential
  Land and
Construction
  Home
Equity
  Consumer   Total  
 
  (Dollars in thousands)
 

Average of impaired loans during the period

  $ 7,342   $ 5,061   $ 2,095   $ 2,414   $ 138   $ 17,050  

Interest income during impairment

  $   $   $   $   $   $  

Cash-basis interest earned

  $   $   $   $   $   $  

 

 
  Nine Months Ended September 30, 2012  
 
   
  Real Estate    
   
 
 
  Commercial   Commercial and
Residential
  Land and
Construction
  Home
Equity
  Consumer   Total  
 
  (Dollars in thousands)
 

Average of impaired loans during the period

  $ 11,294   $ 3,051   $ 2,615   $ 281   $ 83   $ 17,324  

Interest income during impairment

  $   $ 1   $ 14   $   $   $ 15  

Cash-basis interest earned

  $   $ 1   $ 14   $   $   $ 15  

22


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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

September 30, 2013

(Unaudited)

5) Loans (Continued)

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

 
  September 30,    
 
 
  December 31,
2012
 
 
  2013   2012  
 
  (Dollars in thousands)
 

Nonaccrual loans—held-for-investment

  $ 14,615   $ 17,396   $ 17,335  

Restructured and loans over 90 days past due and still accruing

    502     1,722     859  
               

Total nonperforming loans

  $ 15,117   $ 19,118   $ 18,194  
               

Other restructured loans

 
$

10
 
$

704
 
$

1,450
 

Impaired loans, excluding loans held-for-sale

  $ 15,127   $ 19,822   $ 19,644  

        The following table presents the nonperforming loans by class as of September 30, 2013 and December 31, 2012:

 
  September 30, 2013   December 31, 2012  
 
  Nonaccrual   Restructured and
Loans Over
90 Days
Past Due and
Still Accruing
  Total   Nonaccrual   Restructured and
Loans Over
90 Days
Past Due and
Still Accruing
  Total  
 
  (Dollars in thousands)
 

Commercial

  $ 5,224   $ 502   $ 5,726   $ 7,852   $ 859   $ 8,711  

Real estate:

                                     

Commercial and residential

    4,995         4,995     4,676         4,676  

Land and construction

    1,849         1,849     2,223         2,223  

Home equity

    2,415         2,415     2,437         2,437  

Consumer

    132         132     147         147  
                           

Total

  $ 14,615   $ 502   $ 15,117   $ 17,335   $ 859   $ 18,194  
                           

23


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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

September 30, 2013

(Unaudited)

5) Loans (Continued)

        The following table presents the aging of past due loans as of September 30, 2013 by class of loans:

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

Commercial

  $ 1,098   $ 716   $ 2,690   $ 4,504   $ 406,429   $ 410,933  

Real estate:

                                     

Commercial and residential

    134         1,548     1,682     386,095     387,777  

Land and construction

            55     55     30,725     30,780  

Home equity

            447     447     49,653     50,100  

Consumer

              97     97     13,615     13,712  
                           

Total

  $ 1,232   $ 716   $ 4,837   $ 6,785   $ 886,517   $ 893,302  
                           

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

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

Commercial

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

Real estate:

                                     

Commercial and residential

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

Land and construction

            78     78     22,274     22,352  

Home equity

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

Consumer

                    15,714     15,714  
                           

Total

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

        Past due loans 30 days or greater totaled $6,785,000 and $14,932,000 at September 30, 2013 and December 31, 2012, respectively, of which $5,603,000 and $12,020,000 were on nonaccrual. At September 30, 2013, there were also $9,012,000 loans less than 30 days past due included in nonaccrual loans held-for-investment. At December 31, 2012, there were also $5,315,000 loans less than 30 days past due included in nonaccrual loans held-for-investment. Management's classification of a loan as "nonaccrual" is an indication that there is reasonable doubt as to the full recovery of principal or interest on the loan. At that point, the Company stops accruing interest income, and reverses any uncollected interest that had been accrued as income. The Company begins recognizing interest income only as cash interest payments are received and it has been determined the collection of all outstanding principal is not in doubt. The loans may or may not be collateralized, and collection efforts are pursued.

24


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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

September 30, 2013

(Unaudited)

5) Loans (Continued)

Credit Quality Indicators

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

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

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

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

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

        Loss.    Loans classified as loss are considered uncollectable or of so little value that their continuance as assets is not warranted. This classification does not necessarily mean that a loan has no recovery or salvage value; but rather, there is much doubt about whether, how much, or when the recovery would occur. Loans classified as loss are immediately charged off against the allowance for loan losses. Therefore, there is no balance to report at September 30, 2013 or December 31, 2012.

25


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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

September 30, 2013

(Unaudited)

5) Loans (Continued)

        The following table provides a summary of the loan portfolio by loan type and credit quality classification at September 30, 2013 and December 31, 2012:

 
  September 30, 2013   December 31, 2012  
 
  Nonclassified   Classified   Total   Nonclassified   Classified   Total  
 
  (Dollars in thousands)
 

Commercial

  $ 396,102   $ 14,831   $ 410,933   $ 355,440   $ 20,029   $ 375,469  

Real estate:

                                     

Commercial and residential

    380,470     7,307     387,777     345,045     9,889     354,934  

Land and construction

    28,931     1,849     30,780     18,858     3,494     22,352  

Home equity

    47,364     2,736     50,100     41,187     2,678     43,865  

Consumer

    13,354     358     13,712     15,321     393     15,714  
                           

Total

  $ 866,221   $ 27,081   $ 893,302   $ 775,851   $ 36,483   $ 812,334  
                           

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

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

        The recorded investment of troubled debt restructurings at September 30, 2013 was $2,045,000, which included $1,534,000 of nonaccrual loans and $511,000 of accruing loans. The book balance of troubled debt restructurings at December 31, 2012 was $4,107,000, which included $1,798,000 of nonaccrual loans and $2,309,000 of accruing loans. Approximately $722,000 and $1,152,000 in specific reserves were established with respect to these loans as of September 30, 2013 and December 31, 2012, respectively. As of September 30, 2013 and December 31, 2012, the Company had no additional amounts committed on any loan classified as a troubled debt restructuring.

        There were no new loans modified as troubled debt restructurings during the three month period ended September 30, 2013. The following table presents loans by class modified as troubled debt restructurings during the three month period ended September 30, 2012:

 
  During the Three Months Ended
September 30, 2012
 
Troubled Debt Restructurings:
  Number
of
Contracts
  Pre-modification
Outstanding
Recorded
Investment
  Post-modification
Outstanding
Recorded
Investment
 
 
  (Dollars in thousands)
 

Consumer

    2   $ 91   $ 91  
               

Total

    2   $ 91   $ 91  
               

26


Table of Contents


HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

September 30, 2013

(Unaudited)

5) Loans (Continued)

        The troubled debt restructurings described above increased the allowance for loan losses by $21,000 through the allocation of specific reserves, and resulted in no net charge-offs during the three month period ended September 30, 2012.

        There were no new loans modified as troubled debt restructurings during the nine month period ended September 30, 2013. The following table presents loans by class modified as troubled debt restructurings during the nine month period ended September 30, 2012:

 
  During the Nine Months Ended
September 30, 2012
 
Troubled Debt Restructurings:
  Number
of
Contracts
  Pre-modification
Outstanding
Recorded
Investment
  Post-modification
Outstanding
Recorded
Investment
 
 
  (Dollars in thousands)
 

Commercial

    3   $ 163   $ 163  

Consumer

    1     111     111  
               

Total

    4   $ 274   $ 274  
               

        The troubled debt restructurings described above increased the allowance for loan losses by $59,000 through the allocation of specific reserves, and resulted in no net charge-offs during the nine month period ended September 30, 2012.

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

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

6) Income Taxes

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

        Realization of the Company's deferred tax assets is primarily dependent upon the Company generating sufficient taxable income to obtain benefit from the reversal of net deductible temporary differences and utilization of tax credit carryforwards and the net operating loss carryforwards for Federal and California state income tax purposes. The amount of deferred tax assets considered realizable is subject to adjustment in future periods based on estimates of future taxable income. Under generally accepted accounting principles, a valuation allowance is required to be recognized if it is "more likely than not" that a deferred tax asset will not be realized. The determination of the

27


Table of Contents


HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

September 30, 2013

(Unaudited)

6) Income Taxes (Continued)

realizability of the deferred tax assets is highly subjective and dependent upon judgment concerning management's evaluation of both positive and negative evidence, including forecasts of future income, cumulative losses, applicable tax planning strategies, and assessments of current and future economic and business conditions.

        The Company had net deferred tax assets of $23,673,000, and $19,264,000, at September 30, 2013, and December 31, 2012, respectively. After consideration of the matters in the preceding paragraph, the Company determined that it is more likely than not that the net deferred tax asset at September 30, 2013 and December 31, 2012 will be fully realized in future years.

7) Benefit Plans

Supplemental Retirement Plan

        The Company has a supplemental retirement plan (the "Plan") covering current and former key executives and directors. The Plan is a nonqualified defined benefit plan. Benefits are unsecured as there are no Plan assets. The following table presents the amount of periodic cost recognized for the periods indicated:

 
  Three Months Ended
September 30,
  Nine Months Ended
September 30,
 
 
  2013   2012   2013   2012  
 
  (Dollars in thousands)
 

Components of net periodic benefit cost:

                         

Service cost

  $ 303   $ 294   $ 909   $ 882  

Interest cost

    196     193     588     579  

Amortization of prior service cost

        7         21  

Amortization of net actuarial loss

    73     63     219     189  
                   

Net periodic benefit cost

  $ 572   $ 557   $ 1,716   $ 1,671  
                   

Split-Dollar Life Insurance Benefit Plan

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

 
  September 30, 2013   December 31, 2012  
 
  (Dollars in thousands)
 

Change in projected benefit obligation

             

Projected benefit obligation at beginning of year

  $ 4,717   $ 4,525  

Interest cost

    133     185  

Actuarial gain

        7  
           

Projected benefit obligation at end of period

  $ 4,850   $ 4,717  
           

28


Table of Contents


HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

September 30, 2013

(Unaudited)

8) Preferred Stock

Series A Preferred Stock

        On November 21, 2008, the Company issued 40,000 shares of Series A Fixed Rate Cumulative Perpetual Preferred Stock ("Series A Preferred Stock") to the U.S. Treasury under the terms of the U.S. Treasury Capital Purchase Program for $40,000,000 with a liquidation preference of $1,000 per share. On March 7, 2012, in accordance with approvals received from the U.S. Treasury and the Federal Reserve Board, the Company repurchased all of the Series A Preferred Stock and paid all of the related accrued and unpaid dividends. HCC used available cash and proceeds from a $30,000,000 distribution approved by the California Department of Financial Institutions from HBC to HCC. The repurchase of the Series A Preferred Stock accelerated the accretion of the remaining issuance discount on the Series A Preferred Stock. Total dividends and discount accretion on Preferred Stock, including accelerated accretion of approximately $765,000, reduced net income available to common shareholders by $1,206,000 in the first quarter of 2012. On June 12, 2013, the Company completed the repurchase of the common stock warrant issued to the U.S. Department of the Treasury on November 21, 2008, which was exercisable into 462,963 shares of common stock at an exercise price of $12.96. The Company repurchased the warrant for $140,000.

Series C Preferred Stock

        On June 21, 2010, the Company issued to various institutional investors 21,004 shares of Series C Convertible Perpetual Preferred Stock ("Series C Preferred Stock"). The Series C Preferred Stock is mandatorily convertible into 5,601,000 shares of common stock at a conversion price of $3.75 per share upon a subsequent transfer of the Series C Preferred Stock to third parties not affiliated with the holder in a widely dispersed offering. The Series C Preferred Stock is non-voting except in the case of certain transactions that would affect the rights of the holders of the Series C Preferred Stock or applicable law. Holders of Series C Preferred Stock will receive dividends if and only to the extent dividends are paid to holders of common stock. The Series C Preferred Stock is not redeemable by the Company or by the holders and has a liquidation preference of $1,000 per share. The Series C Preferred Stock ranks senior to the Company's common stock.

9) Fair Value

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

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

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

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Table of Contents


HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

September 30, 2013

(Unaudited)

9) Fair Value (Continued)

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

Financial Assets and Liabilities Measured on a Recurring Basis

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

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

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

Assets at September 30, 2013:

                         

Available-for-sale securities:

                         

Agency mortgage-backed securities          

  $ 212,514       $ 212,514      

Corporate bonds

    47,747         47,747      

Trust preferred securities

    20,210         20,210      

I/O strip receivables

    1,647         1,647      

Assets at December 31, 2012:

                         

Available-for-sale securities:

                         

Agency mortgage-backed securities          

  $ 291,244       $ 291,244      

Corporate bonds

    55,588         55,588      

Trust preferred securities

    21,080         21,080      

I/O strip receivables

    1,786           1,786      

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

Assets and Liabilities Measured on a Non-Recurring Basis

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

        The fair value of impaired loans with specific allocations of the allowance for loan losses is generally based on recent real estate appraisals. The appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are

30


Table of Contents


HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

September 30, 2013

(Unaudited)

9) Fair Value (Continued)

routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.

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

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

Assets at September 30, 2013:

                         

Impaired loans—held-for-investment:

                         

Commercial

  $ 3,012           $ 3,012  

Real estate:

                         

Commercial and residential

    2,984             2,984  

Land and construction

    1,363             1,363  

Consumer

    107             107  
                       

  $ 7,466           $ 7,466  
                       

Foreclosed assets:

                         

Commercial

  $ 29           $ 29  

Land and construction

    602             602  
                       

  $ 631           $ 631  
                       

Assets at December 31, 2012:

                         

Impaired loans—held-for-investment:

                         

Commercial

  $ 3,645           $ 3,645  

Real estate:

                         

Commercial and residential

    3,674             3,674  

Land and construction

    1,723             1,723  

Consumer

    130             130  
                       

  $ 9,172           $ 9,172  
                       

Foreclosed assets:

                         

Commercial

  $ 83           $ 83  

Land and construction

    1,187             1,187  
                       

  $ 1,270           $ 1,270  
                       

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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

September 30, 2013

(Unaudited)

9) Fair Value (Continued)

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

 
  September 30, 2013   December 31, 2012  
 
  (Dollars in thousands)
 

Impaired loans held-for-investment:

             

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

  $ 10,744   $ 11,912  

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

    4,383     7,732  
           

Total impaired loans held-for-investment

  $ 15,127   $ 19,644  
           

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

             

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

  $ 10,744   $ 11,912  

Specific valuation allowance

    (3,278 )   (2,740 )
           

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

  $ 7,466   $ 9,172  
           

        Impaired loans held-for-investment which are measured primarily for impairment using the fair value of the collateral were $15,127,000 at September 30, 2013, after partial charge-offs of $153,000 in the first nine months of 2013. In addition, these loans had a specific valuation allowance of $3,278,000 at September 30, 2013. Impaired loans held-for-investment totaling $10,744,000 at September 30, 2013 were carried at fair value as a result of the aforementioned partial charge-offs and specific valuation allowances at period-end. The remaining $4,383,000 of impaired loans were carried at cost at September 30, 2013, as the fair value of the collateral exceeded the cost basis of each respective loan. Partial charge-offs and changes in specific valuation allowances during the first nine months of 2013 on impaired loans held-for-investment carried at fair value at September 30, 2013 resulted in an additional provision for loan losses of $1,072,000.

        Foreclosed assets measured at fair value less costs to sell, had a carrying amount of $631,000, with no valuation allowance at September 30, 2013.

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

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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

September 30, 2013

(Unaudited)

9) Fair Value (Continued)

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

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

 
  September 30, 2013
 
  Fair Value   Valuation
Techniques
  Unobservable Inputs   Range
(Weighted
Average)
 
  (Dollars in thousands)

Impaired loans—held-for-investment:

                 

Commercial

  $ 3,012   Market Approach   Discount adjustment for differences between comparable sales   2% to 3% (2%)

Real estate:

                 

Commercial and residential

    2,984   Market Approach   Discount adjustment for differences between comparable sales   1% to 15% (1%)

Land and construction

    1,363   Market Approach   Discount adjustment for differences between comparable sales   1% to 2% (2%)

Foreclosed assets:

                 

Land and construction

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

 

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

Impaired loans—held-for-investment:

                 

Commercial

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

Real estate:

                 

Commercial and residential

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

Land and construction

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

Foreclosed assets:

                 

Land and construction

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

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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

September 30, 2013

(Unaudited)

9) Fair Value (Continued)

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

        The carrying amounts and estimated fair values of financial instruments at September 30, 2013 are as follows:

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

Assets:

                               

Cash and cash equivalents

  $ 41,898   $ 41,898   $   $   $ 41,898  

Securities available-for-sale

    280,471         280,471         280,471  

Securities held-to-maturity

    89,732         80,505         80,505  

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

    880,685         6,975     868,811     875,786  

FHLB and FRB stock

    10,792                 N/A  

Accrued interest receivable

    4,302         1,883     2,419     4,302  

Loan servicing rights and I/O strips receivables

    2,212         4,236         4,236  

Liabilities:

                               

Time deposits

  $ 286,558   $   $ 286,988   $   $ 286,988  

Other deposits

    908,979         908,979         908,979  

Accrued interest payable

    193         193         193  

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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

September 30, 2013

(Unaudited)

9) Fair Value (Continued)

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

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

Assets:

                               

Cash and cash equivalents

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

Securities available-for-sale

    367,912         367,912         367,912  

Securities held-to-maturity

    51,472         50,964         50,964  

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

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

FHLB and FRB stock

    10,728                 N/A  

Accrued interest receivable

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

Loan servicing rights and I/O strips receivables

    2,495         4,715         4,715  

Liabilities:

                               

Time deposits

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

Other deposits

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

Subordinated debt

    9,279             5,400     5,400  

Accrued interest payable

    277         277         277  

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

Cash and Cash Equivalents

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

Loans

        The carrying amounts of loans held-for-sale approximate fair value resulting in a Level 2 classification.

        Fair values of loans, excluding loans held for sale, are estimated as follows: For variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values resulting in a Level 3 classification. Fair values for other loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality resulting in a Level 3 classification. Impaired loans are valued at the lower of

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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

September 30, 2013

(Unaudited)

9) Fair Value (Continued)

cost or fair value as described previously. The methods utilized to estimate the fair value of loans do not necessarily represent an exit price.

FHLB and FRB Stock

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

Accrued Interest Receivable/Payable

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

Deposits

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

Subordinated Debt

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

Off-balance Sheet Instruments

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

Limitations

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

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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

September 30, 2013

(Unaudited)

10) Equity Plan

        The Company has maintained an Amended and Restated 2004 Equity Plan (the "2004 Plan") for directors, officers, and key employees. The Equity Plan provides for the grant of incentive and non-qualified stock options and restricted stock. The Equity Plan provides that the option price for both incentive and non-qualified stock options will be determined by the Board of Directors at no less than the fair value at the date of grant. Options granted vest on a schedule determined by the Board of Directors at the time of grant. Generally, options vest over four years. All options expire no later than ten years from the date of grant. The 2004 Plan was terminated on May 23, 2013. On May 23, 2013, the Company's shareholders approved the 2013 Equity Incentive Plan (the "2013 Plan") for equity awards including stock options and restricted stock for directors, officers, and key employees. As of September 30, 2013, there were no equity awards issued and 1,750,000 shares available for issuance under the 2013 Plan.

        Stock option activity under the 2004 Plan is as follows:

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

Outstanding at January 1, 2013

    1,314,347   $ 12.90              

Granted

    272,050   $ 6.57              

Exercised

    (8,874 ) $ 3.94              

Forfeited or expired

    (44,102 ) $ 12.31              
                         

Outstanding at September 30, 2013

    1,533,421   $ 11.84     5.8   $ 1,542,000  
                     

Vested or expected to vest

    1,456,750           5.8   $ 1,465,000  
                     

Exercisable at September 30, 2013

    1,066,878           4.5   $ 862,000  
                     

        As of September 30, 2013, there was $1,749,000 of total unrecognized compensation cost related to nonvested stock options granted under the 2004 Plan. That cost is expected to be recognized over a weighted-average period of approximately 3.0 years.

        Restricted stock activity under the 2004 Plan is as follows:

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

Nonvested shares at January 1, 2013

    88,000   $ 5.74  

Granted

    10,000   $ 6.51  

Vested

    (40,000 ) $ 5.16  
             

Nonvested shares at September 30, 2013

    58,000   $ 6.28  
             

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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

September 30, 2013

(Unaudited)

10) Equity Plan (Continued)

        As of September 30, 2013, there was $153,000 of total unrecognized compensation cost related to nonvested restricted stock awards granted under the 2004 Plan. The cost is expected to be recognized over a weighted-average period of approximately 1 year.

11) Subordinated Debt

        The Company has supported its growth through the issuance of trust preferred securities from special purpose trusts and accompanying sales of subordinated debt to these trusts. The subordinated debt issued to the trusts is senior to the outstanding shares of common stock and Series C Preferred Stock. As a result, payments must be made on the subordinated debt before any dividends can be paid on the common stock and Series C Preferred Stock. Under the terms of the subordinated debt, the Company may defer interest payments for up to five years. Interest payments on the subordinated notes payable to the Company's subsidiary grantor Trusts are deductible for tax purposes. The subordinated debt is not registered with the Securities and Exchange Commission. For regulatory reporting purposes, the subordinated debt qualified for Tier 1 capital treatment at September 30, 2012, and December 31, 2012.

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

        During the third quarter of 2013, the Company completed the redemption of its $9,000,000 floating-rate subordinated debt. The Company redeemed its Floating Rate Junior Subordinated Debentures due July 31, 2031 in the amount of $5,000,000 issued to Heritage Statutory Trust II and the Company's Floating Rate Junior Subordinated Debentures due September 26, 2032, in the amount of $4,000,000 issued to Heritage Statutory Trust III (collectively referred to as the "Floating Rate Sub Debt"). The Company used available cash and proceeds from a $9,000,000 distribution from the Bank for the redemption. The Company incurred a total charge of $167,000 in the second quarter of 2013, representing the agency origination fees associated with the Floating Rate Sub Debt.

12) Loss Contingencies

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

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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

September 30, 2013

(Unaudited)

13) Subsequent Event

        On October 24, 2013, the Company announced that its Board of Directors declared a $0.03 per share quarterly cash dividend to holders of common stock and Series C preferred stock (on an as converted basis). The dividend will be paid on November 25, 2013, to shareholders of record on November 7, 2013.

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

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

CRITICAL ACCOUNTING POLICIES

        Critical accounting policies are discussed in our Form 10-K for the year ended December 31, 2012. There are no changes to these policies as of September 30, 2013.

EXECUTIVE SUMMARY

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

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

Performance Overview

        For the three months ended September 30, 2013, net income was $3.2 million, or $0.10 per average diluted common share, compared to $2.5 million, or $0.08 per average diluted common share, for the three months ended September 30, 2012. The Company's annualized return on average assets was 0.90% and annualized return on average equity was 7.58% for the third quarter of 2013, compared to 0.73% and 5.91%, respectively, a year ago.

        For the nine months ended September 30, 2013, net income available to common shareholders was $8.2 million, or $0.26 per average diluted common share, an increase from $6.0 million, or $0.19 per average diluted common share, for the nine months ended September 30, 2012. In the first quarter of 2012, the Company redeemed its $40 million of Series A Fixed Rate Cumulative Perpetual Preferred Stock ("Series A Preferred Stock") issued to the U.S. Treasury Department under the TARP Capital Purchase Program, and recorded the final payment for dividends and discount accretion on its Series A Preferred Stock, which totaled $1.2 million. The Company's annualized return on average assets was 0.78% and annualized return on average equity was 6.44% for the first nine months of 2013, compared to 0.72% and 5.59%, respectively, a year ago.

        Late in the fourth quarter of 2012, the Company received short-term demand deposits in the amount of $467.5 million from one customer for specific transactions. Of this amount, $195.6 million was subsequently withdrawn, for a net outstanding balance of $271.9 million at December 31, 2012. The

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outstanding balance of the short-term demand deposits was $144,000 at September 30, 2013. Because of the short-term nature of these funds, the excess liquidity was placed in low-interest earning deposits at The Federal Reserve Bank at December 31, 2012.

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

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

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

Total Risk-Based

    15.2 %   13.7 %   10.0 %

Tier 1 Risk-Based

    14.0 %   12.5 %   6.0 %

Leverage

    11.5 %   10.2 %   5.0 %

Deposits

        The composition and cost of the Company's deposit base are important in analyzing the Company's net interest margin and balance sheet liquidity characteristics. Except for brokered and State of California time deposits, the Company's depositors are generally located in its primary market area. Depending on loan demand and other funding requirements, the Company also obtains deposits from wholesale sources including deposit brokers. The Company had $62.8 million in brokered deposits at September 30, 2013, compared to $89.2 million at September 30, 2012, and $97.8 million at December 31, 2012. Deposits from title insurance companies, escrow accounts and real estate exchange facilitators decreased to $13.6 million at September 30, 2013, compared to $29.2 million at September 30, 2012, and $21.4 million at December 31, 2012. Certificates of deposit from the State of California totaled $98.0 million at September 30, 2013, compared to $65.0 million at September 30, 2012, and $85.0 million at December 31, 2012. Total deposits at September 30, 2013 were $1.20 billion, compared to $1.14 billion at September 30, 2012 and $1.48 billion at December 31, 2012. Deposits (excluding all time deposits, CDARS deposits, and the short-term demand deposits from one customer of $271.9 million at December 31, 2012) increased to $901.0 million at September 30, 2013, an increase of $54.2 million, or 6% from $846.8 million at September 30, 2012, and increased $17.2 million, or 2%, from $883.8 million at December 31, 2012. The Company has a policy to monitor all deposits that may be sensitive to interest rate changes to help assure that liquidity risk does not become excessive due to concentrations.

        HBC is a member of the Certificate of Deposit Account Registry Service ("CDARS") program. The CDARS program allows customers with deposits in excess of FDIC insured limits to obtain coverage on time deposits through a network of banks within the CDARS program. Deposits gathered through this program are considered brokered deposits under regulatory guidelines. Deposits in the CDARS program totaled $14.3 million at September 30, 2013, compared to $5.1 million at September 30, 2012, and $10.2 million at December 31, 2012.

Liquidity

        Our liquidity position refers to our ability to maintain cash flows sufficient to fund operations and to meet obligations and other commitments in a timely fashion. At September 30, 2013, we had $41.9 million in cash and cash equivalents and approximately $409.7 million in available borrowing capacity from various sources including the Federal Home Loan Bank ("FHLB"), the Federal Reserve Bank of San Francisco ("FRB"), and Federal funds facilities with several financial institutions. The Company also had $233.6 million in unpledged securities available at September 30, 2013. Our loan to deposit ratio increased to 74.70% at September 30, 2013, compared to 70.24% at September 30, 2012, and increased from 54.91% at December 31, 2012. The loan to deposit ratio was 67.27% at December 31, 2012, excluding the short-term demand deposits of $271.9 million from one customer.

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Lending

        Our lending business originates principally through our branch offices located in our primary markets. Total loans, excluding loans held-for-sale, increased 12% to $893.1 million at September 30, 2013, from $799.4 million at September 30, 2012, and increased 10% from $812.3 million at December 31, 2012. The loan portfolio remains well diversified with commercial and industrial ("C&I") loans accounting for 46% of the total loan portfolio at September 30, 2013. Commercial and residential real estate loans accounted for 43% of the total loan portfolio at September 30, 2013, of which 51% were owner-occupied by businesses. Consumer and home equity loans accounted for 8% of the total loan portfolio, and land and construction loans accounted for the remaining 3% of the total loan portfolio at September 30, 2013. The yield on the loan portfolio was 4.85% for the third quarter of 2013, compared to 5.10% for the third quarter of 2012. The yield on the loan portfolio was 4.97% for the nine months ended September 30, 2013, compared to 5.25% for nine months ended September 30, 2012.

Net Interest Income

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

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

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

Management of Credit Risk

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

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increase in the allowance for loan losses would have an adverse effect, which may be material, on our financial condition and results of operation.

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

Noninterest Income

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

Noninterest Expense

        Management considers the control of operating expenses to be a critical element of the Company's performance. Noninterest expense for the third quarter of 2013 increased to $10.4 million, compared to $10.1 million for the same period in 2012. Noninterest expense for the first nine months of 2013 increased to $31.6 million, compared to $30.5 million for the first nine months of 2012. The increase in noninterest expense for the third quarter and first nine months of 2013, compared to the same periods a year ago, was primarily due to increased salaries and employee benefits expense due to annual salary increases and hiring of additional lending relationship officers.

Capital Management

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

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

        On June 21, 2010, HCC issued to various institutional investors 53,996 shares of Series B Mandatorily Convertible Cumulative Perpetual Preferred Stock ("Series B Preferred Stock") and 21,004 shares of Series C Convertible Perpetual Preferred Stock ("Series C Preferred Stock") for an aggregate purchase price of $75 million. The Series B Preferred Stock was mandatorily convertible into 5,601,000 shares of common stock upon approval by the shareholders at a conversion price of $3.75 per share. The Series C Preferred Stock is mandatorily convertible into common stock at a conversion price of $3.75 per share upon both approval by the shareholders and, thereafter, a subsequent transfer of the Series C Preferred Stock to third parties not affiliated with the holder in a widely dispersed offering. At the Company's Special Meeting of Shareholders held on September 15, 2010, its shareholders approved the issuance of common stock upon the conversion of the Series B Preferred Stock and upon the conversion of the Series C Preferred Stock as required by The NASDAQ Stock Market and California corporate law. As a result, on September 16, 2010, the Series B Preferred Stock was converted into 14,398,992 shares of common stock of HCC and the shares of Series B Preferred Stock ceased to be outstanding. The Series C Preferred Stock remains outstanding until it has been converted into common stock in accordance with its terms. The Series C Preferred Stock is non-voting except in the case of certain transactions that would affect the rights of the holders of the Series C Preferred Stock or applicable law. Holders of Series C Preferred Stock will receive dividends if and only to the extent dividends are paid to holders of common stock.

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Table of Contents

        On March 7, 2012, in accordance with approvals received from the U.S. Treasury and the Federal Reserve, the Company repurchased all shares of the Series A Preferred Stock and paid the related accrued and unpaid dividends. The repurchase of the Series A Preferred Stock will save $2.0 million in annual dividends. On June 12, 2013, the Company completed the repurchase of the common stock warrant for $140,000.

        During the third quarter of 2012, the Company completed the redemption of $14 million fixed-rate subordinated debt, and during the third quarter of 2013, the Company completed the redemption of its remaining $9 million of floating-rate subordinated debt.

RESULTS OF OPERATIONS

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

Net Interest Income and Net Interest Margin

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

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

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Table of Contents

Distribution, Rate and Yield

 
  For the Three Months Ended
September 30, 2013
  For the Three Months Ended
September 30, 2012
 
NET INTEREST INCOME AND NET INTEREST MARGIN
  Average
Balance
  Interest
Income/
Expense
  Average
Yield/
Rate
  Average
Balance
  Interest
Income/
Expense
  Average
Yield/
Rate
 
 
  (Dollars in thousands)
 

Assets:

                                     

Loans, gross(1)

  $ 877,417   $ 10,733     4.85 % $ 791,585   $ 10,146     5.10 %

Securities—taxable

    310,460     2,247     2.87 %   408,665     2,681     2.61 %

Securities—tax exempt(2)

    69,866     671     3.81 %   1,182     8     2.69 %

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

    58,294     42     0.29 %   45,877     30     0.26 %
                               

Total interest earning assets(2)

    1,316,037     13,693     4.13 %   1,247,309     12,865     4.10 %
                                   

Cash and due from banks

    23,724                 21,804              

Premises and equipment, net

    7,513                 7,711              

Intangible assets

    1,716                 2,201              

Other assets

    70,491                 80,965              
                                   

Total assets

  $ 1,419,481               $ 1,359,990              
                                   

Liabilities and shareholders' equity:

                                     

Deposits:

                                     

Demand, noninterest-bearing

  $ 418,657               $ 393,204              

Demand, interest-bearing

   
169,233
   
57
   
0.13

%
 
154,735
   
58
   
0.15

%

Savings and money market

    316,247     140     0.18 %   291,251     143     0.20 %

Time deposits—under $100

    22,600     19     0.33 %   27,463     32     0.46 %

Time deposits—$100 and over

    197,464     179     0.36 %   158,898     230     0.58 %

Time deposits—brokered

    71,105     178     0.99 %   94,375     225     0.95 %

CDARS—money market and time deposits

    16,372     2     0.05 %   5,357     2     0.15 %
                               

Total interest-bearing deposits

    793,021     575     0.29 %   732,079     690     0.37 %
                               

Total deposits

    1,211,678     575     0.19 %   1,125,283     690     0.24 %

Subordinated debt

   
4,819
   
51
   
4.20

%
 
19,626
   
346
   
7.01

%

Short-term borrowings

    91     1     4.36 %   1,731     2     0.46 %
                               

Total interest-bearing liabilities

    797,931     627     0.31 %   753,436     1,038     0.55 %
                               

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

    1,216,588     627     0.20 %   1,146,640     1,038     0.36 %

Other liabilities

    34,639                 45,943              
                                   

Total liabilities

    1,251,227                 1,192,583              

Shareholders' equity

    168,254                 167,407              
                                   

Total liabilities and shareholders' equity

  $ 1,419,481               $ 1,359,990              
                                   

                                     
                                   

Net interest income(2) / margin

          13,066     3.94 %         11,827     3.77 %

Less tax equivalent adjustment(2)

          (235 )               (3 )      
                                   

Net interest income

        $ 12,831               $ 11,824        
                                   

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

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

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Table of Contents

 
  For the Nine Months Ended September 30, 2013   For the Nine Months Ended September 30, 2012  
NET INTEREST INCOME AND NET INTEREST MARGIN
  Average
Balance
  Interest
Income/
Expense
  Average
Yield/
Rate
  Average
Balance
  Interest
Income/
Expense
  Average
Yield/
Rate
 
 
  (Dollars in thousands)
 

Assets:

                                     

Loans, gross(1)

  $ 831,328   $ 30,874     4.97 % $ 782,986   $ 30,754     5.25 %

Securities—taxable

    351,290     7,107     2.70 %   398,944     8,753     2.93 %

Securities—tax exempt(2)

    56,405     1,603     3.80 %   397     8     2.69 %

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

    71,265     140     0.26 %   47,785     95     0.27 %
                               

Total interest earning assets(2)

    1,310,288     39,724     4.05 %   1,230,112     39,610     4.30 %
                                   

Cash and due from banks

    23,313                 21,329              

Premises and equipment, net

    7,548                 7,843              

Intangible assets

    1,832                 2,319              

Other assets

    68,803                 73,073              
                                   

Total assets

  $ 1,411,784               $ 1,334,676              
                                   

Liabilities and shareholders' equity:

                                     

Deposits:

                                     

Demand, noninterest-bearing

  $ 423,807               $ 370,278              

Demand, interest-bearing

   
167,138
   
174
   
0.14

%
 
148,407
   
168
   
0.15

%

Savings and money market

    293,801     384     0.17 %   292,661     487     0.22 %

Time deposits—under $100

    23,488     62     0.35 %   27,897     105     0.50 %

Time deposits—$100 and over

    194,185     577     0.40 %   165,004     731     0.59 %

Time deposits—brokered

    81,352     594     0.98 %   90,800     645     0.95 %

CDARS—money market and time deposits

    15,273     5     0.04 %   5,839     8     0.18 %
                               

Total interest-bearing deposits

    775,237     1,796     0.31 %   730,608     2,144     0.39 %
                               

Total deposits

    1,199,044     1,796     0.20 %   1,100,886     2,144     0.26 %

Subordinated debt

   
7,776
   
229
   
3.94

%
 
22,334
   
1,293
   
7.73

%

Short-term borrowings

    148     1     0.90 %   1,656     3     0.24 %
                               

Total interest-bearing liabilities

    783,161     2,026     0.35 %   754,598     3,440     0.61 %
                               

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

    1,206,968     2,026     0.22 %   1,124,876     3,440     0.41 %

Other liabilities

    34,951                 36,872              
                                   

Total liabilities

    1,241,919                 1,161,748              

Shareholders' equity

    169,865                 172,928              
                                   

Total liabilities and shareholders' equity

  $ 1,411,784               $ 1,334,676              
                                   

                                     
                                   

Net interest income(2) / margin

          37,698     3.85 %         36,170     3.93 %

Less tax equivalent adjustment(2)

          (561 )               (3 )      
                                   

Net interest income

        $ 37,137               $ 36,167        
                                   

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

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

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Table of Contents

Volume and Rate Variances

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

 
  Three Months Ended September 30,
2013 vs. 2012
Increase (Decrease) Due to
Change In:
 
 
  Average
Volume
  Average
Rate
  Net
Change
 
 
  (Dollars in thousands)
 

Income from interest earning assets:

                   

Loans, gross

  $ 1,056   $ (469 ) $ 587  

Securities—taxable

    (709 )   275     (434 )

Securities—tax exempt(1)

    660     3     663  

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

    8     4     12  
               

Total interest income from interest earnings assets(1)

    1,015     (187 )   828  
               

Expense on interest-bearing liabilities:

                   

Demand, interest-bearing

    6     (7 )   (1 )

Savings and money market

    8     (11 )   (3 )

Time deposits—under $100

    (4 )   (9 )   (13 )

Time deposits—$100 and over

    35     (86 )   (51 )

Time deposits—brokered

    (57 )   10     (47 )

CDARS—money market and time deposits

    1     (1 )    

Subordinated debt

    (157 )   (138 )   (295 )

Short-term borrowings

    (18 )   17     (1 )
               

Total interest expense on interest-bearing liabilities

    (186 )   (225 )   (411 )
               

Net interest income(1)

  $ 1,201   $ 38     1,239  
                 

Less tax equivalent adjustment(1)

                (232 )
                   

Net interest income

              $ 1,007  
                   

(1)
Reflects tax equivalent adjustment for tax exempt income based on a 35% tax rate.

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Table of Contents

 
  Nine Months Ended September 30,
2013 vs. 2012
Increase (Decrease) Due to
Change In:
 
 
  Average
Volume
  Average
Rate
  Net
Change
 
 
  (Dollars in thousands)
 

Income from interest earning assets:

                   

Loans, gross

  $ 1,768   $ (1,648 ) $ 120  

Securities—taxable

    (949 )   (697 )   (1,646 )

Securities—tax exempt(1)

    1,592     3     1,595  

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

    47     (2 )   45  
               

Total interest income from interest earnings assets(1)

    2,458     (2,344 )   114  
               

Expense on interest-bearing liabilities:

                   

Demand, interest-bearing

    19     (13 )   6  

Savings and money market

    12     (115 )   (103 )

Time deposits—under $100

    (11 )   (32 )   (43 )

Time deposits—$100 and over

    83     (237 )   (154 )

Time deposits—brokered

    (72 )   21     (51 )

CDARS—money market and time deposits

    3     (6 )   (3 )

Subordinated debt

    (429 )   (635 )   (1,064 )

Short-term borrowings

    (10 )   8     (2 )
               

Total interest expense on interest-bearing liabilities

    (405 )   (1,009 )   (1,414 )
               

Net interest income(1)

  $ 2,863   $ (1,335 )   1,528  
                 

Less tax equivalent adjustment(1)

                (558 )
                   

Net interest income

              $ 970  
                   

(1)
Reflects tax equivalent adjustment for tax exempt income based on a 35% tax rate.

        The Company's net interest margin, expressed as a percentage of average earning assets, increased 17 basis points to 3.94% for the third quarter of 2013, from 3.77% for the third quarter of 2012. The increase in the third quarter of 2013 was primarily due to a lower cost of funds, higher yields on securities, and a higher average loan balance, partially offset by a lower yield on loans. For the first nine months of 2013, the net interest margin decreased 8 basis points to 3.85%, compared to 3.93% for the first nine months of 2012, primarily due to a lower yield on loans, and a higher average balance of short-term deposits at the Federal Reserve Bank, partially offset by a higher average balance of loans and a lower cost of funds.

        Net interest income increased to $12.8 million for the third quarter of 2013, compared to $11.8 million for the third quarter of 2012, primarily due to a higher average volume of loans. For the nine months ended September 30, 2013, net interest income was $37.1 million, compared to $36.2 million for the nine months ended September 30, 2012.

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

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Table of Contents

Provision for Loan Losses

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

        Asset quality improvements and net recoveries in the first nine months of 2013 resulted in a credit to the provision for loan losses of $534,000 for the third quarter of 2013 and a credit to the provision for loan losses of $804,000 for the first nine months of 2013. The provision for loan losses was $1.2 million for the third quarter of 2012 and $2.1 million for the first nine months of 2012.

        The allowance for loan losses totaled $19.3 million, or 2.17% of total loans at September 30, 2013, compared to $19.1 million, or 2.39% of total loans at September 30, 2012, and $19.0 million, or 2.34% of total loans at December 31, 2012. The decrease in the allowance for loan losses to total loans at September 30, 2013, compared to September 30, 2012, was primarily due to improved risk grading and credit metrics, as well as a decline in historical charge-off levels. Net recoveries totaled $534,000 for the third quarter of 2013, compared to net charge-offs of $2.1 million for the third quarter of 2012. Provisions for loan losses are charged to operations to bring the allowance for loan losses to a level deemed appropriate by the Company based on the factors discussed under "Allowance for Loan Losses".

Noninterest Income

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

 
  For the Three
Months Ended
September 30,
  Increase
(decrease)
2013 versus 2012
 
 
  2013   2012   Amount   Percent  
 
  (Dollars in thousands)
 

Service charges and fees on deposit accounts

  $ 645   $ 575   $ 70     12 %

Increase in cash surrender value of life insurance

    414     434     (20 )   -5 %

Servicing income

    331     429     (98 )   -23 %

Gain on sales of SBA loans

    103     221     (118 )   -53 %

Gain on sales of securities

        1,105     (1,105 )   -100 %

Other

    245     184     61     33 %
                     

Total noninterest income

  $ 1,738   $ 2,948   $ (1,210 )   -41 %
                     

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Table of Contents


 
  For the Nine
Months Ended
September 30,
  Increase
(decrease)
2013 versus 2012
 
 
  2013   2012   Amount   Percent  
 
  (Dollars in thousands)
 

Service charges and fees on deposit accounts

  $ 1,840   $ 1,766   $ 74     4 %

Increase in cash surrender value of life insurance

    1,240     1,292     (52 )   -4 %

Servicing income

    1,081     1,336     (255 )   -19 %

Gain on sales of SBA loans

    373     633     (260 )   -41 %

Gain on sales of securities

    38     1,164     (1,126 )   -97 %

Other

    744     570     174     31 %
                     

Total noninterest income

  $ 5,316   $ 6,761   $ (1,445 )   -21 %
                     

        Noninterest income was $1.7 million for the third quarter of 2013, compared to $2.9 million for the third quarter of 2012. For the first nine months of 2013, noninterest income was $5.3 million, compared to $6.8 million for the first nine months of 2012. Noninterest income was lower in the third quarter and first nine months of 2013, compared to the same periods in 2012, primarily due to a lower gain on sales of securities and sales of SBA loans. There was no gain on sales of securities for the third quarter of 2013, and a $38,000 gain on sales of securities for the first nine months of 2013, compared to $1.1 million and $1.2 million, respectively, for the comparable periods a year ago.

        Historically, a significant percentage of the Company's noninterest income has been associated with its SBA lending activity, as gains on the sale of loans sold in the secondary market and servicing income from loans sold with servicing rights retained. For the three months ended September 30, 2013, SBA loan sales resulted in a $103,000 gain, compared to a $221,000 gain on sale of SBA loans for the three months ended September 30, 2012. For the nine months ended September 30, 2013, SBA loan sales resulted in a $373,000 gain, compared to a $633,000 gain on sales of SBA loans for the nine months ended September 30, 2012. The gain on sales of SBA loans were lower in the third quarter and first nine months of 2013, compared to the same periods in 2012, primarily due to a lower balance of SBA loans sold. The servicing assets that result from the sales of SBA loans with servicing retained are amortized over the expected term of the loans using a method approximating the interest method. Servicing income generally declines as the respective loans are repaid.

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Noninterest Expense

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

 
  For the Three
Months Ended
September 30,
  Increase
(decrease)
2013 versus 2012
 
 
  2013   2012   Amount   Percent  
 
  (Dollars in thousands)
 

Salaries and employee benefits

  $ 5,772   $ 5,336   $ 436     8 %

Occupancy and equipment

    986     1,041     (55 )   -5 %

Professional fees

    602     587     15     3 %

Software subscriptions

    381     275     106     39 %

Low income housing investment losses

    320     264     56     21 %

Data processing

    259     252     7     3 %

Insurance expense

    255     198     57     29 %

FDIC deposit insurance premiums

    200     248     (48 )   -19 %

Correspondent bank charges

    170     156     14     9 %

Foreclosed assets, net

    8     9     (1 )   -11 %

Subordinated debt redemption charges

        601     (601 )   -100 %

Other

    1,427     1,180     247     21 %
                     

Total noninterest expense

  $ 10,380   $ 10,147   $ 233     2 %
                     

 

 
  For the Nine
Months Ended
September 30,
  Increase
(decrease)
2013 versus 2012
 
 
  2013   2012   Amount   Percent  
 
  (Dollars in thousands)
 

Salaries and employee benefits

  $ 17,647   $ 16,380   $ 1,267     8 %

Occupancy and equipment

    3,082     3,004     78     3 %

Professional fees

    1,984     2,268     (284 )   -13 %

Software subscriptions

    966     878     88     10 %

Low income housing investment losses

    930     795     135     17 %

Data processing

    838     744     94     13 %

Insurance expense

    763     645     118     18 %

FDIC deposit insurance premiums

    666     675     (9 )   -1 %

Correspondent bank charges

    513     455     58     13 %

Subordinated debt redemption charges

    167     601     (434 )   -72 %

Foreclosed assets, net

    (242 )   229     (471 )   -206 %

Other

    4,236     3,783     453     12 %
                     

Total noninterest expense

  $ 31,550   $ 30,457   $ 1,093     4 %
                     

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

Noninterest Expense by Category

 
  For the Three Months Ended September 30,  
 
  2013   Percent
of Total
  2012   Percent
of Total
 
 
  (Dollars in thousands)
 

Salaries and employee benefits

  $ 5,772     56 % $ 5,336     53 %

Occupancy and equipment

    986     9 %   1,041     10 %

Professional fees

    602     6 %   587     6 %

Software subscriptions

    381     4 %   275     3 %

Low income housing investment losses

    320     3 %   264     3 %

Data processing

    259     2 %   252     2 %

Insurance expense

    255     2 %   198     2 %

FDIC deposit insurance premiums

    200     2 %   248     2 %

Correspondent bank charges

    170     2 %   156     1 %

Foreclosed assets, net

    8     0 %   9     0 %

Subordinated debt redemption charges

        0 %   601     6 %

Other

    1,427     14 %   1,180     12 %
                   

Total noninterest expense

  $ 10,380     100 % $ 10,147     100 %
                   

 

 
  For the Nine Months Ended September 30,  
 
  2013   Percent
of Total
  2012   Percent
of Total
 
 
  (Dollars in thousands)
 

Salaries and employee benefits

  $ 17,647     56 % $ 16,380     54 %

Occupancy and equipment

    3,082     10 %   3,004     10 %

Professional fees

    1,984     6 %   2,268     7 %

Software subscriptions

    966     3 %   878     3 %

Low income housing investment losses

    930     3 %   795     3 %

Data processing

    838     3 %   744     2 %

Insurance expense

    763     2 %   645     2 %

FDIC deposit insurance premiums

    666     2 %   675     2 %

Correspondent bank charges

    513     2 %   455     1 %

Subordinated debt redemption charges

    167     1 %   601     2 %

Foreclosed assets, net

    (242 )   -1 %   229     1 %

Other

    4,236     13 %   3,783     13 %
                   

Total noninterest expense

  $ 31,550     100 % $ 30,457     100 %
                   

        Noninterest expense for the third quarter of 2013 was $10.4 million, an increase from $10.1 million for the third quarter of 2012. Noninterest expense for the first nine months of 2013 was $31.6 million, compared to $30.5 million for the first nine months of 2012. The increase in noninterest expense for the third quarter of 2013, compared to the same period a year ago, was primarily due to increased salaries and employee benefits, software subscriptions, and other operating expenses, partially offset by lower subordinated debt redemption charges. The increase in noninterest expense for the first nine months of 2013 compared to the same period a year ago was primarily due to increased salaries and employee benefits, low income housing investment losses and insurance expense, partially offset by lower net foreclosed assets expense, professional fees and lower subordinated redemption charges.

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        The increase in salaries and employee benefits expense was due to annual salary increases and hiring of additional lending relationship officers. Full time equivalent employees were 192 at September 30, 2013, compared to 188 at September 30, 2012. Data processing and software subscriptions expenses were higher in the third quarter and first nine months of 2013 due to one-time system conversion costs. There were no subordinated debt redemption charges for the third quarter of 2013, and $167,000 of subordinated debt redemption charges for the first nine months of 2013, compared to $601,000 for both the third quarter and first nine months of 2012. There was a net gain on the disposition of foreclosed assets of $242,000 for the first nine months of 2013, compared to a net expense of $229,000 on the foreclosed assets for the first nine months of 2012.

Income Tax Expense

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

        The Company's Federal and state income tax expense for the quarter and nine months ended September 30, 2013 was $1.5 million and $3.5 million, respectively. The income tax expense was $939,000 and $3.1 million for the same periods in 2012. The following table shows the Company's effective income tax rates for the periods indicated:

 
  For the Three Months Ended
September 30,
  For the Nine Months Ended
September 30,
 
 
  2013   2012   2013   2012  

Effective income tax rate

    32.0 %   27.4 %   30.1 %   30.1 %

        The increase in the effective income tax rate for the third quarter of 2013, compared to the third quarter of 2012, was primarily due to higher pre-tax income with a higher marginal tax rate as a result of fixed deductions. The difference in the effective tax rate compared to the combined Federal and state statutory tax rate of 42% is primarily the result of the Company's investment in life insurance policies whose earnings are not subject to taxes, tax credits related to investments in low income housing limited partnerships, and tax exempt municipal securities. The Company has net investments of $1.5 million in low-income housing limited partnerships as of September 30, 2013.

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

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

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forecasts of future income, cumulative losses, applicable tax planning strategies, and assessments of current and future economic and business conditions.

        The Company had net deferred tax assets of $23.7 million and $19.3 million at September 30, 2013, and December 31, 2012, respectively. After consideration of the matters in the preceding paragraph, the Company determined that it is more likely than not that the net deferred tax asset at September 30, 2013 and December 31, 2012 will be fully realized in future years.

FINANCIAL CONDITION

        As of September 30, 2013, total assets increased to $1.40 billion, compared to $1.36 billion at September 30, 2012, and decreased from $1.69 billion at December 31, 2012. Excluding the short-term deposits at the Federal Reserve Bank offsetting the short-term demand deposits of $271.9 million from one customer, total assets were $1.42 billion at December 31, 2012. Securities available-for-sale (at fair value) were $280.5 million at September 30, 2013, a decrease of 32% from $410.8 million at September 30, 2012, and a decrease of 24% from $367.9 million at December 31, 2012. Securities held-to-maturity (at amortized cost) were $89.7 million at September 30, 2013, compared to $25.6 million at September 30, 2012, and $51.5 million at December 31, 2012. The total loan portfolio, excluding loans held-for-sale, was $893.1 million at September 30, 2013, an increase of 12% from $799.4 million at September 30, 2012, and an increase of 10% from $812.3 million at December 31, 2012.

        Total deposits, increased 5% to $1.20 billion at September 30, 2013, from $1.14 billion at September 30, 2012 and decreased 1% from $1.21 billion, excluding the short-term demand deposits of $271.9 million from one customer at December 31, 2012. There was no subordinated debt at September 30, 2013 compared to $9.3 million at September 30, 2012 and December 31, 2012, as a result of the redemption of $9 million floating-rate subordinated debt during the third quarter of 2013.

Securities Portfolio

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

 
  September 30,    
 
 
  December 31,
2012
 
 
  2013   2012  
 
  (Dollars in thousands)
 

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

                   

Agency mortgage-backed securities

  $ 212,514   $ 334,911   $ 291,244  

Corporate bonds

    47,747     55,036     55,588  

Trust preferred securities

    20,210     20,809     21,080  
               

Total

  $ 280,471   $ 410,756   $ 367,912  
               

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

                   

Agency mortgage-backed securities

  $ 13,229   $ 15,756   $ 16,659  

Municipals—Tax Exempt

    76,503     9,836     34,813  
               

  $ 89,732   $ 25,592   $ 51,472  
               

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        The following table summarizes the weighted average life and weighted average yields of securities at September 30, 2013:

 
  September 30, 2013
Weighted Average Life
 
 
  After One
and Within
Five Years
  After Five
and Within
Ten Years
  After
Ten Years
  Total  
 
  Amount   Yield   Amount   Yield   Amount   Yield   Amount   Yield  
 
  (Dollars in thousands)
 

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

                                                 

Agency mortgage-backed securities

  $ 150,257     2.80 % $ 62,257     2.27 % $       $ 212,514     2.64 %

Corporate bonds

    2,124     3.41 %   45,623     3.18 %           47,747     3.19 %

Trust preferred securities

                    20,210     4.84 %   20,210     4.84 %
                                           

  $ 152,381     2.81 % $ 107,880     2.66 % $ 20,210     4.84 % $ 280,471     2.90 %
                                           

 

 
  September 30, 2013
Weighted Average Life
 
 
  After One
and Within
Five Years
  After Five
and Within
Ten Years
  After
Ten Years
  Total  
 
  Amount   Yield   Amount   Yield   Amount   Yield   Amount   Yield  
 
  (Dollars in thousands)
 

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

                                                 

Agency mortgage-backed securities

  $ 7,463     1.53 % $     0.00 % $ 5,766     3.28 % $ 13,229     2.29 %

Municipals—Tax Exempt

    1,595     4.46 %   9,691     4.22 %   65,217     3.84 %   76,503     3.90 %
                                           

  $ 9,058     2.04 % $ 9,691     4.22 % $ 70,983     3.79 % $ 89,732     3.66 %
                                           

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

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

        The Company classifies its securities as either available-for-sale or held-to-maturity at the time of purchase. Prior to the third quarter of 2012, the Company's securities were all classified under existing accounting rules as "available-for-sale" to allow flexibility for the management of the portfolio. Accounting guidance requires available-for-sale securities to be marked to fair value with an offset to accumulated other comprehensive income (loss), a component of shareholders' equity. Monthly adjustments are made to reflect changes in the fair value of the Company's available-for-sale securities. The investment securities available-for-sale portfolio totaled $280.5 million at September 30, 2013, a decrease of 32% from $410.8 million at September 30, 2012, and a decrease of 24% from

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$367.9 million at December 31, 2012. At September 30, 2013, the investment securities available-for-sale portfolio was comprised of $212.5 million of agency mortgage-backed securities (all issued by U.S. Government sponsored entities), $47.8 million of corporate bonds, and $20.2 million of single entity issue trust preferred securities. Due to higher interest rates, there was a pre-tax unrealized loss on securities available-for-sale at September 30, 2013 of ($125,000), compared to a pre-tax unrealized gain on securities available-for-sale at September 30, 2012 of $14.3 million, and a pre-tax unrealized gain on securities available-for-sale at December 31, 2012 of $11.8 million.

        The investment securities held-to-maturity portfolio, at amortized cost, totaled $89.7 million at September 30, 2013, compared to $25.6 million at September 30, 2012, and $51.5 million at December 31, 2012. At September 30, 2013, the investment securities held-to-maturity portfolio was comprised of $76.5 million of tax-exempt municipal bonds, and $13.2 million of agency mortgage-backed securities. During the third quarter of 2012, the Company evaluated its available-for-sale portfolio and reclassified at fair value approximately $16.4 million of the mortgage-backed securities with higher price volatility and longer maturities to the held-to-maturity category. The related unrealized after-tax gains of $473,000 at September 30, 2013, remained in accumulated other comprehensive income and will be amortized over the remaining life of the securities as an adjustment of yield, offsetting the related amortization of the premium or accretion of the discount on the transferred securities. No gains or losses were recognized at the time of reclassification. Management considers the held-to-maturity classification of these investment securities to be appropriate based on the Company's positive intent and ability to hold these securities to maturity. The increase in the investment securities held-to-maturity portfolio at September 30, 2013, from September 30, 2012, and December 31, 2012, was primarily due to purchases of higher yielding municipal bonds with favorable tax benefits, which the Company intends to hold until maturity.

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

Loans

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

        Gross loans, excluding loans held-for-sale, represented 64% of total assets at September 30, 2013, 59% at September 30, 2012, and 48% of total assets at December 31, 2012. Gross loans, excluding loans held-for-sale, represented 57% of total assets, excluding the short-term deposits of $271.9 million at the Federal Reserve Bank offsetting the short-term demand deposits from one customer at December 31, 2012. The ratio of loans to deposits increased to 74.70% at September 30, 2013, from 70.24% at September 30, 2012, and increased from 54.91% at December 31, 2012. The loan to deposit ratio was 67.27%, excluding the short-term demand deposits from one customer at December 31, 2012.

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Loan Distribution

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

 
  September 30, 2013   September 30, 2012   December 31, 2012  
 
  Balance   % of Total   Balance   % of Total   Balance   % of Total  
 
  (Dollars in thousands)
 

Commercial

  $ 410,933     46 % $ 377,520     47 % $ 375,469     46 %

Real estate:

                                     

Commercial and residential

    387,777     43 %   336,573     42 %   354,934     44 %

Land and construction

    30,780     3 %   24,068     3 %   22,352     3 %

Home equity

    50,100     6 %   45,565     6 %   43,865     5 %

Consumer

    13,712     2 %   15,649     2 %   15,714     2 %
                           

Total loans

    893,302     100 %   799,375     100 %   812,334     100 %

Deferred loan (fees) costs, net

    (250 )       18         (21 )    
                           

Loans, including deferred fees and costs

    893,052     100 %   799,393     100 %   812,313     100 %
                                 

Allowance for loan losses

    (19,342 )         (19,124 )         (19,027 )      
                                 

Loans, net

  $ 873,710         $ 780,269         $ 793,286        
                                 

        The Company's loan portfolio is concentrated in commercial loans, primarily manufacturing, wholesale, and services, and commercial real estate, with the balance in land development and construction and home equity and consumer loans. The Company does not have any concentrations by industry or group of industries in its loan portfolio, however, 52% of its gross loans were secured by real property at September 30, 2013, compared to 51% at September 30, 2012, and 52% at December 31, 2012. While no specific industry concentration is considered significant, the Company's lending operations are located in areas that are dependent on the technology and real estate industries and their supporting companies.

        The Company has established concentration limits in its loan portfolio for commercial real estate loans, commercial loans, construction loans and unsecured lending, among others. All loan types are within established limits. The Company underwrites to the historical cash flow of the borrowers to determine debt service and stress tests the debt service under higher interest rate scenarios. Financial and performance covenants are used in commercial lending to allow the Company to react to a borrower's deteriorating financial condition should that occur.

        The Company's commercial loans are made for working capital, financing the purchase of equipment or for other business purposes. Commercial loans include loans with maturities ranging from thirty days to one year and "term loans" with maturities normally ranging from one to five years. Short-term business loans are generally intended to finance current transactions and typically provide for periodic principal payments, with interest payable monthly. Term loans normally provide for floating interest rates, with monthly payments of both principal and interest.

        The Company is an active participant in the SBA and U.S. Department of Agriculture guaranteed lending programs, and has been approved by the SBA as a lender under the Preferred Lender Program. The Company regularly makes such guaranteed loans (collectively referred to as "SBA loans"). The guaranteed portion of these loans is typically sold in the secondary market depending on market conditions. When the guaranteed portion of an SBA loan is sold the Company retains the servicing rights for the sold portion. During the third quarter and the first nine months of 2013, loans were sold resulting in a gain on sale of SBA loans of $103,000 and $373,000, respectively. For the third

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quarter and the first nine months of 2012, loans were sold resulting in a gain on sale of SBA loans of $221,000 and $633,000, respectively.

        As of September 30, 2013, commercial and residential real estate mortgage loans of $387.8 million consist primarily of adjustable and fixed rate loans secured by deeds of trust on commercial and residential property. The real estate mortgage loans at September 30, 2013, consist of $196.6 million, or 51%, of commercial owner occupied properties, $190.7 million, or 49%, of commercial investment properties, and $483,000 (less than 1%) in residential properties. Properties securing the commercial real estate mortgage loans are generally located in the Company's primary market, which is the Greater San Francisco Bay Area.

        The Company's commercial real estate loans consist primarily of loans based on the borrower's cash flow and are secured by deeds of trust on commercial and residential property to provide a secondary source of repayment. The Company generally restricts real estate term loans to no more than 75% of the property's appraised value or the purchase price of the property during the initial underwriting of the credit, depending on the type of property and its utilization. The Company offers both fixed and floating rate loans. Maturities on real estate mortgage loans are generally between five and ten years (with amortization ranging from fifteen to twenty-five years and a balloon payment due at maturity); however, SBA and certain other real estate loans that can be sold in the secondary market may be granted for longer maturities.

        The Company's land and construction loans are primarily to finance the development/construction of commercial and single family residential properties. The Company utilizes underwriting guidelines to assess the likelihood of repayment from sources such as sale of the property or availability of permanent mortgage financing prior to making the construction loan. Land and construction loans increased $6.7 million to $30.8 million, at September 30, 2013, from $24.1 million, at September 30, 2012, and increased $8.4 million from $22.4 million, at December 31, 2012.

        The Company makes home equity lines of credit available to its existing customers. Home equity lines of credit are underwritten initially with a maximum 75% loan to value ratio. Home equity lines are reviewed at least semiannually, with specific emphasis on loans with a loan to value ratio greater than 70% and loans that were underwritten from mid-2005 through 2008, when real estate values were at the peak in the cycle. The Company takes measures to work with customers to reduce line commitments and minimize potential losses. There have been no adverse classifications to date as a result of the review.

        Additionally, the Company makes consumer loans for the purpose of financing automobiles, various types of consumer goods, and other personal purposes. Consumer loans generally provide for the monthly payment of principal and interest. Most of the Company's consumer loans are secured by the personal property being purchased or, in the instances of home equity loans or lines, real property.

        With certain exceptions, state chartered banks are permitted to make extensions of credit to any one borrowing entity up to 15% of the bank's capital and reserves for unsecured loans and up to 25% of the bank's capital and reserves for secured loans. For HBC, these lending limits were $25.7 million and $42.8 million at September 30, 2013, respectively.

Loan Maturities

        The following table presents the maturity distribution of the Company's loans (excluding loans held-for-sale) as of September 30, 2013. The table shows the distribution of such loans between those loans with predetermined (fixed) interest rates and those with variable (floating) interest rates. Floating rates generally fluctuate with changes in the prime rate as reflected in the Western Edition of The Wall

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Street Journal. As of September 30, 2013, approximately 62% of the Company's loan portfolio consisted of floating interest rate loans.

 
  Due in
One Year
or Less
  Over One
Year But
Less than
Five Years
  Over
Five Years
  Total  
 
  (Dollars in thousands)
 

Commercial

  $ 303,682   $ 43,710   $ 63,541   $ 410,933  

Real estate:

                         

Commercial and residential

    81,727     185,717     120,333     387,777  

Land and construction

    30,280     500         30,780  

Home equity

    46,232     1,672     2,196     50,100  

Consumer

    13,216     414     82     13,712  
                   

Loans

  $ 475,137   $ 232,013   $ 186,152   $ 893,302  
                   

Loans with variable interest rates

 
$

424,068
 
$

62,804
 
$

67,602
 
$

554,474
 

Loans with fixed interest rates

    51,069     169,209     118,550     338,828  
                   

Loans

  $ 475,137   $ 232,013   $ 186,152   $ 893,302  
                   

Loan Servicing

        As of September 30, 2013 and 2012, $136.0 million and $157.0 million, respectively, in SBA loans were serviced by the Company for others. Activity for loan servicing rights was as follows:

 
  For the Three Months Ended
September 30,
  For the Nine Months Ended
September 30,
 
 
  2013   2012   2013   2012  
 
  (Dollars in thousands)
 

Beginning of period balance

  $ 631   $ 780   $ 709   $ 792  

Additions

    28     49     86     164  

Amortization

    (93 )   (72 )   (229 )   (199 )
                   

End of period balance

  $ 566   $ 757   $ 566   $ 757  
                   

        Loan servicing rights are included in accrued interest receivable and other assets on the unaudited consolidated balance sheets and reported net of amortization. There was no valuation allowance as of September 30, 2013 and 2012, as the fair value of the assets was greater than the carrying value.

        Activity for the I/O strip receivable was as follows:

 
  For the Three Months Ended
September 30,
  For the Nine Months Ended
September 30,
 
 
  2013   2012   2013   2012  
 
  (Dollars in thousands)
 

Beginning of period balance

  $ 1,726   $ 2,140   $ 1,786   $ 2,094  

Unrealized holding loss

    (79 )   (50 )   (139 )   (4 )
                   

End of period balance

  $ 1,647   $ 2,090   $ 1,647   $ 2,090  
                   

Credit Quality

        Financial institutions generally have a certain level of exposure to credit quality risk, and could potentially receive less than a full return of principal and interest if a debtor becomes unable or unwilling to repay. Since loans are the most significant assets of the Company and generate the largest

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portion of its revenues, the Company's management of credit quality risk is focused primarily on loan quality. Banks have generally suffered their most severe earnings declines as a result of customers' inability to generate sufficient cash flow to service their debts and/or downturns in national and regional economies and declines in overall asset values including real estate. In addition, certain debt securities that the Company may purchase have the potential of declining in value if the obligor's financial capacity to repay deteriorates.

        The Company's policies and procedures identify market segments, set goals for portfolio growth or contraction, and establish limits on industry and geographic credit concentrations. In addition, these policies establish the Company's underwriting standards and the methods of monitoring ongoing credit quality. The Company's internal credit risk controls are centered in underwriting practices, credit granting procedures, training, risk management techniques, and familiarity with loan customers as well as the relative diversity and geographic concentration of our loan portfolio.

        The Company's credit risk may also be affected by external factors such as the level of interest rates, employment, general economic conditions, real estate values, and trends in particular industries or geographic markets. As an independent community bank serving a specific geographic area, the Company must contend with the unpredictable changes in the general California market and, particularly, primary local markets. The Company's asset quality has suffered in the past from the impact of national and regional economic recessions, consumer bankruptcies, and depressed real estate values.

        Nonperforming assets are comprised of the following: loans and loans held-for-sale for which the Company is no longer accruing interest; restructured loans which have been current under six months; loans 90 days or more past due and still accruing interest (although they are generally placed on nonaccrual when they become 90 days past due, unless they are both well-secured and in the process of collection); and foreclosed assets. Management's classification of a loan as "nonaccrual" is an indication that there is reasonable doubt as to the full recovery of principal or interest on the loan. At that point, the Company stops accruing interest income, and reverses any uncollected interest that had been accrued as income. The Company begins recognizing interest income only as cash interest payments are received and it has been determined the collection of all outstanding principal is not in doubt. The loans may or may not be collateralized, and collection efforts are pursued. Loans may be restructured by management when a borrower has experienced some change in financial status causing an inability to meet the original repayment terms and where the Company believes the borrower will eventually overcome those circumstances and make full restitution. Foreclosed assets consist of properties acquired by foreclosure or similar means that management is offering or will offer for sale.

        The following table summarizes the Company's nonperforming assets at the dates indicated:

 
  September 30,   December 31,  
 
  2013   2012   2012  
 
  (Dollars in thousands)
 

Nonaccrual loans—held-for-investment

  $ 14,615   $ 17,396   $ 17,335  

Restructured and loans over 90 days past due and still accruing

    502     1,722     859  
               

Total nonperforming loans

    15,117     19,118     18,194  

Foreclosed assets

    631     2,889     1,270  
               

Total nonperforming assets

  $ 15,748   $ 22,007   $ 19,464  
               

Nonperforming assets as a percentage of loans plus foreclosed assets

    1.76 %   2.74 %   2.39 %

Nonperforming assets as a percentage of total assets

    1.12 %   1.62 %   1.15 %

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        Nonperforming assets were $15.7 million, or 1.12% of total assets, at September 30, 2013, compared to $22.0 million, or 1.62% of total assets, at September 30, 2012, and $19.5 million, or 1.15% of total assets, at December 31, 2012. Nonperforming assets to total assets were 1.37% at December 31, 2012, excluding the short-term deposits of $271.9 million at the Federal Reserve Bank offsetting the short-term demand deposits from one customer. Included in total nonperforming assets were foreclosed assets of $631,000 at September 30, 2013, compared to $2.9 million at September 30, 2012, and $1.3 million at December 31, 2012.

        The following table provides a summary of the loan portfolio by loan type and credit quality classification at September 30, 2013, September 30, 2012, and December 31, 2012:

 
  September 30, 2013   September 30, 2012   December 31, 2012  
 
  Nonclassified   Classified   Total   Nonclassified   Classified   Total   Nonclassified   Classified   Total  
 
  (Dollars in thousands)
 

Commercial

  $ 396,102   $ 14,831   $ 410,933   $ 353,187   $ 24,333   $ 377,520   $ 355,440   $ 20,029   $ 375,469  

Real estate:

                                                       

Commercial and residential

    380,470     7,307     387,777     323,924     12,649     336,573     345,045     9,889     354,934  

Land and construction

    28,931     1,849     30,780     18,055     6,013     24,068     18,858     3,494     22,352  

Home equity

    47,364     2,736     50,100     44,626     939     45,565     41,187     2,678     43,865  

Consumer

    13,354     358     13,712     15,244     405     15,649     15,321     393     15,714  
                                       

Total

  $ 866,221   $ 27,081   $ 893,302   $ 755,036   $ 44,339   $ 799,375   $ 775,851   $ 36,483   $ 812,334  
                                       

        Classified loans in the table above are gross of SBA guarantees.

        The following provides a rollforward of troubled debt restructurings ("TDRs") for the nine month periods ending September 30, 2013 and September 30, 2012:

 
  Nine Months Ended September 30, 2013  
 
  Performing
TDRs
  Nonperforming
TDRs
  Total  
 
  (Dollars in thousands)
 

Balance at January 1, 2013

  $ 2,309   $ 1,798   $ 4,107  

Principal repayments/advances/upgrades

    (1,798 )   (91 )   (1,889 )

Net charge-offs

        (372 )   (372 )

New modifications

        199     199  
               

Balance at September 30, 2013

  $ 511   $ 1,534   $ 2,045  
               

 
  Nine Months Ended September 30, 2012  
 
  Performing
TDRs
  Nonperforming
TDRs
  Total  
 
  (Dollars in thousands)
 

Balance at January 1, 2012

  $ 3,073   $ 4,323   $ 7,396  

Principal repayments/advances/upgrades

    (974 )   (2,613 )   (3,587 )

Net charge-offs

    (131 )       (131 )

New modifications

    458     111     569  
               

Balance at September 30, 2012

  $ 2,426   $ 1,821   $ 4,247  
               

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Allowance for Loan Losses

        The allowance for loan losses is an estimate of probable incurred losses in the loan portfolio. Loans are charged-off against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance for loan losses. Management's methodology for estimating the allowance balance consists of several key elements, which include specific allowances on individual impaired loans and the formula driven allowances on pools of loans with similar risk characteristics. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management's judgment, should be charged-off.

        Specific allowances are established for impaired loans. Management considers a loan to be impaired when it is probable that the Company will be unable to collect all amounts due according to the original contractual terms of the loan agreement, including scheduled interest payments. Loans for which the terms have been modified with a concession granted, and for which the borrower is experiencing financial difficulties, are considered troubled debt restructurings and classified as impaired. When a loan is considered to be impaired, the amount of impairment is measured based on the fair value of the collateral less costs to sell if the loan is collateral dependent, or on the present value of expected future cash flows or values that are observable in the secondary market. If the measure of the impaired loans is less than the investment in the loan, the deficiency will be charged off against the allowance for loan losses if the amount is a confirmed loss, or, alternatively, a specific allocation within the allowance will be established. Loans that are considered impaired are specifically excluded from the formula portion of the allowance for loan losses analysis.

        The estimated loss factors for pools of loans that are not impaired are based on determining the probability of default and loss given default for loans within each segment of the portfolio, adjusted for significant factors that, in management's judgment, affect collectability as of the evaluation date. The Company's historical delinquency experience and loss experience are utilized to determine the probability of default and loss given default for segments of the portfolio where the Company has experienced losses in the past. For segments of the portfolio where the Company has no significant prior loss experience, the Company uses quantifiable observable industry data to determine the probability of default and loss given default.

        Loans that demonstrate a weakness for which there is a possibility of loss if the weakness is not corrected, are categorized as "classified." Classified assets include all loans considered as substandard, substandard-nonaccrual, and doubtful and may result from problems specific to a borrower's business or from economic downturns that affect the borrower's ability to repay or that cause a decline in the value of the underlying collateral (particularly real estate), and foreclosed assets. The principal balance of classified assets, net of SBA guarantees, was $23.3 million at September 30, 2013, $46.0 million at September 30, 2012, and $36.8 million at December 31, 2012. Loans held-for-sale are carried at the lower of cost or estimated fair value, and are not allocated an allowance for loan losses.

        It is the policy of management to maintain the allowance for loan losses at a level adequate for risks inherent in the loan portfolio. On an ongoing basis, we have engaged an outside firm to perform independent credit reviews of our loan portfolio. The Federal Reserve Bank of San Francisco and the California Department of Financial Institutions also review the allowance for loan losses as an integral part of the examination process. Based on information currently available, management believes that the allowance for loan losses is adequate. However, the loan portfolio can be adversely affected if California economic conditions and the real estate market in the Company's market area were to further weaken. Also, any weakness of a prolonged nature in the technology industry would have a negative impact on the local market. The effect of such events, although uncertain at this time, could result in an increase in the level of nonperforming loans and increased loan losses, which could

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adversely affect the Company's future growth and profitability. No assurance of the ultimate level of credit losses can be given with any certainty.

        The following tables summarize the Company's loan loss experience, as well as provisions and charges to the allowance for loan losses and certain pertinent ratios for the periods indicated:

 
  Three Months Ended September 30, 2013  
 
  Commercial   Real Estate   Consumer   Total  
 
  (Dollars in thousands)
 

Balance, beginning of period

  $ 12,811   $ 6,388   $ 143   $ 19,342  

Charge-offs

    (254 )   (40 )       (294 )

Recoveries

    820     7     1     828  
                   

Net (charge-offs) recoveries

    566     (33 )   1     534  

Provision (credit) for loan losses

    (10 )   (461 )   (63 )   (534 )
                   

Balance, end of period

  $ 13,367   $ 5,894   $ 81   $ 19,342  
                   

RATIOS:

                         

Annualized net charge-offs (recoveries) to average loans(1)

    -0.26 %   0.02 %   0.00 %   -0.24 %

Allowance for loan losses to total loans(1)

    1.50 %   0.66 %   0.01 %   2.17 %

Allowance for loan losses to nonperforming loans

    88.42 %   38.99 %   0.54 %   127.95 %

(1)
Average loans and total loans exclude loans held-for-sale

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  Three Months Ended September 30, 2012  
 
  Commercial   Real Estate   Consumer   Total  
 
  (Dollars in thousands)
 

Balance, beginning of period

  $ 13,378   $ 6,539   $ 106   $ 20,023  

Charge-offs

    (916 )   (1,334 )       (2,250 )

Recoveries

    149     2         151  
                   

Net (charge-offs) recoveries

    (767 )   (1,332 )       (2,099 )

Provision (credit) for loan losses

    661     525     14     1,200  
                   

Balance, end of period

  $ 13,272   $ 5,732   $ 120   $ 19,124  
                   

RATIOS:

                         

Annualized net charge-offs (recoveries) to average loans(1)

    0.39 %   0.67 %   0.00 %   1.06 %

Allowance for loan losses to total loans(1)

    1.66 %   0.72 %   0.01 %   2.39 %

Allowance for loan losses to nonperforming loans

    69.42 %   29.98 %   0.63 %   100.03 %

(1)
Average loans and total loans exclude loans held-for-sale.


 
  Nine Months Ended September 30, 2013  
 
  Commercial   Real Estate   Consumer   Total  
 
  (Dollars in thousands)
 

Balance, beginning of period

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

Charge-offs

    (1,213 )   (96 )       (1,309 )

Recoveries

    2,158     269     1     2,428  
                   

Net (charge-offs) recoveries

    945     173     1     1,119  

Provision (credit) for loan losses

    (444 )   (313 )   (47 )   (804 )
                   

Balance, end of period

  $ 13,367   $ 5,894   $ 81   $ 19,342  
                   

RATIOS:

                         

Annualized net charge-offs (recoveries) to average loans(1)

    -0.15 %   -0.03 %   0.00 %   -0.18 %

Allowance for loan losses to total loans(1)

    1.50 %   0.66 %   0.01 %   2.17 %

Allowance for loan losses to nonperforming loans

    88.42 %   38.99 %   0.54 %   127.95 %

(1)
Average loans and total loans exclude loans held-for-sale

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  Nine Months Ended September 30, 2012  
 
  Commercial   Real Estate   Consumer   Total  
 
  (Dollars in thousands)
 

Balance, beginning of period

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

Charge-offs

    (3,106 )   (1,480 )       (4,586 )

Recoveries

    670     225         895  
                   

Net (charge-offs) recoveries

    (2,436 )   (1,255 )       (3,691 )

Provision (credit) for loan losses

    2,493     (351 )   (27 )   2,115  
                   

Balance, end of period

  $ 13,272   $ 5,732   $ 120   $ 19,124  
                   

RATIOS:

                         

Annualized net charge-offs (recoveries) to average loans(1)

    0.42 %   0.21 %   0.00 %   0.63 %

Allowance for loan losses to total loans(1)

    1.66 %   0.72 %   0.01 %   2.39 %

Allowance for loan losses to nonperforming loans

    69.42 %   29.98 %   0.63 %   100.03 %

(1)
Average loans and total loans exclude loans held-for-sale.

        The following table provides a summary of the allocation of the allowance for loan losses for specific class at the dates indicated. The allocation presented should not be interpreted as an indication that charges to the allowance for loan losses will be incurred in these amounts or proportions, or that the portion of the allowance allocated to each category represents the total amount available for charge-offs that may occur within these classes.

Allocation of Allowance for Loan Losses

 
  September 30,   December 31,  
 
  2013   2012   2012  
 
  Allowance   Percent
of Loans
in each
category
to total
loans
  Allowance   Percent
of Loans
in each
category
to total
loans
  Allowance   Percent
of Loans
in each
category
to total
loans
 
 
  (Dollars in thousands)
 

Commercial

  $ 13,367     46 % $ 13,272     47 % $ 12,866     46 %

Real estate:

                                     

Commercial and residential

    4,310     43 %   4,916     42 %   4,609     44 %

Land and construction

    373     3 %   325     3 %   399     3 %

Home equity

    1,211     6 %   491     6 %   1,026     5 %

Consumer

    81     2 %   120     2 %   127     2 %
                           

Total

  $ 19,342     100 % $ 19,124     100 % $ 19,027     100 %
                           

        The allowance for loan losses totaled $19.3 million, or 2.17% of total loans at September 30, 2013, compared to $19.1 million, or 2.39% of total loans at September 30, 2012, and $19.0 million, or 2.34% of total loans at December 31, 2012. Loan charge-offs reflect the realization of losses in the portfolio that were partially recognized previously through the provision for loan losses. The Company had net recoveries of $534,000, or 0.24% of average loans, for the third quarter of 2013, compared to net charge-offs of $2.1 million, or 1.06% of average loans, for the third quarter of 2012, and net charge-offs of $766,000, or 0.38% of average loans, for the fourth quarter of 2012. The allowance for loan losses related to the commercial portfolio increased $501,000 at September 30, 2013 from December 31, 2012, as a result of a credit to the provision for loan losses of $444,000 and net recoveries of $945,000. The increase in the allowance for loan losses was primarily due to an increase in the balance of commercial

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loans outstanding, partially offset by a decline in historical charge off levels. The allowance for loan losses related to the real estate portfolio decreased $140,000 at September 30, 2013 from December 31, 2012, as a result of a credit to the provision for loan losses of $313,000 and net recoveries of $173,000. The decrease in the allowance for loan losses was primarily due to improved risk grading and credit metrics on real estate loans, as well as a decline in historical charge off levels.

Deposits

        The composition and cost of the Company's deposit base are important components in analyzing the Company's net interest margin and balance sheet liquidity characteristics, both of which are discussed in greater detail in other sections herein. The Company's liquidity is impacted by the volatility of deposits or other funding instruments or, in other words, by the propensity of that money to leave the institution for rate-related or other reasons. Deposits can be adversely affected if economic conditions in California, and the Company's market area in particular, continue to weaken. Potentially, the most volatile deposits in a financial institution are jumbo certificates of deposit, meaning time deposits with balances that equal or exceed $100,000, as customers with balances of that magnitude are typically more rate-sensitive than customers with smaller balances.

        The following table summarizes the distribution of deposits and the percentage of distribution in each category of deposits for the periods indicated:

 
  September 30, 2013   September 30, 2012   December 31, 2012  
 
  Balance   % to Total   Balance   % to Total   Balance   % to Total  
 
  (Dollars in thousands)
 

Demand, noninterest-bearing

  $ 409,269     34 % $ 405,880     36 % $ 727,684     49 %

Demand, interest-bearing

    178,783     15 %   159,361     14 %   155,951     10 %

Savings and money market

    312,991     26 %   281,579     25 %   272,047     18 %

Time deposits—under $100

    22,029     2 %   26,513     2 %   25,157     2 %

Time deposits—$100 and over

    195,321     17 %   170,430     15 %   190,502     13 %

Time deposits—brokered

    62,833     5 %   89,172     8 %   97,807     7 %

CDARS—money market and time deposits

    14,311     1 %   5,098     0 %   10,220     1 %
                           

Total deposits

  $ 1,195,537     100 % $ 1,138,033     100 % $ 1,479,368     100 %
                           

        The Company obtains deposits from a cross-section of the communities it serves. The Company's business is not generally seasonal in nature. The Company is not dependent upon funds from sources outside the United States. Less than 9% of deposits at September 30, 2013, 6% at September 30, 2012, and December 31, 2012 were from public sources.

        Deposits totaled $1.20 billion at September 30, 2013, compared to $1.14 billion at September 30, 2012, and $1.48 billion at December 31, 2012. Late in the fourth quarter of 2012, the Company received short-term demand deposits in the amount of $467.5 million from one customer for specific transactions. Of this amount, $195.6 million was subsequently withdrawn, for a net outstanding balance of $271.9 million at December 31, 2012. Deposits (excluding all time deposits, CDARS deposits, and the short term demand deposits from one customer at December 31, 2012) increased to $901.0 million at September 30, 2013, an increase of $54.2 million, or 6% from $846.8 million at September 30, 2012, and increased $17.2 million, or 2%, from $883.8 million at December 31, 2012.

        At September 30, 2013, the Company had $112.7 million (at fair value) of securities pledged for $98.0 million in certificates of deposits from the State of California. At September 30, 2012, the Company had $77.6 million of securities pledged for $65.0 million in certificates of deposits from the State of California. At December 31, 2012, the Company had $95.3 million (at fair value) of securities pledged for $85.0 million in certificates of deposits from the State of California. At September 30,

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2013, brokered deposits decreased $26.4 million, or 30%, to $62.8 million, compared to $89.2 million at September 30, 2012, and decreased $35.0 million, or 36%, from $97.8 million at December 31, 2012.

        CDARS deposits were comprised of $7.9 million of money market accounts and $6.4 million of time deposits at September 30, 2013. All of the $5.1 million of CDARS deposits at September 30, 2012, were time deposits. CDARS deposits were comprised of $5.0 million of money market accounts and $5.2 million of time deposits at December 31, 2012.

        The following table indicates the contractual maturity schedule of the Company's time deposits of $100,000 and over, and all CDARS time deposits and brokered deposits as of September 30, 2013:

 
  Balance   % of Total  
 
  (Dollars in thousands)
 

Three months or less

  $ 78,382     30 %

Over three months through six months

    99,427     38 %

Over six months through twelve months

    48,531     18 %

Over twelve months

    38,189     14 %
           

Total

  $ 264,529     100 %
           

        The Company focuses primarily on providing and servicing business deposit accounts that are frequently over $100,000 in average balance per account. As a result, certain types of business clients that the Company serves typically carry average deposits in excess of $100,000. The account activity for some account types and client types necessitates appropriate liquidity management practices by the Company to help ensure its ability to fund deposit withdrawals.

Return on Equity and Assets

        The following table indicates the ratios for return on average assets and average equity, and average equity to average assets for the periods indicated:

 
  Three Months Ended
September 30,
  Nine Months Ended
September 30,
 
 
  2013   2012   2013   2012  

Annualized return on average assets

    0.90 %   0.73 %   0.78 %   0.72 %

Annualized return on average tangible assets

    0.90 %   0.73 %   0.78 %   0.73 %

Annualized return on average equity

    7.58 %   5.91 %   6.44 %   5.59 %

Annualized return on average tangible equity

    7.65 %   5.99 %   6.51 %   5.67 %

Dividend payout ratio(1)

    29.82 %   N/A     11.70 %   N/A  

Average equity to average assets ratio

    11.85 %   12.31 %   12.03 %   12.96 %

(1)
Percentage is calculated based on dividends paid on common stock and Series C Preferred Stock (on an as converted basis) divided by net income.

Off-Balance Sheet Arrangements

        In the normal course of business, the Company makes commitments to extend credit to its customers as long as there are no violations of any conditions established in the contractual arrangements. These commitments are obligations that represent a potential credit risk to the Company, but are not reflected on the Company's consolidated balance sheets. Total unused commitments to extend credit were $353.1 million at September 30, 2013, compared to $297.9 million at September 30, 2012, and $308.9 million at December 31, 2012. Unused commitments represented 40%, 37%, and 38% of outstanding gross loans at September 30, 2013, September 30, 2012, and December 31, 2012, respectively.

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        The effect on the Company's revenues, expenses, cash flows and liquidity from the unused portion of the commitments to provide credit cannot be reasonably predicted because there is no certainty that lines of credit and letters of credit will ever be fully utilized. The following table presents the Company's commitments to extend credit for the periods indicated:

 
  September 30,    
   
 
 
  December 31,
2012
 
 
  2013   2012  
 
  Fixed Rate   Variable Rate   Fixed Rate   Variable Rate   Fixed Rate   Variable Rate  
 
  (Dollars in thousands)
 

Unused lines of credit and commitments to make loans

  $ 7,220   $ 335,384   $ 9,866   $ 278,317   $ 8,410   $ 291,191  

Standby letters of credit

        10,524     2,200     7,564     2,200     7,051  
                           

  $ 7,220   $ 345,908   $ 12,066   $ 285,881   $ 10,610   $ 298,242  
                           

Liquidity and Asset/Liability Management

        Liquidity refers to the Company's ability to maintain cash flows sufficient to fund operations and to meet obligations and other commitments in a timely and cost effective fashion. At various times the Company requires funds to meet short-term cash requirements brought about by loan growth or deposit outflows, the purchase of assets, or liability repayments. An integral part of the Company's ability to manage its liquidity position appropriately is the Company's large base of core deposits, which are generated by offering traditional banking services in its service area and which have historically been a stable source of funds. To manage liquidity needs properly, cash inflows must be timed to coincide with anticipated outflows or sufficient liquidity resources must be available to meet varying demands. The Company manages liquidity to be able to meet unexpected sudden changes in levels of its assets or deposit liabilities without maintaining excessive amounts of balance sheet liquidity. Excess balance sheet liquidity can negatively impact the Company's interest margin. In order to meet short-term liquidity needs the Company utilizes overnight Federal funds purchase arrangements and other borrowing arrangements with correspondent banks, solicits brokered deposits if cost effective deposits are not available from local sources and maintains collateralized lines of credit with the FHLB and FRB. In addition, the Company can raise cash for temporary needs by selling securities under agreements to repurchase and selling securities available-for-sale.

        One of the measures we analyze for liquidity is our loan to deposit ratio. Our loan to deposit ratio was 74.70% at September 30, 2013, compared to 70.24% at September 30, 2012, and 54.91% at December 31, 2012. The loan to deposit ratio was 67.27% at December 31, 2012, excluding the $271.9 million, respectively, of short-term demand deposits from one customer.

FHLB and FRB Borrowings and Available Lines of Credit

        The Company has off-balance sheet liquidity in the form of Federal funds purchase arrangements with correspondent banks, including the FHLB and FRB. The Company can borrow from the FHLB on a short-term (typically overnight) or long-term (over one year) basis. The Company had no overnight borrowings from the FHLB at September 30, 2013, September 30, 2012 and December 31, 2012. The Company had $251.3 million of loans pledged to the FHLB as collateral on an available line of credit of $120.7 million at September 30, 2013.

        The Company can also borrow from FRB's discount window. The Company had $311.5 million of loans pledged to the FRB as collateral on an available line of credit of $234.1 million at September 30, 2013, none of which was outstanding.

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        At September 30, 2013, the Company had Federal funds purchase arrangements available of $55.0 million. There were no Federal funds purchased outstanding at September 30, 2013, September 30, 2012, and December 31, 2012.

        The Company may also utilize securities sold under repurchase agreements to manage our liquidity position. There were no securities sold under agreements to repurchase at September 30, 2013, September 30, 2012, and December 31, 2012.

        The following table summarizes the Company's borrowings under its Federal funds purchased, security repurchase arrangements and lines of credit for the periods indicated:

 
  September 30,    
 
 
  December 31,
2012
 
 
  2013   2012  
 
  (Dollars in thousands)
 

Average balance year-to-date

  $   $ 1,617   $  

Average interest rate year-to-date

    N/A     0.24 %   N/A  

Maximum month-end balance during the quarter

  $   $   $  

Average rate at period-end

    N/A     N/A     N/A  

Capital Resources

        The Company uses a variety of measures to evaluate capital adequacy. Management reviews various capital measurements on a regular basis and takes appropriate action to ensure that such measurements are within established internal and external guidelines. The external guidelines, which are issued by the Federal Reserve Board and the FDIC, establish a risk-adjusted ratio relating capital to different categories of assets and off-balance sheet exposures. There are two categories of capital under the Federal Reserve Board and FDIC guidelines: Tier 1 and Tier 2 Capital. Our Tier 1 Capital currently consists of total shareholders' equity (excluding accumulated other comprehensive income or loss) and the proceeds from the issuance of trust preferred securities (trust preferred securities are counted only up to a maximum of 25% of Tier 1 capital), less goodwill and other intangible assets and disallowed deferred tax assets. Our Tier 2 Capital includes the allowances for loan losses and off-balance sheet credit losses.

        In July 2013, the Federal banking regulators approved a final rule to implement the revised capital adequacy standards of the Basel Committee on Banking Supervision, commonly called Basel III, and to address relevant provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"). The final rule strengthens the definition of regulatory capital, increases risk-based capital requirements, makes selected changes to the calculation of risk-weighted assets, and adjusts the prompt corrective action thresholds. Community banking organizations, such as the Company and the Bank, become subject to the new rule on January 1, 2015 and certain provisions of the new rule will be phased in over the period of 2015 through 2019. The final rule:

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        Management is currently evaluating the provisions of the final rule and their expected impact on the Company and the Bank.

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        The following table summarizes risk-based capital, risk-weighted assets, and risk-based capital ratios of the consolidated Company:

 
  September 30,    
   
   
 
 
  December 31, 2012    
   
 
 
  2013   2012    
   
 
 
  (Dollars in thousands)
   
   
 

Capital components:

                               

Tier 1 Capital

  $ 161,523   $ 154,350   $ 157,947              

Tier 2 Capital

    14,508     13,109     13,254              
                           

Total risk-based capital

  $ 176,031   $ 167,459   $ 171,201              
                           

Risk-weighted assets

  $ 1,155,477   $ 1,042,590   $ 1,054,394              

Average assets for capital purposes

  $ 1,408,107   $ 1,328,119   $ 1,378,011              
 
   
   
   
   
 
 
   
   
   
  Well-Capitalized
Regulatory
Requirements
  Minimum
Regulatory
Requirements
 

Capital ratios:

                               

Total risk-based capital

    15.2 %   16.1 %   16.2 %   10.00 %   8.00 %

Tier 1 risk-based capital

    14.0 %   14.8 %   15.0 %   6.00 %   4.00 %

Leverage(1)

    11.5 %   11.6 %   11.5 %   N/A     4.00 %

(1)
Tier 1 capital divided by quarterly average assets (excluding goodwill, other intangible assets and disallowed deferred tax assets).

        The table above presents the capital ratios of the consolidated Company computed in accordance with applicable regulatory guidelines and compared to the standards for minimum capital adequacy requirements for bank holding companies.

        The following table summarizes risk-based capital, risk-weighted assets, and risk-based capital ratios of HBC:

 
  September 30,    
   
   
 
 
  December 31, 2012    
   
 
 
  2013   2012    
   
 
 
  (Dollars in thousands)
   
   
 

Capital components:

                               

Tier 1 Capital

  $ 144,097   $ 144,530   $ 147,742              

Tier 2 Capital

    14,499     13,123     13,262              
                           

Total risk-based capital

  $ 158,596   $ 157,653   $ 161,004              
                           

Risk-weighted assets

  $ 1,154,758   $ 1,043,754   $ 1,055,061              

Average assets for capital purposes

  $ 1,407,011   $ 1,329,036   $ 1,378,238              
 
   
   
   
   
 
 
   
   
   
  Well-Capitalized
Regulatory
Requirements
  Minimum
Regulatory
Requirements
 

Capital ratios:

                               

Total risk-based capital

    13.7 %   15.1 %   15.3 %   10.00 %   8.00 %

Tier 1 risk-based capital

    12.5 %   13.8 %   14.0 %   6.00 %   4.00 %

Leverage(1)

    10.2 %   10.9 %   10.7 %   5.00 %   4.00 %

(1)
Tier 1 capital divided by quarterly average assets (excluding goodwill, other intangible assets and disallowed deferred tax assets).

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        The table above presents the capital ratios of HBC computed in accordance with applicable regulatory guidelines and compared to the standards for minimum capital adequacy requirements under the FDIC's prompt corrective action authority.

        Quantitative measures established by regulation to help ensure capital adequacy require the Company and HBC to maintain minimum amounts and ratios of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital to average assets (as defined). Management believes that, as of September 30, 2013, September 30, 2012, and December 31, 2012, the Company and HBC met all capital adequacy guidelines to which they were subject.

        As of September 30, 2013 HBC was categorized as "well-capitalized" under the regulatory framework for prompt corrective action. There are no conditions or events since September 30, 2013 that management believes have changed the categorization of the Company or HBC as well-capitalized.

        At September 30, 2013, the Company had total shareholders' equity of $170.5 million, including $19.5 million in preferred stock, $132.3 million in common stock, $23.0 million in retained earnings, and ($4.3) million of accumulated other comprehensive loss.

        The accumulated other comprehensive loss of ($4.3) million at September 30, 2013 decreased from accumulated other comprehensive income of $4.8 million at September 31, 2012, and accumulated other comprehensive income of $2.7 million at December 31, 2012. The decrease was primarily due to an unrealized loss on securities available-for-sale of ($69,000), net of taxes, at September 30, 2013, compared to an unrealized gain on securities available-for-sale of $8.3 million, net of taxes, at September 30, 2012, and an unrealized gain on securities available-for-sale $6.9 million, net of taxes, at December 31, 2012. The components of other comprehensive loss, net of taxes, at September 30, 2013 include the following: an unrealized loss on available-for-sale securities of ($69,000); the remaining unamortized unrealized gain on securities available-for-sale transferred to held-to-maturity of $473,000; a liability adjustment on split dollar insurance contracts of ($2.4) million; a liability adjustment on the supplemental executive retirement plan of ($3.3) million; and an unrealized gain on interest-only strip from SBA loans of $956,000.

        To enhance regulatory capital and to provide liquidity, the Company, through unconsolidated subsidiary grantor trusts, issued the following mandatory redeemable cumulative trust preferred securities of subsidiary grantor trusts: In the first quarter of 2000, the Company issued $7.0 million principal amount of 10.875% fixed-rate subordinated debt due on March 8, 2030, and common securities of $217,000 to a subsidiary trust, which in turn issued a similar amount of trust preferred securities. In the third quarter of 2000, the Company issued $7.0 million principal amount of 10.60% fixed-rate subordinated debt due on September 7, 2030, and common securities of $206,000 to a subsidiary trust, which in turn issued a similar amount of trust preferred securities. In the third quarter of 2001, the Company issued $5.2 million aggregate principal amount of Floating Rate Junior Subordinated Deferrable Interest Debentures due on July 31, 2031 to a subsidiary trust, which in turn issued a similar amount of trust preferred securities. In the third quarter of 2002, the Company issued $4.1 million of aggregate principal amount of Floating Rate Junior Subordinated Deferrable Interest Debentures due on September 26, 2032 to a subsidiary trust, which in turn issued a similar amount of trust preferred securities. The subordinated debt was recorded as a component of long-term debt and included the value of the common stock issued by the trusts to the Company. The common stock was recorded as other assets for the amount issued. Under applicable regulatory guidelines, the trust preferred securities currently qualified as Tier I capital. The subsidiary trusts were not consolidated in the Company's consolidated financial statements. Under the Dodd-Frank Wall Street Reform and Consumer Protection Act, certain trust preferred securities will no longer be eligible to be included as

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Tier 1 capital for regulatory purposes. The trust preferred securities continued to be eligible for Tier 1 capital under Dodd-Frank for bank holding companies with less than $15 billion of assets.

        During the third quarter of 2012, the Company redeemed its 10.875% fixed- rate subordinated debentures in the amount of $7 million issued to Heritage Capital Trust I and the Company's 10.600% fixed-rate subordinated debentures in the amount of $7 million issued to Heritage Statutory Trust I. The related trust securities issued by Capital Trust I and Statutory Trust I were also redeemed in connection with the subordinated debt redemption and the trusts were dissolved.

        During the third quarter of 2013, the Company redeemed its Company's Floating Rate Junior Subordinated Debentures due July 31, 2031 in the amount of $5 million issued to Heritage Statutory Trust II and the Company's Floating Rate Junior Subordinated Debentures due September 26, 2032, in the amount of $4 million issued to Heritage Statutory Trust III (collectively referred to as the "Floating-Rate Sub Debt"). The $5 million Floating-Rate Sub Debt was redeemed on July 31, 2013. The $4 million Floating-Rate Sub Debt was redeemed on September 26, 2013. The related trust securities issued by Statutory Trust II and Statutory Trust III were also redeemed in connection with the subordinated debt redemption and the trusts were dissolved. The Company used available cash and proceeds from a $9 million distribution from the Bank for the redemption. The Company incurred a total charge of $167,000 in the second quarter of 2013, representing the agency origination fees associated with the Floating-Rate Sub Debt. On an annual basis, the redemption of the Floating-Rate Sub Debt will eliminate approximately $360,000 in interest expense.

U.S. Treasury Capital Purchase Program

        The Company received $40 million in November 2008 through the issuance of its Series A Preferred Stock and a warrant to purchase 462,963 shares of its common stock to the Treasury through the U.S. Treasury Capital Purchase Program. The Series A Preferred Stock qualified as a component of Tier 1 capital.

        On March 7, 2012, in accordance with approvals received from the U.S. Treasury and the Federal Reserve, the Company repurchased all of the Series A Preferred Stock and paid the related accrued and unpaid dividends. The repurchase of the Series A Preferred Stock will save $2.0 million in annual dividends. On June 12, 2013, the Company completed the repurchase of the common stock warrant for $140,000.

Series C Preferred Stock

        On June 21, 2010, the Company issued to various institutional investors 21,004 shares of newly issued Series C Preferred Stock. The Series C Preferred Stock is mandatorily convertible into 5,601,000 shares of common stock at a conversion price of $3.75 per share upon a subsequent transfer of the Series C Preferred stock to third parties not affiliates with the holder in a widely dispersed offering. The Series C Preferred Stock is non-voting except in the case of certain transactions that would affect the rights of the holders of the Series C Preferred Stock or applicable law. Holders of Series C Preferred Stock will receive dividends if and only to the extent dividends are paid to holders of common stock. The Series C Preferred Stock is not redeemable by the Company or by the holders and has a liquidation preference of $1,000 per share. The Series C Preferred Stock ranks senior to the Company's common stock.

Market Risk

        Market risk is the risk of loss of future earnings, fair values, or future cash flows that may result from changes in the price of a financial instrument. The value of a financial instrument may change as a result of changes in interest rates, foreign currency exchange rates, commodity prices, equity prices and other market changes that affect market risk sensitive instruments. Market risk is attributed to all

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market risk sensitive financial instruments, including securities, loans, deposits and borrowings, as well as the Company's role as a financial intermediary in customer-related transactions. The objective of market risk management is to avoid excessive exposure of the Company's earnings and equity to loss and to reduce the volatility inherent in certain financial instruments.

Interest Rate Management

        Market risk arises from changes in interest rates, exchange rates, commodity prices and equity prices. The Company's market risk exposure is primarily that of interest rate risk, and it has established policies and procedures to monitor and limit earnings and balance sheet exposure to changes in interest rates. The Company does not engage in the trading of financial instruments, nor does the Company have exposure to currency exchange rates.

        The principal objective of interest rate risk management (often referred to as "asset/liability management") is to manage the financial components of the Company in a manner that will optimize the risk/reward equation for earnings and capital in relation to changing interest rates. The Company's exposure to market risk is reviewed on a regular basis by the Asset/Liability Committee. Interest rate risk is the potential of economic losses due to future interest rate changes. These economic losses can be reflected as a loss of future net interest income and/or a loss of current fair market values. The objective is to measure the effect on net interest income and to adjust the balance sheet to minimize the inherent risk while at the same time maximizing income. Management realizes certain risks are inherent, and that the goal is to identify and manage the risks. Management uses two methodologies to manage interest rate risk: (i) a standard GAP analysis; and (ii) an interest rate shock simulation model.

        The planning of asset and liability maturities is an integral part of the management of an institution's net interest margin. To the extent maturities of assets and liabilities do not match in a changing interest rate environment, the net interest margin may change over time. Even with perfectly matched repricing of assets and liabilities, risks remain in the form of prepayment of loans or securities or in the form of delays in the adjustment of rates of interest applying to either earning assets with floating rates or to interest bearing liabilities. The Company has generally been able to control its exposure to changing interest rates by maintaining primarily floating interest rate loans and a majority of its time certificates with relatively short maturities.

        Interest rate changes do not affect all categories of assets and liabilities equally or at the same time. Varying interest rate environments can create unexpected changes in prepayment levels of assets and liabilities, which may have a significant effect on the net interest margin and are not reflected in the interest sensitivity analysis table. Because of these factors, an interest sensitivity GAP report may not provide a complete assessment of the exposure to changes in interest rates.

        The Company uses modeling software for asset/liability management in order to simulate the effects of potential interest rate changes on the Company's net interest margin, and to calculate the estimated fair values of the Company's financial instruments under different interest rate scenarios. The program imports current balances, interest rates, maturity dates and repricing information for individual financial instruments, and incorporates assumptions on the characteristics of embedded options along with pricing and duration for new volumes to project the effects of a given interest rate change on the Company's interest income and interest expense. Rate scenarios consisting of key rate and yield curve projections are run against the Company's investment, loan, deposit and borrowed funds portfolios. These rate projections can be shocked (an immediate and parallel change in all base rates, up or down) and ramped (an incremental increase or decrease in rates over a specified time period), based on current trends and econometric models or stable economic conditions (unchanged from current actual levels).

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        The following table sets forth the estimated changes in the Company's annual net interest income that would result from the designated instantaneous parallel shift in interest rates noted, as of September 30, 2013. Computations of prospective effects of hypothetical interest rate changes are based on numerous assumptions including relative levels of market interest rates, loan prepayments and deposit decay, and should not be relied upon as indicative of actual results.

 
  Increase/(Decrease)
in Estimated Net
Interest Income
 
 
  Amount   Percent  
 
  (Dollars in thousands)
 

Change in Interest Rates (basis points)

             

+400

  $ 10,770     21.2 %

+300

  $ 8,006     15.8 %

+200

  $ 5,224     10.3 %

+100

  $ 2,456     4.8 %

       0

  $     0.0 %

-100

  $ (4,757 )   -9.4 %

-200

  $ (10,097 )   -19.9 %

        This data does not reflect any actions that we may undertake in response to changes in interest rates such as changes in rates paid on certain deposit accounts based on local competitive factors, which could reduce the actual impact on net interest income.

        As with any method of gauging interest rate risk, there are certain shortcomings inherent to the methodology noted above. The model assumes interest rate changes are instantaneous parallel shifts in the yield curve. In reality, rate changes are rarely instantaneous. The use of the simplifying assumption that short-term and long-term rates change by the same degree may also misstate historic rate patterns, which rarely show parallel yield curve shifts. Further, the model assumes that certain assets and liabilities of similar maturity or period to repricing will react in the same way to changes in rates. In reality, certain types of financial instruments may react in advance of changes in market rates, while the reaction of other types of financial instruments may lag behind the change in general market rates. Additionally, the methodology noted above does not reflect the full impact of annual and lifetime restrictions on changes in rates for certain assets, such as adjustable rate loans. When interest rates change, actual loan prepayments and actual early withdrawals from certificates may deviate significantly from the assumptions used in the model. Finally, this methodology does not measure or reflect the impact that higher rates may have on adjustable-rate loan clients' ability to service their debt. All of these factors are considered in monitoring the Company's exposure to interest rate risk.

ITEM 3—QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

        The information concerning quantitative and qualitative disclosure or market risk called for by Item 305 of Regulation S-K is included as part of Item 2 above.

ITEM 4—CONTROLS AND PROCEDURES

Disclosure Control and Procedures

        The Company has carried out an evaluation, under the supervision and with the participation of the Company's management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures as of September 30, 2013. As defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), disclosure controls and procedures are controls and procedures designed to reasonably assure that information required to be disclosed in our reports filed or

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submitted under the Exchange Act are recorded, processed, summarized and reported on a timely basis. Disclosure controls are also designed to reasonably assure that such information is accumulated and communicated to our management, including the Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. Based upon their evaluation, our Chief Executive Officer and Chief Financial Officer concluded the Company's disclosure controls were effective as of September 30, 2013, the period covered by this report on Form 10-Q.

        During the three and nine months ended September 30, 2013, there were no changes in our internal controls over financial reporting that materially affected, or are reasonably likely to affect, our internal controls over financial reporting.

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Part II—OTHER INFORMATION

ITEM 1—LEGAL PROCEEDINGS

        The Company is involved in certain legal actions arising from normal business activities. Management, based upon the advice of legal counsel, believes the ultimate resolution of all pending legal actions will not have a material effect on the financial statements of the Company.

ITEM 1A—RISK FACTORS

        In addition to the other information set forth in this Report, you should carefully consider the factors discussed in Part I, "Item 1A. Risk Factors" in our Annual Report on Form 10-K for the year ended December 31, 2012, which could materially affect our business, financial condition and/or operating results. There were no material changes from risk factors previously disclosed in our 2012 Annual Report on Form 10-K. The risk factors identified are in addition to those contained in any other cautionary statements, written or oral, which may be made or otherwise addressed in connection with a forward-looking statement or contained in any of our subsequent filings with the Securities and Exchange Commission.

ITEM 2—UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

        None

ITEM 3—DEFAULTS UPON SENIOR SECURITIES

        None

ITEM 4—MINE SAFETY DISCLOSURES

        None

ITEM 5—OTHER INFORMATION

        None

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ITEM 6—EXHIBITS

Exhibit   Description
  3.1   Heritage Commerce Corp Restated Articles of Incorporation, as amended (incorporated by reference to Exhibit 3.1 to the Registrant's Annual Report on Form 10-K filed on March 4, 2010)

 

3.2

 

Certificate of Amendment of Articles of Incorporation of Heritage Commerce Corp as filed with the California Secretary of State on June 1, 2010 (incorporated by reference to Exhibit 3.1 to the Registrant's Registration Statement on Form S-1 filed July 23, 2010).

 

3.3

 

Heritage Commerce Corp Bylaws, as amended (incorporated by reference to the Registrant's Current Report on Form 8-K filed on June 28, 2013)

 

4.1

 

Certificate of Determination for Series C Convertible Perpetual Preferred Stock (incorporated by reference to the Registrant's Form 8-K filed on June 22, 2010)

 

12.1

 

Calculation of Ratio of Earnings to Fixed Charges and Ratio of Earnings to Fixed Charges and Preferred Stock Dividends

 

31.1

 

Certification of Registrant's Chief Executive Officer Pursuant To Section 302 of the Sarbanes-Oxley Act of 2002

 

31.2

 

Certification of Registrant's Chief Financial Officer Pursuant To Section 302 of the Sarbanes-Oxley Act of 2002

 

32.1

 

Certification of Registrant's Chief Executive Officer Pursuant To 18 U.S.C. Section 1350

 

32.2

 

Certification of Registrant's Chief Financial Officer Pursuant To 18 U.S.C. Section 1350

 

101.INS

 

XBRL Instance Document, furnished herewith

 

101.SCH

 

XBRL Taxonomy Extension Schema Document, furnished herewith

 

101.CAL

 

XBRL Taxonomy Extension Calculation Linkbase Document, furnished herewith

 

101.DEF

 

XBRL Taxonomy Extension Definition Linkbase Document, furnished herewith

 

101.LAB

 

XBRL Taxonomy Extension Label Linkbase Document, furnished herewith

 

101.PRE

 

XBRL Taxonomy Extension Presentation Linkbase Document, furnished herewith

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SIGNATURES

        Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

    Heritage Commerce Corp (Registrant)

Date: November 6, 2013

 

/s/ WALTER T. KACZMAREK

Walter T. Kaczmarek
Chief Executive Officer

Date: November 6, 2013

 

/s/ LAWRENCE D. MCGOVERN

Lawrence D. McGovern
Chief Financial Officer

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EXHIBIT INDEX

Exhibit   Description
3.1   Heritage Commerce Corp Restated Articles of Incorporation, as amended (incorporated by reference to Exhibit 3.1 to the Registrant's Annual Report on Form 10-K filed on March 4, 2010)

3.2

 

Certificate of Amendment of Articles of Incorporation of Heritage Commerce Corp as filed with the California Secretary of State on June 1, 2010 (incorporated by reference to Exhibit 3.1 to the Registrant's Registration Statement on Form S-1 filed July 23, 2010).

3.3

 

Heritage Commerce Corp Bylaws, as amended (incorporated by reference to the Registrant's Current Report on Form 8-K filed on June 28, 2013)

4.1

 

Certificate of Determination for Series C Convertible Perpetual Preferred Stock (incorporated by reference to the Registrant's Form 8-K filed on June 22, 2010)

12.1

 

Calculation of Ratio of Earnings to Fixed Charges and Ratio of Earnings to Fixed Charges and Preferred Stock Dividends

31.1

 

Certification of Registrant's Chief Executive Officer Pursuant To Section 302 of the Sarbanes-Oxley Act of 2002

31.2

 

Certification of Registrant's Chief Financial Officer Pursuant To Section 302 of the Sarbanes-Oxley Act of 2002

32.1

 

Certification of Registrant's Chief Executive Officer Pursuant To 18 U.S.C. Section 1350

32.2

 

Certification of Registrant's Chief Financial Officer Pursuant To 18 U.S.C. Section 1350

101.INS

 

XBRL Instance Document, furnished herewith

101.SCH

 

XBRL Taxonomy Extension Schema Document, furnished herewith

101.CAL

 

XBRL Taxonomy Extension Calculation Linkbase Document, furnished herewith

101.DEF

 

XBRL Taxonomy Extension Definition Linkbase Document, furnished herewith

101.LAB

 

XBRL Taxonomy Extension Label Linkbase Document, furnished herewith

101.PRE

 

XBRL Taxonomy Extension Presentation Linkbase Document, furnished herewith

82