Unassociated Document
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
 
FORM 10-Q

 
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
 
For the quarterly period ended September 30, 2006
 
 
OR
 
 
[  ] 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
 
77-0469558
(State or Other Jurisdiction of Incorporation or Organization) 
 
(I.R.S. Employer Identification Number)
 
 
150 Almaden Boulevard
San Jose, California    95113
(Address of Principal Executive Offices including Zip Code)
 
 
(408) 947-6900
(Registrant's Telephone Number, Including Area Code)
 


    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 reports), and (2) has been subject to such filing requirements for the past 90 days. YES [X] NO [   ]
 
    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 [ ]  Accelerated filer [X]  Non-accelerated filer [ ]
 
    Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES [ ] NO [X]
    
    The Registrant had 11,683,797 shares of Common Stock outstanding on October 31, 2006.
 


 
 
 
 
 
Heritage Commerce Corp and Subsidiaries
Quarterly Report on Form 10-Q
Table of Contents
 
PART I. FINANCIAL INFORMATION
 
Page No. 
 
Item 1. Consolidated Financial Statements (unaudited):
 
 
             Consolidated Balance Sheets
 
 
             Consolidated Income Statements
 
 
             Consolidated Statements of Changes in Shareholders' Equity
 
 
             Consolidated Statements of Cash Flows
 
 
             Notes to Consolidated Financial Statements
 
 
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
 
 
Item 3. Quantitative and Qualitative Disclosures About Market Risk
 
31
 
Item 4. Controls and Procedures  
 
32
 
PART II. OTHER INFORMATION
 
 
Item 1.    Legal Proceedings
 
32
 
Item 1A. Risk Factors
 
32
 
Item 2.    Unregistered Sales of Equity Securities and Use of Proceeds
 
 
Item 6.    Exhibits
 
35
 
SIGNATURES
 
 
EXHIBIT INDEX
 
35
 

1
Part I -- FINANCIAL INFORMATION
 
 
ITEM 1 - FINANCIAL STATEMENTS

Heritage Commerce Corp
Consolidated Balance Sheets (Unaudited)
   
September 30,
 
December 31,
(Dollars in thousands)
 
2006
 
2005
Assets
       
Cash and due from banks
 
$
41,438
 
$
35,560
Federal funds sold
   
41,000
   
62,900
     Total cash and cash equivalents
   
82,438
   
98,460
Securities available-for-sale, at fair value
   
173,723
   
198,495
Loans held for sale, at lower of cost or market
   
23,108
   
70,147
Loans, net of deferred costs
   
713,700
   
688,778
Allowance for loan losses
   
(9,379)
 
 
(10,224)
     Loans, net
   
704,321
   
678,554
Federal Home Loan Bank and Federal Reserve Bank stock, at cost
   
6,043
   
5,859
Company owned life insurance
   
35,805
   
34,735
Premises and equipment, net
   
2,494
   
2,541
Accrued interest receivable and other assets
   
34,896
   
41,718
     Total assets
 
$
1,062,828
 
$
1,130,509
             
Liabilities and Shareholders' Equity
           
Liabilities:
           
Deposits
           
Demand, noninterest bearing
 
$
226,297
 
$
248,009
Demand, interest bearing
   
133,636
   
157,330
Savings and money market
   
349,436
   
353,798
Time deposits, under $100
   
31,522
   
35,209
Time deposits, $100 and over
   
101,198
   
109,373
Brokered deposits, $100 and over
   
34,009
   
36,040
     Total deposits
   
876,098
   
939,759
Notes payable to subsidiary grantor trusts
   
23,702
   
23,702
Securities sold under agreement to repurchase
   
21,800
   
32,700
Accrued interest payable and other liabilities
   
21,892
   
22,731
     Total liabilities
   
943,492
   
1,018,892
             
Commitments and contingencies - see Note 7
           
             
Shareholders' equity:
           
Preferred stock, no par value; 10,000,000 shares authorized; none outstanding
   
-
   
-
Common Stock, no par value; 30,000,000 shares authorized;
           
shares outstanding: 11,681,297 at September 30, 2006, and 11,807,649 at December 31, 2005
   
62,959
   
67,602
Retained earnings
   
58,683
   
47,539
Unearned restricted stock award
   
-
   
(803)
Accumulated other comprehensive loss
   
(2,306)
 
 
(2,721)
     Total shareholders' equity
   
119,336
   
111,617
     Total liabilities and shareholders' equity
 
$
1,062,828
 
$
1,130,509
             
See notes to consolidated financial statements
2

 
Heritage Commerce Corp
Consolidated Income Statements (Unaudited)
                 
   
Three Months Ended
 
Nine Months Ended
   
September 30,
 
September 30,
(Dollars in thousands, except per share data)
 
2006
 
2005
 
2006
 
2005
Interest income:
                       
Loans, including fees
 
$
15,958
 
$
14,066
 
$
46,023
 
$
39,532
Securities, taxable
   
1,968
   
1,725
   
5,646
   
5,319
Securities, non-taxable
   
45
   
50
   
136
   
155
Interest bearing deposits in other financial institutions
   
36
   
27
   
96
   
58
Federal funds sold
   
561
   
601
   
2,319
   
1,103
     Total interest income
   
18,568
   
16,469
   
54,220
   
46,167
                         
Interest expense:
                       
Deposits
   
5,027
   
3,531
   
14,379
   
8,824
Notes payable to subsidiary grantor trusts
   
587
   
543
   
1,724
   
1,580
Repurchase agreements and other
   
140
   
195
   
486
   
729
     Total interest expense
   
5,754
   
4,269
   
16,589
   
11,133
                         
Net interest income before provision for loan losses
   
12,814
   
12,200
   
37,631
   
35,034
Provision for loan losses
   
-
   
(494)
 
 
(603)
 
 
313
Net interest income after provision for loan losses
   
12,814
   
12,694
   
38,234
   
34,721
                         
Noninterest income:
                       
Gain on sale of loans
   
832
   
702
   
3,171
   
2,160
Servicing income
   
412
   
510
   
1,321
   
1,368
Increase in cash surrender value of life insurance
   
363
   
331
   
1,070
   
887
Service charges and fees on deposit accounts
   
354
   
332
   
1,008
   
1,120
Gain on sale of leased equipment
   
-
   
-
   
-
   
299
Equipment leasing
   
-
   
-
   
-
   
131
Other
   
338
   
349
   
880
   
1,254
     Total noninterest income
   
2,299
   
2,224
   
7,450
   
7,219
                         
Noninterest expense:
                       
Salaries and employee benefits
   
4,941
   
4,697
   
14,703
   
14,912
Occupancy
   
773
   
779
   
2,324
   
2,471
Professional fees
   
442
   
511
   
1,289
   
1,232
Client services
   
230
   
300
   
772
   
1,052
Advertising and promotion
   
206
   
290
   
763
   
802
Low income housing investment losses and writedowns
   
257
   
260
   
734
   
805
Data processing
   
156
   
167
   
498
   
508
Furniture and equipment
   
140
   
181
   
397
   
584
Amortization of leased equipment
   
-
   
-
   
-
   
334
Other
   
1,167
   
1,293
   
4,085
   
3,966
     Total noninterest expense
   
8,312
   
8,478
   
25,565
   
26,666
                         
Income before income taxes
   
6,801
   
6,440
   
20,119
   
15,274
Income tax expense
   
2,448
   
2,245
   
7,201
   
5,086
                         
Net income
 
$
4,353
 
$
4,195
 
$
12,918
 
$
10,188
                         
Earnings per share:
                       
     Basic
 
$
0.37
 
$
0.36
 
$
1.09
 
$
0.86
                         
     Diluted
 
$
0.36
 
$
0.35
 
$
1.08
 
$
0.84
                         
See notes to consolidated financial statements
 
   
 3
Heritage Commerce Corp
Consolidated Statements of Changes in Shareholders' Equity (Unaudited)
                                     
               
Unearned
     
 Accumulated
           
 
           
Restricted 
 
Unallocated
 
Other
 
 
 
Total
 
 
   
Common Stock
 
Stock
 
ESOP
 
Comprehensive
 
Retained
 
Shareholders'
 
Comprehensive
(Dollars in thousands, except share data)
 
Shares
     
Amount
 
Award
 
Shares
 
Loss
 
Earnings
 
Equity
 
Income
Balance, January 1, 2005
 
11,669,837
 
 
 
 $          67,409
 
$             -
 
$          (193)
 
$              (1,730)
 
$         33,093
 
$             98,579
   
Net Income
   
-
       
-
   
-
   
-
   
-
   
10,188
   
10,188
 
$
10,188
Net change in unrealized gain/loss on securities
                                                   
available-for-sale and Interest-Only ("I/O") strips, net of 
                                                   
reclassification adjustment and deferred income taxes
   
-
       
-
   
-
   
-
   
(536)
   
-
   
(536)
   
(536)
Decrease in minimum pension liability, net of deferred
                                                   
income taxes
   
-
       
-
   
-
   
-
   
(336)
   
-
   
(336)
   
(336)
     Total comprehensive income
                                               
$
9,316
ESOP shares released
   
-
       
285
   
-
   
193
   
-
   
-
   
478
     
Restricted stock award
   
51,000
       
926
   
(926)
 
 
-
   
-
   
-
   
-
     
Amortization of restricted stock award
   
-
       
-
   
84
   
-
   
-
   
-
   
84
     
Redemption payment on commom stock
   
-
       
(12)
 
 
-
   
-
   
-
   
-
   
(12)
 
   
Commom stock repurchased
   
(300,160)
 
 
   
(5,732)
 
       
 
   
 
         
(5,732)
 
   
Stock options exercised
   
359,181
       
4,344
   
-
   
-
   
-
   
-
   
4,344
     
Balance, September 30, 2005
   
11,779,858
 
 
  
 $
67,220
 
$
(842)
 
$
-
 
$
(2,602)
 
$
43,281
 
$
107,057
     
                                                     
                                                     
Balance, January 1, 2006
   
11,807,649
 
 
 
 $
67,602
 
$
(803)
 
$
-
 
$
(2,721)
 
$
47,539
 
$
111,617
     
Net Income
   
-
       
-
   
-
   
-
   
-
   
12,918
   
12,918
 
$
12,918
Net change in unrealized gain/loss on securities
                                                   
available-for-sale and I/O strips, net of reclassification
                                                   
adjustment and deferred income taxes
   
-
       
-
   
-
   
-
   
211
 
 
-
   
211
 
 
211
Decrease in minimum pension liability, net of deferred
                                                   
income taxes
   
-
       
-
   
-
   
-
   
204
   
-
   
204 
   
204 
     Total comprehensive income
                                               
$
13,333
Reclassification of unearned restricted stock award
                                                   
upon adoption of Statement 123 (revised 2004)
   
-
       
(803)
 
 
803
   
-
   
-
   
-
   
-
     
Amortization of restricted stock award
   
-
       
115 
   
-
   
-
   
-
   
-
   
115 
     
Cash dividend declared on commom stock, $0.10 per share
   
-
       
-
   
-
   
-
   
-
   
(1,774)
 
 
(1,774)
 
   
Commom stock repurchased
   
(282,900)
 
 
   
(6,660)
 
 
-
   
-
   
-
   
-
   
(6,660)
 
   
Stock option expense
   
-
       
550
   
-
   
-
   
-
   
-
   
550
     
Stock options exercised
   
156,548
       
2,155
   
-
   
-
   
-
   
-
   
2,155
     
Balance, September 30, 2006
   
11,681,297
 
 
 
 $
62,959
 
$
-
 
$
-
 
$
(2,306)
 
$
58,683
 
$
119,336
     
                                                     
See notes to consolidated financial statements
 
                                                     
                                          
4
Heritage Commerce Corp
Consolidated Statements of Cash Flows (Unaudited)
   
Nine Months Ended
   
September 30,
(Dollars in thousands)
 
2006
 
2005
CASH FLOWS FROM OPERATING ACTIVITIES
       
Net Income
 
$
12,918
 
$
10,188
Adjustments to reconcile net income to net cash provided by operating activities:
           
Depreciation and amortization
   
507
   
798
Provision for loan losses
   
(603)
 
 
313
Gain on sale of leased equipment
   
-
   
(299)
Non-cash compensation expense related to ESOP
   
-
   
478
Stock option expense
   
550
   
-
Amortization of restricted stock award
   
115
   
84
Amortization/accretion of discounts and premiums on securities
   
(872)
 
 
688
Gain on sale of loans
   
(3,171)
 
 
(2,160)
Proceeds from sales of loans held for sale
   
81,906
   
36,690
Originations of loans held for sale
   
(55,172)
 
 
(60,727)
Maturities/paydowns/payoffs of loans held for sale
   
23,476
   
23,711
Increase in cash surrender value of life insurance
   
(1,070)
 
 
(887)
Change in:
           
     Accrued interest receivable and other assets
   
6,097
   
(1,939)
     Accrued interest payable and other liabilities
   
891
   
3,743
Net cash provided by operating activities
   
65,572
   
10,681
             
CASH FLOWS FROM INVESTING ACTIVITIES
           
Net change in loans (including purchase of $10,306 in 2006)
   
(25,164)
 
 
(14,187)
Purchases of securities available for sale
   
(49,098)
 
 
(6,000)
Maturities/paydowns/calls of securities available for sale
   
75,530
   
27,292
Sale of leased equipment
   
-
   
389
Purchase of company owned life insurance
   
-
   
(5,825)
Purchases of Federal Home Loan Bank and Federal Reserve Bank stock
   
(184)
 
 
(1,118)
Purchases of premises and equipment
   
(460)
 
 
(312)
     Net cash provided by investing activities
   
624
   
239
             
CASH FLOWS FROM FINANCING ACTIVITIES
           
Net change in deposits
   
(63,661
)
 
56,659
Payment of other liability
   
(1,378)
 
 
(1,064)
Exercise of stock options
   
2,155
   
4,344
Common stock repurchased
   
(6,660)
 
 
(5,744)
Payment of cash dividend
   
(1,774)
 
 
-
Net decrease in securities sold under agreement to repurchase
   
(10,900)
 
 
(15,100)
     Net cash (used in) provided by financing activities
   
(82,218)
 
 
39,095
             
Net increase (decrease) in cash and cash equivalents
   
(16,022)
 
 
50,015
Cash and cash equivalents, beginning of period
   
98,460
   
57,746
Cash and cash equivalents, end of period
 
$
82,438
 
$
107,761
             
Supplemental disclosures of cash paid during the period for:
           
Interest
 
$
16,919
 
$
11,077
Income taxes
 
$
780
 
$
2,850
             
See notes to consolidated financial statements
5

HERITAGE COMMERCE CORP
Notes to Consolidated Financial Statements
September 30, 2006
(Unaudited)
1) Basis of Presentation
 
The unaudited consolidated financial statements of Heritage Commerce Corp (the “Company”) and its wholly owned subsidiary, Heritage Bank of Commerce (“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 thereto included in the Company’s Form 10-K for the year ended December 31, 2005. The Company has 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 are Delaware Statutory business trusts formed for the exclusive purpose of issuing and selling trust preferred securities.
 
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 the Company’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 accounting principles generally accepted in the United States of America 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.
 
Certain amounts reported in previous consolidated financial statements have been reclassified to conform to the 2006 presentation.
 
The results for the three and nine months ended September 30, 2006 are not necessarily indicative of the results expected for any subsequent period or for the entire year ending December 31, 2006.
 
Recent Accounting Pronouncements
 
In February, 2006, Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 155, Accounting for Certain Hybrid Instruments. This standard amended the guidance in FASB Statements No. 133, Accounting for Derivative Instruments and Hedging Activities, and No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. Statement 155 permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation and clarifies which interest-only and principal-only strips are not subject to the requirements of Statement 133. Statement 155 is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. The adoption of this standard is not expected to have a material impact on the Company’s financial statements.
 
In March, 2006, FASB issued Statement No. 156, Accounting for Servicing of Financial Assets - An Amendment of FASB Statement No. 140. This standard amends the guidance in Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities with respect to the accounting for separately recognized servicing assets and servicing liabilities. Among other requirements, Statement 156 requires an entity to recognize a servicing asset or servicing liability each time it undertakes an obligation to service a financial asset by entering into a servicing contract in certain situations, including a transfer of loans with servicing retained that meets the requirements for sale accounting. Statement 156 is effective as of the beginning of an entity's first fiscal year that begins after September 15, 2006. The adoption of this standard is not expected to have a material impact on the Company’s financial statements.
6

In June 2006, FASB issued FASB Interpretation No. (“FIN”) 48, Accounting for Uncertainty in Income Taxes. This Interpretation clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes. This Interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This Interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. This Interpretation is effective for fiscal years beginning after December 15, 2006. The adoption of this standard is not expected to have a material impact on the Company’s consolidated balance sheets or income statements.
 
In September 2006, FASB issued Statement No. 157, Fair Value Measurements. This Statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (“GAAP”), and expands disclosures about fair value measurements. This Statement applies under other accounting pronouncements that require or permit fair value measurements, the Board having previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. Accordingly, this Statement does not require any new fair value measurements. However, for some entities, the application of this Statement will change current practice. This Statement is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The adoption of this standard is not expected to have a material impact on the Company’s financial statements.
 
In September 2006, the Securities and Exchange Commission released Staff Accounting Bulletin (SAB) No. 108. This SAB provides detailed guidance to registrants in the determination of what is material to their financial statements. SAB 108 is required to be applied to financial statements issued after November 15, 2006. Upon adoption, the cumulative effect of applying the new guidance is to be reflected as an adjustment to opening retained earnings as of the beginning of the current fiscal year. The Company is currently evaluating the impact of applying SAB 108.
 
2) Securities Available-for-Sale
 
In November 2005, FASB issued FASB Staff Positions FAS 115-1 and FAS 124-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (“FSP 115-1/124-1”). FSP 115-1/124-1 provides guidance on determining when investments in certain debt and equity securities are considered impaired, whether that impairment is other-than-temporary, and on measuring such impairment loss. FSP 115-1/124-1 also includes accounting considerations subsequent to the recognition of other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. This FSP is required to be applied to reporting periods beginning after December 15, 2005. Application of FSP 115-1/124-1 did not affect the Company’s consolidated balance sheets or income statements.
 
The following table shows the gross unrealized losses and fair value of the Company’s securities with unrealized losses aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at September 30, 2006:

   
Less Than 12 Months
 
12 Months or More
 
Total
   
Fair
 
Unrealized
 
Fair
 
Unrealized
 
Fair
 
Unrealized
(Dollars in thousands)
 
Value
 
Losses
 
Value
 
Losses
 
Value
 
Losses
U.S. Treasury
 
$
-
 
$
-
 
$
5,942
 
$
(58)
 
$
5,942
 
$
(58)
U.S. Government Agencies
   
26,294
   
(79)
 
 
14,880
   
(172)
 
 
41,174
   
(251)
Mortgage-Backed Securities
   
10,667
   
(50)
 
 
70,020
   
(3,091)
 
 
80,687
   
(3,141)
Municipals - Tax Exempt
   
-
   
-
   
8,119
   
(188)
 
 
8,119
   
(188)
Collateralized Mortgage Obligations
   
-
   
-
   
4,261
   
(201)
 
 
4,261
   
(201)
Total
 
$
36,961
 
$
(129)
 
$
103,222
 
$
(3,710
)
$
140,183
 
$
(3,839)
                                     
As of September 30, 2006, the Company held 96 securities, of which 68 had fair values below amortized cost. Fifty-four securities have been carried with an unrealized loss for over 12 months. Rising interest rates resulted in lower market values.  No security has sustained a downgrade in credit rating. The issuers are of high credit quality and all principal amounts are expected to be paid when securities mature. The fair value is expected to recover as the securities approach their maturity date and/or market rates decline. Because the Company has the ability and intent to hold these securities until a recovery of fair value, which may be maturity, the Company does not consider these securities to be other-than-temporarily impaired at September 30, 2006.
7

Securities classified as U.S. Government Agencies as of September 30, 2006 were issued by the Federal National Mortgage Association, Federal Home Loan Mortgage Corporation, and the Federal Home Loan Bank.
 
The securities portfolio of the Company is also used as collateral to meet requirements imposed as a condition of deposit by some depositors, such as political subdivisions (public funds) or bankruptcy trustees, and other contractual obligations such as repurchase agreements. Securities with amortized cost of $55,625,000 and $68,057,000 as of September 30, 2006 and 2005 were pledged to secure public and certain other deposits as required by law or contract and other contractual obligations. A portion of these deposits can only be secured by U.S. Treasury securities. The Company has not used interest rate swaps or other derivative instruments to hedge fixed rate loans or to otherwise mitigate interest rate risk.
 
3) Stock-Based Compensation
 
The Company has a stock option plan (the “Plan”) for directors, officers, and key employees. The Plan provides for the grant of incentive and non-qualified stock options. The 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. On May 25, 2006, the shareholders of Heritage Commerce Corp approved an amendment to the Heritage Commerce Corp 2004 Stock Option Plan to authorize 550,000 additional shares for issuance. As of September 30, 2006, there are 417,253 shares available for future grants under the Plan. Option activity under the Plan is as follows:
                 
       
Weighted
 
Weighted Average
 
Aggregate
   
Number
 
Average
 
Remaining Contractual
 
Intrinsic
Total Stock Options
 
of Shares
 
Exercise Price
 
Life (Years)
 
Value
Outstanding at January 1, 2006:
   
753,978
 
$
12.92
           
Granted
   
222,400
 
$
23.67
           
Exercised
   
(156,548)
 
$
10.04
           
Forfeited or expired
   
(41,346)
 
$
16.31
           
Outstanding at September 30, 2006:
   
778,484
 
$
16.39
   
7.28
 
$
5,252,000
Exercisable at September 30, 2006
   
395,379
 
$
12.04
   
5.49
 
$
4,386,000
                         
The weighted average grant-date fair value of options granted for the nine months ended September 30, 2006 and 2005 was $7.57 and $5.90, respectively. The total intrinsic value of options exercised in the nine months ended September 30, 2006 and 2005 was $2,078,000 and $3,447,000, respectively.
 
Cash received from option exercise under all share-based payment arrangements for the nine months ended September 30, 2006 and 2005 was $1,572,000 and $3,384,000, respectively. The actual tax benefit realized for the tax deductions from the option exercise of the share-based payment arrangements totaled $583,000 and $960,000, respectively, for the nine months ended September 30, 2006 and 2005.
8

A summary of the status of the Company’s nonvested shares as of September 30, 2006 and changes during the nine months ended September 30, 2006, is presented below:
         
       
Weighted-Average
Nonvested Options
 
Shares
 
Grant Date Fair Value
Outstanding at January 1, 2006:
   
289,806
 
$
5.47
Granted
   
222,400
 
$
7.57
Vested
   
(87,755)
 
$
6.27
Forfeited or expired
   
(41,346)
 
$
5.57
Outstanding at September 30, 2006
   
383,105
 
$
6.71
             
As of September 30, 2006, there was $2,651,000 of total unrecognized compensation cost related to nonvested share-based compensation arrangements granted under the Company’s stock plan. That cost is expected to be recognized over a weighted-average period of approximately 2.4 years. The total fair value of options vested during the nine months ended September 30, 2006 is approximately $550,000.

Prior to 2006, the Company accounted for stock-based awards to employees using the intrinsic value method in accordance with Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees.” No compensation expense was recognized in the financial statements for stock option arrangements, as the Company’s stock option plan provides for the issuance of options at a price of no less than the fair market value at the date of the grant.

Statement of Financial Accounting Standards ("Statement”) No. 123, “Accounting for Stock-Based Compensation,” requires the disclosure of pro forma net income and earnings per share had the Company adopted the fair value method at the grant date of all stock options. Under Statement 123, the fair value of stock-based awards to employees is calculated through the use of option pricing models, even though such models were developed to estimate the fair value of freely tradable, fully transferable options without vesting restrictions, which differ significantly from the Company's stock option awards. Those models also require subjective assumptions, which affect the calculated values.

In December 2004, the FASB issued Statement 123 (revised 2004), "Share-Based Payment". This Statement requires that compensation costs related to share-based payment transactions be recognized in the financial statements. Measurement of the cost of employee service is based on the grant-date fair value of the equity or liability instruments issued. That cost is recognized over the period during which an employee is required to provide service in exchange for the award. Additionally, liability awards will be remeasured each reporting period. Statement 123R replaces Statement 123, and supersedes APB Opinion 25. On April 14, 2005, the SEC issued rule 2005-57, which allowed companies to delay implementation of Statement 123R to the beginning of 2006.

The Company adopted Statement 123R on January 1, 2006, which has resulted in an increase in noninterest expense of $215,000 and $550,000 for the three and nine months ended September 30, 2006. The income tax benefit recognized in the income statement for stock option expense was $6,000 and $10,000 for the three and nine months ended September 30, 2006. The Company elected the modified prospective method, under which prior periods are not revised for comparative purposes. The following table presents the Company’s pro forma net income and earnings per common share for the three and nine months ended September 30, 2005 as if the Company had applied the requirements of Statement 123R:
9

         
   
Three Months Ended
 
Nine Months Ended
   
September 30,
 
September 30,
(Dollars in thousands, except per share data)
 
2005
 
2005
Net income as reported
 
$
4,195
 
$
10,188
Less: Compensation expense for stock options determined
           
under fair value method
   
(119)
 
 
(348)
Pro forma net income
 
$
4,076
 
$
9,840
             
Net income per common share - basic
           
     As reported
 
$
0.36
 
$
0.86
     Pro forma
 
$
0.35
 
$
0.83
Net income per common share - diluted
           
     As reported
 
$
0.35
 
$
0.84
     Pro forma
 
$
0.34
 
$
0.81
             
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model that uses the assumptions noted in the following table.
         
   
Nine Months Ended
   
September 30,
   
2006
 
2005
Expected life in months (1)
   
84
   
84
Volatility (1)
   
21%
 
 
17%
Weighted average risk-free interest rate (2)
   
4.84%
 
 
4.13%
Expected dividends (3)
   
0.86%
 
 
0%
             
(1)  
The expected life of employee stock options represents the weighted average period the stock options are expected to remain outstanding. It is estimated based on historical experience. Volatility is based on the historical volatility of the stock price over the same period of the expected life of the option.
(2)  
Based on the U.S. Treasury constant maturity interest rate with a term consistent with the expected life of the options granted.
(3)  
The Company began paying cash dividends on common stock in 2006. Each grant’s dividend yield is calculated by annualizing the most recent quarterly cash dividend and dividing that amount by the market price of the Company’s common stock as of the grant date.
 
Forfeitures for options granted prior to 2006 were recognized as they occurred. Beginning in 2006, the Company estimates the impact of forfeitures based on the Company’s historical experience with previously granted stock options in determining stock option expense. The Company issues new shares of common stock to satisfy stock option exercises.

The Company awarded 51,000 restricted shares of common stock to Walter T. Kaczmarek, President and Chief Executive Officer of the Company, pursuant to the terms of a Restricted Stock Agreement dated March 17, 2005. The grant price was $18.15. Under the terms of the Restricted Stock Agreement, the restricted shares will vest 25% per year at the end of years three, four, five and six, provided Mr. Kaczmarek is still with the Company. Compensation cost associated with the restricted stock issued is measured based on the market price of the stock at the grant date and is expensed on a straight-line basis over the service period. Restricted stock compensation expense for the three and nine months ended September 30, 2006 was $39,000 and $115,000, respectively, compared to $39,000 and $84,000, respectively, in the same periods of 2005.
10

4) Earnings Per Share
 
Basic earnings per share (“EPS”) is computed by dividing net income by the weighted average common shares outstanding during the period. Diluted EPS reflects potential dilution from outstanding stock options during the period, using the treasury stock method. There were 215,093 and 33,957 stock options for three months ended September 30, 2006 and 2005 and 128,905 and 16,443 for nine months ended September 30, 2006 and 2005, respectively, considered to be antidilutive and excluded from the computation of diluted earnings per share. For each of the periods presented, net income is the same for basic and diluted earnings per share. Reconciliation of weighted average shares used in computing basic and diluted earnings per share is as follows:
                 
   
Three Months Ended  
 
Nine Months Ended 
   
September 30, 
 
September 30, 
   
2006
 
2005
 
2006
 
2005
Weighted average common shares outstanding - used
                       
     in computing basic earnings per share
   
11,781,135
   
11,789,546
   
11,812,718
   
11,795,669
Dilutive effect of stock options outstanding,
                       
     using the treasury stock method
   
176,089
   
309,344
   
192,214
   
337,387
Shares used in computing diluted earnings per share
   
11,957,224
   
12,098,890
   
12,004,932
   
12,133,056
                         
5)  Comprehensive Income
 
Comprehensive income includes net income and other comprehensive income, which represents the changes in net assets during the period from non-owner sources. The Company's sources of other comprehensive income are unrealized gains and losses on securities available-for-sale and I/O strips, which are treated like available-for-sale securities, and the additional minimum liability related to the Company's supplemental retirement plan. The items in other comprehensive income are presented net of deferred income tax effects. Reclassification adjustments result from gains or losses on securities that were realized and included in net income of the current period that also had been included in other comprehensive income as unrealized gains and losses. The Company’s comprehensive income was as follows:
                 
   
Three Months Ended
 
Nine Months Ended
   
September 30,
 
September 30,
(Dollars in thousands)
 
2006
 
2005
 
2006
 
2005
Net Income
 
$
4,353
 
$
4,195
 
$
12,918
 
$
10,188
Other comprehensive income (loss):
                       
     Unrealized gains (losses) on available-for-sale of securities
                       
          and I/O strips during the period
   
2,335
   
(1,138)
 
 
285 
   
(924)
     Less: Deferred income tax on unrealized gains (losses) on
                       
                available-for-sale of securities and I/O strips
   
(981)
 
 
478
   
(74)
 
 
388
      Net unrealized gains (losses) on available-for-sale
                       
     securities and I/O strips, net of deferred income tax
   
1,354
   
(660
)
 
211
   
(536)
                         
     Minimum pension liability adjustment during the period
   
36
   
(685)
 
 
352
   
(580)
     Less: Deferred income tax on minimum pension liability adjustment
   
(15)
 
 
288
   
(148)
 
 
244
     Minimum pension liability adjustment, net of deferred income tax
   
21
   
(397)
 
 
204
   
(336)
Other comprehensive income (loss)
   
1,375
   
(1,057)
 
 
415
   
(872)
Comprehensive income
 
$
5,728
 
$
3,138
 
$
13,333
 
$
9,316
                         
11

6)  
Supplemental Retirement Plan
 
The Company has a supplemental retirement plan covering current and former key executives and directors (“Plan”). 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 three and nine months ended September 30, 2006 and 2005:
                 
   
Three Months Ended
 
Nine Months Ended
   
September 30,
 
September 30,
(Dollars in thousands)
 
2006
 
2005
 
2006
 
2005
Components of net periodic benefits cost
                       
     Service cost
 
$
200
 
$
204
 
$
600
 
$
617
     Interest cost
   
138
   
123
   
414
   
  342 
     Prior service cost
   
9
   
15
   
27
   
21
     Amortization of loss
   
36
   
73
   
108
   
174
     Net periodic cost
 
$
383
 
$
415
 
$
1,149
 
$
1,154
                         
 
7)  
Commitments and Contingencies
 
Financial Instruments with Off-Balance Sheet Risk
 
HBC is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its clients. These financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk, in excess of the amounts recognized in the balance sheets.
 
HBC's exposure to credit loss in the event of non-performance of the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments. HBC uses the same credit policies in making commitments and conditional obligations as it does for loans. Credit risk is the possibility that a loss may occur because a party to a transaction fails to perform according to the terms of the contract. HBC controls the credit risk of these transactions through credit approvals, limits, and monitoring procedures. Management does not anticipate any significant losses as a result of these transactions.
 
Commitments to extend credit as of September 30, 2006 and December 31, 2005 were as follows:
         
   
September 30,
 
December 31,
(Dollars in thousands)
 
2006
 
2005
Commitments to extend credit
 
$
305,772
 
$
328,031
Standby letters of credit
   
9,440
   
6,104
   
$
315,212
 
$
334,135
             
 
Generally, commitments to extend credit as of September 30, 2006 are at variable rates, typically based on the prime rate (with a margin). Commitments generally expire within one year.
 
Commitments to extend credit are agreements to lend to a client as long as there is no violation of conditions established in the contract. Commitments generally have fixed expiration dates or other termination clauses. Since some of the commitments are expected to expire without being drawn upon, the total commitment amount does not necessarily represent future cash requirements. HBC evaluates each client's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by HBC upon the extension of credit, is based on management's credit evaluation of the borrower. Collateral held varies but may include cash, marketable securities, accounts receivable, inventory, property, plant and equipment, income-producing commercial properties, and/or residential properties. Fair value of these instruments is not material.
 
Standby letters of credit are written with conditional commitments issued by HBC to guarantee the performance of a client to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to clients.
12

ITEM 2 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
 
RESULTS OF OPERATIONS 

Discussions of certain matters in this Report on Form 10-Q 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 (the “Exchange Act”), and as such, may involve risks and uncertainties. Forward-looking statements, which are based on certain assumptions and describe future plans, strategies, and expectations, are generally identifiable by the use of words such as “believe”, “expect”, “intend”, “anticipate”, “estimate”, “project”, “assume”, “plan”, “predict”, “forecast” or similar expressions. These forward-looking statements relate to, among other things, expectations of the business environment in which the Company operates, projections of future performance, potential future performance, potential future credit experience, perceived opportunities in the market, and statements regarding the Company's mission and vision. The Company's actual results, performance, and achievements may differ materially from the results, performance, and achievements expressed or implied in such forward-looking statements due to a wide range of factors. These factors include, but are not limited to, changes in interest rates, reducing interest margins or increasing interest rate risk, general economic conditions nationally or, in the State of California, legislative and regulatory changes adversely affecting the business in which the Company operates, monetary and fiscal policies of the US Government, real estate valuations, the availability of sources of liquidity at a reasonable cost, competition in the financial services industry, and other risks. All of the Company's operations and most of its customers are located in California. In addition, acts and threats of terrorism or the impact of military conflicts have increased the uncertainty related to the national and California economic outlook and could have an effect on the future operations of the Company or its customers, including borrowers. The Company does not undertake, and specifically disclaims any obligation, to update any forward-looking statements to reflect occurrences or unanticipated events or circumstances after the date of such statements.
 
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 an analysis including comparisons with peer group financial institutions and with 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 mainly in the southern and eastern regions of the general San Francisco Bay area of California. 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.
 
Through its asset and liability management process, the Company monitors a number of ratios to analyze the Company’s performance over time and also to compare the Company against similarly sized and situated companies in the banking industry. Management considers the following ratios to be important benchmarks for the Company’s performance and financial conditions:
 
·  
Return on average assets: Net income as a percentage of average assets. Measures the earning power of the balance sheet.
 
·  
Return on average equity: Net income as a percentage of average shareholders’ equity. Measures the return on invested capital.
 
·  
Net interest margin: Net interest income as a percentage of average interest earning assets. Measures the earning power of interest earning assets funded by interest bearing liabilities.
 
·  
Efficiency ratio: Noninterest expense divided by the sum of net interest income and noninterest income. Measures the cost of producing revenue as a percentage of total revenue.
 
There is no single ratio or metric that summarizes the performance of the Company. The ratios above each take an element of the Company’s performance and quantify it so that it can be compared over time and benchmarked against other peer companies. Management uses these and other ratios and metrics in assessing and planning the Company’s performance.
13

Capital Management and Share Repurchases
 
Heritage Commerce Corp and Heritage Bank of Commerce meet the regulatory definition of “well capitalized” at September 30, 2006. As part of its asset and liability 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 February 7, 2006, the Board of Directors authorized the repurchase of up to $10 million of common stock through June 30, 2007. Shares may be repurchased in open market purchases or in privately negotiated transactions as permitted under applicable rules and regulations. The repurchase program may be modified, suspended or terminated by the Board of Directors at any time without notice. The extent to which the Company repurchases its shares and the timing of such repurchases will depend upon market conditions and other corporate considerations.
 
On February 7, 2006, May 4, 2006, July 31, 2006, and October 26, 2006, the Company’s Board of Directors declared a $0.05 per share quarterly cash dividend.
 
Recent Management Changes
 
On May 5, 2006, Kenneth A. Corsello resigned as the Company’s Executive Vice President and Chief Credit Officer.
 
On May 12, 2006, Richard E. Hagarty was promoted to Executive Vice President and Chief Credit Officer of Heritage Bank of Commerce.
 
On July 27, 2006, the Company’s Board of Directors elected Jack W. Conner as Chairman of the Board, succeeding William Del Biaggio, Jr., who will remain on the Board of Directors as Founding Chairman and will continue serving the Bank as an Executive Vice President.
 
CRITICAL ACCOUNTING POLICIES
 
General
 
HCC’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). The financial information contained within our consolidated financial statements is, to a significant extent, based on approximate measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. In certain instances, we use a discount factor and prepayment assumptions to determine the present value of assets and liabilities. A change in the discount factor or prepayment speeds could increase or decrease the values of those assets and liabilities which would result in either a beneficial or adverse impact to our financial results. We use historical loss factors as one factor in determining the inherent loss that may be present in our loan portfolio. Actual losses could differ significantly from the historical factors that we use. The Company adopted Statement 123R on January 1, 2006, and elected the modified prospective method, under which prior periods are not revised for comparative purposes. Other estimates that we use are related to the expected useful lives of our depreciable assets. In addition, GAAP itself may change from one previously acceptable method to another method, although the economics of our transactions would be the same.
14

Allowance for Loan Losses
 
The allowance for loan losses is an estimate of the losses in our loan portfolio. The allowance is based on two basic principles of accounting: (1) Statement of Financial Accounting Standards (“Statement”) No. 5 “Accounting for Contingencies,” which requires that losses be accrued when they are probable of occurring and estimable and (2) Statement No. 114, “Accounting by Creditors for Impairment of a Loan,” which requires that losses be accrued based on the differences between the impaired loan balance and value of collateral, if the loan is collateral dependent, or present value of future cash flows or values that are observable in the secondary market.
 
The formula portion of the allowance is calculated by applying loss factors to pools of outstanding loans. Loss factors are based on the Company's historical loss experience, adjusted for significant factors that, in management's judgment, affect the collectibility of the portfolio as of the evaluation date. The adjustment factors for the formula allowance may include existing general economic and business conditions affecting the key lending areas of the Company, in particular the real estate market, credit quality trends, collateral values, loan volumes and concentrations, seasoning of the loan portfolio, specific industry conditions within portfolio segments, recent loss experience in particular segments of the portfolio, duration of the current business cycle, and bank regulatory examination results. The evaluation of the inherent loss with respect to these conditions is subject to a higher degree of uncertainty.
 
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 note agreement. When a loan is considered to be impaired, the amount of impairment is measured based on the fair value of the collateral if the loan is collateral dependent or on the present value of expected future cash flow.
 
Loan Sales and Servicing
 
The amounts of gains recorded on sales of loans and the initial recording of servicing assets and I/O strips are based on the estimated fair values of the respective components. In recording the initial value of the servicing assets and the fair value of the I/O strips receivable, the Company uses estimates which are made on management’s expectations of future prepayment and discount rates. In evaluating the servicing assets, management used discounted cash flow modeling techniques, which require estimates regarding the amount and times of future cash flows, including assumptions about loan repayment rates and costs to service as well as interest rate assumptions that contemplate the risks involved. For the nine months ended September 30, 2006, management’s estimate of constant prepayment rate (“CPR”) was 17% and the discount rate assumption was 10%. These prepayment and discount rates were based on current market conditions and historical performance of the various pools of loans sold with servicing retained. If actual prepayments with respect to sold loans occur more quickly than projected, the carrying value of the servicing assets may have to be adjusted through a charge to earnings. A corresponding decrease in the value of the I/O strip receivable would also be expected.
 
Stock Based Compensation
 
The accounting policy for stock based compensation is described in Note 3 to the Company’s consolidated financial statements includes herein.
15

RESULTS OF OPERATIONS
 
Overview
 
For the three months and nine months ended September 30, 2006, consolidated net income was $4.4 million and $12.9 million, compared to $4.2 million and $10.2 million for the three and nine months ended September 30, 2005, an increase of 4% and 27%, respectively. Earnings per diluted share were $0.36 and $1.08 for the three and nine months ended September 30, 2006, compared to $0.35 and $0.84 for the three and nine months ended September 30, 2005, an increase of 3% and 29%, respectively. The earnings improvement was primarily due to increases in key market interest rates, such as prime and Federal funds, and their favorable impact on the Company’s net interest margin. Improved loan quality, continued control of operating expenses, and a nonrecurring gain on sale of the Capital Group loan portfolio contributed to stronger earnings in 2006. Annualized return on average assets and return on average equity for the three months ended September 30, 2006 were 1.61% and 14.43%, compared to 1.45% and 15.64%, for the same period in 2005, respectively. Returns on average assets and average equity for the first nine months of 2006 were 1.57% and 14.76%, compared to 1.20% and 13.13% for the first nine months of 2005, respectively.

Net interest income increased $0.6 million and $2.6 million, or 5% and 7%, for the three and nine months ended September 30, 2006 compared to the same period in 2005. The Company's net interest margin was 5.22% and 5.03%, for the three and nine months ended September 30, 2006, an increase of 62 and 53 basis points from 4.60% and 4.50%, for the three and nine months ended September 30, 2005, respectively.

The Company's shareholders' equity at September 30, 2006 was $119.3 million, compared to $107.1 million at September 30, 2005 and $111.6 million at December 31, 2005. The increase in shareholders’ equity from these prior periods was primarily attributable to net income and proceeds from the exercise of common stock options, partially offset by cash dividends and the repurchase of common stock. Book value per share increased to $10.22 at September 30, 2006, from $9.09 at September 30, 2005 and $9.45 at December 31, 2005. The Company's leverage capital ratio was 13.2% at September 30, 2006 compared to 11.2% at September 30, 2005 and 11.6% at December 31, 2005.
 
Net Interest Income and Net Interest Margin 
 
Net interest income is the largest component of the Company's total revenue. Net interest income is the difference between the interest and fees earned on loans and investments and interest expense on deposits and other liabilities. Net interest income depends on two factors: (1) the volume or balance of earning assets compared to the volume or balance of interest bearing deposits and liabilities, and (2) the interest rate earned on those interest earning assets compared with the interest rate on those interest bearing liabilities. Net interest margin is net interest income expressed as a percentage of average earning assets. To maintain its net interest margin, the Company must manage the relationship between interest earned and paid.
 
The following 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.
16

                           
   
For the Three Months Ended
   
For the Three Months Ended
   
September 30, 2006
   
September 30, 2005
       
Interest
 
Average
       
Interest
 
Average
   
Average
 
Income/
 
Yield/
   
Average
 
Income/
 
Yield/
(Dollars in thousands)
 
Balance
 
Expense
 
Rate
   
Balance
 
Expense
 
Rate
Assets:
                                     
Loans, gross
 
$
739,121
 
$
15,958
   
8.57%
 
 
$
755,621
 
$
14,066
   
7.39%
ecurities
   
189,491
   
2,013
   
4.21%
 
   
225,042
   
1,775
   
3.13%
Interest bearing deposits in other financial institutions
   
2,849
   
36
   
5.01%
 
   
3,379
   
27
   
3.17%
Federal funds sold
   
42,095
   
561
   
5.29%
 
   
69,007
   
601
   
3.46%
     Total interest earning assets
   
973,556
 
$
18,568
   
7.57%
 
   
1,053,049
 
$
16,469
   
6.20%
Cash and due from banks
   
36,575
                 
40,214
           
Premises and equipment, net
   
2,450
                 
2,818
           
Other assets
   
62,322
                 
51,708
           
    Total assets
 
$
1,074,903
               
$
1,147,789
           
                                       
Liabilities and shareholders' equity:
                                     
Deposits:
                                     
Demand, interest bearing
 
$
140,205
 
$
783
   
2.22%
 
 
$
131,037
 
$
441
   
1.34%
Savings and money market
   
357,003
   
2,676
   
2.97%
 
   
375,927
   
1,727
   
1.82%
Time deposits, under $100
   
30,987
   
264
   
3.38%
 
   
37,154
   
231
   
2.47%
Time deposits, $100 and over
   
105,984
   
979
   
3.66%
 
   
117,984
   
777
   
2.61%
Brokered time deposits, $100 and over
   
34,031
   
325
   
3.79%
 
   
38,084
   
355
   
3.70%
Notes payable to subsidiary grantor trusts
   
23,702
   
587
   
9.83%
 
   
23,702
   
543
   
9.09%
Securities sold under agreement to repurchase
   
21,800
   
140
   
2.55%
 
   
33,222
   
195
   
2.33%
     Total interest bearing liabilities
   
713,712
 
$
5,754
   
3.20%
 
   
757,110
 
$
4,269
   
2.24%
Demand deposits, noninterest bearing
   
218,766
                 
262,628
           
Other liabilities
   
22,735
                 
21,633
           
     Total liabilities
   
955,213
                 
1,041,371
           
Shareholders' equity:
   
119,690
                 
106,418
           
     Total liabilities and shareholders' equity
 
$
1,074,903
               
$
1,147,789
           
 
                                     
Net interest income / margin
       
$
12,814
   
5.22%
 
       
$
12,200
   
4.60%
                                       
Note: Yields and amounts earned on loans include loan fees of $83,000 and $385,000 for the three month periods ended September 30, 2006 and 2005, respectively. Nonaccrual loans are included in the average balance calculation above.
17

 
                           
   
For the Nine Months Ended
   
For the Nine Months Ended
   
September 30, 2006
   
September 30, 2005
       
Interest
 
Average
       
Interest
 
Average
   
Average
 
Income/
 
Yield/
   
Average
 
Income/
 
Yield/
(Dollars in thousands)
 
Balance
 
Expense
 
Rate
   
Balance
 
Expense
 
Rate
Assets:
                                     
Loans, gross
 
$
738,272
 
$
46,023
   
8.33%
 
 
$
760,072
 
$
39,532
   
6.95%
Securities
   
195,394
   
5,782
   
3.96%
 
   
230,060
   
5,474
   
3.18%
Interest bearing deposits in other financial institutions
   
2,805
   
96
   
4.58%
 
   
2,889
   
58
   
2.68%
Federal funds sold
   
63,635
   
2,319
   
4.87%
 
   
47,699
   
1,103
   
3.09%
     Total interest earning assets
   
1,000,106
 
$
54,220
   
7.25%
 
   
1,040,720
 
$
46,167
   
5.93%
Cash and due from banks
   
36,584
                 
38,353
           
Premises and equipment, net
   
2,439
                 
2,959
           
Other assets
   
63,813
                 
49,088
           
     Total assets
 
$
1,102,942
               
$
1,131,120
           
                                       
Liabilities and shareholders' equity:
                                     
Deposits:
                                     
Demand, interest bearing
 
$
148,879
 
$
2,451
   
2.20%
 
 
$
130,424
 
$
1,127
   
1.16%
Savings and money market
   
359,642
   
7,455
   
2.77%
 
   
359,175
   
4,046
   
1.51%
Time deposits, under $100
   
32,475
   
761
   
3.13%
 
   
37,634
   
619
   
2.20%
Time deposits, $100 and over
   
108,419
   
2,729
   
3.37%
 
   
116,290
   
2,063
   
2.37%
Brokered time deposits, $100 and over
   
34,849
   
983
   
3.77%
 
   
35,478
   
969
   
3.65%
Notes payable to subsidiary grantor trusts
   
23,702
   
1,724
   
9.72%
 
   
23,702
   
1,580
   
8.91%
Securities sold under agreement to repurchase
   
26,653
   
486
   
2.44%
 
   
43,460
   
729
   
2.24%
     Total interest bearing liabilities
   
734,619
 
$
16,589
   
3.02%
 
   
746,163
 
$
11,133
   
1.99%
Demand deposits, noninterest bearing
   
227,588
                 
260,389
           
Other liabilities
   
23,687
                 
20,852
           
     Total liabilities
   
985,894
                 
1,027,404
           
Shareholders' equity:
   
117,048
                 
103,716
           
     Total liabilities and shareholders' equity
 
$
1,102,942
               
$
1,131,120
           
 
                                     
Net interest income / margin
       
$
37,631
   
5.03%
 
       
$
35,034
   
4.50%
                                       
Note: Yields and amounts earned on loans include loan fees of $509,000 and $1,048,000 for the nine month periods ended September 30, 2006 and 2005, respectively. Nonaccrual loans are included in the average balance calculation above.
 
The Company sold its Capital Group loan portfolio, which consisted primarily of “factoring” type loans, during the first quarter of 2006, resulting in a gain on sale of $671,000. The sale of the Capital Group loan portfolio negatively impacted the Company’s net interest margin in 2006
 
The following table sets forth an analysis of the changes in net interest income resulting from changes in the average volume of interest earning assets and liabilities and changes in the average rates earned and paid. The total change is shown in the column designated “Net Change” and is allocated in the columns to the left, for the portions attributable to volume changes and rate changes that occurred during the period indicated. Changes due to both volume and rate have been allocated to the change in volume.
18

             
   
Three Months Ended September 30,
   
2006 vs. 2005
   
Increase (Decrease) Due to Change In:
   
Average
 
Average
 
Net
(Dollars in thousands)
 
Volume
 
Rate
 
Change
Interest income on interest earning assets:
                 
Loans, gross
 
$
(363)
 
$
2,255
 
$
1,892
Securities
   
(375)
 
 
613
   
238
Interest bearing deposits in other financial institutions
   
(7)
 
 
16
   
9
Federal funds sold
   
(359)
 
 
319
   
(40)
     Total interest income on interest earning assets
 
$
(1,104)
 
$
3,203
 
$
2,099
                   
Interest expense on interest bearing liabilities:
                 
Demand, interest bearing
 
$
50
 
$
292
 
$
342
Savings and money market
   
(138)
 
 
1,087
   
949
Time deposits, under $100
   
(53)
 
 
86
   
33
Time deposits, $100 and over
   
(109)
 
 
311
   
202
Brokered time deposits, $100 and over
   
(39)
 
 
9
   
(30)
Notes payable to subsidiary grantor trusts
   
-
   
44
   
44
Securities sold under agreement to repurchase
   
(74)
 
 
19
   
(55)
     Total interest expense on interest bearing liabilities
 
$
(363)
 
$
1,848
 
$
1,485
     Net interest income
 
$
(741)
 
$
1,355
 
$
614
                   

             
   
Nine Months Ended September 30,
   
2006 vs. 2005
   
Increase (Decrease) Due to Change In:
   
Average
 
Average
 
Net
(Dollars in thousands)
 
Volume
 
Rate
 
Change
Interest income on interest earning assets:
                 
Loans, gross
 
$
(1,332)
 
$
7,823
 
$
6,491
Securities
   
(1,032)
 
 
1,340
   
308
Interest bearing deposits in other financial institutions
   
(3)
 
 
41
   
38
Federal funds sold
   
582
   
634
   
1,216
     Total interest income on interest earning assets
 
$
(1,785)
 
$
9,838
 
$
8,053
                   
Interest expense on interest bearing liabilities:
                 
Demand, interest bearing
 
$
305
 
$
1,019
 
$
1,324
Savings and money market
   
14
   
3,395
   
3,409
Time deposits, under $100
   
(120)
 
 
262
   
142
Time deposits, $100 and over
   
(202)
 
 
868
   
666
Brokered time deposits, $100 and over
   
(17)
 
 
31
   
14
Notes payable to subsidiary grantor trusts
   
1
   
143
   
144
Securities sold under agreement to repurchase
   
(307)
 
 
64
   
(243)
     Total interest expense on interest bearing liabilities
 
$
(326)
 
$
5,782
 
$
5,456
     Net interest income
 
$
(1,459)
 
$
4,056
 
$
2,597
                   
 
Provision for Loan Losses 
 
The provision for loan losses represents the current period expense associated with maintaining an appropriate allowance for credit losses. The loan loss provision 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. Periodic fluctuations in the provision for loan losses result from management’s assessment of the adequacy of the allowance for loan losses; however, actual loan losses may vary from current estimates.
19

The Company recorded no provision for loan losses for the three months ended September 30, 2006 and had a cumulative negative provision for loan losses of $603,000 for the nine months ended September 30, 2006. The reversal reflects sound credit quality as demonstrated by a decrease in nonperforming loans to $2,962,000 at September 30, 2006 from $3,672,000 at December 31, 2005. The Company had a negative provision for loan losses of $494,000 for the three months ended September 30, 2005. Net provision for loan losses for the nine months ended September 30, 2005 was $313,000. See additional discussion under the caption "Allowance for Loan Losses.”
 
Noninterest Income 
 
The following table sets forth the various components of the Company’s noninterest income for the periods indicated:
                 
   
Three Months Ended
 
Increase (Decrease)
   
September 30,
 
2006 versus 2005
(Dollars in thousands)
 
2006
 
2005
 
Amount
 
Percent
Gain on sale of loans
 
$
832
 
$
702
 
$
130
   
19%
Servicing income
   
412
   
510
   
(98)
 
 
-19%
Increase in cash surrender value of life insurance
   
363
   
331
   
32
   
10%
Service charges and fees on deposit accounts
   
354
   
332
   
22
   
7%
Other
   
338
   
349
   
(11)
 
 
-3%
     Total noninterest income
 
$
2,299
 
$
2,224
 
$
75
   
3%
                         

                 
   
Nine Months Ended
 
Increase (Decrease)
   
September 30,
 
2006 versus 2005
(Dollars in thousands)
 
2006
 
2005
 
Amount
 
Percent
Gain on sale of loans
 
$
3,171
 
$
2,160
 
$
1,011
   
47%
Servicing income
   
1,321
   
1,368
   
(47)
 
 
-3%
Increase in cash surrender value of life insurance
   
1,070
   
887
   
183
   
21%
Service charges and fees on deposits accounts
   
1,008
   
1,120
   
(112)
 
 
-10%
Gain on sale of leased equipment
   
-
   
299
   
(299)
 
 
-100%
Equipment leasing
   
-
   
131
   
(131)
 
 
-100%
Other
   
880
   
1,254
   
(374)
 
 
-30%
     Total noninterest income
 
$
7,450
 
$
7,219
 
$
231
   
3%
                         
Noninterest income was primarily comprised of the gain on sale of Small Business Administration (“SBA”) and other guaranteed loans, loan-servicing income, and the gain on sale of the Capital Group loan portfolio. The Company has an ongoing program of originating SBA loans and selling the government guaranteed portion in the secondary market, while retaining the servicing of the whole loans. Gain on sales of SBA, other guaranteed loans, and other “factoring type loans contributed $832,000 and $3,171,000, during the third quarter and the first nine months of 2006, compared to $702,000 and $2,160,000, during the third quarter and the first nine months of 2005, respectively. The Company sold its Capital Group loan portfolio, which consisted primarily of “factoring” type loans, during the first quarter of 2006, resulting in a gain on sale of $671,000. The increase in the cash surrender value of life insurance was primarily the result of additional policies purchased during 2005. The year-to-date decrease in deposit service charges and fees was primarily because higher interest rates applied to collected balances created a waiver of (or credit against) service charges for many business customers. The Company sold all leased equipment during the second quarter of 2005.
20

Noninterest Expense 
 
The following table sets forth the various components of the Company’s noninterest expense for the periods indicated:
                 
   
Three Months Ended
 
Increase (Decrease)
   
September 30,
 
2006 versus 2005
(Dollars in thousands)
 
2006
 
2005
 
Amount
 
Percent
Salaries and employee benefits
 
$
4,941
 
$
4,697
 
$
244
   
5%
Occupancy
   
773
   
779
   
(6)
 
 
-1%
Professional fees
   
442
   
511
   
(69)
 
 
-14%
Client services
   
230
   
300
   
(70)
 
 
-23%
Advertising and promotion
   
206
   
290
   
(84)
 
 
-29%
Low income housing investment losses and writedowns
   
257
   
260
   
(3)
 
 
-1%
Data processing
   
156
   
167
   
(11)
 
 
-7%
Furniture and equipment
   
140
   
181
   
(41)
 
 
-23%
Other
   
1,167
   
1,293
   
(126)
 
 
-10%
     Total noninterest expense
 
$
8,312
 
$
8,478
 
$
(166)
 
 
-2%
                         

                 
   
Nine Months Ended
 
Increase (Decrease)
   
September 30,
 
2006 versus 2005
(Dollars in thousands)
 
2006
 
2005
 
Amount
 
Percent
Salaries and employee benefits
 
$
14,703
 
$
14,912
 
$
(209)
 
 
-1%
Occupancy
   
2,324
   
2,471
   
(147)
 
 
-6%
Professional fees
   
1,289
   
1,232
   
57
   
5%
Client services
   
772
   
1,052
   
(280)
 
 
-27%
Advertising and promotion
   
763
   
802
   
(39)
 
 
-5%
Low income housing investment losses and writedowns
   
734
   
805
   
(71)
 
 
-9%
Data processing
   
498
   
508
   
(10)
 
 
-2%
Furniture and equipment
   
397
   
584
   
(187)
 
 
-32%
Amortization of leased equpiment
   
-
   
334
   
(334)
 
 
-100%
Other
   
4,085
   
3,966
   
119
   
3%
     Total noninterest expense
 
$
25,565
 
$
26,666
 
$
(1,101)
 
 
-4%
                         
21

The following table indicates the percentage of noninterest expense in each category:
                 
   
For The Three Months Ended September 30,
       
Percent
     
Percent
(Dollars in thousands)
 
2006
 
of Total
 
2005
 
of Total
Salaries and employee benefits
 
$
4,941
   
59%
 
$
4,697
   
55%
Occupancy
   
773
   
9%
 
 
779
   
9%
Professional fees
   
442
   
5%
 
 
511
   
6%
Client services
   
230
   
3%
 
 
300
   
4%
Advertising and promotion
   
206
   
3%
 
 
290
   
4%
Low income housing investment losses and writedowns
   
257
   
3%
 
 
260
   
3%
Data processing
   
156
   
2%
 
 
167
   
2%
Furniture and equipment
   
140
   
2%
 
 
181
   
2%
Other
   
1,167
   
14%
 
 
1,293
   
15%
     Total noninterest expense
 
$
8,312
   
100%
 
$
8,478
   
100%
                         

                 
   
For The Nine Months Ended September 30,
       
Percent
     
Percent
(Dollars in thousands)
 
2006
 
of Total
 
2005
 
of Total
Salaries and employee benefits
 
$
14,703
   
57%
 
$
14,912
   
56%
Occupancy
   
2,324
   
9%
 
 
2,471
   
9%
Professional fees
   
1,289
   
5%
 
 
1,232
   
5%
Client services
   
772
   
3%
 
 
1,052
   
4%
Advertising and promotion
   
763
   
3%
 
 
802
   
3%
Low income housing investment losses and writedowns
   
734
   
3%
 
 
805
   
3%
Data processing
   
498
   
2%
 
 
508
   
2%
Furniture and equipment
   
397
   
2%
 
 
584
   
2%
Amortization of leased equpiment
   
-
   
0%
 
 
334
   
1%
Other
   
4,085
   
16%
 
 
3,966
   
15%
     Total noninterest expense
 
$
25,565
   
100%
 
$
26,666
   
100%
                         
The decrease in noninterest expense to the nine months ended September 30, 2006 was primarily due to the following factors:
 
·  
Occupancy and furniture and equipment decreased primarily as a result of lower depreciation on leasehold improvements.
 
·  
Client services decreased primarily due to the decrease in services fees charged to the Company from the third party vendors, such as courier service fees.
 
·  
Advertising and promotion decreased primarily due to certain sponsorships discontinued in the third quarter of 2006.
 
·  
The Company sold all of the leased equipment in the second quarter of 2005, and therefore did not have amortization of leased equipment in 2006.
22

Income Taxes
 
Income tax expense for the three and nine months ended September 30, 2006 was $2.4 million and $7.2 million, respectively, as compared to $2.2 million and $5.1 million for the same periods in the prior year. The following table shows the effective income tax rate for each period indicated.
                 
   
Three Months Ended
 
Nine Months Ended
   
September 30,
 
September 30,
   
2006
 
2005
 
2006
 
2005
Effective income tax rate
   
36.0%
 
 
34.9%
 
 
35.8%
 
 
33.3%
                         
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 and investments in tax-free municipal securities. The effective tax rate in 2006 is higher compared to 2005 because pre-tax income increased more than the savings from tax advantaged investments.
 
FINANCIAL CONDITION 
 
As of September 30, 2006, total assets were $1.1 billion, compared to $1.2 billion as of September 30, 2005. Total available-for-sale securities were $174 million as of September 30, 2006, a decrease of 17% from $209 million as of September 30, 2005. The total loan portfolio was $714 million as of September 30, 2006, a decrease of 3% from $738 million as of September 30, 2005. Total deposits were $876 million as of September 30, 2006, a decrease of 10% from $975 million as of September 30, 2005.
 
Securities Portfolio 
 
A major component of the Company's earning assets is its securities portfolio. The following table sets forth the estimated fair value of securities at the dates indicated:

             
   
September 30,
 
December 31,
(Dollars in thousands)
 
2006
 
2005
 
2005
Securities available-for-sale (at fair value)
                 
U.S. Treasury
 
$
5,942
 
$
11,918
 
$
6,920
U.S. Government Agencies
   
62,345
   
84,367
   
82,041
Municipal - Tax Exempt
   
8,119
   
8,596
   
8,268
Mortgage-Backed
   
87,548
   
90,098
   
91,868
Collateralized Mortgage Obligations
   
9,769
   
14,436
   
9,398
     Total
 
$
173,723
 
$
209,415
 
$
198,495
                   
Securities classified as U.S. Government Agencies as of September 30, 2006 were issued by the Federal National Mortgage Association, Federal Home Loan Mortgage Corporation, and the Federal Home Loan Bank.
23

The following table summarizes the composition of the Company’s securities available-for-sale and the weighted average yields at September 30, 2006:
                                         
   
September 30, 2006
   
Maturity
           
After One and
 
After Five and
               
   
Within One Year
 
Within Five Years
 
Within TenYears
 
After Ten Years
 
Total
(Dollars in thousands)
 
Amount
 
Yield
 
Amount
 
Yield
 
Amount
 
Yield
 
Amount
 
Yield
 
Amount
 
Yield
Securities available for sale:
                                                           
U.S. Treasury
 
$
5,942
   
3.50%
 
$
-
   
-
 
$
-
   
-
 
$
-
   
-
 
$
5,942
   
3.50%
U.S. Government Agencies
   
31,364
   
4.45%
 
 
30,981
   
4.80%
 
 
-
   
-
   
-
   
-
   
62,345
   
4.62%
Municipal - Tax Exempt
   
2,200
   
2.55%
 
 
5,919
   
3.09%
 
 
-
   
-
   
-
   
-
   
8,119
   
2.95%
Mortgage-Backed
   
-
   
-
   
2,126
   
3.43%
 
 
7,674
   
4.42%
 
 
77,748
   
4.29%
 
 
87,548
   
4.28%
Collateralized Mortgage Obligations
   
-
   
-
   
-
   
-
   
5,508
   
5.63%
 
 
4,261
   
2.82%
 
 
9,769
   
4.41%
     Total
 
$
39,506
   
4.20%
 
 
39,026
   
4.47%
 
$
13,182
   
4.92%
 
$
82,009
   
4.22%
 
$
173,723
   
4.32%
                                                             
Securities that are classified as available for sale are carried at their fair value. This means that the carrying amount will increase or decrease based on changes in interest rates or, very rarely, changes in credit rating.
 
As of September 30, 2006, the only securities where the aggregate carrying value of the Company's investment in securities of a single issuer exceeded 10% of the Company's shareholders' equity were direct obligations of the U.S. Treasury or U.S. Government Agencies.
 
Loans and Loan Servicing
 
Total loans (excluding loans held of sale) were $714 million at September 30, 2006, compared to $738 million at September 30, 2005. The Company’s allowance for loan losses was $9.4 million, or 1.31% of total loans, at September 30, 2006, as compared to $11.1 million, or 1.51% of total loans, at September 30, 2005. As of September 30, 2006 and 2005, the Company had $3.0 million and $2.7 million, respectively, in nonperforming loans.
 
The loan portfolio is primarily comprised of commercial loans to companies principally engaged in manufacturing, wholesale and service businesses and commercial real estate loans, with the balance in land development and construction, home equity and consumer loans.
 
The following table summarizes the composition of the Company’s loan portfolio at the dates indicated:
                         
   
September 30,
 
September 30,
 
December 31,
(Dollars in thousands)
 
2006
 
% to Total
 
2005
 
% to Total
 
2005
 
% to Total
Commercial
 
$
281,488
   
40%
 
$
298,900
   
41%
 
$
256,713
   
37%
Real estate - mortgage
   
227,732
   
32%
 
 
242,141
   
33%
 
 
237,566
   
35%
Real estate - land and construction
   
160,137
   
22%
 
 
148,650
   
20%
 
 
149,851
   
22%
Home equity
   
41,784
   
6%
 
 
45,477
   
6%
 
 
41,772
   
6%
Consumer
   
1,387
   
0%
 
 
1,776
   
0%
 
 
1,721
   
0%
     Total loans
   
712,528
   
100%
 
 
736,944
   
100%
 
 
687,623
   
100%
Deferred loan costs
   
1,172
         
1,035
         
1,155
     
Allowance for loan losses
   
(9,379)
 
       
(11,112)
 
       
(10,224)
 
   
     Loans, net
 
$
704,321
       
$
726,867
       
$
678,554
     
                                     
The change in the Company's loan portfolio compared to September 30, 2005 is primarily due to the decreases in commercial and mortgage loans, offset by an increase in land and construction loans. In the fourth quarter of 2005, the Company entered into negotiations for the sale of its Capital Group loan portfolio consisting primarily of “factoring” type loans. In contemplation of the sale, $32 million, net of the respective allowance for loan losses, was moved from commercial loans into loans held-for-sale at December 31, 2005. The sale of the Capital Group loan portfolio was completed in 2006, resulting in a gain of $671,000. In the second quarter of 2006, the Company acquired a portfolio of fixed and adjustable rate closed end home equity loans with an average yield of 6.504% for $10.3 million. The fixed closed end home equity loans acquired with a face value of $8.5 million and an average yield of 6.498% are amortized over periods ranging from 5 to 15 years. The adjustable closed end home equity loans acquired with a face value of $1.8 million and an average yield of 6.533% are amortized over 30 years with the balance of the unpaid principal due at the end of the 15th year.
24

The following table presents the maturity distribution of the Company's loans as of September 30, 2006. 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 Street Journal. As of September 30, 2006, approximately 78% of the Company's loan portfolio consisted of floating interest rate loans.
                   
       
Over One
         
   
Due in
 
Year But
         
   
One Year
 
Less than
 
Over
     
(Dollars in thousands)
 
or Less
 
Five Years
 
Five Years
 
Total
 
Commercial
 
$
267,422
 
$
11,277
 
$
2,789
 
$
281,488
 
Real estate - mortgage
   
98,895
   
68,473
   
60,364
   
227,732
 
Real estate - land and construction
   
158,060
   
2,077
   
-
   
160,137
 
Home equity
   
32,264
   
-
   
9,520
   
41,784
 
Consumer
   
1,274
   
113
   
-
   
1,387
 
     Total loans
 
$
557,915
 
$
81,940
 
$
72,673
 
$
712,528
 
                           
Loans with variable interest rates
 
$
523,350
 
$
24,631
 
$
9,610
 
$
557,591
 
Loans with fixed interest rates
   
34,565
   
57,309
   
63,063
   
154,937
 
     Total loans
 
$
557,915
 
$
81,940
 
$
72,673
 
$
712,528
 
                           
At September 30, 2006 and 2005, the Company serviced Small Business Administration and other guaranteed loans, which were sold to the secondary market, of approximately $181 million and $178 million, respectively.
 
Activity for loan servicing rights follows:
                 
   
For the Three Months Ended
 
For the Nine Months Ended
   
September 30,
 
September 30,
(Dollars in thousands)
 
2006
 
2005
 
2006
 
2005
Beginning of period balance
 
$
2,161
 
$
2,170
 
$
2,171
 
$
2,213
Additions
   
314
   
240
   
912
   
718
Amortization
   
(365)
 
 
(231)
 
 
(973)
 
 
(752)
End of period balance
 
$
2,110
 
$
2,179
 
$
2,110
 
$
2,179
                         
Loan servicing income is reported net of amortization. There was no valuation allowance as of September 30, 2006 and 2005, as the fair market value of the assets was greater than the carrying value.
 
Activity for I/O strip receivables follows:
                 
   
For the Three Months Ended
 
For the Nine Months Ended
   
September 30,
 
September 30,
(Dollars in thousands)
 
2006
 
2005
 
2006
 
2005
Beginning of period balance
 
$
4,792
 
$
4,673
 
$
4,679
 
$
3,954
Additions
   
8
   
441
   
788
   
1,322
Amortization
   
(395)
 
 
(288)
 
 
(1,001)
 
 
(932)
Unrealized gain (loss)
   
(224)
 
 
(55)
 
 
(285)
 
 
427
End of period balance
 
$
4,181
 
$
4,771
 
$
4,181
 
$
4,771
                         
25

Nonperforming Assets 
 
Nonperforming assets consist of nonaccrual loans, loans past due 90 days and still accruing, and other real estate owned. Management generally places loans on nonaccrual status when they become 90 days past due, unless they are well secured and in the process of collection. When a loan is placed on nonaccrual status, any interest previously accrued but not collected is reversed against income, and the amortization of deferred fees and costs is discontinued. Loans are charged off when management determines that collection has become unlikely. Other real estate owned (“OREO”) consists of real property acquired through foreclosure on the related underlying defaulted loans. The following table shows nonperforming assets at the dates indicated:
             
   
September 30,
 
December 31,
(Dollars in thousands)
 
2006
 
2005
 
2005
Nonaccrual loans
 
$
2,083
 
$
2,715
 
$
3,672
Loans 90 days past due and still accruing
   
879
   
-
   
-
Restructured loans
   
-
   
-
   
-
     Total nonperforming loans
   
2,962
   
2,715
   
3,672
Other real estate owned
   
-
   
-
   
-
     Total nonperforming assets
 
$
2,962
 
$
2,715
 
$
3,672
                   
Nonperforming assets as a percentage of
                 
loans plus other real estate owned
   
0.42%
 
 
0.37%
 
 
0.53%
 
Allowance for Loan Losses
 
The Company assigns to all of its loans a risk grade consistent with the system recommended by regulatory agencies. Grades range from “Pass” to “Loss” depending on credit quality, with “Pass” representing loans that involve an acceptable degree of risk and “Loss” representing probable charge offs. Management conducts a critical evaluation of the loan portfolio monthly. This evaluation includes periodic loan by loan review for certain loans to evaluate the level of impairment, as well as detailed reviews of other loans (either individually or in pools) based on an assessment of various factors which include: past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower's ability to repay, collateral values, loan volumes and concentrations, size and complexity of the loans, recent loss experience in particular segments of the portfolio, bank regulatory examination results, and current economic conditions in the Company's marketplace, in particular the state of the technology industry and the real estate market.
 
This process attempts to assess the risk of loss inherent in the portfolio by segregating loans into several components for purposes of determining an appropriate level of the allowance. Additionally, the Company maintains a program for regularly scheduled reviews of certain new and renewed loans by an outside loan review consultant. Any loans identified during an external review process that expose the Company to increased risk are appropriately downgraded and an increase in the allowance for loan losses is established for such loans as needed. Further, the Company is examined periodically by the Board of Governors of the Federal Reserve System (“FRB”) and the California Department of Financial Institutions (“DFI”), at which time a further review of loan quality is conducted.
 
Loans that demonstrate a weakness, for which there is a possibility of loss if the weakness is not corrected, are categorized as “classified.” Classified loans include all loans considered as substandard and loss that 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).
 
The principal balance of classified loans, which consists of all loans internally graded as substandard, was approximately $20 million and $15 million, respectively, at September 30, 2006 and 2005.
 
It is the policy of management to maintain the allowance for loan losses at a level adequate for risks inherent in the loan portfolio. Based on information currently available to analyze loan loss delinquency and a history of actual charge-offs, management believes that the loan loss allowance is adequate.
 
The loan portfolio can be adversely affected if California economic conditions and the real estate market in the Company’s market area were to 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 adversely affect the Company's future growth and profitability. No assurance of the ultimate level of credit losses can be given with any certainty.
26

 
The following table summarizes the Company’s loan loss experience as well as provisions, net charge-offs to the allowance for loan losses and certain pertinent ratios for the periods indicated:
             
   
Nine Months Ended
 
For the Year Ended
   
September 30,
 
December 31,
(Dollars in thousands)
 
2006
 
2005
 
2005
Allowance for loan losses balance, beginning of period
 
$
10,224
 
$
12,497
 
$
12,497
Net charge-offs
   
(242)
 
 
(1,738)
 
 
(1,915)
Provision for loan losses
   
(603)
 
 
313
   
313
Reclassification to loans held for sale
   
-
   
40
   
(671)
Allowance for loan losses balance, end of period
 
$
9,379
 
$
11,112
 
$
10,224
                   
Ratios
                 
Net charge-offs to average loans*
   
0.05%
 
 
0.32%
 
 
0.26%
Allowance for loan losses to total loans*
   
1.31%
 
 
1.51%
 
 
1.48%
Allowance for loan losses to nonperforming assets
   
317%
 
 
409%
 
 
278%
                   
* Average loans and total loans exclude loans held for sale.
                 
                   
Historical net charge-offs are not necessarily indicative of the amount of net charge-offs that the Company will realize in the future.
 
The formula allowance is calculated by applying estimated reserve factors to pools of similar loans and specific allowances for individual impaired loans. Reserve factors are based on historical loss experience, adjusted for significant factors that, in management's judgment, may affect the collectibility of the portfolio as of the evaluation date.
 
In adjusting the historical reserve factors applied to the respective segments of the loan portfolio, management considered the following factors:
 
·  
Levels and trends in delinquencies, nonaccruals, charge-offs and recoveries
·  
Trends in volume and loan terms
·  
Lending policy or procedural changes
·  
Experience, ability, and depth of lending management and staff
·  
National and local economic trends and conditions
·  
Concentrations of credit
 
There can be no assurance that the adverse impact of any of these conditions on the Bank will not be in excess of the current level of estimated losses.
 
In an effort to improve its analysis of risk factors associated with its loan portfolio, the Company continues to monitor and to make appropriate changes to its internal loan policies. As the Company adds new products, increases the complexity of the loan portfolio, and expands the geographic coverage, the Company will enhance the methodologies to keep pace with the size and complexity of the loan portfolio. These efforts better enable the Company to assess risk factors prior to granting new loans and to assess the sufficiency of the allowance for loan losses.
 
Management believes that it has adequately provided an allowance for estimated probable losses in the loan portfolio. Significant deterioration in Northern California real property values or economic downturns could impact future operating results, liquidity or capital resources and require additional provisions to the allowance or cause losses in excess of the allowance.
27

Deposits
 
Total deposits were $876 million at September 30, 2006 and $975 million at September 30, 2005. For nine months ended September 30, 2006 from the same period in 2005, (i) noninterest bearing demand deposits decreased $32 million, or 12%, primarily due to decreases in title and escrow companies’ accounts; (ii) interest bearing demand deposits increased $3 million, or 3%, as a result of the increasing rate environment; (iii) savings and money market deposits decreased $48 million, or 12%, primarily due to decreases in high rate balances of title companies, real estate exchange companies, and escrow accounts; (iv) time deposits decreased $19 million, or 12%, primarily due to account maturities; and (v) brokered deposits decreased $4 million, or 11%.
 
The following table presents the Company’s deposit mix as of September 30, 2006 and 2005:
                 
(Dollars in thousands)
 
2006
 
% to Total
 
2005
 
% to Total
Demand, noninterest bearing
 
$
226,297
   
26%
 
$
258,464
   
26%
Demand, interest bearing
   
133,636
   
15%
 
 
130,327
   
13%
Savings and money market
   
349,436
   
40%
 
 
397,070
   
41%
Time deposits, under $100
   
31,522
   
4%
 
 
37,685
   
4%
Time deposits, $100 and over
   
101,198
   
11%
 
 
113,609
   
12%
Brokered deposits, $100 and over
   
34,009
   
4%
 
 
38,039
   
4%
     Total deposits
 
$
876,098
   
100%
 
$
975,194
   
100%
                         
As of September 30, 2006 and 2005, approximately $2.4 million, or less than 1%, of deposits were from public sources, and approximately $25 million and $75 million, or 3% and 8%, of deposits were from title and escrow companies, respectively.
 
The Company obtains deposits from a cross-section of the communities it serves. The Company's business is not seasonal in nature. Brokered deposits generally mature within one to three years. The Company is not dependent upon funds from sources outside the United States.

The following table indicates the maturity schedule of the Company’s time deposits of $100,000 or more as of September 30, 2006:
         
Time Deposits of $100,000 and Over, including Brokered Deposits
       
(Dollars in thousands)
 
Balance
 
% of Total
Three months or less
 
$
52,422
   
39%
Over three months through six months
   
28,206
   
21%
Over six months through twelve months
   
25,329
   
19%
Over twelve months
   
29,250
   
21%
     Total
 
$
135,207
   
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 whom 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.
28

Liquidity and Asset/Liability Management
 
To meet liquidity needs, the Company maintains a portion of its funds in cash deposits in other banks, in Federal funds sold, and in securities. At September 30, 2006, the Company’s primary liquidity ratio was 17.3%, comprised of $79 million in securities available-for-sale with maturities (or probable calls) of up to five years, less $11 million of securities that were pledged to secure public and certain other deposits as required by law or contract; Federal funds sold of $41 million, and $41 million in cash and due from banks, as a percentage of total unsecured deposits of $865 million. At December 31, 2005 and September 30, 2005, the Company's primary liquidity ratio was 20.2% and 21.2%, respectively.
 
The following table summarizes the Company's securities sold under agreement to repurchase for the periods indicated:

         
   
September 30,
(Dollars in thousands)
 
2006
 
2005
YTD average balance
 
$
26,653
 
$
43,460
YTD average interest rate
   
2.44%
 
 
2.24%
Maximum month-end balance
 
$
21,800
 
$
32,700
Average rate at September 30
   
2.56%
 
 
2.34%
             
The Company has Federal funds purchase and lines of credit arrangements totaling $74 million with correspondent banks. As of September 30, 2006, the Company had borrowing capacity of approximately $90 million under a borrowing arrangement with the Federal Home Loan Bank secured by certain loans and securities.
 
Capital Resources 
 
The following table summarizes risk-based capital, risk-weighted assets, and risk-based capital ratios of the Company:

                 
   
September 30,
 
December 31,
   
(Dollars in thousands)
 
2006
 
2005
 
2005
   
Capital components:
                       
     Tier 1 Capital
 
$
142,967
 
$
129,018
 
$
133,715
     
     Tier 2 Capital
   
9,754
   
11,295
   
10,427
     
          Total risk-based capital
 
$
152,721
 
$
140,313
 
$
144,142
     
                         
Risk-weighted assets
 
$
839,097
 
$
962,090
 
$
941,567
     
Average assets for the quarter
 
$
1,079,571
 
$
1,149,088
 
$
1,157,704
     
 
                     
Minimum 
 
                     
Regulatory
Capital ratios
                     
Requirements
     Total risk-based capital
   
18.2%
 
 
14.6%
 
 
15.3%
 
 
8%
     Tier 1 risk-based capital
   
17.0%
 
 
13.4%
 
 
14.2%
 
 
4%
     Leverage (1)
   
13.2%
 
 
11.2%
 
 
11.6%
 
 
4%
                         
 
 
The table above presents the capital ratios of the Company 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.
 
The Company’s Tier 1 capital consists primarily of shareholders’ equity (excluding unrealized gains and losses on securities) plus notes payable to subsidiary grantor trusts, less intangible assets. Tier 2 capital consists primarily of the allowance for loan losses.
29

At September 30, 2006 and 2005, and December 31, 2005, the Company’s capital met all minimum regulatory requirements. As of September 30, 2006, management believes that HBC was considered “Well Capitalized” under the Prompt Corrective Action provisions.
 
To enhance regulatory capital and to provide liquidity the Company, through unconsolidated subsidiary grantor trusts, has issued mandatorily redeemable cumulative trust preferred securities. Under applicable regulatory guidelines, the Trust Preferred securities currently qualify as Tier I capital. The subsidiary trusts are not consolidated in the Company’s consolidated financial statements and the subordinated debt payable to the subsidiary grantor trusts is recorded as debt of the Company to the related trusts. The following table shows the subsidiary grantor trusts:
                 
           
Date of
 
Stated
Subsidiary Grantor Trusts
 
Balance
 
Interest Rate
 
Original Issue
 
Maturity
Heritage Capital Trust I
 
$
7,217,000
   
10.875
%
 
3/23/2000
   
3/8/2030
Heritage Commerce Corp Statutory Trust I
   
7,206,000
   
10.600
%
 
9/7/2000
   
9/7/2030
Heritage Statutory Trust II
   
5,155,000
   
3-month Libor Plus 3.580
%
 
7/31/2001
   
7/31/2031
Heritage Commerce Corp Statutory Trust III
   
4,124,000
   
3-month Libor Plus 3.400
%
 
9/26/2002
   
9/26/2032
   
$
23,702,000
                 
                         
Market Risk
 
Market risk is the risk of loss to future earnings, to fair values, or to 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 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 Sensitivity
 
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; 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 of deposit 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. Because of these factors, an interest sensitivity gap report may not provide a complete assessment of the exposure to changes in interest rates. To supplement traditional GAP analysis, the Company performs simulation modeling to estimate the potential effects of changing interest rate environments. The process allows the Company to explore the complex relationships within the GAP over time and various interest rate environments.

Liquidity risk represents the potential for loss as a result of limitations on the Company's ability to adjust for future cash flows to meet the needs of depositors and borrowers and to fund operations on a timely and cost-effective basis. The liquidity policy approved annually by the board of directors requires monthly review of the Company's liquidity by the Asset/Liability Committee, which is composed of senior executives, and the Finance and Investment Committee of the board of directors.

The Company's internal Asset/Liability Committee and the Finance and Investment Committee of the Board of Directors each meet monthly to monitor the Company's investments, liquidity needs and to oversee its asset/liability management. The Company evaluates the rates offered on its deposit products on a regular basis.
30

ITEM 3 - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 
 
As a financial institution, the Company's primary component of market risk is interest rate volatility. Fluctuations in interest rates will ultimately impact both the level of income and expense recorded on most of the Company's assets and liabilities, and the market value of interest earning assets and interest earning liabilities, other than those which have a short term to maturity. Based upon the nature of the Company's operations, the Company is not subject to foreign exchange or commodity price risk. The Company has no market risk sensitive instruments held for trading purposes. As of September 30, 2006, the Company does not use interest rate derivatives to hedge its interest rate risk.
 
The Company's exposure to market risk is reviewed on a regular basis by the Asset/Liability Committee (“ALCO”). 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 an interest rate shock simulation model to manage interest rate risk.
 
The Company applies a market value (“MV”) methodology to gauge its interest rate risk exposure as derived from its simulation model. Generally, MV is the discounted present value of the difference between incoming cash flows on interest earning assets and other investments and outgoing cash flows on interest bearing liabilities and other liabilities. The application of the methodology attempts to quantify interest rate risk as the change in the MV which would result from a theoretical 200 basis point (1 basis point equals 0.01%) change in market interest rates. Both a 200 basis point increase and a 200 basis point decrease in market rates are considered.
 
At September 30, 2006, it was estimated that the Company's MV would increase 21.0% in the event of a 200 basis point increase in market interest rates. The Company's MV at the same date would decrease 30.2% in the event of a 200 basis point decrease in market interest rates.
 
Presented below, as of September 30, 2006 and 2005, is an analysis of the Company's interest rate risk as measured by changes in MV for instantaneous and sustained parallel shifts of 200 basis points in market interest rates:
                                 
   
September 30, 2006
 
September 30, 2005
   
$ Change
 
% Change
 
Market Value as a % of
 
$ Change
 
% Change
 
Market Value as a % of
   
in Market
 
in Market
 
Present Value of Assets
 
in Market
 
in Market
 
Present Value of Assets
(Dollars in thousands)
 
Value
 
Value
 
MV Ratio
 
Change (bp)
 
Value
 
Value
 
MV Ratio
 
Change (bp)
Change in rates
                                               
+ 200 bp
 
$
34,859
   
21.0%
 
 
19.1%
 
 
331
 
$
68,151
   
36.8%
 
 
21.9%
 
 
588
0 bp
 
$
-
   
0.0%
 
 
15.8%
 
 
0
 
$
-
   
0.0%
 
 
16.0%
 
 
0
- 200 bp
 
$
(50,121)
 
 
-30.2%
 
 
11.0%
 
 
(477)
 
$
(46,522)
 
 
-25.1%
 
 
12.0%
 
 
(402)
                                                 
Management believes that the MV methodology overcomes three shortcomings of the typical maturity gap methodology. First, it does not use arbitrary repricing intervals and accounts for all expected future cash flows. Second, because the MV method projects cash flows of each financial instrument under different interest rate environments, it can incorporate the effect of embedded options on an institution’s interest rate risk exposure. Third, it allows interest rates on different instruments to change by varying amounts in response to a change in market interest rates, resulting in more accurate estimates of cash flows.

However, as with any method of gauging interest rate risk, there are certain shortcomings inherent to the MV methodology. 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 MV methodology 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 of deposit 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.
31

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, 2006. 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 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, 2006, the period covered by this report on Form 10-Q.
 
During the three months ended September 30, 2006, 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.
 
 
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 information on the financial condition of the Company contained in this report, the following risks may affect the Company. If any of these risks occurs, our business, financial condition or operating results could be adversely affected.
 
Changes in market interest rates may adversely affect the Company’s performance
 
The Company’s earnings are impacted by changing interest rates. Changes in interest rates impact the demand for new loans, the credit profile of existing loans, the prepayment characteristics of loans sold to the secondary market, the rates received on loans, other investments, and rates paid on deposits and other borrowings. The Board of Governors of the Federal Reserve System increased short-term interest rates 200 basis points during 2005 and 100 basis points in 2006. Although a prolonged trend of interest rate increase could adversely effect the Company, further increases in 2006 should continue to have a positive effect on the Company’s net interest margin and net interest income.
 
Business focus and economic and competitive conditions in the San Francisco Bay Area could adversely affect the Company’s operations
 
Most of the Company’s operations and a vast majority of its customers are located in the Bay Area of California. A deterioration in economic and business conditions in the Bay Area, particularly in the technology and real estate industries on which this area depends, could have a material adverse impact on the quality of the Company’s loan portfolio and the demand for the Company’s products and services. A downturn in the national economy might further exacerbate local economic conditions.
 
The banking and financial services business in California, generally, and in the Company's market areas, specifically, is highly competitive. The increasingly competitive environment is a result primarily of changes in regulation, changes in technology and product delivery systems, and the consolidation among financial service providers. The Company competes for loans, deposits and customers for financial services with other commercial banks, savings and loan associations, securities and brokerage companies, mortgage companies, insurance companies, finance companies, money market funds, credit unions, and other non-bank financial service providers. Many of these competitors are much larger in total assets and capitalization, have greater access to capital markets and offer a broader array of financial services than the Company. In order to compete with the other financial service providers, the Company principally relies upon local promotional activities, personal service relationships established by officers, directors, and employees with its customers, and specialized services tailored to meet its customers' needs. In those instances where the Company is unable to accommodate a customer's needs, the Company seeks to arrange for such loans on a participation basis with other financial institutions or to have those services provided in whole or in part by its correspondent banks.
32

We are subject to extensive regulation that could restrict our activities and impose financial requirements or limitations on the conduct of our business.
 
Bank holding companies and California-charted commercial banks operate in a highly regulated environment and are subject to supervision and examination by federal and state regulatory agencies. We are subject to the Bank Holding Company Act of 1956, as amended, and to regulation and supervision by the Board of Governors of the Federal Reserve System (“FRB”). HBC is subject to regulation and supervision by the FDIC, and the California Department of Financial Institutions (“DFI”). The cost of compliance with regulatory requirements may adversely affect our results of operations or financial condition. Federal and state laws and regulations govern numerous matters including: changes in the ownership or control of banks and bank holding companies; maintenance of adequate capital and the financial condition of a financial institution; permissible types, amounts and terms of extensions of credit and investments; permissible non-banking activities; the level of reserves against deposits; and restrictions on dividend payments.
 
The FDIC and DFI possess cease and desist powers to prevent or remedy unsafe or unsound practices or violations of law by banks subject to their regulation, and the FRB possesses similar powers with respect to bank holding companies. These and other restrictions limit the manner in which we may conduct our business and obtain financing.
 
We are dependent upon the services of our management team.
 
We are dependent upon the ability and experience of a number of our key management personnel who have substantial experience with our operations, the financial services industry and the markets in which we offer our services. It is possible that the loss of the services of one or more of our senior executives or key managers would have an adverse effect on our operations. Our success also depends on our ability to continue to attract, manage and retain other qualified personnel as we grow. We cannot assure that we will continue to attract or retain such personnel.
 
Terrorist activities could cause reductions in investor confidence and substantial volatility in real estate and securities markets.
 
It is impossible to predict the extent to which terrorist activities may occur in the United States or other regions, or their effect on a particular security issue. It is also uncertain what effects any past or future terrorist activities and/or any consequent actions on the part of the United States government and others will have on the United States and world financial markets, local, regional and national economics, and real estate markets across the United States. Among other things, reduced investor confidence could result in substantial volatility in securities markets, a decline in general economic conditions and real estate related investments and an increase in loan defaults. Such unexpected losses and events could materially affect our results of operations.
 
ITEM 2 - UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
 
In February 2006, the Company’s Board of Directors authorized the purchase of up to $10 million of its common stock, which represents approximately 455,000 shares, or 4%, of its outstanding shares at current market price. The share repurchase authorization is valid through June 30, 2007.
 
The Company intends to finance the purchase using its available cash. Shares may be repurchased by the Company in open market purchases or in privately negotiated transactions as permitted under applicable rules and regulations. The repurchase program may be modified, suspended or terminated by the Board of Directors at any time without notice. The extent to which the Company repurchases its shares and the timing of such repurchases will depend upon market conditions and other corporate considerations.
33

Repurchases of equity securities for the third quarter of 2006 are presented in the table below:
                 
               
Approximate
           
Total Number of
 
Dollar of Shares That
           
Shares Purchased
 
May Yet Be
   
Total Number of
 
Price Paid
 
as Part of Publicly
 
Purchased
Settlement Date
 
Shares Purchased
 
Per Share
 
Announced Plans
 
Under the Plan
08/09/06
   
7,000
 
$
24.45
   
7,000
 
$
8,152,542
08/10/06
   
6,500
 
$
23.88
   
6,500
 
$
7,997,333
08/11/06
   
6,500
 
$
23.75
   
6,500
 
$
7,842,982
08/14/06
   
6,500
 
$
23.23
   
6,500
 
$
7,691,972
08/15/06
   
6,500
 
$
23.33
   
6,500
 
$
7,540,334
08/16/06
   
6,500
 
$
23.28
   
6,500
 
$
7,389,014
08/17/06
   
6,500
 
$
23.41
   
6,500
 
$
7,236,822
08/18/06
   
6,500
 
$
23.26
   
6,500
 
$
7,085,637
08/21/06
   
6,500
 
$
23.35
   
6,500
 
$
6,933,875
08/22/06
   
6,500
 
$
23.29
   
6,500
 
$
6,782,477
08/23/06
   
6,500
 
$
23.28
   
6,500
 
$
6,631,164
08/24/06
   
2,400
 
$
23.39
   
2,400
 
$
6,575,039
08/25/06
   
6,500
 
$
23.59
   
6,500
 
$
6,421,686
08/28/06
   
6,500
 
$
23.42
   
6,500
 
$
6,269,459
08/29/06
   
6,500
 
$
23.07
   
6,500
 
$
6,119,532
08/30/06
   
6,500
 
$
23.26
   
6,500
 
$
5,968,354
08/31/06
   
6,500
 
$
23.54
   
6,500
 
$
5,815,327
09/01/06
   
6,500
 
$
23.57
   
6,500
 
$
5,662,101
09/05/06
   
6,500
 
$
23.54
   
6,500
 
$
5,509,085
09/06/06
   
6,500
 
$
23.47
   
6,500
 
$
5,356,554
09/07/06
   
6,500
 
$
23.42
   
6,500
 
$
5,204,332
09/08/06
   
6,500
 
$
23.96
   
6,500
 
$
5,048,570
09/11/06
   
6,500
 
$
23.78
   
6,500
 
$
4,893,979
09/12/06
   
6,500
 
$
23.65
   
6,500
 
$
4,740,244
09/13/06
   
6,500
 
$
23.62
   
6,500
 
$
4,586,691
09/14/06
   
6,500
 
$
23.73
   
6,500
 
$
4,432,453
09/15/06
   
6,500
 
$
23.88
   
6,500
 
$
4,277,255
09/18/06
   
6,500
 
$
23.83
   
6,500
 
$
4,122,339
09/19/06
   
6,500
 
$
24.01
   
6,500
 
$
3,966,307
09/20/06
   
6,500
 
$
24.04
   
6,500
 
$
3,810,025
09/21/06
   
6,500
 
$
24.01
   
6,500
 
$
3,653,982
09/22/06
   
6,500
 
$
23.67
   
6,500
 
$
3,500,135
09/25/06
   
6,500
 
$
24.56
   
6,500
 
$
3,340,480
     
210,900
         
210,900
     
                         
 
34

ITEM 6 - EXHIBITS
 
Exhibit             Description
 
31.1              Certification of Registrant’s Chief Executive Officer Pursuant To Section 302 of the Sarbanes-Oxley Act of 2003
 
31.2              Certification of Registrant’s Chief Financial Officer Pursuant To Section 302 of the Sarbanes-Oxley Act of 2003
 
32.1     Certification of Registrant’s Chief Executive Officer Pursuant To18 U.S.C. Section 1350

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

 
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
     
 November 9, 2006
 
 /s/ Walter T. Kaczmarek
 Date
                                          Walter T. Kaczmarek
   
        Chief Executive Officer
     
 November  9, 2006
 
 /s/ Lawrence D. McGovern
 Date
 
    Lawrence D. McGovern
   
  Chief Financial Officer
 
 
EXHIBIT INDEX
 
Exhibit             Description
 
31.1              Certification of Registrant’s Chief Executive Officer Pursuant To Section 302 of the Sarbanes-Oxley Act of 2003
 
31.2              Certification of Registrant’s Chief Financial Officer Pursuant To Section 302 of the Sarbanes-Oxley Act of 2003
 
32.1     Certification of Registrant’s Chief Executive Officer Pursuant To18 U.S.C. Section 1350

32.2     Certification of Registrant’s Chief Financial Officer Pursuant To 18 U.S.C. Section 1350
 
 
 
 
35