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Table of Contents

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 


FORM 10-K


 

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

For the fiscal year ended December 31, 2010.

 

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:  000-25020

Heritage Oaks Bancorp

(Exact name of registrant as specified in its charter)

 

California

 

77-0388249

(State or other jurisdiction of

 

(I.R.S. Identification No.)

Incorporation or organization)

 

 

 

 

 

545 12th Street

 

 

Paso Robles, California

 

93446

(Address of Principal Executive Offices)

 

(Zip Code)

 

(805) 369-5200

(Registrant’s Telephone Number)

 

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

 

Securities registered pursuant to Section 12(g) of the Act:

 

 

Title of each class

 

Name of exchange on which registered

 

Common Stock, no par value

 

NASDAQ Capital Market

 

Convertible Perpetual Preferred Stock, Series C

 

 

 

Liquidation preference: $3.25 per share

 

 

 

Indicate by check mark if the registrant is a well-known, seasoned issuer as defined in Rule 405 of the Securities Act. 

Yes [  ]   No [X]

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. 

Yes [  ]   No [X]

 

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

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File require to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes [  ]   No [  ]

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K [  ].

 

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

 

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

 

The aggregate market value of the voting and non-voting common equity held by non-affiliates of the Registrant at June 30, 2010 was $74.4 million.  As of March 10, 2011, the Registrant had 25,081,819 shares of Common Stock outstanding.

 

 

 



Table of Contents

 

Documents Incorporated By Reference

 

The information required in Part III, Items 10 through 14 are incorporated by reference to the registrant’s definitive proxy statement for the 2011 annual meeting of shareholders.

 

Heritage Oaks Bancorp

and Subsidiaries

 

Table of Contents

 

 

Page

Part I

 

 

 

Item 1. Business

3

Item 1A. Risk Factors

15

Item 1B. Unresolved Staff Comments

24

Item 2. Properties

24

Item 3. Legal Proceedings

24

Item 4. (Removed and Reserved)

25

 

 

Part II

 

 

 

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

26

Item 6. Selected Financial Data

28

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

29

Item 7A. Quantitative and Qualitative Disclosures about Market Risk

56

Item 8. Financial Statements and Supplementary Data

58

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

107

Item 9A. Controls and Procedures

107

Item 9B. Other Information

108

 

 

Part III

 

 

 

Item 10. Directors, Executive Officers and Corporate Governance

108

Item 11. Executive Compensation

108

Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

108

Item 13. Certain Relationships and Related Transactions, and Director Independence

108

Item 14. Principal Accounting Fees and Services

108

 

 

Part IV

 

 

 

Item 15. Exhibits, Financial Statement Schedules

109

 

 

Signatures

110

 

 

Exhibit Index

111

 

 

Certifications

115

 

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Table of Contents

 

Part I

 

Certain statements contained in this Annual Report on Form 10-K (“Annual Report”), including, without limitation, statements containing the words “believes”, “anticipates”, “intends”, “expects”, and words of similar impact, constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities and Exchange Act of 1934.  Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievements of the Company to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements.  Such factors include, among others, the following: the ongoing financial crisis in the United States, and the response of the federal and state governments and our regulators thereto, continued migration of classified loans, general economic and business conditions in those areas in which the Company operates, demographic changes, competition, fluctuations in interest rates, the recent disruptions of the United States credit markets, changes in business strategy or development plans, changes in governmental regulation, credit quality, the impact of the recent capital raise to support the Company’s business, economic, political and global changes arising from the war on terrorism, the Bank’s beliefs as to the adequacy of its existing and anticipated allowance for loan losses, beliefs and expectations about, and requirements to comply with current regulatory enforcement actions taken by regulatory authorities having oversight of the Bank’s operations, financial policies of the United States government and continued weakness in the real estate markets within which we operate, and other factors referenced in this report, including in “Item 1A. Risk Factors.”  The Company disclaims any obligation to update any such factors or to publicly announce the results of any revisions to any of the forward-looking statements contained herein to reflect future events or developments. 

 

Item 1.  Business

 

General

 

Heritage Oaks Bancorp (the "Company", “we” or “our”) is a California corporation organized in 1994 to act as the holding company of Heritage Oaks Bank (the “Bank").  In 1994, the Company acquired all of the outstanding common stock of the Bank in a holding company formation transaction.

 

In October 2006, the Company formed Heritage Oaks Capital Trust II (the “Trust II”).  Trust II is a statutory business trust formed under the laws of the State of Delaware and is a wholly-owned, non-financial, non-consolidated subsidiary of the Company.

 

In September 2007, the Company formed Heritage Oaks Capital Trust III (the “Trust III”).  Trust III was a statutory business trust formed under the laws of the state of Delaware and was a wholly-owned, non-financial, non-consolidated subsidiary of the Company.  In June of 2010 the Company repurchased all of the securities issued by Trust III, and dissolved the trust in December 2010.

 

Other than holding the shares of the Bank, the Company conducts no significant activities, although it is authorized, with the prior approval of the Board of Governors of the Federal Reserve System (the "Federal Reserve Board"), the Company's principal regulator, to engage in a variety of activities which are deemed closely related to the business of banking. The Company has also incorporated a subsidiary, CCMS Systems, Inc. which is currently inactive and has not been capitalized. The Company has no present plans to capitalize or activate this subsidiary, nor engage in such other permitted activities.

 

Banking Services

 

The Bank was licensed by the California Department of Financial Institutions (“DFI”) and commenced operation in January 1983.  As a California state bank, the Bank is subject to primary supervision, examination and regulation by the DFI and the Federal Deposit Insurance Corporation (“FDIC”).  The Bank is also subject to certain other federal laws and regulations.  The deposits of the Bank are insured by the FDIC up to the applicable limits thereof. 

 

The Company is headquartered in Paso Robles, California with two branch offices in Paso Robles, San Luis Obispo and Santa Barbara, three branch offices in Santa Maria, and single branch locations in Arroyo Grande, Atascadero, Cambria, Morro Bay, Templeton and San Miguel.  The Bank conducts commercial banking business in the counties of San Luis Obispo and Santa Barbara, including accepting demand, savings, money market account and time deposits, and making commercial, real estate, SBA, agricultural, credit card, and consumer loans. 

 

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Table of Contents

 

The Bank also offers residential mortgage banking services, installment note collection, issues cashier’s checks and money orders, sells travelers checks, and provides bank-by-mail, night depository, safe deposit boxes, online banking, and other customary banking services.  The Bank does not offer trust services or international banking services and does not plan to do so in the near future.

 

At December 31, 2010, the Company had $982.6 million in consolidated assets, $650.8 million in net consolidated loans, $798.2 million in consolidated deposits, and $121.3 million in stockholders' equity.   

 

The Bank’s operating policies since inception have emphasized small business, commercial, and retail banking.  Most of the Bank’s customers are retail customers, and small to medium-sized businesses.  The areas in which the Bank has directed virtually all of its lending activities are: commercial loans and lines of credit, consumer loans including residential mortgages, construction financing, and other real estate loans or commercial loans secured by real estate.  A more detailed discussion of the loan portfolio can be found under Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations and Note 3. Loans, of the consolidated financial statements, filed on this Form 10-K.

 

Most of the Bank’s deposits are obtained through promotional activities and advertising in the local media.  Product offerings include: personal and business checking and savings accounts, time deposit accounts, Individual Retirement Accounts (“IRAs”), and money market accounts.  A more detailed discussion of the Bank’s deposits can be found under Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations of this Form 10-K.

 

The principal sources of the Company’s consolidated revenues are (i) interest and fees on loans, (ii) interest on investments, (iii) service charges on deposit accounts and other charges and fees, (iv) mortgage origination fees and (v) miscellaneous income. 

 

The following provides a breakdown of the components that make up the Company’s consolidated revenues for the years ended December 31, 2010, 2009 and 2008:

 

 

 

For The Years Ended December 31,

 

 

 

 

 

Percent

 

 

 

Percent

 

 

 

Percent

 

(dollar amounts in thousands)

 

2010

 

Composition

 

2009

 

Composition

 

2008

 

Composition

 

Interest and fees on loans

 

$

44,129

 

73.1%

 

$

45,530

 

81.7%

 

$

47,038

 

83.5%

 

Interest on investments

 

6,665

 

11.1%

 

4,029

 

7.2%

 

3,112

 

5.5%

 

Service charges, other charges and fees

 

2,428

 

4.0%

 

2,965

 

5.3%

 

3,284

 

5.8%

 

Mortgage origination fees

 

2,020

 

3.4%

 

1,253

 

2.2%

 

568

 

1.0%

 

Miscellaneous income

 

5,048

 

8.4%

 

1,980

 

3.6%

 

2,354

 

4.2%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total consolidated revenues

 

$

60,290

 

100.0%

 

$

55,757

 

100.0%

 

$

56,356

 

100.0%

 

 

The Company has not engaged in any material research activities relating to the development of new services or the improvement of existing bank services, except as otherwise discussed herein.  There has been no significant change in the types of services offered by the Bank since its inception.  The Company has no present plans regarding "a new line of business" requiring the investment of a material amount of total assets.  Most of the Company’s business originates from San Luis Obispo and Santa Barbara Counties and there is no emphasis on foreign sources and application of funds.  The Company’s business, based upon performance to date, does not appear to be seasonal.  Additionally, Management is unaware of any material effect upon the Company’s capital expenditures, earnings or competitive position as a result of federal, state or local environmental regulations.

 

The Bank holds service marks issued by the U.S. Patent and Trademark Office for the “Acorn” design, the “Oakley” design and “Deeply Rooted in Your Hometown.”

 

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Table of Contents

 

Employees

 

As of December 31, 2010, the Bank had 281 full-time equivalent employees.  The Bank believes that its employee relations are positive.

 

Local Economic Climate

 

The economy in the Company’s service area is based primarily on agriculture, tourism, light industry, and retail trade. Services supporting these industries have also developed in the areas of medical, financial and educational services.  The population of San Luis Obispo County, the City of Santa Maria (in Northern Santa Barbara County), and the City of Santa Barbara totaled approximately 267,000, 85,000, and 86,000 respectively, according to the most recent economic data provided by the U.S. Census Bureau.  The moderate climate allows a year round growing season in the local economy’s agricultural sector.  Vineyards and ranches also contribute largely to the local economy.  The Central Coast’s leading agricultural industry is the production of wine grapes and wine. Vineyards in production have grown significantly over the last decade.  Access to numerous recreational activities and destinations including lakes, mountains and beaches provide for a relatively stable tourist industry from many areas including the Los Angeles/Orange County basin, the San Francisco Bay area and the San Joaquin Valley. The economy in the Company’s primary markets of San Luis Obispo and Santa Barbara counties has not been immune to the current downturn in national and state economic conditions.  Weakened economic conditions have resulted in, among other things, increased unemployment, increased vacancy rates, and lower occupancy rates in the hospitality industry within the Company’s primary markets. 

 

Management acknowledges that as economic conditions continue to wane on state and national levels and if the level of unemployment continues to rise, conditions within our primary market may continue to be negatively impacted.  Additional job losses and any prolonged decline in economic activity may further impact certain borrowers to whom the Bank has extended credit and whose loans have continued to perform.

 

Competition

 

Banking and the financial services industry in California generally, and in the Company’s service area specifically, is highly competitive.  The increasingly competitive environment is a result primarily of changes in regulation, changes in technology and product delivery systems, the accelerating pace of consolidation among financial services providers and the organization of new banking entities.

 

In order to compete with other financial institutions in its service area, the Bank relies principally upon local advertising programs, direct personal contact by officers, directors, employees and specialized services.  The Bank emphasizes to customers the advantages of dealing with a locally owned and community oriented institution.  The Bank also seeks to provide special services and programs for individuals in its primary service area who are employed in the agricultural, professional and business fields, such as loans for equipment, tools of trade or expansion of practices or businesses.  Larger banks may have a competitive advantage because of larger marketing campaigns and possibly greater branch distribution.  They also provide services, such as trust services, international banking, discount brokerage and insurance services that the Bank is not authorized or prepared to offer currently.  To compensate for this, the Bank has made arrangements with correspondent banks and with others to provide such services for its customers.  For borrowers requiring loans in excess of the Bank’s legal lending limits, the Bank offers loans on a participating basis with correspondent banks and with other independent banks and will retain the portion of such loans  that are within its lending limit.

 

The financial services industry is undergoing rapid technological changes involving frequent introductions of new technology-driven products and services that have further increased competition.  There is no assurance that these technological improvements, if made, will increase the Company’s operational efficiency or that the Company will be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to our customers.

 

Effect of Government Policies and Recent Legislation

 

Banking is a business that depends on interest rate differentials. In general, the difference between the interest rate paid by the Company on deposits and other borrowings and the interest rate received by the Company on loans extended to its customers and interest earned on securities held in its investment portfolio comprise the major portion of the Company’s earnings.  These rates are highly sensitive to many factors that are beyond the control of the Company.  Accordingly, the earnings and growth of the Company are subject to the influence of domestic and foreign economic conditions, including inflation, recession and unemployment.

 

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Table of Contents

 

The commercial banking business is not only affected by general economic conditions but is also influenced by the monetary and fiscal policies of the federal government and the policies of regulatory agencies, particularly the Federal Reserve Board. The Federal Reserve Board implements national monetary policies (with objectives such as curbing inflation, combating recession and providing liquidity) by its open-market operations in U.S. Government securities, by adjusting the required level of reserves for financial institutions subject to its reserve requirements and by varying the discount rates applicable to borrowings by depository institutions.  The actions of the Federal Reserve Board in these areas influence the growth of bank loans, investments and deposits. Such interest rates also effect the Bank’s pricing on loans and what is paid on deposits.  The nature and impact on the Company from future changes in monetary policies cannot be predicted.

 

From time to time, legislation is enacted which has the effect of increasing the cost of doing business, limiting or expanding permissible activities or affecting the competitive balance between banks and other financial institutions.  Proposals to change the laws and regulations governing the operations and taxation of banks, bank holding companies and other financial institutions are frequently made in Congress, in the California legislature and before various bank regulatory and other professional agencies.  See also “Supervision and Regulation”.

 

 

Supervision and Regulation

 

Regulatory Order and Written Agreement

 

The Bank stipulated to the issuance of a consent order (the “Order”), effective March 4, 2010, with the FDIC, its principal federal banking regulator, and the DFI which requires the Bank to take certain measures to improve its safety and soundness.  The Bank’s stipulation to the issuance by the FDIC and the DFI of the Order resulted from certain findings in a report of examination resulting from an examination of the Bank conducted in September 2009. In entering into the stipulation to entry of the Order, the Bank did not concede the findings or admit to any of the assertions in the report of examination (“ROE”). 

 

On March 4, 2010, the Company entered into a written agreement with the Federal Reserve Board (the “Written Agreement”), which requires the Company to take certain measures to improve its safety and soundness. The Written Agreement provides, among other things, that the Company shall not: declare or pay dividends without prior approval of the Federal Reserve Board, take dividends from the Bank, make any distribution of interest, principal or other sums on subordinated debt or trust preferred securities or incur, increase, or guarantee any debt.

 

Under the Order, the Bank is required to take certain measures as more fully discussed below.  The Bank has taken several steps to comply with the Order, the most significant of which was the completion of a capital raise of approximately $60.0 million in March 2010.  The Bank intends to fully comply with the Order and will continue to take all steps necessary to achieve such compliance.  The Bank’s most recent regulatory examination concluded in late 2010 and a final report of examination is still pending.

 

Among the corrective actions required are for the Bank to develop and adopt a plan to maintain the minimum capital requirements for a “well-capitalized” bank, and to reach and maintain a Tier 1 leverage ratio of at least 10% and a Total Risk Based capital ratio of 11.5% at the Bank level beginning 90 days from the issuance of the Order.  As of December 31, 2010 the Bank's leverage ratio and total risk-based capital ratio were 10.52% and 14.75%, respectively and are in compliance with the Order.

 

In addition, pursuant to the Order, the Bank must retain qualified management, must notify the FDIC and the DFI in writing when it proposes to add any individual to its Board of Directors or to employ any new senior executive officer, and must conduct an independent study of management and personnel structure of the Bank.  A consultant was retained to complete the required management study, and the Bank completed the study and implementation by the Board of a plan to address the findings of such study during 2010.

 

Under the Order the Bank’s Board of Directors must also increase its participation in the affairs of the Bank, assuming full responsibility for the approval of sound policies and objectives and for the supervision of all the Bank’s activities.  The Board of Directors believes it has always provided appropriate oversight of the Bank, but has recently taken additional steps to reevaluate such oversight and enhance where appropriate the frequency and duration and the scope and depth of matters covered at its Board meetings in response to the current economic environment and concerns raised in the ROE.

 

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In direct response to the ROE, a joint regulatory compliance committee was formed at both the Bank and Company levels to oversee the Bank’s and Company’s response to all regulatory matters, including the Order and the Written Agreement.  Detailed tracking of the Order’s requirements, and the Bank’s progress in responding thereto, is reviewed and reported at such committee meetings, with regular reports then being provided by the committee to the full Board.  Further, and prior to the issuance of the Order, the Boards of both the Bank and the Company directed Chairman Michael Morris, to significantly increase his direct oversight of Management and involvement in Bank and Company affairs to ensure an appropriate response at both the Bank and Company to the concerns raised in the 2009 examination of the Bank.

 

The Order further requires the Bank to increase its Allowance for Loan Losses (“ALLL”), as of the date of the ROE, by $3.5 million and to review and revise its ALLL methodology.  The Bank subsequently made provision of approximately $19.3 million for ALLL during the third and fourth quarters of 2009 increasing the allowance for loan losses to $14.4 million as of December 31, 2009 and to $24.9 million as of December 31, 2010.  The Bank also revised its policy for determining the adequacy of the ALLL to include an assessment of market conditions and other qualitative factors. The Bank’s policy otherwise continues to provide for a comprehensive determination of the adequacy of its ALLL which is to be reviewed promptly and regularly at least once each calendar quarter and be properly reported, and any deficiency in the allowance must be remedied in the calendar quarter it is discovered, by a charge to current operating earnings.

 

With respect to classified assets which existed as of the date of the ROE, the Order also requires the Bank to charge-off or collect all assets classified as “Loss” and one-half of the assets classified as “Doubtful,” and within 180 days of the Order, to reduce its level of assets classified as “Substandard” to no more than the greater of $50.0 million or 50% of Tier 1 capital plus the ALLL.  As of December 31, 2009, the Bank met the requirement to charge-off or collect all assets classified as “Loss” and one-half of the assets classified as “Doubtful” as of the date of the ROE.  The Bank complied with the requirement of the 2009 ROE in this regard and reduced the specific group of classified assets identified during the 2009 ROE to less than $50 million or 50% of Tier 1 capital plus ALLL well before the 180 day deadline.  However, due to the continued migration of loans to classified status during 2010; as of December 31, 2010 the Bank continues to have classified assets over $50 million and over 50% of Tier 1 capital plus ALLL.

 

The Order requires that the Bank develop or revise, adopt and implement a plan, which must be approved by the FDIC and DFI, to reduce the amount of Commercial Real Estate loans extended, particularly focusing on reducing loans for construction and land development.  In addition, the Bank was required to develop a plan for reducing the number of pass graded loans designated as “watch list” credits to an acceptable level, and develop or revise its written lending and collection policies to provide more effective guidance and control over the Bank’s lending function.  The Bank believes it has accomplished all of these requirements.

 

The Order restricts the Bank from taking certain actions without the prior written consent of the FDIC and the DFI, including paying cash dividends, and from extending additional credit to certain types of borrowers. The Bank has not paid cash dividends since the first quarter of 2008.  In addition, the Bank has put processes and controls in place to ensure extensions of credit, directly or indirectly, are not granted to those who are related to borrowers of loans charged-off or classified as “Loss”, “Substandard” or “Doubtful” in the ROE.  The Bank has also acknowledged that neither the loan committee nor the Board of Directors will approve any extension to a borrower classified “Substandard” or “Doubtful” in the ROE without first collecting all past due interest in cash.

 

The Order further requires the Bank to develop or revise, adopt and implement a revised liquidity policy, and to adopt a contingency funding plan to adequately address contingency funding sources and appropriately reduce contingency funding reliance on off-balance sheet sources.  The Bank has since revised its current liquidity policy and has developed a contingency funding plan.

 

The Order also requires that the Bank prepare and submit a revised business plan, that is to include a comprehensive budget, and a 3 year strategic plan, and to further revise its investment policy.  The Bank has since prepared a comprehensive budget, revised the investment policy and developed a revised business plan and 3 year strategic plan. 

 

On March 4, 2010, the Company entered into a written agreement with the FRB (the “Written Agreement”), which requires the Company to take certain measures to improve its safety and soundness. Under the Written Agreement, the Company is required to develop and submit for approval, a plan to maintain sufficient capital at the Company and the Bank within 60 days of the date of the Written Agreement. The Written Agreement further provides, among other things, that the Company shall not: declare or pay dividends without prior approval of the FRB, take dividends from the Bank, make any distribution of interest, principal or other sums on subordinated debt or trust preferred securities, incur, increase, or guarantee any debt.

 

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Although the Company and Bank believe they have taken all necessary steps to achieve compliance with the Order and Written Agreement, ultimate compliance is determined by the regulatory agencies.  As previously stated, the Bank’s most recent regulatory examination concluded in late 2010 and a final report of examination is still pending.  Therefore the Company and the Bank cannot confirm compliance with the full scope of the Order at this time.

 

The forgoing discussion of the Order and Written Agreement are qualified by reference to the complete text of the Order and Written Agreement, which can be found on the Current Reports on Form 8-K filed with the SEC on March 10, 2010, and March 8, 2010, respectively.  See also Note 22. Regulatory Order and Written Agreement, of the consolidated financial statements, filed on this Form 10-K.

 

General

 

The Company and the Bank are extensively regulated under both federal and state law.  Set forth below is a summary description of certain laws that relate to the regulation of the Company and the Bank.  The description does not purport to be complete and is qualified in its entirety by reference to the applicable laws and regulations.  The following requirements and limitations are separate and distinct from the Order and Written Agreement discussed above. 

 

The Company

 

The Company is a bank holding company within the meaning of the Bank Holding Company Act of 1956, as amended (the "Bank Holding Company Act"), and is registered as such with, and subject to the supervision of, the Federal Reserve Board.  The Company is required to file with the Federal Reserve Board quarterly and annual reports and such additional information as the Federal Reserve Board may require pursuant to the Bank Holding Company Act.  The Federal Reserve Board may conduct examinations of bank holding companies and related subsidiaries.

 

The Company is required to obtain the approval of the Federal Reserve Board before it may acquire all or substantially all of the assets of any bank, or ownership or control of the voting shares of any bank if, after giving effect to such acquisition of shares, the Company would own or control more than 5% of the voting shares of such bank.  Prior approval of the Federal Reserve Board is also required for the merger or consolidation of the Company with another bank holding company.

 

The Company is prohibited by the Bank Holding Company Act, except in certain statutorily prescribed instances, from acquiring direct or indirect ownership or control of more than 5% of the outstanding voting shares of any company that is not a bank or bank holding company and from engaging, directly or indirectly, in activities other than those of banking, managing or controlling banks or furnishing services to its subsidiaries.  However, the Company may, subject to the prior approval of the Federal Reserve Board, engage in any, or acquire shares of companies engaged in, activities that are deemed by the Federal Reserve Board to be so closely related to banking or managing or controlling banks as to be a proper incident thereto.  See discussion under "Financial Modernization Act" below for additional information.

 

The Federal Reserve Board may require that the Company terminate an activity or terminate control of or liquidate or divest subsidiaries or affiliates when the Federal Reserve Board determines that the activity or the control or the subsidiary or affiliates constitutes a significant risk to the financial safety, soundness or stability of any of its banking subsidiaries.  The Federal Reserve Board also has the authority to regulate provisions of certain bank holding company debt, including authority to impose interest ceilings and reserve requirements on such debt.  Under certain circumstances, the Company must file written notice and obtain approval from the Federal Reserve Board prior to purchasing or redeeming its equity securities.

 

Under the Federal Reserve Board's regulations, a bank holding company is required to serve as a source of financial and managerial strength to its subsidiary banks and may not conduct its operations in an unsafe and unsound manner.  In addition, it is the Federal Reserve Board's policy that in serving as a source of strength to its subsidiary banks, a bank holding company should stand ready to use available resources to provide adequate capital funds to its subsidiary banks during periods of financial stress or adversity and should maintain the financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary banks.  A bank holding company's failure to meet its obligations to serve as a source of strength to its subsidiary banks will generally be considered by the Federal Reserve Board to be an unsafe and unsound banking practice or a violation of the Federal Reserve Board's regulations or both.

 

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The Company and the Bank are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit, sale or lease of property or furnishing of services.  For example, with certain exceptions, neither  the Company nor the Bank may condition an extension of credit to a customer on either (1) a requirement that the customer obtain additional services provided by us or (2) an agreement by the customer to refrain from obtaining other services from a competitor.

 

The Company is subject to the periodic reporting requirements of the Securities Exchange Act of 1934, as amended, and files reports and proxy statements pursuant to such Act with the Securities and Exchange Commission (the “SEC”).

 

The Bank

 

The Bank is chartered under the laws of the State of California and its deposits are insured by the FDIC to the extent provided by law.  The Bank is subject to the supervision of, and is regularly examined by, the DFI and the FDIC. For the Bank, such supervision and regulation includes comprehensive reviews of all major aspects of the Bank’s business and condition.  Various requirements and restrictions under the laws of the United States and the State of California affect the operations of the Bank.  Federal and California statutes relate to many aspects of the Bank’s operations, including reserves against deposits, interest rates payable on deposits, loans, investments, mergers and acquisitions, borrowings, dividends and locations of branch offices.  Further, the Bank is required to maintain certain levels of capital.

 

If, as a result of an examination of a bank, the FDIC or the DFI should determine that the financial condition, capital resources, asset quality, earnings prospects, management, liquidity, or other aspects of a bank’s operations are unsatisfactory or that a bank or its respective management is violating or has violated any law or regulation, various remedies are available to these regulatory agencies. 

 

Such remedies include the power to enjoin "unsafe or unsound" practices, to require affirmative action to correct any conditions resulting from any violation or practice, issue an administrative order that can be judicially enforced, direct an increase in capital, restrict growth, assess civil monetary penalties, remove officers and directors, and ultimately to terminate deposit insurance, which for a California chartered bank would result in a revocation of the bank’s charter.

 

Please also refer to the discussion titled “Regulatory Order and Written Agreement” under this section “Supervision and Regulation” of Item 1. Business of this Form 10-K.

 

Capital Standards

 

The Federal banking agencies have adopted risk-based capital adequacy guidelines intended to provide a measure of capital that reflects the degree of risk associated with a banking organization's operations for both transactions resulting in asset recognition on the balance sheet, and the extension of credit facilities such as letters of credit and recourse arrangements, which are recorded as off balance sheet items.  Under these guidelines, nominal dollar amounts of assets and credit equivalent amounts of off balance sheet items are multiplied by one of several risk adjustment percentages, which range from 0% for assets with low credit risk, such as certain U.S. Treasury securities, to 100% for assets with relatively high credit risk, such as loans.

 

A banking organization's risk-based capital ratios are determined by dividing its qualifying capital by its total risk adjusted assets and off balance sheet items.  A banking organization’s or holding company’s capital is generally classified into one of two tiers.  Tier I capital consists primarily of common equity, non-cumulative perpetual preferred stock (cumulative perpetual preferred stock for bank holding companies) and minority interests in certain subsidiaries, less most intangible assets, any disallowed portion of deferred tax assets and certain other limitations.  Tier II capital may consist of a limited amount of the allowance for loan losses, cumulative preferred stock, long term preferred stock, eligible term subordinated debt and certain other instruments with characteristics of equity.  The inclusion of elements of Tier II capital is subject to certain other requirements and limitations of the federal banking agencies.  The federal banking agencies require a minimum ratio of total qualifying capital to risk-adjusted assets of 8%, a minimum ratio of Tier I capital to risk-adjusted assets of 4%, and a minimum amount of Tier I capital to total assets, referred to as the leverage ratio, of 4%.

 

Regulatory agencies have the discretion to set individual minimum capital requirements for specific institutions at levels significantly above the minimum guidelines and ratios.  Future changes in regulations or practices could further reduce the amount of capital recognized or increase the minimum amount of capital required for capital adequacy purposes.  Such a change could affect the ability of the Company to grow and could restrict the amount of profits, if any, available for the payment of dividends. In addition, the DFI has authority to take possession of the business and properties of a bank in the event that the tangible shareholders' equity of a Bank is less than the greater of (i) 4% of the bank’s total assets or (ii) $1,000,000.

 

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The regulatory capital requirements, as well as the actual capital ratios for the Bank and the Company as of December 31, 2010, are presented in detail in Note 12. Regulatory Matters, of the consolidated financial statements, filed on this Form 10-K.  See also “Capital” within Management’s Discussion and Analysis of Financial Condition and Results of Operations of this Form 10-K.  As of December 31, 2010, both the Bank and the Company exceeded the minimum capital requirements to be well capitalized.  However, enhanced capital requirements are currently in place for the Bank as illustrated in the discussion titled “Regulatory Order and Written Agreement” under this section “Supervision and Regulation” and Note 22. Regulatory Order and Written Agreement, of the consolidated financial statements, filed on this Form 10-K.  The Company’s and the Bank’s capital ratios at December 31, 2010 also exceed these enhanced requirements.

 

Prompt Corrective Action and Other Enforcement Mechanisms

 

An institution that, based upon its capital levels, is classified as “well capitalized,” “adequately capitalized” or “undercapitalized” may be treated as though it were in the next lower capital category if the appropriate federal banking agency, after notice and opportunity for hearing, determines that an unsafe or unsound condition or an unsafe or unsound practice warrants such treatment.  At each successive lower capital category, an insured depository institution is subject to more restrictions. In addition to measures taken under the prompt corrective action provisions, banking organizations may be subject to potential enforcement actions by the federal banking agencies for unsafe or unsound practices in conducting their businesses or for violations of any law, rule, regulation or any condition imposed in writing by the agency or any written agreement with the agency.  These actions may include: the imposition of a conservator or receiver or the issuance of a cease-and-desist order that can be judicially enforced; the termination of deposit insurance; the imposition of civil money penalties; the issuance of directives to increase capital; the issuance of formal and informal agreements; the issuance of removal and prohibition orders against institution-affiliated parties; and the enforcement of such actions through injunctions or restraining orders based upon a judicial determination that the agency would be harmed if such equitable relief was not granted.

 

Additionally, a holding company's inability to serve as a source of strength to its subsidiary banking organizations could serve as an additional basis for a regulatory action against the holding company.  Please also refer to the discussion titled “Regulatory Order and Written Agreement” under the section “Supervision and Regulation” of Item 1. Business of this Form 10-K.

 

Safety and Soundness Standards 

 

The Federal Deposit Insurance Corporation Improvement Act (“FDICIA”) imposes certain specific restrictions on transactions and requires federal banking regulators to adopt overall safety and soundness standards for depository institutions related to internal control, loan underwriting, documentation and asset growth.  Among other things, FDICIA limits the interest rates paid on deposits by undercapitalized institutions, restricts the use of brokered deposits, limits the aggregate extensions of credit by a depository institution to an executive officer, director, principal shareholder or related interest and reduces deposit insurance coverage for deposits offered by undercapitalized institutions for deposits by certain employee benefits accounts.  The federal banking agencies may require an institution to submit to an acceptable compliance plan as well as have the flexibility to pursue other more appropriate or effective courses of action given the specific circumstances and severity of an institution's noncompliance with one or more standards.

 

Premiums for Deposit Insurance

 

The Bank’s deposits have historically been insured by the FDIC up to $100,000 per insured depositor, except certain types of retirement accounts which are insured up to $250,000 per insured depositor.  On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law which permanently increased the maximum amount of deposit insurance per depositor from $100,000 to $250,000.  Additionally on November 9, 2010 the FDIC issued a Final Rule implementing section 343 of the Dodd-Frank Wall Street Reform and Consumer Protection Act which provides for unlimited insurance coverage of noninterest-bearing transaction accounts. Beginning December 31, 2010, through December 31, 2012, all noninterest-bearing transaction accounts are fully insured, regardless of the balance of the account, at all FDIC-insured institutions.

 

On October 19, 2010, the Board of Directors of the FDIC, as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, adopted a plan (the Restoration Plan) to ensure the Deposit Insurance Fund (“DIF”) ratio increases to a level of 1.35% of estimated insured deposits by September 30, 2020.  The adoption of the Restoration Plan goes into effect on January 1, 2011 and makes no changes to the current deposit insurance rate schedule.  The Board also adopted a notice of proposed rulemaking that sets a long-term DIF ratio of 2% of estimated insured deposits and provides for more predictable deposit insurance assessment rates.

 

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On November 12, 2009 the FDIC also adopted a final rule amending assessment regulations to require insured depository institutions to prepay their quarterly risk-based assessments on December 30, 2009 for the fourth quarter of 2009 and for all of 2010, 2011 and 2012, except for those institutions where the FDIC grants an exemption.  The Bank was notified in the fourth quarter of 2009 by the FDIC that it was exempt from prepayment of assessments for 2010, 2011 and 2012 due in large part to the recent Consent Order issued to the Bank, as more fully discussed above under “Regulatory Order and Written Agreement,” and Note 22. Regulatory Order and Written Agreement, of the consolidated financial statements, filed on this Form 10-K.  However, as a result of the Consent Order, deposit insurance assessment costs have risen, and are expected to remain elevated during 2011.

 

The FDIC is authorized to terminate a depository institution’s deposit insurance if it finds that the institution is being operated in an unsafe and unsound manner or has violated any rule, regulation, order or condition administered by the institution’s regulatory authorities. Any such termination of deposit insurance would likely have a material adverse effect on the Bank, the severity of which would depend on the amount of deposits affected by such a termination.

 

Under federal law, deposits and certain claims for administrative expenses and employee compensation against an insured depository institution are afforded a priority over other general unsecured claims against such an institution, including federal funds and letters of credit, in the liquidation or other resolution of such an institution by any receiver appointed by regulatory authorities. Such priority creditors would include the FDIC.

 

The Dodd-Frank Wall Street Reform and Consumer Protection Act

 

On July 21, 2010, President Obama signed into law the sweeping financial regulatory reform act entitled the "Dodd-Frank Wall Street Reform and Consumer Protection Act" (the "Dodd-Frank Act") that implements significant changes to the regulation of the financial services industry, including provisions that, among other things:

 

·      Centralize responsibility for consumer financial protection by creating a new agency within the Federal Reserve Board, the Bureau of Consumer Financial Protection, with broad rulemaking, supervision and enforcement authority for a wide range of consumer protection laws that would apply to all banks and thrifts. Smaller financial institutions, including the Bank, will be subject to the supervision and enforcement of their primary federal banking regulator with respect to the federal consumer financial protection laws.

 

·      Apply the same leverage and risk-based capital requirements that apply to insured depository institutions to bank holding companies.

 

·      Require the FDIC to seek to make its capital requirements for banks countercyclical so that the amount of capital required to be maintained increases in times of economic expansion and decreases in times of economic contraction.

 

·      Change the assessment base for federal deposit insurance from the amount of insured deposits to consolidated assets less tangible capital.

 

·      Implement corporate governance revisions, including executive compensation and proxy access by stockholders.

 

·      Make permanent the $250,000 limit for federal deposit insurance and increase the cash limit of Securities Investor Protection Corporation protection from $100,000 to $250,000, and provide unlimited federal deposit insurance until January 1, 2013 for non-interest bearing demand transaction accounts at all insured depository institutions.

 

·      Repeal the federal prohibitions on the payment of interest on demand deposits effective July 21, 2011, thereby permitting depository institutions to pay interest on business transaction and other accounts.

 

Many aspects of the Dodd-Frank Act are subject to rulemaking by various regulatory agencies and will take effect over several years, making it difficult to anticipate the overall financial impact on the Company, its customers or the financial industry more generally. The elimination of the prohibition on the payment of interest on demand deposits could materially increase our interest expense, depending on our competitors' responses. Provisions in the legislation that require revisions to the capital requirements of the Company and the Bank could require the Company and the Bank to seek additional sources of capital in the future.

 

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Sarbanes-Oxley Act of 2002

 

On July 30, 2002, the Sarbanes-Oxley Act of 2002 (“SOX”), was signed into law to address corporate and accounting fraud. SOX establishes a new accounting oversight board that will enforce auditing standards and restricts the scope of services that accounting firms may provide to their public company audit clients.  Among other things, SOX also (i) requires chief executive officers and chief financial officers to certify to the accuracy of periodic reports filed with the SEC; (ii) imposes new disclosure requirements regarding internal controls, off-balance-sheet transactions, and pro forma (non-GAAP) disclosures; (iii) accelerates the time frame for reporting of insider transactions and periodic disclosures by public companies; and (iv) requires companies to disclose whether or not they have adopted a code of ethics for senior financial officers and whether the audit committee includes at least one “audit committee financial expert.”

 

Under SOX, the SEC is required to regularly and systematically review corporate filings, based on certain enumerated factors.  To deter wrongdoing, SOX: (i) subjects bonuses issued to top executives to disgorgement if a restatement of a company’s financial statements was due to corporate misconduct; (ii) prohibits an officer or director from misleading or coercing an auditor; (iii) prohibits insider trades during pension fund “blackout periods;” (iv) imposes new criminal penalties for fraud and other wrongful acts; and (v) extends the period during which certain securities fraud lawsuits can be brought against a company or its officers.

 

As a public reporting company, the Company is subject to the requirements of SOX and related rules and regulations issued by the SEC and NASDAQ. The Company has incurred additional expense as a result of the Act, although not material, and does not expect that such compliance will have a material impact on our business in future periods.

 

Financial Services Modernization Legislation

 

On November 12, 1999, the Gramm-Leach-Bliley Act of 1999 (the “Financial Services Modernization Act”) was signed into law.  The Financial Services Modernization Act is intended to modernize the banking industry by removing barriers to affiliation among banks, insurance companies, the securities industry and other financial service providers.  It provides financial organizations with the flexibility of structuring such affiliations through a holding company structure or through a financial subsidiary of a bank, subject to certain limitations.  The Financial Services Modernization Act establishes a new type of bank holding company, known as a financial holding company, which may engage in an expanded list of activities that are “financial in nature,” which include securities and insurance brokerage, securities underwriting, insurance underwriting and merchant banking.  The Company has not sought “financial holding company” status and has no present plans to do so.

 

The Financial Services Modernization Act also sets forth a system of functional regulation that makes the Federal Reserve Board the “umbrella supervisor” for holding companies, while providing for the supervision of the holding company’s subsidiaries by other federal and state agencies.

 

In addition, the Bank is subject to other provisions of the Financial Services Modernization Act, including those relating to the Community Reinvestment Act, privacy and safe-guarding confidential customer information, regardless of whether the Company elects to become a financial holding company or to conduct activities through a financial subsidiary of the Bank.  The Company does not, however, currently intend to file notice with the Federal Reserve Board to become a financial holding company or to engage in expanded financial activities through a financial subsidiary of the Bank.

 

The Company and the Bank do not believe that the Financial Services Modernization Act will have a material adverse effect on its operations in the near-term.  However, to the extent that it permits banks, securities firms, and insurance companies to affiliate, the financial services industry may experience further consolidation.  The Financial Services Modernization Act is intended to grant to community banks certain powers as a matter of right that larger institutions have accumulated on an ad hoc basis.  Nevertheless, this act may have the result of increasing the amount of competition that the Company faces from larger institutions and other types of companies offering financial products, many of which may have substantially more financial resources than the Company.

 

USA Patriot Act of 2001

 

On October 26, 2001, The Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism, or the Patriot Act, of 2001 was signed into law. Among other things, the Patriot Act (i) prohibits banks from providing correspondent accounts directly to foreign shell banks; (ii) imposes due diligence requirements on banks opening or holding accounts for foreign financial institutions or wealthy foreign individuals; (iii) requires financial institutions to establish an anti-money-laundering compliance program; and (iv) eliminates civil liability for persons who file suspicious activity reports.

 

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The Patriot Act also increases governmental powers to investigate terrorism, including expanded government access to account records and to make rules to implement the Patriot Act.  On March 9, 2006, the USA Patriot Improvement and Reauthorization Act was signed into law which extended and modified the original act.  While we believe the Patriot Act, as amended and reauthorized, may, to some degree, affect our operations, we do not believe that it will have a material adverse effect on our business and operations.

 

Transactions between Affiliates

 

Transactions between a bank and its “affiliates” are quantitatively and qualitatively restricted under the Federal Reserve Act.  The Federal Reserve Board issued Regulation W on October 31, 2002 which comprehensively implements Sections 23A and 23B of the Federal Reserve Act.  Sections 23A and 23B and Regulation W restrict loans by a depository institution to its affiliates, asset purchases by a depository institution from its affiliates and other transactions between a depository institution and its affiliates.  Regulation W unifies in one public document the Federal Reserve Board’s interpretations of Section 23A and 23B.  Regulation W had an effective date of April 1, 2003.

 

Community Reinvestment Act

 

The Bank is subject to certain fair lending requirements and reporting obligations involving home mortgage lending operations and Community Reinvestment Act (“CRA”) activities.  The CRA generally requires the federal banking agencies to evaluate the record of a financial institution in meeting the credit needs of their local communities, including low and moderate income neighborhoods.  In addition to substantial penalties and corrective measures that may be required for a violation of certain fair lending laws, the federal banking agencies may take compliance with such laws and CRA into account when regulating and supervising other activities.  When a bank holding company applies for approval to acquire a bank or another bank holding company, the Federal Reserve Board will review the assessment of each subsidiary bank of the applicant bank holding company and such records may be the basis for denying the application.  A bank’s compliance with its CRA obligations is based on a performance-based evaluation system which bases CRA ratings on an institution’s lending service and investment performance, resulting in a rating by the appropriate bank regulatory agency of “outstanding,” “satisfactory,” “needs to improve” or “substantial noncompliance.”  In its last examination by the FDIC, the Bank received a CRA rating of “Satisfactory.”

 

Privacy

 

Federal banking rules limit the ability of banks and other financial institutions to disclose non-public information about consumers to nonaffiliated third parties.  Pursuant to these rules, financial institutions must provide: initial notices to customers about privacy policies, describing the conditions under which they may disclose non-public information to nonaffiliated third parties and affiliates, annual privacy policies notices to current customers and a reasonable method for customers to “opt out” of disclosures to nonaffiliated third parties.

 

These privacy provisions affect how consumer information is transmitted through diversified financial companies and conveyed to outside vendors.  We have implemented our privacy policies in accordance with the law.  In recent years, a number of states have implemented their own versions of privacy laws.  For example, in 2003, California adopted standards that are more restrictive than federal law, allowing bank customers the opportunity to bar financial companies from sharing information with affiliates.

 

Predatory Lending

 

The term “predatory lending,” much like the terms “safety and soundness” and “unfair and deceptive practices,” is far-reaching and covers a potentially broad range of behavior.  As such, it does not lend itself to a concise or a comprehensive definition.  But typically predatory lending involves at least one, and perhaps all three, of the following elements: making unaffordable loans based on the assets of the borrower rather than on the borrower’s ability to repay an obligation, or asset-based lending; inducing a borrower to refinance a loan repeatedly in order to charge high points and fees each time the loan is refinanced, or loan flipping; and engaging in fraud or deception to conceal the true nature of the loan obligation from an unsuspecting or unsophisticated borrower.

 

Federal Reserve Board regulations aimed at curbing such lending significantly widened the pool of high-cost home-secured loans covered by the Home Ownership and Equity Protection Act of 1994, a federal law that requires extra disclosures and consumer protections to borrowers.

 

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The following loan transaction characteristics trigger coverage under the Home Ownership and Equity Protection Act of 1994: interest rates for first lien mortgage loans in excess of 8 percentage points above comparable Treasury securities; subordinate-lien loans of 10 percentage points above Treasury securities; and fees such as optional insurance and similar debt protection costs paid in connection with the credit transaction, when combined with points and fees if deemed excessive.

 

In addition, the regulation bars loan flipping by the same lender or loan servicer within a year.  Lenders also will be presumed to have violated the law which says loans shouldn’t be made to people unable to repay them, unless they document that the borrower has the ability to repay.  Lenders that violate the rules face cancellation of loans and penalties equal to the finance charges paid.  The Company does not expect these rules and potential state action in this area to have a material impact on our financial condition or results of operations.

 

Bank Secrecy Act and Money Laundering Control Act

 

In 1970, Congress passed the Currency and Foreign Transactions Reporting Act, otherwise known as the Bank Secrecy Act (the “BSA”), which established requirements for recordkeeping and reporting by banks and other financial institutions.  The BSA was designed to help identify the source, volume and movement of currency and other monetary instruments into and out of the United States in order to help detect and prevent money laundering connected with drug trafficking, terrorism and other criminal activities.  The primary tool used to implement BSA requirements is the filing of Suspicious Activity Reports.  Today, the BSA requires that all banking institutions develop and provide for the continued administration of a program reasonably designed to assure and monitor compliance with certain recordkeeping and reporting requirements regarding both domestic and international currency transactions.  These programs must, at a minimum, provide for a system of internal controls to assure ongoing compliance, provide for independent testing of such systems and compliance, designate individuals responsible for such compliance and provide appropriate personnel training.

 

 

Government Actions in Response to the Financial Crises

 

Emergency Economic Stabilization Act

 

In response to the financial crisis affecting the banking system and financial markets in recent years, the Emergency Economic Stabilization Act (“EESA”) was signed into law on October 3, 2008 and established the Troubled Asset Relief Program (“TARP”). As part of TARP, the United States Department of the Treasury (“Treasury”) established the Capital Purchase Program (“CPP”) to provide up to $700 billion of funding to eligible financial institutions through the purchase of capital stock and other financial instruments for the purpose of stabilizing and providing liquidity to the U.S. financial markets. In connection with EESA, there have been numerous actions by the FRB, Congress and the Treasury, the FDIC, the SEC and others to further the economic and banking industry stabilization efforts under EESA. It remains unclear at this time what further legislative and regulatory measures will be implemented under EESA affecting the Company.

 

The Company participated in the CPP and on March 20, 2009 issued and sold 21,000 shares of its Series A Preferred Stock to Treasury and issued a warrant for the purchase of 611,650 shares, in exchange for $21.0 million.  For further details on the Company’s participation in the CPP, please see Note 21. Preferred Stock, of the consolidated financial statements filed with this form 10-K.  Because of the Company’s participation in the CPP, it is subject to certain limitations on executive compensation and the payment of dividends.  The Company believes it is compliant with all such limitations.

 

American Recovery and Reinvestment Act of 2009

 

On February 17, 2009, the American Recovery and Reinvestment Act of 2009 (“ARRA”) was signed into law.  ARRA is intended to provide tax breaks for individuals and businesses, direct aid to distressed states and individuals and provide infrastructure spending.  In addition, ARRA imposes new executive compensation and expenditure limits on all previous and future TARP recipients and expands the class of employees to whom the limits and restrictions apply.  ARRA also provides the opportunity for additional repayment flexibility for existing TARP recipients.  Among other things, ARRA prohibits the payment of bonuses, other incentive compensation and severance to certain highly paid employees (except in the form of restricted stock subject to specified limitations and conditions) and requires each TARP recipient to comply with certain other executive compensation related requirements.  These provisions modify the executive compensation provisions that were included in EESA and, in most instances, apply retroactively for so long as any obligation arising from financial assistance provided to the recipient under TARP remains outstanding.

 

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In addition, ARRA directs the Treasury to review previously-paid bonuses, retention awards and other compensation paid to the senior executive officers and certain other highly-compensated employees of each TARP recipient to determine whether any such payments were excessive, inconsistent with the purposes of ARRA or the TARP, or otherwise contrary to the public interest. If the Treasury determines that any such payments have been made by a TARP recipient, the Treasury will seek to negotiate with the TARP recipient and the subject employee for appropriate reimbursements to the U.S. government (not the TARP recipient) with respect to any such compensation or bonuses. ARRA also permits the Treasury, subject to consultation with the appropriate federal banking agency, to allow a TARP recipient to repay any assistance previously provided to such TARP recipient under the TARP, without regard to whether the TARP recipient has replaced such funds from any source, and without regard to any waiting period. Any TARP recipient that repays its TARP assistance pursuant to this provision would no longer be subject to the executive compensation provisions under ARRA.

 

Future Legislation and Regulatory Initiatives

 

Various other legislative and regulatory initiatives, including proposals to overhaul the banking regulatory system are from time to time introduced in Congress and state legislatures, as well as regulatory agencies. Currently, the Congress is actively considering significant changes in the manner of regulating financial institutions including combining one or more of the FRB, FDIC, Comptroller of the Currency and the Office of Thrift Supervision and creating a new consumer protection agency for financial products. The current legislation being considered and other future legislation regarding financial institutions may change banking statutes, the operating environment of the Company and the Bank in substantial and unpredictable ways and could increase or decrease the cost of doing business, limit or expand permissible activities or affect the competitive balance depending upon whether any of this potential legislation will be enacted. If enacted, the effect of implementing regulations could impact positively or negatively, the financial condition or results of operations of the Company and/or the Bank. The nature and extent of future legislative and regulatory changes affecting financial institutions is unpredictable at this time. The Company cannot determine the ultimate effect that such potential legislation, if enacted, would have upon its financial condition or operations.

 

Where You Can Find More Information

 

Under the Securities Exchange Act of 1934 Sections 13 and 15(d), periodic and current reports must be filed with the SEC. The Company electronically files the following reports with the SEC: Form 10-K (Annual Report), Form 10-Q (Quarterly Report), Form 8-K (Current Report), insider ownership reports and Form DEF 14A (Proxy Statement).  The Company may file additional forms. The SEC maintains an Internet site, www.sec.gov, in which all forms filed electronically may be accessed. Additionally, all forms filed with the SEC and additional shareholder information is available free of charge on the Company’s website: www.heritageoaksbancorp.com.  The Company posts these reports to its website as soon as reasonably practicable after filing them with the SEC.  None of the information on or hyperlinked from the Company’s website is incorporated into this Annual Report on Form 10-K.

 

The Company also posts its Committee Charters, Code of Ethics, Code of Conduct and Corporate Governance Guidelines on the Company website.

 

 

Item 1A.  Risk Factors

 

An investment in our common stock is subject to risks inherent to our business.  The material risks and uncertainties that Management believes may affect our business are described below.  Before making an investment decision, you should carefully consider the risks and uncertainties described below together with all of the other information included or incorporated by reference in this Annual Report.  The risks and uncertainties described below are not the only ones facing our business.  Additional risks and uncertainties that Management is not aware of or focused on or that Management currently deems immaterial may also impair our business operations.  This Annual Report is qualified in its entirety by these risk factors.

 

If any of the following risks actually occur, our financial condition and results of operations could be materially and adversely affected.  If this were to happen, the value of our common stock could decline significantly, and you could lose all or part of your investment.

 

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Risks Associated With Our Business

 

Our Banking subsidiary is operating under a Consent Order with the FDIC and DFI and the Company is operating under a Written Agreement with the Federal Reserve Bank of San Francisco to address, among other things, lending, credit and capital related issues.

 

In light of the current challenging operating environment, along with our elevated level of non-performing assets, delinquencies and adversely classified assets, we are subject to increased regulatory scrutiny and additional regulatory restrictions and have become subject to certain enforcement actions under a Consent Order issued by the FDIC and DFI to the Bank on March 4, 2010 and Written Agreement with the Federal Reserve Board entered into on March 4, 2010.  These enforcement actions followed the FDIC’s regularly scheduled examination of our banking subsidiary during the fourth quarter of 2009 and are based on discussions the Bank had following the examination.  Such enforcement actions place limitations on our business and may adversely affect our ability to implement our business plans.  These enforcement actions require, among other things, the Bank to take certain steps to strengthen its balance sheet, such as reducing the level of classified assets, increasing capital levels and addressing other criticisms of the examination.  These enforcement actions are more fully discussed in “Supervision and Regulation – Regulatory Order and Written Agreement” and Note 22. Regulatory Order and Written Agreement, of the consolidated financial statements, filed on this Form 10-K. If the Company fails to comply with these enforcement actions, it may become subject to further regulatory enforcement actions up to and including the appointment of a conservator or receiver for the Bank.

 

Even though the Bank remains well-capitalized, the regulatory agencies have the authority to restrict our operations to those consistent with adequately capitalized institutions.  For example, the regulatory agencies have imposed restrictions that place limitations on our lending activities.  The regulatory agencies also have the power to limit the rates paid by the Bank to attract retail deposits in its local markets.

 

Our Level of Classified Assets Expose Us to Increased Lending Risk. Further, if Our Allowance for Loan Losses is Insufficient to Absorb Losses in Our Loan Portfolio, Our Earnings May Decline

 

If the level of loans the Bank currently categorizes as substandard and doubtful do not perform according to the terms and/or the underlying collateral for such loans is insufficient to cover the Bank’s recorded investment, the allowance for loan losses may not be sufficient to absorb potential losses.  This could result in additional loan losses which may further adversely impact our operating results.  Further, our level of classified assets will take time to resolve.  While we believe that we are making progress in identifying and resolving classified assets, no assurance can be given that we will continue to make progress, particularly if the local economies in which we operate suffer further deterioration.

 

We believe that the Company’s allowance for loan losses is maintained at a level adequate to absorb probable, estimable losses inherent in our loan portfolio as of the corresponding balance sheet date.  We make various assumptions and judgments about the collectability of our loan portfolio, including the creditworthiness of our borrowers and the probability of such borrowers making payments, as well as the value of real estate and other assets serving as collateral for the repayment of many of our loans. In determining an appropriate level of the allowance for loan losses, significant factors we consider include: loss experience in particular segments of the portfolio, trends and absolute levels of classified loans, trends and absolute levels in delinquent loans, trends in risk ratings, trends in industry charge-offs by particular segments and changes in existing general economic and business conditions. If our assumptions are incorrect, our allowance for loan losses may be insufficient to cover losses inherent in our loan portfolio, resulting in additions to our allowance. Our regulators, as an integral part of their regular examination process, periodically review our allowance for loan losses and may require us to increase it by recognizing additional provisions for loan losses or to decrease our allowance for loan losses by recognizing loan charge-offs. Any additional provisions for loan losses or charge-offs, as required by these regulatory agencies, could have a material adverse effect on our financial condition and results of operations.

 

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We Are Highly Dependent On Real Estate and Any Further Downturn in the Real Estate Market May Hurt Our Business

 

A significant portion of our loan portfolio is dependent on real estate.  A decline in current economic conditions, a decline in the local housing market or rising interest rates could have an adverse effect on the demand for new loans, the ability of borrowers to repay outstanding loans, the value of real estate and other collateral securing loans, the value of real estate owned by us, as well as our financial condition and results of operations in general and the market value of our common stock.  Acts of nature, including earthquakes, floods and fires, which may cause uninsured damage and other loss of value to real estate that secures these loans may also negatively impact our financial condition.

 

We Have Concentration in Higher Risk Commercial Real Estate Loans

 

We have high concentration in commercial real estate (“CRE”) loans. CRE loans, as defined by final guidance issued by Bank regulators, are defined as construction, land development, other land loans, loans secured by multi-family (5 or more units) residential properties and loans secured by non-farm non-residential properties.  Following this definition, approximately 65.1% of our lending portfolio can be classified as CRE lending as of December 31, 2010.  CRE loans generally involve a higher degree of credit risk than certain other types of lending due, among other things, to the generally large amounts loaned to individual borrowers.  Losses incurred on loans to a small number of borrowers could have a material adverse impact on our operating results and financial condition.  In addition, commercial real estate loans generally depend on the cash flow from the property to service the debt.  Cash flow may be significantly affected by general economic conditions which may result in non-performance by certain borrowers.

 

Additionally, federal banking regulators recently issued final guidance regarding commercial real estate lending.  This guidance suggests that institutions that are potentially exposed to significant commercial real estate concentration risk will be subject to increased regulatory scrutiny.  Institutions that have experienced rapid growth in commercial real estate lending, have notable exposure to a specific type of commercial real estate lending or are approaching or exceed certain supervisory criteria that measure an institution’s commercial real estate portfolio against its capital levels, may be subject to increased regulatory scrutiny.  We are subject to increased regulatory scrutiny because of our commercial real estate portfolio and, as a result, the Bank must develop or revise, adopt, and implement a plan to systematically reduce the amount of loans within this category as outlined in the Consent Order issued to the Bank on March 4, 2010.

 

Liquidity Risk Could Impair Our Ability to Fund Operations and Jeopardize Our Financial Condition

 

Liquidity is essential to our business. An inability to raise funds through deposits, borrowings, the sale of loans and other sources could have a material adverse effect on our liquidity. Our access to funding sources in amounts adequate to finance our activities could be impaired by factors that affect us specifically or the financial services industry in general. Factors that could detrimentally impact our access to liquidity sources include a decrease in the level of our business activity due to a market downturn or adverse regulatory action against us.  Our ability to acquire deposits or borrow could also be impaired by factors that are not specific to us, such as a severe disruption of the financial markets or negative views and expectations about the prospects for the financial services industry in general.

 

We Depend On Cash Dividends From Our Subsidiary Bank To Meet Our Cash Obligations, but Our Consent Order and Written Agreement Prohibit the Payment of Such Dividends Without Prior Regulatory Approval Which May Impair Our Ability to Fulfill Our Obligations

 

As a holding company, dividends from our subsidiary bank provide a substantial portion of our cash flow used to service the interest payments on our trust preferred securities, our preferred stock and other obligations, including any cash dividends. Various statutory provisions restrict the amount of dividends our subsidiary bank can pay to us without regulatory approval.  As outlined in the Consent Order and Written Agreement, previously mentioned, the Bank cannot pay any cash dividends or other payments to the holding company without prior written consent of the regulatory authorities.  Additionally, the Company cannot declare or pay any dividends (including those on outstanding preferred stock issued to the U.S. Treasury under the TARP Capital Purchase Program) or make any distributions of principal, interest or other sums on its trust preferred securities without prior written approval of the Federal Reserve.  To date, we have deferred four payments on our TARP preferred stock.  If we defer six dividend payments, the U.S. Treasury will have the right to appoint two directors to our Board.

 

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The Recent Recession and Changes in Domestic and Foreign Financial Markets Have Adversely Affected Our Industry and May Have a Material Impact on Our Operating Results and Financial Condition

 

The recent recession has resulted in significant business failures and job losses. Further, dramatic declines in the housing market with decreasing home prices and increasing delinquencies and foreclosures, have negatively impacted the credit performance of mortgage and construction loans and resulted in significant losses to many financial institutions. Concerns over the stability of the financial markets and the economy have resulted in decreased lending by financial institutions to customers and to each other.  This market turmoil and tightening of credit has led to increased commercial and consumer delinquencies, lack of customer confidence, increased market volatility and widespread reduction in general business activity.  The resulting economic pressure on consumers and businesses and volatility in the financial markets may adversely affect our business, financial condition, results of operations and stock price.  These challenging conditions may not improve in the near future and we may face the following risks as a result:

 

·     Increased regulation of our industry, compliance with which may increase our costs and limit our ability to pursue business opportunities.

 

·     The process we use to estimate losses inherent in our credit exposure requires difficult, subjective and complex judgments, including forecasts of economic conditions and how these economic conditions might impair the ability of our borrowers to repay loans.  The level of uncertainty concerning economic conditions may adversely affect the accuracy of our estimates which may, in turn, impact the reliability of the process.

 

·     The value of the portfolio of investment securities that we hold may be adversely affected.

 

·     Higher FDIC premiums because market developments have significantly depleted the insurance fund of the FDIC and reduced the ratio of reserves to insured deposits.

 

·     If current levels of market disruption and volatility continue or worsen, there can be no assurance that we will not experience an adverse effect, which may be material, to our business, financial condition and results of operations.

 

We Cannot Accurately Predict the Effect of the Current Economic Downturn on Our Future Results of Operations or Market Price of Our Stock

 

The national economy and the financial services sector in particular remain challenged with weakness in the broader economy despite high levels of government stimulus. We cannot accurately predict the severity or duration of the current economic downturn, which has adversely impacted the markets we serve. Any further deterioration in the economies of the nation as a whole or in our markets would have an adverse effect which could be material on our business, financial condition, results of operations, prospects and could also cause the market price of our stock to decline.

 

Recently Enacted Legislation and Other Measures Undertaken by the U.S. Treasury, the FRB and Other Governmental Agencies Over the Last Two Years May Not Result in Improved Economic Conditions

 

On October 3, 2008, the Emergency Economic Stabilization Act of 2008 (the “EESA”) was signed into law, which, among other measures, authorized the Treasury Secretary to establish the Troubled Asset Relief Program (“TARP”). EESA gives broad authority to Treasury to purchase, manage, modify, sell and insure the troubled mortgage related assets that triggered the current economic crisis as well as other “troubled assets.” EESA includes additional provisions directed at bolstering the economy, including: authority for the FRB to pay interest on depository institution balances; and mortgage loss mitigation and homeowner protection.

 

Pursuant to the TARP, the Treasury has the authority to, among other things, purchase up to $700 billion of mortgages, mortgage-backed securities and certain other financial instruments from financial institutions for the purpose of stabilizing and providing liquidity to the U.S. financial markets.  Under the TARP, the Treasury has created a capital purchase program, pursuant to which it is providing access to capital to financial institutions through a standardized program to acquire preferred stock (accompanied by warrants) from eligible financial institutions that will serve as Tier 1 capital.

 

EESA followed, and has been followed by, numerous actions by the FRB, Congress, Treasury and others to address the liquidity and credit crisis that has followed the sub-prime meltdown that commenced in 2007. These measures include homeowner relief that encourage loan restructuring and modification; the establishment of significant liquidity and credit facilities for financial institutions and investment banks; the lowering of the federal funds rate; and other emergency actions designed to stabilize the financial sector and mitigate economic pressures.

 

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On February 17, 2009, The American Recovery and Reinvestment Act of 2009 (the “Stimulus Bill”) was signed into law.  The Stimulus Bill included a wide variety of programs intended to stimulate the economy and provide for extensive infrastructure, energy, health and education needs.

 

If, as a result of the above actions taken, economic conditions do not improve, our operating results and financial condition may be adversely impacted beyond what has been realized.

 

FDIC Deposit Insurance Assessments May Increase Substantially Which Would Adversely Affect Our Net Earnings

 

FDIC deposit insurance premiums for the year ended December 31, 2010 was $2.7 million.  The Company currently expects the level of deposit insurance premiums to remain elevated for the foreseeable future which will impact future operating results.

 

Declines in Asset Values May Result in Impairment Charges and Adversely Affect the Value of Our Investments, Financial Performance and Capital

 

We maintain an investment portfolio that includes, but is not limited to, mortgage-backed securities. The market value of investments in our portfolio has become increasingly volatile over the last two years.  The market value of investments may be affected by factors other than the underlying performance of the servicer of the securities or the mortgages underlying the securities, such as ratings downgrades, adverse changes in the business climate and a lack of liquidity in the secondary market for certain investment securities. On a quarterly basis, we evaluate investments and other assets for impairment. We may be required to record impairment charges if our investments suffer a decline in value that is considered other-than-temporary. If we determine that a significant impairment has occurred, we would be required to charge against earnings the credit-related portion of the other-than-temporary impairment, which may have a material adverse effect on our results of operations in the periods in which the charges occur.  For a more detailed discussion of investments the Company holds, including other than temporary impairment recognized during 2010, please see Note 2. Investments, of the consolidated financial statements, filed on this Form 10-K.

 

Our Business Is Subject To Interest Rate Risk and Changes in Interest Rates May Adversely Affect Our Performance and Financial Condition

 

Our earnings and cash flows are highly dependent upon net interest income.  Net interest income is the difference between interest income earned on interest-earning assets such as loans and securities and interest expense paid on interest-bearing liabilities such as deposits and borrowed funds.  Our net interest income (including net interest spread and margin) and overall earnings are impacted by changes in interest rates and monetary policy.  Changes in interest rates and monetary policy can impact the demand for new loans, the credit profile of our borrowers, the yields earned on loans and securities and rates paid on deposits and borrowings.  Given our current volume and mix of interest-bearing liabilities and interest-earning assets, we would expect our interest rate spread (the difference in the rates paid on interest-bearing liabilities and the yields earned on interest-earning assets) as well as net interest income to increase if interest rates rise and, conversely, to decline if interest rates fall.  Although we believe our current level of interest rate sensitivity is reasonable, significant fluctuations in interest rates (such as a sudden and substantial increase in Prime and Overnight Fed Funds rates) as well as increasing competition may require the Bank to increase rates on deposits at a faster pace than the increase in the rate it earns on interest-earning assets.  The impact of any sudden and substantial move in interest rates and/or increased competition may have an adverse effect on our business, financial condition and results of operations, as the Bank’s net interest income (including the net interest spread and margin) may be negatively impacted.

 

Additionally, a sustained decrease in market interest rates could adversely affect our earnings.  When interest rates decline, borrowers tend to prepay existing higher-rate, fixed-rate loans by refinancing to lower interest rates loan.   Under those circumstances, we may not be able to reinvest those prepayments in assets earning interest rates as high as the rates on the prepaid loans.

 

Failure to Successfully Execute Our Strategy May Adversely Affect Our Performance

 

Our financial performance and profitability depends on our ability to execute our corporate growth strategy.  Continued growth, however, may present operating and other problems that could adversely affect our business, financial condition and results of operations.  Accordingly, there can be no assurance that we will be able to execute our growth strategy or maintain the level of profitability that we have recently experienced.

 

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Factors that may adversely affect our ability to attain our long-term financial performance goals include those stated elsewhere in this section, as well as: inability to control non-interest expense, including, but not limited to, rising employee compensation costs, regulatory compliance, healthcare cost, limitations imposed on us in the Consent Order and/or Written Agreement, inability to increase non-interest income and continuing ability to expand, through de novo branching or identifying acquisition targets at attractive valuation levels.

 

We Face Strong Competition from Financial Service and Other Companies That Offer Banking Service Which May Hurt Our Business

 

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

 

Additionally, technology and other changes are allowing parties to complete financial transactions that historically have involved banks through alternative methods.  For example, consumers can now maintain funds that would have historically been held as bank deposits in brokerage accounts or mutual funds.  Consumers can also complete transactions such as paying bills and/or transferring funds directly without the assistance of banks.

 

The process of eliminating banks as intermediaries, known as “disintermediation,” could result in the loss of fee income, as well as the loss of customer deposits and the related income generated from those deposits.  The loss of these revenue streams and the lower cost deposits as a source of funds could have a material adverse effect on our financial condition and results of operations.

 

We May Not Be Able to Attract and Retain Skilled People

 

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

 

Because of Our Participation in the Troubled Asset Relief Program (‘‘TARP’’), We Are Subject to Several Restrictions, Including Restrictions on Compensation Paid to Our Executives

 

Certain standards for executive compensation and corporate governance apply to us for the period during which the U.S. Treasury holds an equity position in us. These standards generally apply to our Chief Executive Officer, Chief Financial Officer and the three next most highly compensated senior executive officers. The standards include, among other things, (1) ensuring that incentive compensation for senior executives does not encourage unnecessary and excessive risks that threaten the value of the financial institution; (2) required claw back of any bonus or incentive compensation paid to a senior executive based on statements of earnings, gains or other criteria that are later proven to be materially inaccurate; (3) prohibition on making golden parachute payments to senior executives; and (4) agreement not to deduct for tax purposes, executive compensation in excess of $500,000 for each senior executive. In particular, the change to the deductibility limit on executive compensation may increase the overall cost of our compensation programs in future periods. Pursuant to the American Recovery and Reinvestment Act of 2009 (the ‘‘Stimulus Bill’’), more commonly known as the economic stimulus recovery package, further compensation restrictions, including significant limitations on incentive compensation, have been imposed on our senior executive officers and most highly compensated employees. Such restrictions and any future restrictions on executive compensation, which may be adopted, could adversely affect our ability to hire and retain senior executive officers.

 

Our Internal Operations Are Subject to a Number of Risks

 

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

 

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·                  Information Systems

 

We rely heavily on communications and information systems to conduct our business.  Any failure, interruption or breach in security of these systems could result in failures or disruptions in our customer relationship management, general ledger, deposit, loan and other systems.  While we have policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of our information systems, there can be no assurance that any such failures, interruptions or security breaches will not occur or, if they do occur, that they will be adequately addressed.  The occurrence of any failures, interruptions or security breaches of our information systems could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our financial condition and results of operations.

 

·                  Technological Advances

 

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

 

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

 

·                  Severe Weather, Natural Disasters, Acts of War or Terrorism and Other External Events

 

Severe weather, natural disasters, acts of war or terrorism and other adverse external events could have a significant impact on our ability to conduct business.  Such events could affect the stability of our deposit base; impair the ability of borrowers to repay outstanding loans, impair the value of collateral securing loans, cause significant property damage, result in loss of revenue and/or cause us to incur additional expenses.  For example, the Central Coast of California is subject to earthquakes and fires.  Operations in our market could be disrupted by both the evacuation of large portions of the population as well as damage and or lack of access to our banking and operation facilities.  While we have not experienced such an occurrence to date, other severe weather or natural disasters, acts of war or terrorism or other adverse external events may occur in the future.  Although management has established disaster recovery policies and procedures, the occurrence of any such event could have a material adverse effect on our business, which, in turn, could have a material adverse effect on our financial condition and results of operations.

 

 

Risks Associated With Our Industry

 

We Are Subject to Government Regulation That May Limit or Restrict Our Activities Which May Adversely Impact Our Operations

 

The financial services industry is regulated extensively.  Federal and State regulation is designed primarily to protect the deposit insurance funds and consumers and not to benefit shareholders.  These regulations can sometimes impose significant limitations on our operations.  New laws and regulations or changes in existing laws and regulations or repeal of existing laws and regulations may adversely impact our business.  We anticipate that continued compliance with various regulatory provisions will impact future operating expenses.  Further, federal monetary policy, particularly as implemented through the Federal Reserve System, significantly affects economic conditions which may impact the Bank.

 

New Legislative and Regulatory Proposals May Affect Our Operations and Growth

 

Proposals to change the laws and regulations governing the operations and taxation of banks and financial institutions and federal insurance premiums paid by banks and financial institutions and companies that control such institutions are frequently raised in the U.S. Congress, state legislatures and before bank regulatory authorities.  The likelihood of any major changes in the future and the impact such changes might have on us or our subsidiaries are impossible to determine.  Similarly, proposals to change the accounting treatment applicable to banks and other depository institutions are frequently raised by the SEC, the federal banking agencies, the IRS and other appropriate authorities.

 

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The likelihood and impact of any additional future changes in law or regulation and the impact such changes might have on us or our subsidiaries are impossible to determine at this time.

 

 

Risks Associated With Our Stock

 

Our Participation in the U.S. Treasury’s Capital Purchase Program (“CPP”) May Pose Certain Risks to Holders of Our Common Stock

 

Under the terms of the CPP, the Company sold to the U.S. Treasury $21.0 million in preferred stock and a warrant to purchase approximately $3.2 million of the Company’s common stock.  Although the Company believes that its participation in the CPP is in the best interests of our shareholders in that it enhances Company and Bank capital and provides additional funds for future growth, it may pose certain risks to the holders of our common stock such as the following:

 

·                 Under the terms outlined by the U.S. Treasury for participants in the CPP, the Company issued a warrant to the U.S Treasury to purchase shares of its common stock.  The issuance of this warrant may be dilutive to current common stockholders in that it reduces earnings per common share. Additionally, the ownership interest of the existing holders of our common stock will be diluted to the extent the warrant is exercised.  The U.S. Treasury has the right to purchase 611,650 shares of our common stock at a price of $5.15 per share, which would result in an approximate 2.4% ownership interest.

 

·                 Although the U.S. Treasury has agreed not to vote any of the shares of common stock it receives upon exercise of the warrant, a transferee of any portion of the warrant or of any shares of common stock acquired upon exercise of the warrant is not bound by this restriction and therefore has the ability to become a shareholder of the Company and possess voting power.

 

·                 The preferred equity issued to the U.S. Treasury is non-voting, however, the terms of the CPP stipulate that the U.S. Treasury may vote their senior equity in matters deemed by the U.S. Treasury to have an impact on their holdings.

 

·                 The Purchase Agreement between the Company and the U.S Treasury provides that before the earlier of (1) March 20, 2012 and (2) the date on which all of the shares of the preferred stock have been redeemed by us or transferred by the U.S. Treasury to third parties, we may not, without consent of the U.S. Treasury, (a) increase the quarterly cash dividend on our common stock above $0.08 per share, the amount of the last quarterly cash dividend per share declared prior to October 14, 2008 or (b) subject to limited exceptions, redeem, repurchase or otherwise acquire shares of our common stock or preferred stock other than the preferred stock. In addition, we are unable to pay any dividends on our common stock unless we are current in our dividend payments on the preferred stock. These restrictions, together with the potentially dilutive impact of the warrant issued to the U.S. Treasury, may have a negative effect on the value of our common stock.

 

·                 Although the Company does not foresee any material changes to the terms associated with its participation in the CPP, the U.S. Government, as a sovereign body, may at any time change the terms of our participation in the CPP and or significantly influence Company policy.

 

For more information about the Company’s participation in the CPP, see Note 21. Preferred Stock, of the consolidated financial statements, filed on this Form 10-K.

 

Our Outstanding Preferred Stock Impacts Net Income Available to Our Common Stockholders and Earnings per Common Share and May be Dilutive to Common Stockholders

 

Accrued dividends and the accretion on our outstanding preferred stock reduce net income available to common stockholders and our earnings per common share.  Additionally, our Series C Preferred Stock may be dilutive to common stockholders to the extent the Company is profitable and must consider the dilutive nature of these securities in its calculation of earnings per common share.  Also, the Company’s preferred stock will receive preferential treatment in the event of the Company’s liquidation, dissolution or winding-down.

 

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Our Stock Trades Less Frequently Than Others

 

Although our common stock is listed for trading on the NASDAQ Capital Market, the trading volume in our common stock is less than that of other larger financial service companies.  A public trading market having the desired characteristics of depth, liquidity and orderliness depends on the presence in the marketplace of willing buyers and sellers of our common stock at any given time.  This presence depends on the individual decisions of investors and general economic and market conditions over which we have no control.  Given the lower trading volume of our common stock, significant sales of our common stock, or the expectation of these sales, could cause our stock price to fall.

 

Our Stock Price is Affected by a Variety of Factors

 

Stock price volatility may make it more difficult for you to resell your common stock when you want and at prices you find attractive.  Our stock price can fluctuate significantly in response to a variety of factors discussed in this section, including, among other things: actual or anticipated variations in quarterly results of operations; recommendations by securities analysts; operating and stock price performance of other companies that investors deem comparable to our company; news reports relating to trends, concerns and other issues in the financial services industry; and perceptions in the marketplace regarding our company and/or its competitors and the industry in which we operate.

 

These factors may adversely affect the trading price of our common stock, regardless of our actual operating performance, and could prevent you from selling your common stock at or above the public offering price.  In addition, the stock markets, from time to time, experience extreme price and volume fluctuations that may be unrelated or disproportionate to the operating performance of companies.  These broad fluctuations may adversely affect the market price of our common stock, regardless of our trading performance.

 

Any Future Issuance of Preferred or Common Stock Adversely Affect the Market Price of Our Common Stock

 

We are not restricted from issuing additional shares of common stock or securities that are convertible into or exchangeable for, or that represent the right to receive, common stock.  We frequently evaluate opportunities to access the capital markets, taking into account our regulatory capital ratios, financial condition and other relevant considerations.  In March of 2010, the Company raised gross proceeds of approximately $60.0 million though a private placement, as more fully disclosed in Note 21. Preferred Stock, of the consolidated financial statements, filed on this Form 10-K.  Any future issuances of equity may result in additional common shares outstanding and/or reduce the amount of income available to common shareholders.

 

In addition, we face significant regulatory and other governmental risk as a financial institution and as a participant in the CPP and it is possible that capital requirements and directives may, in the future, require us to change the amount or composition of our current capital including common equity.  As a result we may determine, or our regulators may require us to raise additional capital.  There may also be market perceptions regarding the capital we raised in 2010 or the need to raise additional capital, which may have an adverse effect on the price of our common stock.

 

Holders of Our Junior Subordinated Debentures Have Rights That Are Senior to Those of Our Common Shareholders

 

We have supported our continued growth through two issuances of trust preferred securities from two separate special purpose trusts, one of which was dissolved in 2010.  At December 31, 2010, we had outstanding trust preferred securities totaling $8.0 million.  Payments of the principal and interest on the trust preferred securities of these special purpose trusts are fully and unconditionally guaranteed by us.  Further, the accompanying junior subordinated debentures we issued to the special purpose trusts are senior to our shares of common stock.  As a result, we must make payments on the junior subordinated debentures  before any dividends can be paid on our common stock and, in the event of our bankruptcy, dissolution or liquidation, the holders of the junior subordinated debentures must be satisfied before any distributions can be made on our common stock.  We have the right to defer distributions on our junior subordinated debentures and the related trust preferred securities for up to five years during which time no cash dividends may be paid on our common stock.

 

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Our Common Stock is Not an Insured Deposit

 

Our common stock is not a bank deposit and is not insured against loss by the FDIC, any other deposit insurance fund or by any other public or private entity.  Investment in our common stock is inherently risky for the reasons described in this “Risk Factors” section and elsewhere in this report and is subject to market forces that affect the price of common stock in any company.  As a result, if you acquire our common stock, you may lose some or all of your investment.

 

Our Articles of Incorporation and By-Laws, As Well As Certain Banking Laws, May Have an Anti-Takeover Effect

 

Provisions of our articles of incorporation, bylaws and federal banking laws, including regulatory approval requirements, could make it more difficult for a third party to acquire us, even if doing so would be perceived to be beneficial to our shareholders.  The combination of these provisions may hinder a non-negotiated merger or other business combination, which, in turn, could adversely affect the market price of our common stock.

 

 

Item 1B.  Unresolved Staff Comments

 

None.

 

 

Item 2.  Properties

 

The Company’s headquarters and a branch location are located at 545 12th Street in Paso Robles, California.  It is an office occupied solely by the Bank.  Additionally, the Company occupies a three story administrative facility from where all administrative functions are based.  This facility is located at 1222 Vine Street in Paso Robles, California.  The Company also occupies fourteen other branches within the counties of San Luis Obispo and Santa Barbara.  The Bank currently owns one of the fifteen branches that it occupies and leases the remaining branches from various parties for an approximate aggregate amount of $200 thousand per month.  Additionally, the Company subleases part of three branches to unaffiliated parties.

 

In June of 2007, the Company sold four of its properties to First States Group, L.P. (“First States”), an unaffiliated party, in a sale-leaseback transaction for approximately $12.8 million.  In connection with the sale, the Bank entered into four separate lease agreements with First States Investors, LLC to lease back three branches and one administrative facility.  The three branches are located in Paso Robles, Arroyo Grande and Santa Maria, California.  The administrative facility is located in Paso Robles, California.  Each of the four leases contains an annual rent escalation clause equal to the lower of CPI-U (Consumer Price Index for all Urban Consumers) or 2.5 percent.  Each of the four leases provide for an initial term of 15 years with the option to renew for two 10 year terms.  The Company entered into this transaction in order to convert non-earning assets to earning assets.

 

The Company believes its facilities are adequate for its present needs.  The Company believes that the insurance coverage on all properties is adequate.  Most of the leases contain multiple renewal options and provisions for rental increases, principally for changes in the cost of living index, property taxes and maintenance.

 

 

Item 3.  Legal Proceedings

 

The Bank is, from time to time, subject to various pending and threatened legal actions which arise out of the normal course of its business.  The Bank is party to the following litigation:

 

Alpert, et al v. Cuesta Title Company, et al.  San Luis Obispo County Sup. Ct. Case no. CV 098220.  Plaintiffs have sued a title company, title insurer, Hurst Financial and related individuals on a variety of claims related to Hurst Financial’s lending practices.  The Bank, which made a commercial loan to a developer which also borrowed from Hurst Financial, is named in two causes of action alleging (1) negligence and (2) aiding and abetting Hurst Financial’s allegedly illegal lending practices.  The Bank did not lend to any of the plaintiffs or to Hurst Financial, nor did the Bank have any contact whatsoever with the plaintiffs in relation to their transactions with Hurst Financial.  The Bank has foreclosed upon and now owns one of the properties Hurst Financial purportedly financed for the developer using funds raised from the plaintiffs.  The Bank believes the action against it is without merit.  The matter has been tendered to the Bank’s insurance carrier, and the Bank is actively defending the case.  The Bank anticipates a favorable outcome to the case and does not expect the litigation to have any significant financial impact to the Bank.

 

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Gardality v. Heritage Oaks Bank, et al.  San Diego County Sup. Ct. Case no. 37-2010-00055218-CU-NC. Plaintiff sued the Bank and 157 other defendants.  The pleading indicates the plaintiff’s claim is connected to funds he borrowed from Estate Financial, Inc. (“EFI”) as the developer of a real estate project.  EFI was a customer of the Bank and is now a debtor in a bankruptcy proceeding.  The complaint was poorly written and legally deficient to the point where it is impossible to determine the nature or validity of the claim.  The Bank had no contact with the plaintiff prior to service of the complaint and believes that plaintiff’s action against it is without merit.  The matter has been tendered to the Bank’s insurance carrier and the Bank is actively defending the case.

 

The plaintiff dismissed the defective complaint against the Bank at the Bank’s request, and had not filed a new complaint as of 12/31/10.  However, on February 3, 2011, the Bank learned that Mr. Gardality has re-filed a complaint and intends to serve the Bank with process. The Bank currently anticipates a favorable outcome to the matter and does not expect the litigation to have any material financial impact to the Bank.

 

Except as indicated above, neither the Company nor the Bank is involved in any legal proceedings other than routine legal proceedings occurring in the ordinary course of business.  The majority of such proceedings have been initiated by the Bank in the process of collecting on delinquent loans.  To the extent such matters are defense matters, they are each covered by one or more policies of insurance carried by the Bank and do not carry an exposure of loss in excess of the coverage available. Such routine legal proceedings, in the aggregate, are believed by Management to be immaterial to the financial condition, results of operations and cash flows of the Company as of December 31, 2010.

 

 

Item 4.  (Removed and Reserved)

 

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Part II

 

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

 

Market Information

 

The Company’s Common Stock trades on the NASDAQ Capital Market under the symbol “HEOP.”  The following table summarizes those trades of the Company’s Common Stock on NASDAQ, setting forth the approximate high and low closing sales prices for each quarterly period ended since January 1, 2009:

 

 

Closing Prices

Quarters Ended

 

High

 

Low

 

December 31, 2010

 

$

 3.69

 

$

 3.05

 

September 30, 2010

 

3.80

 

3.07

 

June 30, 2010

 

4.25

 

3.20

 

March 31, 2010

 

5.26

 

3.45

 

 

 

 

 

 

 

December 31, 2009

 

$

 7.35

 

$

 4.00

 

September 30, 2009

 

7.35

 

5.70

 

June 30, 2009

 

6.75

 

4.20

 

March 31, 2009

 

5.45

 

3.25

 

 

Holders

 

As of February 8, 2011, there were 2,041 holders of the Company’s Common Stock.  There are no other classes of common equity securities outstanding.

 

Dividends

 

Dividends the Company declares are subject to the restrictions set forth in the California General Corporation Law (the “Corporation Law”).  The Corporation Law provides that a corporation may make a distribution to its shareholders if the corporation’s retained earnings equal at least the amount of the proposed distribution.  The Corporation Law also provides that, in the event that sufficient retained earnings are not available for the proposed distribution, a corporation may nevertheless make a distribution to its shareholders if it meets two conditions, which generally stated are as follows: (i) the corporation’s assets equal at least 1-1/4 times its liabilities, and (ii) the corporation’s current assets equal at least its current liabilities or, if the average of the corporation’s earnings before taxes on income and before interest expenses for the two preceding fiscal years was less than the average of the corporation’s interest expenses for such fiscal years, then the corporation’s current assets must equal at least 1-1/4 times its current liabilities.  See also Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations, for limitations on dividends resulting from the issuance of junior subordinated debentures.

 

The payment of cash dividends by the Bank is subject to restrictions set forth in the California Financial Code (the “Financial Code”).  The Financial Code provides that a bank may not make a cash distribution to its shareholders in excess of the lesser of (a) bank’s retained earnings; or (b) bank’s net income for its last three fiscal years, less the amount of any distributions made by the bank or by any majority-owned subsidiary of the bank to the shareholders of the bank during such period.  However, a bank may, with the approval of the DFI, make a distribution to its shareholders in an amount not exceeding the greatest of (x) its retained earnings; (y) its net income for its last fiscal year; or (z) its net income for its current fiscal year.  In the event that the DFI determines that the shareholders’ equity of a bank is inadequate or that the making of a distribution by the bank would be unsafe or unsound, the DFI may order the bank to refrain from making a proposed distribution.  The FDIC may also restrict the payment of dividends if such payment would be deemed unsafe or unsound or if after the payment of such dividends, the bank would be included in one of the “undercapitalized” categories for capital adequacy purposes pursuant to federal law. (See, “Item 1 - Description of Business - Prompt Corrective Action and Other Enforcement Mechanisms”).

 

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

 

However, under the Consent Order stipulated to the Bank in February 2010 and issued by the FDIC and DFI in March 2010, the Bank may not pay cash dividends or make other payments to the holding company without prior written consent of the regulatory authorities.  Additionally, under the Written Agreement the Company entered into with the Federal Reserve Bank of San Francisco in March 2010, the Company may not receive any dividends or other forms of payment from its banking subsidiary representing a reduction in the banking subsidiary’s capital or make payments to its shareholders without the prior approval of the Federal Reserve Bank of San Francisco and the Director of the Division of Banking Supervision and Regulation of the Board of Governors of the Federal Reserve System.

 

Further, under the terms of the Company’s participation in the U.S. Treasury’s TARP CPP, the Company must obtain approval by the U.S. Treasury for a period of three years following the initial date of the U.S. Treasury’s investment for any proposed increases in the payment of cash dividends on its common stock.  Additionally, the Company may not pay dividends on its common stock because it is not current with all dividends on its Series A Senior Preferred Stock issued to the U.S. Treasury.

 

No dividends have been paid to holders of the Company’s common stock during each of the preceding two years.

 

Securities Authorized for Issuance under Equity Compensation Plans

 

The table below summarizes information as of December 31, 2010 relating to equity compensation plans of the Company pursuant to which grants of options, restricted stock or other rights to acquire shares may be granted from time to time.  These plans are discussed more fully under Note 15. Share-Based Compensation Plans, of the consolidated financial statements, filed on this Form 10-K.

 

 

 

Number of

 

 

 

 

 

 

 

Securities To Be

 

Weighted Average

 

Number of Securities

 

 

 

Issued Upon Exercise

 

Exercise Price of

 

Remaining Available

 

Plan Category

 

of Outstanding Options

 

Outstanding Options

 

For Future Issuance

 

Equity compensation plans approved by security holders:

 

740,537

(1)

$

 6.53

 

110,742

(2)

Equity compensation plans not approved by security holders:

 

N/A

 

N/A

 

N/A

 

 

(1) Under the 2005 Equity Based Compensation Plan, the Company is authorized to issue restricted stock awards.  Restricted stock awards are not included in the table above.  At December 31, 2010 there were 77,651 shares of restricted stock issued and outstanding.  See also Note 15. Share Based Compensation Plans, of the Consolidated Financial Statements on this Form 10-K for more information on the Company’s equity compensation plans.

 

(2) Includes securities available for issuance of stock options and restricted stock.

 

Purchases of Equity Securities

 

The Company is not currently authorized to make repurchases of its common stock, nor did it make repurchases of its common stock during 2010 or 2009.

 

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Table of Contents

 

Item 6.  Selected Financial Data

 

The table below provides selected financial data for the five years ended December 31, 2010, 2009, 2008, 2007 and 2006 and for the three months ended December 31, 2010 and 2009:

 

 

For The Three Months Ended,

 

 

 

 

December 31,

 

At or For The Years Ended December 31,

 

(dollar amounts in thousands, except per share data)

 

2010

 

2009

 

2010

 

2009

 

2008

 

2007

 

2006

 

Consolidated Income Data:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest income

 

$

12,462

 

$

13,534

 

$

50,794

 

$

49,559

 

$

50,150

 

$

45,174

 

$

36,372

 

Interest expense

 

1,645

 

2,698

 

8,047

 

10,049

 

12,564

 

14,751

 

9,316

 

Net interest income

 

10,817

 

10,836

 

42,747

 

39,510

 

37,586

 

30,423

 

27,056

 

Provision for loan losses

 

5,831

 

9,500

 

31,531

 

24,066

 

12,215

 

660

 

600

 

Net interest income after provision for loan losses

 

4,986

 

1,336

 

11,216

 

15,444

 

25,371

 

29,763

 

26,456

 

Non interest income

 

1,788

 

1,445

 

9,496

 

6,198

 

6,206

 

5,349

 

4,952

 

Non interest expense

 

12,462

 

8,826

 

40,032

 

34,516

 

29,434

 

23,908

 

20,955

 

(Loss)/income before income taxes

 

(5,688

)

(6,045

)

(19,320

)

(12,874

)

2,143

 

11,204

 

10,453

 

Provision for income taxes

 

(6,205

)

(2,629

)

(1,760

)

(5,825

)

497

 

4,287

 

3,791

 

Net (loss)/income

 

$

517

 

$

(3,416

)

$

(17,560

)

$

(7,049

)

$

1,646

 

$

6,917

 

$

6,662

 

Dividends and accretion on preferred stock

 

491

 

351

 

5,008

 

964

 

-    

 

-    

 

-    

 

Net (loss) / income available to common shareholders

 

$

26

 

$

(3,767

)

$

(22,568

)

$

(8,013

)

$

1,646

 

$

6,917

 

$

6,662

 

Share Data:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(Loss) / earnings per common share - basic

 

$

0.00

 

$

(0.49

)

$

(1.30

)

$

(1.04

)

$

0.22

 

$

0.99

 

$

1.00

 

(Loss) / earnings per common share - diluted

 

$

0.00

 

$

(0.49

)

$

(1.30

)

$

(1.04

)

$

0.21

 

$

0.96

 

$

0.96

 

Dividend payout ratio (1)

 

0.00%

 

0.00%

 

0.00%

 

0.00%

 

37.68%

 

35.55%

 

41.01%

 

Common book value per share

 

$

3.85

 

$

8.07

 

$

3.85

 

$

8.07

 

$

9.03

 

$

9.04

 

$

7.42

 

Actual shares outstanding at end of period (2)

 

25,082,344

 

7,771,952

 

25,082,344

 

7,771,952

 

7,753,078

 

7,683,829

 

6,662,921

 

Weighted average shares outstanding - basic

 

25,004,697

 

7,704,060

 

17,312,306

 

7,697,234

 

7,641,726

 

6,984,174

 

6,650,620

 

Weighted average shares outstanding - diluted

 

26,247,491

 

7,704,060

 

17,312,306

 

7,697,234

 

7,753,013

 

7,228,804

 

6,925,582

 

Consolidated Balance Sheet Data:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total cash and cash equivalents

 

$

22,951

 

$

40,738

 

$

22,951

 

$

40,738

 

$

24,571

 

$

46,419

 

$

23,034

 

Total investments and other securities

 

$

224,966

 

$

121,180

 

$

224,966

 

$

121,180

 

$

50,762

 

$

47,556

 

$

38,445

 

Total gross loans

 

$

677,303

 

$

728,679

 

$

677,303

 

$

728,679

 

$

680,147

 

$

613,217

 

$

444,983

 

Allowance for loan losses

 

$

(24,940

)

$

(14,372

)

$

(24,940

)

$

(14,372

)

$

(10,412

)

$

(6,143

)

$

(4,081

)

Total assets

 

$

982,612

 

$

945,177

 

$

982,612

 

$

945,177

 

$

805,588

 

$

745,554

 

$

541,774

 

Total deposits

 

$

798,206

 

$

775,465

 

$

798,206

 

$

775,465

 

$

603,521

 

$

644,808

 

$

420,521

 

Federal Home Loan Bank borrowings

 

$

45,000

 

$

65,000

 

$

45,000

 

$

65,000

 

$

109,000

 

$

8,000

 

$

50,000

 

Junior subordinated debt

 

$

8,248

 

$

13,403

 

$

8,248

 

$

13,403

 

$

13,403

 

$

13,403

 

$

16,496

 

Total stockholders’ equity

 

$

121,256

 

$

83,751

 

$

121,256

 

$

83,751

 

$

70,032

 

$

69,450

 

$

49,472

 

Selected Other Balance Sheet Data:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Average assets

 

$

996,856

 

$

949,856

 

$

995,223

 

$

887,628

 

$

779,575

 

$

605,736

 

$

503,877

 

Average earning assets

 

$

937,384

 

$

893,787

 

$

935,991

 

$

829,329

 

$

722,061

 

$

555,871

 

$

455,497

 

Average stockholders’ equity

 

$

122,470

 

$

88,779

 

$

121,865

 

$

86,949

 

$

71,748

 

$

55,927

 

$

47,236

 

Selected Financial Ratios:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Return on average assets

 

0.21%

 

-1.43%

 

-1.76%

 

-0.79%

 

0.21%

 

1.14%

 

1.32%

 

Return on average stockholders’ equity

 

1.67%

 

-15.27%

 

-14.41%

 

-8.11%

 

2.29%

 

12.37%

 

14.10%

 

Net interest margin (3)

 

4.58%

 

4.81%

 

4.57%

 

4.76%

 

5.21%

 

5.47%

 

5.94%

 

Efficiency ratio (4)

 

98.30%

 

70.84%

 

77.85%

 

75.34%

 

67.27%

 

66.83%

 

65.47%

 

Capital Ratios:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Average stockholders’ equity to average assets

 

12.29%

 

9.35%

 

12.24%

 

9.80%

 

9.20%

 

9.23%

 

9.37%

 

Leverage Ratio

 

10.83%

 

8.24%

 

10.83%

 

8.24%

 

8.90%

 

9.60%

 

11.00%

 

Tier 1 Risk-Based Capital ratio

 

13.94%

 

9.59%

 

13.94%

 

9.59%

 

9.37%

 

10.08%

 

11.51%

 

Total Risk-Based Capital ratio

 

15.21%

 

10.85%

 

15.21%

 

10.85%

 

10.62%

 

11.04%

 

12.36%

 

Selected Asset Quality Ratios:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Non-performing loans to total gross loans (5)

 

4.85%

 

5.26%

 

4.85%

 

5.26%

 

2.75%

 

0.06%

 

0.01%

 

Non-performing assets to total gross loans

 

5.83%

 

5.39%

 

5.83%

 

5.39%

 

2.94%

 

0.06%

 

0.01%

 

Non-performing assets to total assets (6)

 

4.02%

 

4.15%

 

4.02%

 

4.15%

 

2.48%

 

0.05%

 

0.01%

 

Allowance for loan losses to total gross loans

 

3.68%

 

1.97%

 

3.68%

 

1.97%

 

1.53%

 

1.00%

 

0.92%

 

Allowance for loan losses to non-performing loans

 

75.99%

 

37.50%

 

75.99%

 

37.50%

 

55.75%

 

1817.46%

 

7420.00%

 

Net charge-offs (recoveries) to average loans

 

0.36%

 

1.52%

 

2.96%

 

2.83%

 

1.21%

 

0.00%

 

0.10%

 

 

(1) For 2008 cash dividends totaling $0.08 per share were paid.  For the years 2007 and 2006, cash dividends totaling $0.32 and $0.41 per share were paid. In the first quarter of 2006, the Company paid a special cash dividend of $0.25 per share.  No cash dividends were paid in 2010 and 2009.

(2) Actual shares have been adjusted to fully reflect stock dividends and stock splits.

(3) Net interest margin represents net interest income as a percentage of average interest-earning assets.

(4) Efficiency ratio is defined as total non interest expense as a percent of the combined net interest income plus non interest income, exclusive of gains and losses on the sale of investment securities, sale of other real estate owned, sale of SBA loans, sale of fixed assets, and OTTI.

(5) Non-performing loans are defined as loans that are past due 90 days or more as well as loans placed in non-accrual status.

(6) Non-performing assets are defined as assets that are past due 90 days or more and assets placed in non-accrual status plus other real estate owned.

 

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Table of Contents

 

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

 

The following is an analysis of the financial condition and results of operations of the Company as of and for the years ended December 31, 2010, 2009 and 2008.  The analysis should be read in connection with the consolidated financial statements and notes thereto appearing elsewhere in this report.

 

Financial Overview

 

For the year ended December 31, 2010, the Company recorded a net loss of approximately $17.6 million or $1.30 per common share.  This compares to a net loss of $7.0 million or $1.04 per common share for 2009 and net income of $1.6 million or $0.21 per common share for 2008.

 

The year 2010 was one of the most challenging in the Company’s history.  Continued economic weakness and a challenging credit environment resulted in additional credit losses which required an elevated level of loan loss provisioning.  Provisions for loan losses totaled $31.5 million for 2010, an increase of $7.5 million from that reported for 2009.  Although the Company recorded a higher annual level of loan loss provision expense in 2010 than it did in prior year, this elevated provisioning enabled the Company to significantly increase its allowance for loan and lease losses (“ALLL”) by $10.6 million and contributed to a 171 basis point increase in ALLL as a percentage of total gross loans from 1.97% at prior year-end to 3.68% as of December 31, 2010.  Write-downs on foreclosed assets also contributed to the year over year decline in operating results, which were largely due to continued depressed values of certain types of commercial, construction and land properties.  Write-downs on foreclosed assets totaled $3.7 million for 2010, an increase of $2.2 million from that reported in 2009.  Further contributing to the net loss for 2010 was a $7.1 million valuation allowance, and corresponding charge to income tax expense, that the Company recorded against its net deferred tax assets.

 

Although operating results for 2010 were negatively impacted by the charges noted above, the Company made good progress in improving core earnings as evidenced by a 14.2% increase in total revenues (net interest income plus non-interest income) that grew to $52.2 million, $6.5 million higher than reported for 2009.

 

·                Net interest income increased to $42.7 million in 2010, which was $3.2 million or 8.2% higher than that reported for 2009 while net interest margin was 4.57% in 2010, as compared to the 4.76% reported for 2009. The increase in net interest income was due to a $107 million increase in average earning assets, primarily investment securities, in comparison to prior year’s average earning asset balances. The increase in earning assets was driven by growth in our core deposit balances and the $60 million capital raise in first quarter, 2010 both of which drove higher investment security balances as the loan portfolio declined. Partly offsetting the increase to net interest income was a 19 basis point reduction in net interest margin caused by a $51.4 million reduction in outstanding loans and reversal of $3 million of interest accrued on non-performing loans.

 

·                Non-interest revenues in 2010 grew to $9.5 million reflecting a $3.3 million or 53.2% increase over 2009. This increase was driven by higher mortgage origination fees which grew $0.8 million or 61.2% to $2.0 million in 2010 largely due to higher mortgage refinance volumes.  The Company also benefited from the extinguishment of $5.2 million in higher cost junior subordinated debentures during 2010 as the repurchase of trust preferred securities issued by Heritage Oaks Capital Trust III, resulted in a $1.7 million pre-tax gain.

 

Non-interest expenses totaled $40.0 million for 2010, representing an increase of $5.5 million compared to 2009.  The year over year increase was driven by a $2.2 million increase in write-downs on foreclosed assets, a $2.5 million increase in compensation costs and a $0.7 million increase in deposit insurance expense.

 

Increases in compensation costs in 2010 can be attributed to additional senior management hires and build out of the special assets department to work through problem loans.  2010 was also impacted by a one-time charge of $0.4 million related to accrued compensation balances.  The Company’s efficiency ratio was 77.9% in 2010 as compared to 75.3% reported for 2009.  Management is implementing additional cost reduction measures in an effort to reduce operating costs and increase efficiency in 2011.

 

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Table of Contents

 

As noted previously, gross loan balances declined $51.4 million or 7.1% in 2010 to $677.3 million, which resulted from weakened new loan demand, normal portfolio payoffs that exceeded new loan originations and higher levels of charged-off loans. In fourth quarter, 2010 the Company increased gross loans outstanding $3.4 million over third quarter. The Company continued to grow deposit balances in 2010.  Total deposits were $798.2 million at December 31, 2010, $22.7 million or 2.9% higher than that reported at December 31, 2009.  Excluding the pay down of brokered deposits in 2010, customer deposits increased $33.9 million.  The majority of this growth occurred within the lower cost, core non-interest bearing demand deposits, regular savings and money market accounts.

 

The Company continued to work-through its problem loans in 2010 by reducing $43.1 million of its exposure to land, development and construction loans which have been the most problematic portions of the loan portfolio and substantially increased its allowance for loan losses.  During 2010 the Company placed $54.4 million in loan balances on non-accrual status, increased the level of scrutiny placed on certain types of credit and increased loan workout and collection activities.  Additions to non-accruing balances were offset by pay-downs on such credits of $18.9 million, charge-offs of $23.9 million, and transfer of loans back to accruing status of $3.9 million.  The Company also transferred $13.1 million in non-performing balances to foreclosed collateral during 2010.  Non-performing assets totaled $39.5 million at December 31, 2010, $0.4 million above that reported at December 31, 2009.  The Company’s efforts to reduce its exposure to loan losses resulted in a $10.6 million increase to the allowance for loan losses which totaled $24.9 million at December 31, 2010.  At year-end 2010, the allowance for loan losses represented 3.68% of total gross loans, as compared to 1.97% of total gross loans at December 31, 2009.  The allowance for loan losses to non-performing loans was 76.0% at December 31, 2010, substantially improved from the 37.5% reported for December 31, 2009.

 

Despite the various headwinds the Company faced in 2010, it was able to increase capital by completing a private equity placement during March 2010, in which the Company successfully raised $60.0 million of additional capital.  This additional capital significantly strengthened the Company’s balance sheet, allowing it to continue to work-through problem assets, accelerate resolution of problem loans, increase earning assets and achieve compliance with the capital ratio requirements of the Consent Order.  The Company’s total risk-based capital, Tier I risk-based capital and Tier 1 leverage ratios were 15.21%, 13.94%, and 10.83% respectively as of December 31, 2010, as compared to the 10.85%, 9.59% and 8.24% reported at December 31, 2009.

 

In 2010 the Company added to its senior management talent and increased staffing in the Special Assets department. The Company also hired Thomas J. Tolda as Executive Vice President and Chief Financial Officer following the departure of the Company’s previous Chief Financial Officer.  Mr. Tolda brings to the Company a considerable level of experience and depth of knowledge, with a 25 year banking career, including senior management positions within community banking and major multi-national financial services organizations.  In January 2011, Lawrence P. Ward, CEO announced he would retire from the Company at the end of 2011 and continue as a member of the Company’s Board of Directors. Mr. Ward led the Company’s very successful growth from $54 million in 1993 to near $1 billion in 2010. The Company has planned for an orderly transition and will be searching for Mr. Ward’s replacement both internally and externally.

 

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Table of Contents

 

Recent Developments

 

Regulatory Order and Written Agreement

 

On March 4, 2010, the FDIC and the DFI issued a joint Consent Order to the Bank that required, among other things, the Bank to increase its capital ratios, reduce its classified asset levels and increase Board oversight of Management. The Board and Management have aggressively responded to the Order, and as of December 31, 2010 believe the Bank is well on its way to resolving all the provisions outlined therein.  Additionally, a Written Agreement was entered into between the Company and the Federal Reserve Bank of San Francisco on March 4, 2010.  The Company believes that as of December 31, 2010 it is in full compliance with the terms of the Written Agreement.

 

For additional information concerning the Consent Order and the Written Agreement, please see “Supervision and Regulation – Regulatory Order and Written Agreement” and Note 22. Regulatory Order and Written Agreement, of the consolidated financial statements, filed on this Form 10-K.  For the full text of the Order and Written Agreement, please also refer to Company’s current reports on Form 8-K, which were filed with the Securities and Exchange Commission on March 10, 2010 and March 8, 2010, respectively.

 

Private Placement

 

On March 12, 2010 the Company announced that it completed a private placement of 52,088 shares of its Series B Mandatorily Convertible Adjustable Cumulative Perpetual Preferred Stock (“Series B Preferred Stock”) and 1,189,538 shares of its Series C Convertible Perpetual Preferred Stock (“Series C Preferred Stock”), raising gross proceeds of approximately $56.0 million. In addition, approximately $4.0 million was placed in escrow for a second closing of 4,072 shares of Series B Preferred Stock, which then closed during the second quarter of 2010.  Total gross proceeds raised in the private placement were $60.0 million and total costs associated with the capital raising efforts were $4.0 million, which represent a reduction of the addition to equity from the private placement.

 

In June 2010, the Company received shareholder approval to convert all outstanding shares of Series B Preferred Stock to common stock and as a result the Company issued 17,279,995 shares of common stock in June 2010.  For additional information regarding the Company’s March 2010 private placement, please see Note 21. Preferred Stock, of the consolidated financial statements, filed on this Form 10-K.

 

 

Results of Operations

 

The Company reported net losses of $17.6 million and $7.0 million for the years ended December 31, 2010 and 2009, respectively.  For the year ended December 31, 2008 the Company reported net income of $1.6 million.  Fully diluted net losses per common share were $1.30 and $1.04 for the years ended December 31, 2010 and 2009, respectively.  The Company reported fully diluted net income per common share of $0.21 for the year ended December 31, 2008. As previously discussed, earnings were negatively impacted on a year over year basis due in large part to the substantial increase in provisions for loan losses required because of continued weakness in the loan portfolio.  Additionally, the valuation allowance expense for deferred tax assets, write-downs on the values of foreclosed assets, higher compensation cost associated with the expansion of the management team and special assets department and weaker new loan demand all contributed to a year over year decline in operating results.

 

 

Net Interest Income and Margin

 

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

 

31



Table of Contents

 

The table below sets forth average balance sheet information, interest income and expense, average yields and rates and net interest income and margin for the years ended December 31, 2010, 2009 and 2008.  The average balance of non-accruing loans has been included in loan totals:

 

 

 

For The Year Ended,

 

For The Year Ended,

 

For The Year Ended,

 

 

 

December 31, 2010

 

December 31, 2009

 

December 31, 2008

 

 

 

 

 

Yield/

 

Income/

 

 

 

Yield/

 

Income/

 

 

 

Yield/

 

Income/

 

(dollar amounts in thousands)

 

Balance

 

Rate

 

Expense

 

Balance

 

Rate

 

Expense

 

Balance

 

Rate

 

Expense

 

Interest Earning Assets

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Investments with other banks

 

$

119

 

1.68%

 

$

2

 

$

119

 

2.52%

 

$

3

 

$

214

 

3.74%

 

$

8

 

Interest bearing due from

 

38,630

 

0.23%

 

90

 

16,950

 

0.29%

 

49

 

-    

 

0.00%

 

-    

 

Federal funds sold

 

4,414

 

0.11%

 

5

 

14,555

 

0.14%

 

21

 

6,583

 

2.13%

 

140

 

Investment securities taxable

 

156,911

 

3.46%

 

5,422

 

67,197

 

4.55%

 

3,060

 

42,080

 

5.28%

 

2,223

 

Investment securities non taxable

 

26,664

 

4.30%

 

1,146

 

20,589

 

4.35%

 

896

 

17,079

 

4.34%

 

741

 

Loans (1) (2)

 

709,253

 

6.22%

 

44,129

 

709,919

 

6.41%

 

45,530

 

656,105

 

7.17%

 

47,038

 

Total interest earning assets

 

935,991

 

5.43%

 

50,794

 

829,329

 

5.98%

 

49,559

 

722,061

 

6.95%

 

50,150

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Allowance for loan losses

 

(20,698

)

 

 

 

 

(12,342

)

 

 

 

 

(7,845

)

 

 

 

 

Other assets

 

79,930

 

 

 

 

 

70,641

 

 

 

 

 

65,359

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total assets

 

$

995,223

 

 

 

 

 

$

887,628

 

 

 

 

 

$

779,575

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest Bearing Liabilities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest bearing demand

 

$

70,935

 

0.50%

 

$

352

 

$

66,652

 

0.82%

 

$

548

 

$

74,170

 

0.60%

 

$

447

 

Savings

 

27,739

 

0.26%

 

73

 

24,665

 

0.24%

 

60

 

25,678

 

0.81%

 

208

 

Money market

 

281,754

 

1.00%

 

2,813

 

222,343

 

1.44%

 

3,207

 

193,215

 

1.93%

 

3,720

 

Time deposits

 

232,450

 

1.81%

 

4,210

 

220,120

 

2.30%

 

5,069

 

159,496

 

3.34%

 

5,328

 

Total interest bearing deposits

 

612,878

 

1.22%

 

7,448

 

533,780

 

1.66%

 

8,884

 

452,559

 

2.14%

 

9,703

 

Federal funds purchased

 

-    

 

0.00%

 

-    

 

188

 

1.06%

 

2

 

3,406

 

2.55%

 

87

 

Securities sold under agreement to repurchase

 

-    

 

0.00%

 

-    

 

650

 

0.15%

 

1

 

2,283

 

2.01%

 

46

 

Federal Home Loan Bank borrowing

 

62,041

 

0.54%

 

332

 

76,953

 

0.76%

 

588

 

76,881

 

2.51%

 

1,933

 

Federal Reserve Bank borrowing

 

-    

 

0.00%

 

-    

 

14

 

0.49%

 

-    

 

-    

 

0.00%

 

-    

 

Junior subordinated debentures

 

10,479

 

2.34%

 

245

 

13,403

 

4.28%

 

574

 

13,403

 

5.93%

 

795

 

Other secured borrowing

 

445

 

4.94%

 

22

 

-    

 

0.00%

 

-    

 

-    

 

5.93%

 

-    

 

Total borrowed funds

 

72,965

 

0.82%

 

599

 

91,208

 

1.28%

 

1,165

 

95,973

 

2.98%

 

2,861

 

Total interest bearing liabilities

 

685,843

 

1.17%

 

8,047

 

624,988

 

1.61%

 

10,049

 

548,532

 

2.29%

 

12,564

 

Non interest bearing demand

 

178,096

 

 

 

 

 

167,226

 

 

 

 

 

151,529

 

 

 

 

 

Total funding

 

863,939

 

0.93%

 

 

 

792,214

 

1.27%

 

 

 

700,061

 

1.79%

 

 

 

Other liabilities

 

9,419

 

 

 

 

 

8,465

 

 

 

 

 

7,766

 

 

 

 

 

Total liabilities

 

873,358

 

 

 

 

 

800,679

 

 

 

 

 

707,827

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Stockholders’ Equity

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total stockholders’ equity

 

121,865

 

 

 

 

 

86,949

 

 

 

 

 

71,748

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total liabilities and stockholders’ equity

 

$

995,223

 

 

 

 

 

$

887,628

 

 

 

 

 

$

779,575

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net interest income

 

 

 

 

 

 

$

42,747

 

 

 

 

 

 

$

39,510

 

 

 

 

 

$

37,586

 

Net interest margin (3)

 

 

 

4.57%

 

 

 

 

 

4.76%

 

 

 

 

 

5.21%

 

 

 

 

(1) Non-accruing loans have been included in total loans.

(2) Loan fees of $656; $918; $1,297 for the years ending December 31, 2010, 2009, and 2008 respectively have been included in interest income computation.

(3) Net interest margin has been calculated by dividing the net interest income by total average earning assets.

 

32



Table of Contents

 

The table below sets forth changes from 2009 to 2010 for average interest-earning assets and their respective average yields:

 

 

 

For The Year Ended,

 

 

 

For The Year Ended,

 

 

 

 

December 31,

 

Variance

 

December 31,

 

 

(dollar amounts in thousands)

 

2010

 

2009

 

dollar

 

percentage

 

2010

 

2009

 

Variance

Investments with other banks

 

$

 119

 

$

 119

 

$

-    

 

0.00%

 

1.68%

 

2.52%

 

-0.84%

Interest bearing due from

 

38,630

 

16,950

 

21,680

 

127.91%

 

0.23%

 

0.29%

 

-0.06%

Federal funds sold

 

4,414

 

14,555

 

(10,141

)

-69.67%

 

0.11%

 

0.14%

 

-0.03%

Investment securities taxable

 

156,911

 

67,197

 

89,714

 

133.51%

 

3.46%

 

4.55%

 

-1.09%

Investment securities non-taxable

 

26,664

 

20,589

 

6,075

 

29.51%

 

4.30%

 

4.35%

 

-0.05%

Loans (1) (2)

 

709,253

 

709,919

 

(666

)

-0.09%

 

6.22%

 

6.41%

 

-0.19%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total interest earning assets

 

$

 935,991

 

$

 829,329

 

$

 106,662

 

12.86%

 

5.43%

 

5.98%

 

-0.55%

 

(1) Non-accruing loans have been included in loan totals.

(2) Loan fees of $656 and $918 have been included in the interest income computation for the years ended December 31, 2010 and 2009, respectively.

 

At December 31, 2010, average interest earning assets were approximately $106.7 million higher than that reported for the year ended December 31, 2009.  Higher average balances of investment securities stemming from the $56.0 million in net proceeds the Company received from its March 2010 private placement, coupled with an increase in average core deposit balances led to the year over year increase in average interest-earning assets.  Although the increase in investment balances ultimately contributed to a year over year increase in interest income, the lower yields earned on these investments, due in large part to the current lower interest rate environment, contributed to a decline in earning asset yields in 2010.

 

Anemic loan demand through 2010, made it difficult for the Company to originate and fund new, high quality credits.  This, along with normal portfolio attrition and pay-downs on loans outpaced new loan originations, leading to loan portfolio contraction for most of 2010, a decline in interest and fees earned on loans and ultimately a decrease in the overall yield on the loan portfolio.  Additionally, the Company transferred $54.4 million in loans to non-accrual status during 2010, which resulted in interest reversals of $0.6 million, contributing to the year over year decline in interest and fees earned on loans.  Furthermore, average impaired loan balances in 2010 were approximately $11.4 million higher than that reported for 2009, which placed additional pressure on loan portfolio yields in 2010.  Total forgone interest on impaired loans (including interest reversed when a loan is initially placed on non-accrual and all interest income lost prospectively) totaled approximately $3.0 million for 2010, impacting the yield on earning assets by approximately 32 basis points.  For 2009 forgone interest totaled $1.3 million and impacted the yield on earning assets by 16 basis points.  A lower overall yield on the loan portfolio, coupled with an increase in lower yielding investment securities resulted in lower earning asset yields which lead to a year over year decline in the net interest margin.

 

The table below sets forth changes from 2009 to 2010 for average interest-bearing liabilities and the respective average rates paid:

 

 

 

For The Year Ended,

 

 

 

For The Year Ended,

 

 

 

 

December 31,

 

Variance

 

December 31,

 

 

(dollar amounts in thousands)

 

2010

 

2009

 

dollar

 

percentage

 

2010

 

2009

 

Variance

Interest bearing demand

 

$

 70,935

 

$

 66,652

 

$

 4,283

 

6.43%

 

0.50%

 

0.82%

 

-0.32%

Savings

 

27,739

 

24,665

 

3,074

 

12.46%

 

0.26%

 

0.24%

 

0.02%

Money market

 

281,754

 

222,343

 

59,411

 

26.72%

 

1.00%

 

1.44%

 

-0.44%

Time deposits

 

232,450

 

220,120

 

12,330

 

5.60%

 

1.81%

 

2.30%

 

-0.49%

Federal funds purchased

 

-    

 

188

 

(188

)

-100.00%

 

0.00%

 

1.06%

 

-1.06%

Securities sold under repurchase agreements

 

-    

 

650

 

(650

)

-100.00%

 

0.00%

 

0.15%

 

-0.15%

Federal Home Loan Bank borrowing

 

62,041

 

76,953

 

(14,912

)

-19.38%

 

0.54%

 

0.76%

 

-0.22%

Federal Reserve Bank borrowing

 

-    

 

14

 

(14

)

-100.00%

 

0.00%

 

0.49%

 

-0.49%

Junior subordinated debentures

 

10,479

 

13,403

 

(2,924

)

-21.82%

 

2.34%

 

4.28%

 

-1.94%

Other secured borrowing

 

445

 

-    

 

445

 

N/M

 

4.94%

 

0.00%

 

4.94%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total interest bearing liabilities

 

$

 685,843

 

$

 624,988

 

$

 60,855

 

9.74%

 

1.17%

 

1.61%

 

-0.44%

 

33



Table of Contents

 

Average interest bearing liabilities increased $60.9 million in 2010 from the $685.8 million reported at December 31, 2009.  The year over year increase can be attributed to higher average balances of core interest bearing deposits, including increases in money market and time deposit accounts, which resulted from promotional activities and added focus on attracting and retaining core relationships.  The yield on interest-bearing liabilities was 1.17% for the year ended December 31, 2010, representing a decline of 44 basis points.  In an effort to augment the decline in earning asset yields and reduce pressure on the net interest margin, the Company lowered offering rates significantly during the latter half of 2010.  As a result, the Company significantly reduced the cost of money market and time deposits during 2010.  Additionally, the Company restructured and paid down higher cost FHLB borrowings during 2010, contributing to the decline in the cost of interest bearing liabilities.  Further, in June 2010 the Company eliminated $5.2 million in junior subordinated debentures from the balance sheet, associated with the repurchase of trust preferred securities issued by Heritage Oaks Capital Trust III.  These borrowings previously accrued interest at a rate of 6.89% per annum.

 

The hypothetical impacts of sudden interest rate movements applied to the Company’s asset and liability balances are modeled monthly.  The results of these models indicate how much of the Company’s net interest income is “at risk” from various rate changes over a one year horizon.  This exercise is valuable in identifying risk exposures.  The results for the Company’s December 31, 2010 balances indicate that the net interest income at risk over a one year time horizon from a 1.0% and 2.0% upward and downward rate movement are within the Company’s policy guidelines for such changes.  See Item 7A.  Quantitative and Qualitative Disclosures About Market Risk.

 

The following table sets forth the dollar difference in interest earned and paid for each major category of interest-earning assets and interest-bearing liabilities and the amount of such change attributable to changes in average balances (volume) or changes in interest rates for the three years ended December 31, 2010, 2009 and 2008:

 

 

 

For The Year Ended,

 

For The Year Ended,

 

For The Year Ended,

 

 

 

December 31, 2010

 

December 31, 2009

 

December 31, 2008

 

(dollar amounts in thousands)

 

Volume

 

Rate

 

Total

 

Volume

 

Rate

 

Total

 

Volume

 

Rate

 

Total

 

Interest income:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Investments with other banks

 

$

-    

 

$

(1

)

$

(1

)

$

(3

)

$

(2

)

$

(5

)

$

(7

)

$

7

 

$

-    

 

Interest bearing due from

 

51

 

(10

)

41

 

49

 

-    

 

49

 

-    

 

-    

 

-    

 

Federal funds sold

 

(18

)

2

 

(16

)

81

 

(200

)

(119

)

8,811

 

(9,456

)

(645

)

Investment securities taxable

 

3,251

 

(889

)

2,362

 

1,178

 

(341

)

837

 

881

 

96

 

977

 

Investment securities non-taxable (2)

 

396

 

(17

)

379

 

232

 

3

 

235

 

36

 

11

 

47

 

Taxable equivalent adjustment (2)

 

(135

)

6

 

(129

)

(79

)

(1

)

(80

)

(12

)

(4

)

(16

)

Loans (1)

 

(43

)

(1,358

)

(1,401

)

3,680

 

(5,188

)

(1,508

)

12,099

 

(7,486

)

4,613

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net increase / (decrease)

 

3,502

 

(2,267

)

1,235

 

5,138

 

(5,729

)

(591

)

21,808

 

(16,832

)

4,976

 

Interest expense:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Savings, NOW, money market

 

711

 

(1,288

)

(577

)

292

 

(852

)

(560

)

1,627

 

(2,163

)

(536

)

Time deposits

 

270

 

(1,129

)

(859

)

1,679

 

(1,938

)

(259

)

618

 

(2,250

)

(1,632

)

Other borrowings

 

(102

)

(133

)

(235

)

(38

)

(1,352

)

(1,390

)

1,490

 

(1,407

)

83

 

Federal funds purchased

 

(1

)

(1

)

(2

)

(52

)

(33

)

(85

)

72

 

(48

)

24

 

Long term borrowings

 

(143

)

(186

)

(329

)

-    

 

(221

)

(221

)

82

 

(208

)

(126

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net increase / (decrease)

 

735

 

(2,737

)

(2,002

)

1,881

 

(4,396

)

(2,515

)

3,889

 

(6,076

)

(2,187

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total net increase / (decrease)

 

$

2,767

 

$

470

 

$

3,237

 

$

3,257

 

$

(1,333

)

$

1,924

 

$

17,919

 

$

(10,756

)

$

7,163

 

 

(1) Loan fees of $656, $918 and $1,297 for 2010, 2009, and 2008, respectively have been included in the interest income computation.

(2) Adjusted to a fully taxable equivalent basis using a tax rate of 34%.

 

34


 


Table of Contents

 

Non-Interest Income

 

The table below sets forth changes for 2010, 2009 and 2008 in non-interest income exclusive of gains on the sale of securities, SBA loans and premises as well as OTTI charges:

 

 

 

For The Years Ended

 

Variances

 

 

 

December 31,

 

2010

 

2009

 

(dollar amounts in thousands)

 

2010

 

2009

 

2008

 

dollar

 

percentage

 

dollar

 

percentage

 

Fees and service charges

 

$

2,428

 

$

2,965

 

$

3,284

 

$

(537

)

-18.1%

 

$

(319

)

-9.7%

 

Mortgage origination fees

 

2,020

 

1,253

 

568

 

767

 

61.2%

 

685

 

120.6%

 

Debit/credit card transaction fee income

 

1,249

 

976

 

895

 

273

 

28.0%

 

81

 

9.1%

 

Earnings on bank owned life insurance

 

585

 

504

 

474

 

81

 

16.1%

 

30

 

6.3%

 

Bancard merchant fee income

 

198

 

180

 

231

 

18

 

10.0%

 

(51

)

-22.1%

 

Other

 

435

 

426

 

717

 

9

 

2.1%

 

(291

)

-40.6%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

6,915

 

$

6,304

 

$

6,169

 

$

611

 

9.7%

 

$

135

 

2.2%

 

 

For the year ended December 31, 2009, non-interest income, exclusive of realized gains and losses, increased $611 thousand or 9.7% when compared to the same period ended a year earlier.

 

Several factors contributed to the year over year variance in non-interest income.  As evidenced in the table above, debit/credit card transaction and interchange fee income increased $273 thousand or 28.0% in 2010.  The Company attributes this growth to the greater focus consumers have placed on cashless transactions as well as additional core deposit relationships the Bank obtained during 2010.  Earnings on bank owned life insurance increased $81 thousand or 16.1% in 2010, and is attributable to additional policies the Bank purchased for certain executive officers, resulting from the expansion of the management team.  Service charge fee income declined $537 thousand or 18.1% in 2010. Management believes the decline within this category can be attributed to better cash management practices by business customers in an effort to control costs in the current economic environment.

 

The majority of the year over year increase in non-interest income can be attributed to a $767 thousand or 61.2% increase in mortgage origination fee income.  A continuation of the favorable interest rate environment during 2010 contributed to a significant increase in re-financing activity.  This in conjunction with further expansion of the mortgage origination team led to increased volume in 2010 and consequently higher fee income.

 

For 2010 total non-interest income was approximately $9.5 million, which represents an increase of $3.3 million or 53.2% over that reported for 2009.  Contributing to the significant increase in addition to the items listed above, was a $1.7 million gain the Company realized upon the extinguishment of $5.2 million in junior subordinated debentures.  See also Note 9. Borrowings, of the consolidated financial statements, filed on this Form 10-K for additional discussion concerning the extinguishment of these borrowings.  Further contributing to the year over year increase in total non-interest income was a $304 thousand decline in losses on the sale of OREO, as well as an increase of $450 thousand on the sale of investment securities.

 

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Table of Contents

 

Non-Interest Expenses

 

The table below sets forth changes in non-interest expense for 2010, 2009, and 2008:

 

 

 

For The Years Ended

 

Variances

 

 

 

December 31,

 

2010

 

2009

 

(dollar amounts in thousands)

 

2010

 

2009

 

2008

 

dollar

 

percentage

 

dollar

 

percentage

 

Salaries and employee benefits

 

$

18,042

 

$

15,502

 

$

15,561

 

$

2,540

 

16.4%

 

$

(59

)

-0.4%

 

Occupancy and equipment

 

5,458

 

4,917

 

4,542

 

541

 

11.0%

 

375

 

8.3%

 

Promotional

 

690

 

644

 

823

 

46

 

7.1%

 

(179

)

-21.7%

 

Data processing

 

2,676

 

2,743

 

2,704

 

(67

)

-2.4%

 

39

 

1.4%

 

Loan administration costs

 

1,251

 

1,289

 

258

 

(38

)

-2.9%

 

1,031

 

399.6%

 

Write-downs of foreclosed assets

 

3,686

 

1,514

 

-    

 

2,172

 

143.5%

 

1,514

 

100.0%

 

FDIC and other regulatory fees

 

2,657

 

1,984

 

475

 

673

 

33.9%

 

1,509

 

317.7%

 

Audit and tax advisory costs

 

571

 

625

 

464

 

(54

)

-8.6%

 

161

 

34.7%

 

Director fees

 

551

 

355

 

318

 

196

 

55.2%

 

37

 

11.6%

 

Outside services

 

1,712

 

1,801

 

922

 

(89

)

-4.9%

 

879

 

95.3%

 

Telephone / communications costs

 

369

 

275

 

324

 

94

 

34.2%

 

(49

)

-15.1%

 

Amortization of intangible assets

 

514

 

1,049

 

861

 

(535

)

-51.0%

 

188

 

21.8%

 

Stationery and supplies

 

460

 

431

 

428

 

29

 

6.7%

 

3

 

0.7%

 

Provision for unfunded loan commitments

 

80

 

-    

 

-    

 

80

 

100.0%

 

-    

 

0.0%

 

Other

 

1,315

 

1,387

 

1,754

 

(72

)

-5.2%

 

(367

)

-20.9%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

40,032

 

$

34,516

 

$

29,434

 

$

5,516

 

16.0%

 

$

5,082

 

17.3%

 

 

Salaries and Employee Benefits

 

Salaries and employee benefits are the largest component of the Company’s non-interest expenses, and totaled $18.0 million for the year ended December 31, 2010. Expenses within this category increased $2.5 million in 2010.  The year over year increase can be attributed to further expansion of the Company’s management team and Special Assets department.  Additionally, during 2010 the Company incurred a one-time charge of $0.4 million to update accrued compensation balances, contributing further to the year over year increase.

 

For the years ended December 31, 2010, 2009 and 2008 the total number of full time equivalent employees were 281, 265 and 223, respectively.

 

Occupancy and Equipment

 

Expenses within this category increased $541 thousand during 2010 from that reported for 2009.  The year over year increase within this category can be attributed to: an increase in depreciation expense associated with various leasehold improvements and equipment purchases, higher property tax costs, increased licensing costs associated with various process improvement initiatives throughout the organization, and a decline in sublease rental income resulting from the relocation on one branch office during late 2009.

 

FDIC and Other Regulatory Fees

 

For the year ended December 31, 2010, regulatory assessment costs increased $0.7 million over that reported for 2009.  As the FDIC has moved to replenish the Deposit Insurance Fund, insurance premiums have risen.  The Bank’s deposit insurance assessment rates have also increased during 2010 in part because of the regulatory Order.  The Bank currently expects premiums for 2011 to remain elevated. The significant increase from 2008 to 2009 can be attributed to $1.0 million in one-time charges associated with a special assessment imposed on all insured institutions by the FDIC and an update of the Bank’s FDIC assessment accrual during the third quarter of 2009.

 

Core Deposit Intangible (“CDI”) Amortization

 

Amortizations for the Hacienda acquisition in October 2003 and the Business First National Bank acquisition in October 2007 are scheduled pursuant to analysis prepared by a third party at the time of acquisition to determine the fair value of deposits acquired in accordance with U.S. GAAP.  Accordingly, expense incurred for CDI amortization for the years ended December 31, 2010, 2009 and 2008 was $0.5 million, $1.0 million and $0.9 million, respectively.

 

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Table of Contents

 

Director Fees

 

Increases within this category can be attributed to increased oversight by the Bank and Company’s board pursuant to the terms of the Consent Order the Bank stipulated to in March of 2010 and to an increase of the total number of Board Members.

 

 

Loan Administration Costs

 

For the year ended December 31, 2010 expenses within this category increased $2.2 million over that reported for 2009.  The primary factor behind the year over year increase can be attributed to an increase in write-downs on foreclosed assets resulting from updated appraisal information for certain commercial and construction/land properties.  Write-downs on foreclosed assets totaled $3.7 million during 2010.  The significant increase in loan department costs from 2008 to 2009 can be attributed to the write-down of one foreclosed property by $1.3 million as well as additional costs incurred with the management of problem assets.

 

 

Provision for Income Taxes

 

The amount of the tax provision is determined by applying the Company’s statutory income tax rates to pre-tax book income, adjusted for permanent differences between pre-tax book income and actual taxable income. Such permanent differences include, but are not limited to, tax-exempt interest income and earnings on bank-owned life insurance.  For the years ended December 31, 2010 and 2009 the Company recorded an income tax benefit of $1.8 million and $5.8 million, respectively.  For the year ended December 31, 2008 the Company recorded provisions for income taxes of $0.5 million.  The Company’s effective tax rate for the years ended December 31, 2010, 2009 and 2008 was -9.1%, -45.2% and 23.2%, respectively.  During 2010 the Company established a valuation allowance for a portion of its deferred tax assets in the amount of $7.1 million.  The establishment of this valuation allowance resulted in a reduction in the income tax benefit the Company recorded in 2010, leading to a year over year increase in the effective tax rate.  The effective tax rates for the years ended December 31, 2009 and 2008 were impacted significantly by the substantial provisions the Bank made to the allowance for loan losses during those years, significantly reducing pre-tax income.  As a result, income from permanent items such as interest on municipal securities and earnings on holdings of bank owned life insurance had a greater impact on the income tax provision than in prior periods.  See also Note 10. Income Taxes, of the consolidated financial statements, filed on this Form 10-K for a more detailed discussion concerning the valuation allowance the Company established for a portion of its deferred tax assets.

 

Provision for Loan Losses

 

An allowance for loan losses was established to provide for those loans that may not be repaid in their entirety for a variety of reasons.  The allowance is maintained at a level considered by Management to be adequate to provide for probable incurred losses.  The allowance is increased by provisions charged to earnings and is reduced by charge-offs, net of recoveries.  The provision for loan losses is based upon Management’s analysis of the adequacy of the allowance for loan losses as of the date of the balance sheet, which includes, among other things, an analysis of past loan loss experience and Management’s evaluation of the loan portfolio under current economic conditions.

 

The Company recognizes that credit losses will be experienced and the risk of loss will vary with, among other things, general economic conditions; the type of loan being made; the creditworthiness of the borrower over the term of the loan and in the case of a collateralized loan, the quality of the collateral for such loan.  The allowance for loan losses represents the Company’s best estimate of the allowance necessary to provide for probable estimable losses in the portfolio as of the balance sheet date.  In making this determination, the Company analyzes the ultimate collectability of loans in the portfolio by incorporating feedback provided by internal loan staff, Management’s findings from internal loan reviews, findings from an independent semi-annual loan review function, and information provided by examinations performed by regulatory agencies.  The Company makes monthly evaluations as to the adequacy of the allowance for loan losses and makes adjustments to the related provision for loan losses accordingly.

 

The Company’s provision for loan losses was $31.5 million, $24.1 million and $12.2 million for the years ended December 31, 2010, 2009 and 2008.  Provisions for loan losses in 2010 were $7.5 million higher than that reported for 2009, which is reflective of additional credit losses the Company incurred during 2010 as well as continued weakness in economic conditions.

 

37



Table of Contents

 

Looking forward into 2011, Management anticipates continued weakness in economic conditions on national, state and local levels yet slightly improved in comparison to 2010.  Continued economic pressures may negatively impact the financial condition of borrowers to whom the Bank has extended credit and as a result the Bank may be required to make further additional provisions to the allowance for loan losses during 2011.  That said, Management has and will continue to take a proactive stance with respect to managing credit quality and minimizing the overall negative effects of problem credit.

 

Financial Condition

 

During 2010 the Company focused heavily on the identification and resolution of problem assets in an effort to position the Company for improved asset quality and growth in future periods.  The focus placed on improving asset quality in conjunction with a decline in new loan demand, led to a $51.4 million decrease in gross loan balances during 2010.  The Company also placed $54.4 million of loan balances on non-accrual, transferred $13.1 million to foreclosed collateral, and charged-off $23.9 million in loan balances during 2010.  This contributed to an increase in the allowance for loan losses of $10.6 million, bringing the balance of the allowance to $24.9 million, representing 3.68% of total gross loans at December 31, 2010.

 

Deposits increased $22.7 million to $798.2 million during 2010.  The majority of the growth can be attributed to an increase in core deposit balances, resulting from promotional efforts and initiatives focused on gathering and retaining core relationships.  The increase in low cost, core deposits allowed the Company to pay-down $26.5 million in higher cost FHLB borrowing.

 

Shareholders’ equity increased $37.5 million to $121.3 million during 2010.  The increase resulted from the successful completion of a private placement in 2010 in which the Company raised $60.0 million in total gross proceeds.  This additional capital significantly strengthened the Company’s balance sheet, allowing Management to continue to focus on improving asset quality and further building the core franchise.

 

Pay-downs in the loan portfolio, coupled with the proceeds the Company received from its March 2010 Private Placement, led to an increase in the balance of the investments portfolio.  Investment securities increased $103.8 million to $225.0 million during 2010.  In the absence of significant new loan demand, the Company made selective investments primarily in agency-backed mortgage securities and municipal bonds.  These investments helped to mitigate net interest margin compression by actively managing the level of lower yielding, excess, overnight liquidity.

 

38



Table of Contents

 

Loans

 

The table below sets forth the composition of the loan portfolio as of December 31, 2010, 2009, 2008, 2007 and 2006:

 

 

 

2010

 

2009

 

2008

 

2007

 

2006

 

(dollar amounts in thousands)

 

Amount

 

Percent

 

Amount

 

Percent

 

Amount

 

Percent

 

Amount

 

Percent

 

Amount

 

Percent

 

Real Estate Secured

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Multi-family residential

 

$

 17,637

 

2.6%

 

$

 20,631

 

2.8%

 

$

 16,206

 

2.4%

 

$

 12,779

 

2.1%

 

$

 9,563

 

2.1%

 

Residential 1 to 4 family

 

21,804

 

3.2%

 

25,483

 

3.5%

 

23,910

 

3.5%

 

24,326

 

4.0%

 

5,267

 

1.2%

 

Home equity line of credit

 

30,801

 

4.5%

 

29,780

 

4.1%

 

26,409

 

3.9%

 

17,470

 

2.8%

 

10,792

 

2.4%

 

Commercial

 

348,583

 

51.6%

 

337,940

 

46.5%

 

285,631

 

41.8%

 

274,266

 

44.7%

 

204,470

 

46.0%

 

Farmland

 

15,136

 

2.2%

 

13,079

 

1.8%

 

10,723

 

1.6%

 

11,557

 

1.9%

 

18,101

 

4.1%

 

Commercial

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Commercial and industrial

 

145,811

 

21.6%

 

157,270

 

21.6%

 

157,674

 

23.1%

 

134,178

 

21.8%

 

72,550

 

16.3%

 

Agriculture

 

15,168

 

2.2%

 

17,698

 

2.4%

 

13,744

 

2.0%

 

11,367

 

1.9%

 

12,117

 

2.7%

 

Other

 

153

 

0.0%

 

238

 

0.0%

 

620

 

0.1%

 

535

 

0.1%

 

309

 

0.1%

 

Construction

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Single family residential

 

11,525

 

1.7%

 

15,538

 

2.1%

 

11,414

 

1.7%

 

10,239

 

1.6%

 

7,785

 

1.7%

 

Single family residential - Spec.

 

2,391

 

0.4%

 

3,400

 

0.5%

 

15,395

 

2.3%

 

18,718

 

3.1%

 

10,805

 

2.4%

 

Tract

 

-    

 

0.0%

 

2,215

 

0.3%

 

2,431

 

0.4%

 

1,664

 

0.3%

 

179

 

0.0%

 

Multi-family

 

2,218

 

0.3%

 

2,300

 

0.3%

 

5,808

 

0.9%

 

9,054

 

1.5%

 

5,343

 

1.2%

 

Hospitality

 

-    

 

0.0%

 

14,306

 

2.0%

 

18,630

 

2.7%

 

16,784

 

2.7%

 

4,723

 

1.1%

 

Commercial

 

27,785

 

4.1%

 

27,128

 

3.7%

 

21,484

 

3.2%

 

30,677

 

5.0%

 

52,766

 

11.9%

 

Land

 

30,685

 

4.5%

 

52,793

 

7.2%

 

61,681

 

9.1%

 

31,064

 

5.1%

 

24,111

 

5.4%

 

Installment loans to individuals

 

7,392

 

1.1%

 

8,327

 

1.1%

 

7,851

 

1.2%

 

7,977

 

1.3%

 

5,598

 

1.3%

 

All other loans (including overdrafts)

 

214

 

0.0%

 

553

 

0.1%

 

536

 

0.1%

 

562

 

0.1%

 

504

 

0.1%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total loans, gross

 

$

 677,303

 

100.0%

 

$

 728,679

 

100.0%

 

$

 680,147

 

100.0%

 

$

 613,217

 

100.0%

 

$

 444,983

 

100.0%

 

Deferred loan fees

 

1,613

 

 

 

1,825

 

 

 

1,701

 

 

 

1,732

 

 

 

1,625

 

 

 

Reserve for loan losses

 

24,940

 

 

 

14,372

 

 

 

10,412

 

 

 

6,143

 

 

 

4,081

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total loans, net

 

$

 650,750

 

 

 

$

 712,482

 

 

 

$

 668,034

 

 

 

$

 605,342

 

 

 

$

 439,277

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Loans held for sale

 

$

 11,008

 

 

 

$

 9,487

 

 

 

$

 7,939

 

 

 

$

 902

 

 

 

$

 1,764

 

 

 

 

Real Estate Secured

 

At December 31, 2010, real estate secured balances were $434.0 million or $7.0 million higher than that reported at December 31, 2009.  The year over year increase can be attributed to increases in commercial real estate balances which stemmed from the completion of several large hospitality and commercial construction projects and their subsequent reclassification to the commercial real estate category.  Absent these significant transfers which totaled $23.9 million, commercial real estate balances declined $13.4 million during 2010, which was due to weakened loan demand in conjunction with pay-downs, and pay-offs.  Contributing further to the year over year decline in commercial real estate balances, exclusive of the reclassifications mentioned, was the resolution of several large problem credits in the form of pay-downs, transfers to foreclosed collateral and one significant charge-off, all totaling $8.5 million. Partially offsetting the decline in commercial real estate balances was the funding of several new loans during 2010 totaling $13.3 million.  The Company has remained very selective with respect to new loan originations given the current economic environment.  However, we remain committed to providing credit to our core relationships that continue to demonstrate financial strength despite current economic conditions.

 

At December 31, 2010, real estate secured balances as well as related unfunded commitments represented 413% of the Bank’s total risk-based capital which is down significantly from the 556% reported at December 31, 2009.  The year over year decline can be attributed to the additional capital the Company raised during 2010.

 

At December 31, 2010, $162.1 million or 37.3% of real estate secured balances were owner occupied.  This compares to $174.6 million or 40.9% of total real estate secured balances reported at December 31, 2009.

 

39



Table of Contents

 

In September 2004, the Company issued an $11.7 million irrevocable standby letter of credit to guarantee the payment of taxable variable rate demand bonds that has since been reduced to $11.4 million. The primary purpose of the bond issue was to refinance existing debt and provide funds for capital improvement and expansion of an assisted living facility. The project is 100% complete and near full occupancy. The letter of credit was renewed in September 2010 and will expire in September 2011.

 

The following provides a break-down of the Bank’s real estate secured portfolio as of December 31, 2010:

 

 

 

December 31, 2010

 

 

 

Percent of Bank

 

 

 

Single

 

 

 

 

 

Undisbursed

 

Total Bank

 

Percent

 

Total Risk

 

Number

 

Largest

 

(dollar amounts in thousands)

 

Balance

 

Commitment

 

Exposure

 

Composition

 

Based Capital

 

of Loans

 

Loan

 

Real Estate Secured

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Retail

 

$

38,520

 

$

2,124

 

$

40,644

 

8.9%

 

36.5%

 

55

 

$

5,000

 

Professional

 

73,706

 

160

 

73,866

 

16.1%

 

66.4%

 

94

 

10,000

 

Hospitality

 

97,178

 

480

 

97,658

 

21.3%

 

87.8%

 

48

 

10,692

 

Multi-family

 

17,637

 

-    

 

17,637

 

3.8%

 

15.9%

 

21

 

3,128

 

Home equity lines of credit

 

30,801

 

20,251

 

51,052

 

11.1%

 

45.9%

 

324

 

1,680

 

Residential 1 to 4 family

 

21,804

 

647

 

22,451

 

4.9%

 

20.2%

 

68

 

2,400

 

Farmland

 

15,136

 

381

 

15,517

 

3.4%

 

13.9%

 

23

 

2,693

 

Healthcare / medical

 

16,916

 

-    

 

16,916

 

3.7%

 

15.2%

 

31

 

2,155

 

Restaurants / hospitality

 

6,960

 

-    

 

6,960

 

1.5%

 

6.3%

 

13

 

2,541

 

Commercial

 

101,166

 

500

 

101,666

 

22.2%

 

91.4%

 

127

 

5,000

 

Other

 

14,137

 

172

 

14,309

 

3.1%

 

12.9%

 

25

 

2,100

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total real estate secured

 

$

433,961

 

$

24,715

 

$

458,676

 

100.0%

 

412.4%

 

829

 

$

47,389

 

 

Commercial

 

Commercial loans, primarily consisting of commercial and industrial (“C&I”) and agricultural loans, totaled $161.1 million at December 31, 2010.  This represents a decline of $14.1 million from that reported at December 31, 2009.  The year over year decline in commercial balances can be attributed to declines in C&I balances stemming in large part from pay-downs and pay-offs as well as the charge-off of problem credits within this segment of the loan portfolio.  Significant pay-downs and pay-offs on C&I credits totaled $9.3 million during 2010, while charge-offs totaled $12.2 million.  Of these charge-offs $3.6 million can be attributed to the full charge-off of one credit due to the current on-going litigation surrounding the borrower and uncertainty regarding full repayment.

 

At December 31, 2010, C&I balances and related unfunded commitments represented 195% of the Bank’s total risk-based capital compared to the 289% reported at December 31, 2009.  The year over year decline can be attributed to the additional capital the Company raised during 2010.  The Company’s credit exposure within the C&I segment remains diverse with respect to the industries that credit has been extended to.

 

At December 31, 2010 agriculture balances totaled $15.2 million, down $2.5 million compared to that reported at December 31, 2009.  The year to date decline can be attributed in large part to the work-through of one problem loan during the second quarter of 2010.  The Company received $1.9 million from the sale of collateral related to this particular loan and subsequently charged-off the remaining balance of $0.9 million.  At December 31, 2010 agriculture balances represented 13.6% of the Bank’s total risk-based capital.  This compares to 21.7% of the Bank’s total risk-based capital as of December 31, 2009.

 

40


 


Table of Contents

 

The following table provides a break-down of the commercial and industrial segment of the commercial loan portfolio as of December 31, 2010:

 

 

 

 

December 31, 2010

 

 

 

Percent of Bank

 

 

 

Single

 

 

 

 

 

 

Undisbursed

 

Total Bank

 

Percent

 

Total Risk

 

Number

 

Largest

 

(dollar amounts in thousands)

 

 

Balance

 

Commitment

 

Exposure

 

Composition

 

Based Capital

 

of Loans

 

Loan

 

Commercial and Industrial

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Agriculture

 

 

$

2,660

 

$

4,101

 

$

6,761

 

3.1%

 

6.1

%

42

 

$

2,000

 

Oil gas and utilities

 

 

2,160

 

1,241

 

3,401

 

1.6%

 

3.1

%

11

 

1,161

 

Construction

 

 

21,595

 

20,029

 

41,624

 

19.2%

 

37.4

%

171

 

5,438

 

Manufacturing

 

 

8,638

 

10,630

 

19,268

 

8.9%

 

17.3

%

90

 

1,675

 

Wholesale and retail

 

 

12,822

 

4,755

 

17,577

 

8.1%

 

15.8

%

124

 

1,148

 

Transportation and warehousing

 

 

2,247

 

295

 

2,542

 

1.2%

 

2.3

%

32

 

596

 

Media and information services

 

 

7,914

 

1,624

 

9,538

 

4.4%

 

8.6

%

28

 

4,500

 

Financial services

 

 

7,987

 

2,717

 

10,704

 

4.9%

 

9.6

%

50

 

1,500

 

Real estate / rental and leasing

 

 

19,163

 

6,739

 

25,902

 

11.9%

 

23.3

%

108

 

3,500

 

Professional services

 

 

19,211

 

9,158

 

28,369

 

13.1%

 

25.5

%

170

 

2,925

 

Healthcare / medical

 

 

15,405

 

7,010

 

22,415

 

10.3%

 

20.2

%

117

 

11,355

 

Restaurants / hospitality

 

 

22,381

 

2,165

 

24,546

 

11.3%

 

22.1

%

120

 

6,000

 

All other

 

 

3,628

 

614

 

4,242

 

2.0%

 

3.8

%

75

 

1,550

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Commercial and industrial

 

 

$

145,811

 

$

71,078

 

$

216,889

 

100.0%

 

195.1

%

1,138

 

$

43,348

 

 

Construction

 

At December 31, 2010, construction balances were $43.9 million, $21.0 million less than that reported at December 31, 2009. The decline in construction balances can be attributed in large part to the re-classification of several large hospitality and commercial construction loans to commercial real estate, following the completion of the underlying projects. Contributing further to the decline within this category was the continuation of problem asset resolution, with charge-offs of $1.3 million, payments received on loans from the liquidation of underlying collateral totaling $4.2 million and transfers to foreclosed collateral totaling $0.9 million.

 

At December 31, 2010, total construction balances represented 39.5% of the Bank’s total risk-based capital.  This compares to the 79.7% reported at December 31, 2009.  Total construction commitments represented 48.1% of the Bank’s total risk-based capital at December 31, 2010.  This compares to the 103.8% reported at December 31, 2009.  The significant decline in these ratios can be attributed to the additional capital the Company raised during 2010.

 

Construction loans are typically granted for a one year period and are amortized over a period not more than 30 years with 10 to 15 year maturities.

 

All loans the Bank originates that are considered construction or for acquisition and development are monitored by a construction budget.  Draw requests are aligned with monthly projections and reviewed against documents submitted by the borrower.  In addition a third party construction inspector conducts regular on-site visits to the project site and provides a written report comparing the loan balance to work completed, budget accuracy, as well as the adequacy of funds left to disburse against the remaining costs to complete the project.

 

As part of its ongoing monitoring of acquisition and development loans, the Bank periodically evaluates the appropriateness of continued use of interest reserves.  Various factors are considered by the Bank when determining the continued use of an interest reserve with focus placed on certain “red flags” during the life-cycle of acquisition and development projects (acquisition, development, and construction).  Such red flags are designed to alert the Bank to potential significant delays or execution risk for the overall project, which would indicate that continued use of an interest reserve is not appropriate, and include such things as the borrower’s delay, neglect, or failure to: (1) perform appropriate engineering and environmental studies, (2) prepare site plans, (3) submit formal applications to relevant planning and zoning authorities, (4) subdivide, level, or grade the site, (5) build out required site improvements, and (6) properly manage the construction phase of the project.

 

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Table of Contents

 

As of December 31, 2010 there were a total of six loans with interest reserves.  The aggregate interest reserve balance associated with these loans was $0.4 million as of December 31, 2010, compared to the $1.1 million reported at December 31, 2009.  The differences in underwriting practices for loans with interest reserves versus those without interest reserves are nominal.  Construction and development loans are underwritten by examining the various financial and environmental factors specific to the project in need of financing.  The viability of the project is then assessed against the financial strength of the sponsor/guarantor and their historical track record of performance.  This process is essentially the same whether the proposed loan will include an interest reserve or not.

 

At December 31, 2010 the outstanding balance of loans with an interest reserve totaled $18.1 million, compared to the $29.3 million reported at December 31, 2009. As of December 31, 2010 two loans totaling $1.5 million were non-accruing.

 

The following provides a break-down of the Bank’s construction portfolio as of December 31, 2010:

 

 

 

 

December 31, 2010

 

 

 

Percent of Bank

 

 

 

Single

 

 

 

 

 

 

Undisbursed

 

Total Bank

 

Percent

 

Total Risk

 

Number

 

Largest

 

(dollar amounts in thousands)

 

 

Balance

 

Commitment

 

Exposure

 

Composition

 

Based Capital

 

of Loans

 

Loan

 

Construction

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Single family residential

 

 

$

11,525

 

$

4,298

 

$

15,823

 

29.5%

 

14.2%

 

18

 

$

3,325

 

Single family residential - Spec.

 

 

2,391

 

109

 

2,500

 

4.7%

 

2.2%

 

2

 

1,750

 

Multi-family

 

 

2,218

 

-

 

2,218

 

4.1%

 

2.0%

 

2

 

1,751

 

Commercial

 

 

27,785

 

5,243

 

33,028

 

61.7%

 

29.7%

 

11

 

7,600

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total construction

 

 

$

43,919

 

$

9,650

 

$

53,569

 

100.0%

 

48.1%

 

33

 

$

14,426

 

 

Land

 

At December 31, 2010, land balances totaled $30.7 million, representing a decline of $22.1 million from that reported at December 31, 2009.  The decline can be attributed to several factors including charge-offs of $3.1 million, transfers to foreclosed collateral of $4.7 million and payments received from the sale of collateral of problem loans of $5.9 million.  Additionally, the largest note within this segment was bifurcated into two separate notes in the absence of meaningful demand for tract construction which was the underlying purpose of the loan.  The re-financing of this note resulted in a new $5.4 million credit within the C&I segment and a corresponding pay-down within the tract land category.  C&I financing was made available for a rock quarry operation that developed on the site of the project in the absence of demand for tract construction.  Recent appraisals of the underlying collateral indicate the loans are well secured and the borrower continues to perform under the terms of the respective notes.

 

At December 31, 2010 total land loan balances represented 27.6% of the Bank’s total risk-based capital compared to the 64.8% reported at December 31, 2009.  Total land commitments represented 28.9% of the Bank’s total-risked based capital at December 31, 2010 compared to the 65.8% reported at December 31, 2009.   The significant decline in these ratios can be attributed to the additional capital the Company raised in 2010 and very limited new loan originations.

 

The following provides a break-down of the Bank’s land portfolio as of December 31, 2010:

 

 

 

 

December 31, 2010

 

 

 

Percent of Bank

 

 

 

Single

 

 

 

 

 

 

Undisbursed

 

Total Bank

 

Percent

 

Total Risk

 

Number

 

Largest

 

(dollar amounts in thousands)

 

 

Balance

 

Commitment

 

Exposure

 

Composition

 

Based Capital

 

of Loans

 

Loan

 

Land

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Single family residential

 

 

$

6,068

 

$

233

 

$

6,301

 

19.6%

 

5.7%

 

29

 

$

1,000

 

Single family residential - Spec.

 

 

708

 

-

 

708

 

2.2%

 

0.6%

 

5

 

271

 

Tract

 

 

14,199

 

-

 

14,199

 

44.2%

 

12.8%

 

9

 

7,521

 

Commercial

 

 

8,792

 

1,185

 

9,977

 

31.1%

 

9.0%

 

15

 

1,500

 

Hospitality

 

 

918

 

-

 

918

 

2.9%

 

0.8%

 

2

 

644

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total land

 

 

$

30,685

 

$

1,418

 

$

32,103

 

100.0%

 

28.9%

 

60

 

$

10,936

 

 

42



Table of Contents

 

Installment

 

At December 31, 2010, installment loans totaled $7.4 million, a decline of $0.9 million from that reported at December 31, 2009.  Loans within this category include loans to individual borrowers including automobile purchases, personal loans, and credit card purchases as well as loans for other consumer goods.  The Bank typically grants such loans to borrowers within the Bank’s primary market area.

 

Loans Held for Sale

 

At December 31, 2010 loans held for sale totaled $11.0 million which represents an increase of $1.5 million from that reported at December 31, 2009.  The year over year increase can be attributed in part to the strong demand the Company has seen for mortgage re-financing, given the lower interest rate environment during 2010.

 

Foreign Loans

 

At December 31, 2010, there were no foreign loans outstanding.

 

Maturities and Sensitivities of Loans to Changes in Interest Rates

 

The following table provides a summary of the approximate maturities and sensitivity to change in interest rates for the loan portfolio as well as information about fixed and variable rate loans at December 31, 2010.  Loans currently at their floor were classified as fixed in the table below:

 

 

 

 

 

 

 

Due Over

 

Due Over

 

Due Over

 

 

 

 

 

 

 

Due Less

 

Due

 

12 Months

 

3 Years

 

5 Years

 

 

 

 

 

 

 

Than 3

 

3 To 12

 

Through

 

Through

 

Through

 

Due Over

 

 

 

(dollar amounts in thousands)

 

Months

 

Months

 

3 Years

 

5 Years

 

15 Years

 

15 Years

 

Total

 

Real Estate Secured

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Multi-family residential

 

$

776

 

$

1,381

 

$

4,743

 

$

2,181

 

$

6,289

 

$

2,267

 

$

17,637

 

Residential 1 to 4 family

 

4,680

 

5,337

 

3,909

 

2,314

 

3,057

 

2,507

 

21,804

 

Home equity line of credit

 

18,219

 

-

 

-

 

200

 

784

 

11,598

 

30,801

 

Commercial

 

35,026

 

25,688

 

57,070

 

35,236

 

192,587

 

2,976

 

348,583

 

Farmland

 

4,075

 

261

 

5,825

 

42

 

4,933

 

-

 

15,136

 

Commercial

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Commercial and industrial

 

37,906

 

38,578

 

26,301

 

30,237

 

12,494

 

295

 

145,811

 

Agriculture

 

6,052

 

4,285

 

1,240

 

427

 

3,164

 

-

 

15,168

 

Other

 

15

 

1

 

36

 

101

 

-

 

-

 

153

 

Construction

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Single family residential

 

5,798

 

5,727

 

-

 

-

 

-

 

-

 

11,525

 

Single family residential - Spec.

 

1,250

 

1,141

 

-

 

-

 

-

 

-

 

2,391

 

Tract

 

-

 

-

 

-

 

-

 

-

 

-

 

-

 

Multi-family

 

479

 

-

 

1,739

 

-

 

-

 

-

 

2,218

 

Hospitality

 

-

 

-

 

-

 

-

 

-

 

-

 

-

 

Commercial

 

3,366

 

13,468

 

6,601

 

-

 

4,350

 

-

 

27,785

 

Land

 

9,342

 

12,113

 

7,650

 

1,539

 

41

 

-

 

30,685

 

Installment loans to individuals

 

1,322

 

615

 

1,646

 

1,488

 

1,340

 

981

 

7,392

 

All other loans (including overdrafts)

 

214

 

-

 

-

 

-

 

-

 

-

 

214

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total loans, gross

 

$

128,520

 

$

108,595

 

$

116,760

 

$

73,765

 

$

229,039

 

$

20,624

 

$

677,303

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Variable rate loans

 

69,118

 

21,908

 

26,710

 

19,393

 

1,778

 

-

 

138,907

 

Fixed rate loans

 

59,402

 

86,687

 

90,050

 

54,372

 

227,261

 

20,624

 

538,396

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total loans, gross

 

$

128,520

 

$

108,595

 

$

116,760

 

$

73,765

 

$

229,039

 

$

20,624

 

$

677,303

 

 

43



Table of Contents

 

Summary of Market Condition

 

The current recessive economic conditions resulted in a decline in loan demand which largely contributed to contraction in the loan portfolio during 2010.  Economic pressures have also resulted in an overall decline in business activity which has impacted some borrowers to whom the Company has extended credit. The Company realizes that a continued decline in the national, state and local economies may further impact such borrowers, as well as the values of real estate within our market footprint used to secure certain loans.  As such, Management continues to closely monitor the credits within the Company’s commercial and commercial real estate segments of the loan portfolio for additional signs of deterioration.  The Bank employs stringent lending standards and remains very selective with regard to loan originations including commercial real estate, real estate construction, land and commercial loans that it chooses to originate in an effort to effectively manage risk in this difficult credit environment.  The Company has devoted considerable resources to monitoring credit in order to take appropriate steps when and if necessary to mitigate any material adverse impacts on the Company.

 

Credit Quality

 

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

 

The credit quality of the loan portfolio is impacted by numerous factors including the economic environment in the markets the Company operates in which can have a direct impact on the value of real estate securing collateral dependent loans. Weak economic conditions have also impacted certain borrowers the Company has extended credit to, making it difficult for those borrowers to continue to make timely repayment on their loans.  An inability of certain borrowers to continue to perform under the original terms of their respective loan agreements in conjunction with declines in real estate collateral values may result in increases in provisions for loan losses that have an adverse impact on the Company’s operating results.

 

See also Note 3. Loans, of the consolidated financial statements, filed on this Form 10-K, for a more detailed discussion concerning credit quality, including the Company’s related policy.

 

Allowance for Loan and Lease Losses

 

The Company maintains an allowance for loan losses at a level considered by Management to be adequate to provide for probable losses as of the balance sheet date.  The allowance is comprised of three components: specific credit allocation, general portfolio allocation and subjectively determined allocation.  The allowance is increased by provisions for loan losses charged to earnings and decreased by loan charge-offs, net of recovered balances.  Please see Note 5. Allowance for Loan Losses, of the consolidated financial statements, filed on this Form 10-K for a detailed discussion concerning the Company’s methodology for determining an adequate allowance.  Please also see Note 1. Summary of Significant Accounting Policies and Note 4. Allowance for Loan Losses of the consolidated financial statements for additional discussion concerning the allowance for loan losses, loan charge-offs, and credit risk management.

 

The determination of the amount of the allowance and any corresponding increase or decrease in the level of provisions for loan losses is based on Management’s best estimate of the current credit quality of the loan portfolio and any probable inherent losses as of the balance sheet date.  The nature of the process in which Management determines the appropriate level of the allowance involves the exercise of considerable judgment.  While Management utilizes its best judgment and all available information in determining the adequacy of the allowance, the ultimate adequacy of the allowance is dependent upon a variety of factors beyond the Company’s control, including but not limited to, the performance of the loan portfolio, changes in current and future economic conditions and the view of regulatory agencies regarding the level of classified assets.  Continued weakness in economic conditions and any other factor that may adversely affect credit quality result in higher levels of past due and non-accruing loans, defaults and additional loan charge-offs which may require additional provisions for loan losses in future periods and increased allowance for loan losses.

 

44



Table of Contents

 

For reporting purposes, the Company allocates the allowance for loan losses across product types within the loan portfolio.  However, substantially all of the allowance is available to absorb all credit losses without restriction, unless specific reserves have been established.  The following table provides a summary of the allowance for loan losses and its allocation to each major loan category of the loan portfolio as well as the percentage that each major category comprises as compared to total gross loan balances as of December 31, 2010, 2009, 2008, 2007, and 2006:

 

 

 

2010

 

2009

 

2008

 

2007

 

2006

 

 

 

 

 

Percent

 

 

 

Percent

 

 

 

Percent

 

 

 

Percent

 

 

 

Percent

 

 

 

Amount

 

of Total

 

Amount

 

of Total

 

Amount

 

of Total

 

Amount

 

of Total

 

Amount

 

of Total

 

(dollars amounts in thousands)

 

Allocated

 

Loans

 

Allocated

 

Loans

 

Allocated

 

Loans

 

Allocated

 

Loans

 

Allocated

 

Loans

 

Real Estate Secured

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Multi-family residential

 

$

118

 

2.6%

 

$

119

 

2.8%

 

$

250

 

2.4%

 

$

129

 

2.1%

 

$

86

 

2.1%

 

Residential 1 to 4 family

 

447

 

3.2%

 

264

 

3.5%

 

364

 

3.5%

 

246

 

4.0%

 

49

 

1.2%

 

Home equity line of credit

 

219

 

4.5%

 

179

 

4.1%

 

406

 

3.9%

 

172

 

2.8%

 

98

 

2.4%

 

Commercial

 

10,862

 

51.6%

 

6,081

 

46.5%

 

4,354

 

41.8%

 

2,747

 

44.7%

 

1,878

 

46.0%

 

Farmland

 

239

 

2.2%

 

208

 

1.8%

 

167

 

1.6%

 

117

 

1.9%

 

167

 

4.1%

 

Commercial

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Commercial and industrial

 

9,024

 

21.6%

 

4,635

 

21.6%

 

2,405

 

23.1%

 

1,339

 

21.8%

 

665

 

16.3%

 

Agriculture

 

482

 

2.2%

 

178

 

2.4%

 

208

 

2.0%

 

117

 

1.9%

 

110

 

2.7%

 

Other

 

1

 

0.0%

 

1

 

0.0%

 

10

 

0.1%

 

6

 

0.1%

 

4

 

0.1%

 

Construction

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Single family residential

 

632

 

1.7%

 

304

 

2.1%

 

177

 

1.7%

 

98

 

1.6%

 

69

 

1.7%

 

Single family residential - Spec.

 

75

 

0.4%

 

46

 

0.5%

 

239

 

2.3%

 

190

 

3.1%

 

98

 

2.4%

 

Tract

 

-

 

0.0%

 

190

 

0.3%

 

42

 

0.4%

 

18

 

0.3%

 

-

 

0.0%

 

Multi-family

 

349

 

0.3%

 

90

 

0.3%

 

94

 

0.9%

 

92

 

1.5%

 

49

 

1.2%

 

Hospitality

 

-

 

0.0%

 

107

 

2.0%

 

281

 

2.7%

 

166

 

2.7%

 

45

 

1.1%

 

Commercial

 

297

 

4.1%

 

270

 

3.7%

 

333

 

3.2%

 

307

 

5.0%

 

486

 

11.9%

 

Land

 

2,000

 

4.5%

 

1,644

 

7.2%

 

947

 

9.1%

 

313

 

5.1%

 

220

 

5.4%

 

Installment loans to individuals

 

166

 

1.1%

 

40

 

1.1%

 

125

 

1.2%

 

80

 

1.3%

 

53

 

1.3%

 

All other loans (including overdrafts)

 

29

 

0.0%

 

16

 

0.1%

 

10

 

0.1%

 

6

 

0.1%

 

4

 

0.1%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total allowance for loan losses

 

$

24,940

 

100.0%

 

$

14,372

 

100.0%

 

$

10,412

 

100.0%

 

$

6,143

 

100.0%

 

$

4,081

 

100.0%

 

 

Allocation of the Allowance for Loan Losses

 

The allowance for loan losses increased $10.6 million or 73.5% during 2010.  The increase in the allowance can be attributed to increased charge-offs, continued elevated levels of non-performing and classified loans relative to historical periods and sustained weakness in general economic conditions.  At December 31, 2010 the level of classified loans totaled $75.5 million which was up slightly from the $75.4 million reported at December 31, 2009.  A continuation of the elevated level of classified loans, coupled with an increase in estimated loss factors applied to such balances, contributed significantly to the year over year increase in the allowance for loan losses.  Specifically, the level of classified commercial and industrial, and commercial real estate loans increased $12.8 million to $57.8 million at December 31, 2010.  Given these segments of the loan portfolio accounted for $15.4 million or 73.3% of total net charge-offs in 2010, the Company increased loss factors for these areas of the portfolio.  At December 31, 2010 commercial and industrial, and commercial real estate reserves account for $19.8 million or 79.5% of the total allowance for loan losses.  This compares to the $10.7 million or 74.6% of total reserves allocated to the commercial and industrial and commercial real estate segments at December 31, 2009.  Contributing further to the year over year increase in the allowance for loan losses was increase in the dollar amount of reserves allocated to the construction and land segments.  Although the level of classified construction and land balances declined $11.1 million to $7.9 million at December 31, 2010, the Company significantly increased loss factors for such credits given our past loss experience for such credits has been more severe on a relative basis compared to other segments of the loan portfolio.

 

45



Table of Contents

 

As mentioned, sustained weakness in general economic conditions during 2010 also contributed to the year over year increase in the level of the allowance for loan losses.  Weakened economic conditions in the Company’s market area has resulted in increased job losses, contributing to a decline in economic activity and a protracted decline in the value of real estate used as collateral.  These pressures have increased the potential for losses as the ability for certain borrowers’ to service debt has become strained and collateral values remained depressed.  As a result, the Company further increased the allowance for commercial and industrial, commercial real estate, and construction / land loans to reflect the impact that such pressures could have on borrowers within those segments.

 

The allowance for loan losses represented 3.68% of total gross loans at December 31, 2010 as compared to 1.97% reported at December 31, 2009.  As of December 31, 2010 Management believes the allowance for loan losses was sufficient to cover current estimable losses in the Company’s loan portfolio.

 

Summary of Credit Losses

 

For the year ended December 31, 2010 charge-offs totaled $23.9 million, representing an increase of $3.6 million or 18.1% from that reported for 2009.  Losses occurred primarily in the commercial and industrial, commercial real estate, and construction / land segments of the portfolio.  Net charge-offs totaled $21.0 million and increased $0.9 million or 4.3% during 2010 from that reported for 2009.

 

Approximately 51.4% of losses during 2010 occurred in the commercial and industrial portfolio, of which $4.4 million or 36.3% can be attributed to losses incurred on two large relationships.  Approximately $3.6 million of these charge-offs can be attributed to one loan, where the Company charged-off the entire remaining balance due to the on-going litigation surrounding the borrower and the uncertainty of repayment.  The remaining $0.8 million of these two significant losses is attributable to the full charge-off of the remaining balance of the loan.  However, after working with the borrower, the Company was able to recover $0.5 million of the loss in December 2010.  Management is currently working to fully recover the borrower’s remaining outstanding balance on the loan.  Other losses in the commercial and industrial portfolio are primarily attributable to smaller business lines of credit.  Such losses averaged $0.1 million per loan.

 

Commercial real estate losses accounted for 18.9% of total losses during 2010.  Of these losses $1.5 million or 33.6% can be attributed to one relationship.  The Company subsequently took possession of the collateral and is actively working to liquidate it.  Other losses within the commercial real estate portfolio averaged $0.2 million per loan and have primarily resulted from weakened economic conditions and declines in property values securing such loans.

 

Construction and land losses accounted for 17.8% of total losses during 2010.  Approximately $1.3 million or 30.4% of these losses can be attributed to one relationship and is related to a housing development in the Company’s market area.  Other losses within the construction and land portfolio are related to the construction of personal, speculative development, and multi-family residential properties and have resulted from the economic pressures placed on certain borrowers in conjunction with the significant decline witnessed in the values of construction and land properties over the last few years.  Losses in the construction and land portfolio, exclusive of the one significant loss mentioned, averaged $0.1 million per loan.

 

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The following table provides an analysis of the allowance for loan losses for the years ended December 31, 2010, 2009, 2008, 2007 and 2006:

 

 

 

For The Years Ended December 31,

 

(dollars amounts in thousands)

 

2010

 

2009

 

2008

 

2007

 

2006

 

Balance, beginning of period

 

$

14,372

 

$

10,412

 

$

6,143

 

$

4,081

 

$

3,881

 

Balance of Business First National Bank, beginning of period

 

-

 

-

 

-

 

1,381

 

-

 

Charge-offs:

 

 

 

 

 

 

 

 

 

 

 

Real Estate Secured

 

 

 

 

 

 

 

 

 

 

 

Multi-family residential

 

-

 

-

 

-

 

-

 

-

 

Residential 1 to 4 family

 

753

 

558

 

555

 

-

 

-

 

Home equity line of credit

 

10

 

-

 

-

 

-

 

-

 

Commercial

 

4,502

 

339

 

340

 

-

 

-

 

Farmland

 

235

 

-

 

-

 

-

 

-

 

Commercial

 

 

 

 

 

 

 

 

 

 

 

Commercial and industrial

 

12,249

 

5,816

 

3,854

 

233

 

508

 

Agriculture

 

1,489

 

2,224

 

-

 

-

 

-

 

Other

 

-

 

-

 

-

 

-

 

-

 

Construction

 

1,259

 

2,218

 

1,837

 

16

 

-

 

Land

 

2,985

 

8,886

 

1,434

 

-

 

-

 

Installment loans to individuals

 

371

 

163

 

20

 

-

 

44

 

All other loans

 

-

 

-

 

36

 

-

 

9

 

 

 

 

 

 

 

 

 

 

 

 

 

Total charge-offs

 

23,853

 

20,204

 

8,076

 

249

 

561

 

Recoveries:

 

 

 

 

 

 

 

 

 

 

 

Real Estate Secured

 

 

 

 

 

 

 

 

 

 

 

Multi-family residential

 

-

 

-

 

-

 

-

 

-

 

Resiential 1 to 4 family

 

87

 

21

 

2

 

-

 

-

 

Home equity line of credit

 

-

 

-

 

-

 

-

 

-

 

Commercial

 

27

 

-

 

-

 

-

 

-

 

Farmland

 

6

 

-

 

-

 

-

 

-

 

Commercial

 

 

 

 

 

 

 

 

 

 

 

Commercial and industrial

 

1,349

 

54

 

107

 

191

 

101

 

Agriculture

 

87

 

4

 

-

 

-

 

-

 

Other

 

-

 

-

 

-

 

-

 

-

 

Construction

 

10

 

16

 

-

 

70

 

-

 

Land

 

1,311

 

-

 

-

 

-

 

-

 

Installment loans to individuals

 

13

 

2

 

1

 

3

 

56

 

All other loans

 

-

 

1

 

20

 

6

 

4

 

 

 

 

 

 

 

 

 

 

 

 

 

Total recoveries

 

2,890

 

98

 

130

 

270

 

161

 

 

 

 

 

 

 

 

 

 

 

 

 

Net charge-offs / (recoveries)

 

20,963

 

20,106

 

7,946

 

(21

)

400

 

 

 

 

 

 

 

 

 

 

 

 

 

Provisions for loan losses

 

31,531

 

24,066

 

12,215

 

660

 

600

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, end of period

 

$

24,940

 

$

14,372

 

$

10,412

 

$

6,143

 

$

4,081

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross loans, end of period

 

$

677,303

 

$

728,679

 

$

680,147

 

$

613,217

 

$

444,983

 

Allowance for loan losses to total gross loans

 

3.68%

 

1.97%

 

1.53%

 

1.00%

 

0.92%

 

Net charge-offs to average loans

 

2.96%

 

2.83%

 

1.21%

 

0.00%

 

0.10%

 

Non-performing loans to allowance for loan losses

 

131.59%

 

241.28%

 

179.36%

 

5.50%

 

1.35%

 

 

Non-Performing Loans

 

Non-performing assets comprise loans placed on non-accrual, loans that are 90 days or more past due and still accruing, and foreclosed assets.  Generally, the Company places loans on non-accruing status when (1) the full and timely collection of all amounts due become uncertain, (2) a loan becomes 90 days or more past due (unless well-secured and in the process of collection) or (3) any portion of outstanding principal has been charged-off.

 

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See also Note 1. Summary of Significant Accounting Policies and Note 3. Loans of the consolidated financial statements, filed on this Form 10-K, for additional discussion concerning non-performing loans as well as discussion concerning credit quality.

 

The following table provides a summary of the Bank’s non-performing assets as of December 31, 2010 and 2009:

 

 

 

December 31,

 

Variance

 

(dollar amounts in thousands)

 

2010

 

2009

 

Dollar

 

Percent

 

 

 

 

 

 

 

 

 

 

 

Loans delinquent 90 days or more and still accruing

 

$

-

 

$

151

 

$

(151

)

-100.0%

 

 

 

 

 

 

 

 

 

 

 

Non Accruing Loans:

 

 

 

 

 

 

 

 

 

Commercial real estate

 

$

17,752

 

$

11,035

 

$

6,717

 

60.9%

 

Residential 1-4 family

 

748

 

1,147

 

(399

)

-34.8%

 

Home equity lines of credit

 

1,019

 

320

 

699

 

218.4%

 

Commercial and industrial

 

3,921

 

8,429

 

(4,508

)

-53.5%

 

Agriculture

 

246

 

3,172

 

(2,926

)

100.0%

 

Farmland

 

2,626

 

-   

 

2,626

 

100.0%

 

Construction

 

3,040

 

3,838

 

(798

)

-20.8%

 

Land

 

3,371

 

10,182

 

(6,811

)

-66.9%

 

Other

 

96

 

47

 

49

 

104.3%

 

 

 

 

 

 

 

 

 

 

 

Total non-accruing loans

 

$

32,819

 

$

38,170

 

$

(5,351

)

-14.0%

 

 

 

 

 

 

 

 

 

 

 

Other real estate owned

 

$

6,668

 

$

946

 

$

5,722

 

604.9%

 

 

 

 

 

 

 

 

 

 

 

Total non-performing assets

 

$

39,487

 

$

39,267

 

$

220

 

0.6%

 

 

 

 

 

 

 

 

 

 

 

Ratio of allowance for loan losses to total gross loans

 

3.68%

 

1.97%

 

 

 

 

 

Ratio of allowance for loan losses to total non-performing loans

 

75.99%

 

37.50%

 

 

 

 

 

Ratio of non-performing loans to total gross loans

 

4.85%

 

5.26%

 

 

 

 

 

Ratio of non-performing assets to total assets

 

4.02%

 

4.15%

 

 

 

 

 

 

The following table reconciles the change in total non-accruing balances for the year ended December 31, 2010:

 

 

 

Balance

 

Additions to

 

 

 

Transfers to

 

Returns to

 

 

 

Balance

 

 

 

December 31,

 

Non-Accruing

 

Net

 

Foreclosed

 

Preforming

 

 

 

December 31,

 

(dollar amounts in thousands)

 

2009

 

Balances

 

Paydowns

 

Collateral

 

Status

 

Charge-offs

 

2010

 

Real Estate Secured

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Multi-family residential

 

$

-

 

$

-

 

$

-

 

$

-

 

$

-

 

$

-

 

$

-

 

Residential 1 to 4 family

 

1,147

 

858

 

(267

)

(235

)

-

 

(755

)

748

 

Home equity line of credit

 

320

 

709

 

(2

)

-

 

-

 

(8

)

1,019

 

Commercial

 

11,035

 

24,967

 

(3,912

)

(6,303

)

(3,517

)

(4,518

)

17,752

 

Farmland

 

-

 

3,810

 

(372

)

(577

)

-

 

(235

)

2,626

 

Commercial

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Commercial and industrial

 

8,429

 

9,997

 

(1,588

)

(288

)

(381

)

(12,248

)

3,921

 

Agriculture

 

3,172

 

1,160

 

(2,599

)

-

 

-

 

(1,487

)

246

 

Other

 

-

 

-

 

-

 

-

 

-

 

-

 

-

 

Construction

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Single family residential

 

940

 

1,310

 

(610

)

-

 

-

 

(329

)

1,311

 

Single family residential - Spec.

 

683

 

1,250

 

-

 

(538

)

-

 

(145

)

1,250

 

Tract

 

2,215

 

-

 

(1,646

)

(363

)

-

 

(206

)

-

 

Multi-family

 

-

 

900

 

(4

)

-

 

-

 

(417

)

479

 

Hospitality

 

-

 

-

 

-

 

-

 

-

 

-

 

-

 

Commercial

 

-

 

2,080

 

(1,919

)

-

 

-

 

(161

)

-

 

Land

 

10,182

 

6,959

 

(5,925

)

(4,726

)

-

 

(3,119

)

3,371

 

Installment loans to individuals

 

47

 

423

 

(95

)

(35

)

-

 

(244

)

96

 

All other loans

 

-

 

-

 

-

 

-

 

-

 

-

 

-

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Totals

 

$

38,170

 

$

54,423

 

$

(18,939

)

$

(13,065

)

$

(3,898

)

$

(23,872

)

$

32,819

 

 

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Table of Contents

 

Non-performing loans totaled $32.8 million as of December 31, 2010, representing a decline of $5.4 million or 14.0% from that reported at December 31, 2009.  During 2010 the Company continued to tighten lending standards and intensified efforts to identify and resolve problem credits.  One outcome from these efforts was accelerating the transfer of loans to non-accrual status.  During 2010 the Company placed $54.4 million in loans on non-accrual.  The results of the Company’s work-through efforts and greater resources allocated to the resolution of problem assets were $18.9 million in principal pay-downs on non-performing loans, $3.9 million in return of loans to accruing status and $13.1 million in transfers to foreclosed collateral.  As of December 31, 2010, $28.3 million or 86.1% of non-accruing loans were secured by real estate with the average loan outstanding to current estimated collateral value of 77.4% as of December 31, 2010.

 

Continued softness in the economy and in real estate markets have resulted in an increase in the number of and dollar volume of non-performing assets relative to historical periods.  As evidenced in the tables above, current economic conditions have significantly impacted certain borrowers in the commercial real estate, commercial and industrial, and construction / land segments of the loan portfolio.  Approximately $28.1 million or 85.6% of all non-accruing loans were commercial real estate, commercial and industrial and construction / land as of December 31, 2010.  This is down $5.4 million or 16.1% from such balances reported at December 31, 2009.  The year over year decline can be attributed to the work-through of problem credits in the construction / land segment, including pay-downs and transfers to foreclosed collateral as well as charge-offs occurring in the commercial and industrial segment.

 

The recorded investment in impaired loans as of December 31, 2010 was $35.6 million, down $12.4 million since prior year-end.  Impaired loans at December 31, 2010 included troubled debt restructurings (“TDRs”) of $10.4 million which represented a decrease of $2.5 million since December 31, 2009.  Of the balance of TDRs at December 31, 2010, $2.8 million were accruing.  In a majority of cases, the Company has granted concessions regarding interest rates, payment structure and maturity.  Forgone interest related to TDRs totaled $0.2 million for the year ended December 31, 2010 and $0.1 million for the year ended December 31, 2009.  As of December 31, 2010, the Company was not committed to lend any additional funds to borrowers whose obligations to the Company were restructured.

 

While credit quality is consistently monitored, the Company has implemented additional precautionary actions to minimize future losses. The Company is unable to be certain that it will not experience an increase in problem loans, given the continued weakness in the economy and the stress it imposes on borrowers.

 

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Table of Contents

 

Other Real Estate Owned (“OREO”)

 

The following table provides a summary for the year to date change in the balance of OREO as of December 31, 2010:

 

 

 

Balance

 

 

 

 

 

 

 

Balance

 

 

 

December 31,

 

 

 

 

 

 

 

December 31,

 

(dollars in thousands)

 

2009

 

Additions

 

Sales

 

Writedowns

 

2010

 

Real Estate Secured

 

 

 

 

 

 

 

 

 

 

 

Multi-family residential

 

$

-

 

$

-

 

$

-

 

$

-

 

$

-

 

Residential 1 to 4 family

 

367

 

235

 

(198

)

(244

)

160

 

Home equity line of credit

 

-

 

-

 

-

 

-

 

-

 

Commercial

 

165

 

6,303

 

(666

)

(1,921

)

3,881

 

Farmland

 

-

 

577

 

(577

)

-

 

-

 

Commercial

 

 

 

 

 

 

 

 

 

 

 

Commercial and industrial

 

-

 

538

 

-

 

(2

)

536

 

Agriculture

 

-

 

-

 

-

 

-

 

-

 

Other

 

-

 

-

 

-

 

-

 

-

 

Construction

 

 

 

 

 

 

 

 

 

 

 

Single family residential

 

-

 

-

 

-

 

-

 

-

 

Single family residential - Spec.

 

-

 

538

 

-

 

(63

)

475

 

Tract

 

-

 

363

 

-

 

(112

)

251

 

Multi-family

 

-

 

-

 

-

 

-

 

-

 

Hospitality

 

-

 

-

 

-

 

-

 

-

 

Commercial

 

-

 

-

 

-

 

-

 

-

 

Land

 

414

 

4,726

 

(2,465

)

(1,310

)

1,365

 

Installment loans to individuals

 

-

 

-

 

-

 

-

 

-

 

All other loans

 

-

 

-

 

-

 

-

 

-

 

 

 

 

 

 

 

 

 

 

 

 

 

Totals

 

$

946

 

$

13,280

 

$

(3,906

)

$

(3,652

)

$

6,668

 

 

As of December 31, 2010, the balance of OREO was $6.7 million, an increase of $5.7 million from that reported at December 31, 2009.  During 2010 the Company transferred $13.3 million in non-performing loan balances to OREO status following any related charge-offs, and was able to dispose of $3.9 million of its OREO through sale of the related assets.  Two categories that accounted for the majority of OREO balances during 2010 were commercial real estate and land.  The majority of the increase in commercial real estate OREO can be attributed to two separate properties within the Company’s primary market area.  Write-downs of $1.7 million can be attributed to these two properties which followed receipt of current appraisals.  The Company is actively marketing these properties for eventual sale.  Approximately $3.5 million of the increase in land OREO can be attributed to two relationships.

 

The purpose of these related loans was for tract and hospitality construction / development.  The Company wrote-down one of these properties by $0.8 million during 2010 following the receipt of updated appraisal information.  The Company sold two of these properties during 2010 for $2.1 million and is marketing the remaining significant property within this category for eventual sale.

 

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Table of Contents

 

Other Earning Assets

 

The following table summarizes the balances of the Company’s other earning assets as of December 31, 2010, 2009 and 2008:

 

 

 

2010

 

2009

 

2008

 

(dollar amounts in thousands)

 

Amount

 

Percent

 

Amount

 

Percent

 

Amount

 

Percent

 

Federal Home Loan Bank stock

 

$

5,180

 

2.2

%

$

5,828

 

3.9

%

$

5,123

 

8.2

%

Securities available for sale

 

224,966

 

94.5

%

121,180

 

81.6

%

50,762

 

81.0

%

Interest bearing due from

 

4,264

 

1.8

%

17,046

 

11.5

%

-

 

0.0

%

Federal funds sold

 

3,500

 

1.5

%

4,350

 

2.9

%

6,650

 

10.6

%

Interest bearing deposits with other banks

 

119

 

0.0

%

119

 

0.1

%

119

 

0.2

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total other earning assets

 

$

238,029

 

100.0

%

$

148,523

 

100.0

%

$

62,654

 

100.0

%

 

Federal Home Loan Bank Stock (“FHLB”)

 

As a member of the Federal Home Loan Bank of San Francisco, the Bank is required to hold a specified amount of FHLB capital stock based on the level of borrowings the Bank has obtained from the FHLB.  As such, the amount of FHLB stock the Bank carries can vary from one period to another based on, among other things, the current liquidity needs of the Bank.  At December 31, 2010, the Bank held $5.2 million in FHLB stock, a decline of $0.6 million from that reported at December 31, 2009.

 

Investment Securities

 

The Company manages its securities portfolio to provide liquidity and as an additional source for earnings. The Bank has an Asset/Liability Committee that develops investment policies based upon its operating needs and market circumstance. The Bank’s investment policy is formally reviewed and approved annually by the Board of Directors. The Asset/Liability Committee is responsible for reporting and monitoring compliance with the investment policy and provides reports to the Bank’s Board of Directors on a regular basis.  The Company’s investment portfolio is comprised primarily of securities issued by U.S. Government sponsored agencies, private label mortgage backed securities and municipal bonds.  Disclosures concerning the amortized cost, gross unrealized gains and losses and fair values of the Company’s investments portfolio are provided under Note 2 Investment Securities, of the consolidated financial statements, filed on this Form 10-K.

 

At December 31, 2010, the balance of the investment portfolio was $225.0 million or $103.8 million higher than that reported at December 31, 2009.  The Company made purchases totaling $164.9 million during 2010.  A decline in new loan originations coupled with the $56.0 million in net proceeds the Company received from its March 2010 private placement, contributed significantly to the year over year increase in the balance of the investment portfolio.

 

Securities available for sale are carried at fair value with related unrealized net gains or losses, net of deferred income taxes, recorded as an adjustment to equity capital.  At December 31, 2010 the securities portfolio had net unrealized losses, net of taxes of $1.1 million, substantially unchanged from that reported at December 31, 2009.  Unrealized losses in the investment portfolio in the last two years can be attributed in part to rising longer term interest rates and/or volatile capital markets.

 

At December 31, 2010, the Bank owned seven whole loan private label mortgage-backed securities (“PMBS”) with a remaining principal balance of $10.3 million.  PMBS do not carry a government guarantee (explicit or implicit) and require much more detailed due diligence in the form of pre and post purchase analysis.  All PMBS bonds were rated AAA by one or more of the major rating agencies at the time of purchase. Due to the severe and prolonged downturn in the economy, PMBS bonds have seen deterioration in price, credit quality and liquidity.  At December 31, 2010, three bonds totaling $5.5 million were below investment grade.  All three of these securities are in senior or super senior tranche positions within their respective bond structures which give the Bank priority to underlying cash flows.

 

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Table of Contents

 

As more fully disclosed in Note 2. Investment Securities, of the consolidated financial statements, filed on this Form 10-K, during 2010 the Company performed quarterly analyses with the assistance of an independent third party on several PMBS in the investment portfolio for other than temporary impairment (“OTTI”).  Based on those analyses, the Company recognized $0.2 million in OTTI credit related losses during 2010.  These losses are primarily attributable to one security for which the Company had already realized OTTI in the fourth quarter of 2009.  Total credit related OTTI losses on this one security totaled $0.4 million as of December 31, 2010.

 

The Bank performs monthly analyses on PMBS bonds in the portfolio including, but not limited to, updates on credit enhancements, loan-to-values, credit scores, delinquency rates and default rates. These investment securities continue to demonstrate cash flows as expected based on pre-purchase analyses.  As of December 31, 2010, Management does not believe that losses on PMBS in the portfolio, other than those previously discussed, are other than temporary.

 

All fixed and adjustable rate mortgage pools contain a certain amount of risk related to the uncertainty of prepayments of the underlying mortgages.  Interest rate changes have a direct impact upon prepayment rates.  The Bank uses simulation models to test the average life, duration, market volatility and yield volatility of adjustable rate mortgage pools under various interest rate assumptions to monitor volatility.  Stress tests are performed quarterly.

 

The following table sets forth the maturity distribution of available for sale securities in the investment portfolio and the weighted average yield for each category at December 31, 2010:

 

 

 

 

 

 

 

Weighted

 

 

 

Amortized

 

 

 

Average

 

(dollar amounts in thousands)

 

Cost

 

Fair Value

 

Yield

 

Due in one year or less

 

$

39,815

 

$

40,483

 

1.11

%

Due after one year through five years

 

120,666

 

121,032

 

2.29

%

Due after five years through ten years

 

34,020

 

32,686

 

4.24

%

Due after ten years

 

32,369

 

30,765

 

4.34

%

 

 

 

 

 

 

 

 

Total

 

$

226,870

 

$

224,966

 

2.64

%

 

Deposits and Borrowed Funds

 

The following table sets forth information for the last three fiscal years regarding the composition of deposits at December 31, the average rates paid on each of these categories and the year over year variance from 2009 to 2010:

 

 

 

2010

 

2009

 

 

Variance

 

 

2008

 

 

 

 

 

Average

 

 

 

Average

 

 

 

 

 

 

 

Average

 

(dollar amounts in thousands)

 

Balance

 

Rate Paid

 

Balance (1)

 

Rate Paid

 

Dollar

 

Percent

 

Balance (2)

 

Rate Paid

 

Non interest bearing demand

 

$

182,658

 

0.00

%

$

174,635

 

0.00

%

$

8,023

 

4.59

%

$

147,044

 

0.00

%

Interest bearing demand

 

67,938

 

0.50

%

77,765

 

0.82

%

(9,827

)

-12.64

%

72,952

 

0.60

%

Savings

 

29,144

 

0.26

%

27,166

 

0.24

%

1,978

 

7.28

%

21,835

 

0.81

%

Money market

 

287,120

 

1.00

%

260,671

 

1.44

%

26,449

 

10.15

%

201,701

 

1.93

%

Time deposits

 

231,346

 

1.81

%

235,228

 

2.30

%

(3,882

)

-1.65

%

159,989

 

3.34

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total deposits

 

$

798,206

 

0.94

%

$

775,465

 

1.27

%

$

22,741

 

2.93

%

$

603,521

 

1.61

%

 

(1) Includes $10.2 million in brokered time deposits with an average rate of 1.52%, and $1.0 million in brokered money market balances with an average rate of 0.72%.

 

(2) Includes $20.1 million in brokered time deposits with an average rate of 3.66%, and $28.5 million in brokered money market balances with an average rate of 1.24%.

 

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The following table provides a maturity distribution of certificates of time deposits of $100,000 and over as of December 31, 2010 and 2009:

 

(dollar amounts in thousands)

 

2010

 

2009

 

Less than 3 months

 

$

20,887

 

$

28,748

 

3 to 12 months

 

51,738

 

66,676

 

Over 1 year

 

45,217

 

21,996

 

 

 

 

 

 

 

Total

 

$

117,842

 

$

117,420

 

 

At December 31, 2010 the Bank had 34,185 deposit accounts consisting of non-interest bearing (“demand”), interest-bearing demand and money market accounts with balances totaling $537.7 million for an average balance per account of approximately $16 thousand; 9,550 savings accounts with balances totaling $29.1 million for an average balance per account of approximately $3 thousand; and 5,019 time certificate of deposit accounts, exclusive of brokered, with balances totaling $231.3 million, for an average balance per account of approximately $46 thousand.

 

Total deposit balances were $798.2 million at December 31, 2010, an increase of $22.7 million from that reported at December 31, 2009.  Increased deposit balances can be attributed to higher balances of non-interest bearing demand, money market, savings, and time deposits.  Increases within these categories were partially offset by a decline in interest bearing checking accounts as the Company allowed certain higher cost, more rate sensitive balances to run-off.  The Company continued its focus on gathering and retaining core relationships during 2010 which has helped to reduce the overall cost of funding.  As of December 31, 2010 the Bank had no brokered deposits.  Core deposits (demand, savings, money market and time certificates less than $100,000) represented $680.3 million or 85.2% of total deposits at December 31, 2010 compared to $657.0 million or 84.7% of total deposits at December 31, 2009.  Management’s continued focus on lower cost deposit gathering in 2010 helped to reduce overall cost of funds by 33 basis points to 0.94% from 1.27% reported for 2009.

 

Borrowed Funds

 

The Bank has a variety of sources from which it may obtain secondary funding.  These sources include, among others, the Federal Home Loan Bank (“FHLB”), the Federal Reserve Bank (“FRB”) and credit lines established with correspondent banks.  At December 31, 2010, FHLB borrowings were $45.0 million or $20.0 million lower than that reported at December 31, 2009.  The year over year decline in FHLB borrowing can be attributed to an increase in deposit balances during 2010 and the capital raise in March, 2010 both of which provided the company less need for wholesale funding.  At December 31, 2010, the Bank’s remaining capacity to borrow from the FHLB was $96.7 million while the unused credit line at the FRB was $12.1 million.  Additionally, in September 2004, the Bank issued a Letter of Credit in the amount of $11.7 million which has since been reduced to $11.4 million to a customer to guarantee their performance to other parties.  The Letter of Credit was issued pursuant to a Letter of Credit Reimbursement Agreement between the Bank and the FHLB.  It is collateralized by a blanket lien with the FHLB that includes all qualifying loans on the Bank’s balance sheet.  The letter of credit was renewed in 2010 and will expire in September 2011.  The letter of credit was undrawn as of December 31, 2010.  For additional information related to the Bank’s borrowings with the FHLB, please see Note 9. Borrowings, of the consolidated financial statements filed on this Form 10-K.

 

Capital

 

At December 31, 2010, the balance of stockholders’ equity was $121.3 million or $37.5 million higher than that reported at December 31, 2009.  During 2010 the Company raised $56.0 million in net proceeds in a private placement accounting for the majority of the year over year variance in the balance of shareholders’ equity.  For additional information related to the Company’s March 2010 private placement, see Note 21. Preferred Stock, of the consolidated financial statements, filed on this Form 10-K.

 

Regulatory Capital

 

The Company and its Bank subsidiary seek to maintain strong levels of capital above the “well-capitalized” thresholds as determined by regulatory agencies by an amount commensurate with our risk profile.  The Company’s potential sources of capital include retained earnings and the issuance of equity.  Although the Company and Bank rely primarily on earnings from its operations to generate capital, the absence of earnings in the last two years have required the Company to obtain additional capital through the issuance of preferred and common equity.

 

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As previously mentioned, the Company completed a private placement during 2010 leading to the issuance of 17,279,995 shares of its common stock and 1,189,538 shares of Series C Preferred Stock for total net proceeds of $56.0 million.  Additionally, during 2009 the Company issued 21,000 shares of Series A Senior Preferred Stock to the U.S. Treasury as part of its participation in the CPP for $21.0 million.  The proceeds received from these issuances qualify as Tier I Capital.  For additional information related to the Company’s March 2010 private placement, see Note 21. Preferred Stock, of the consolidated financial statements, filed on this Form 10-K. The Company and its Bank subsidiary were considered “well-capitalized” as of December 31, 2010 and have historically maintained capital levels above the “well-capitalized” threshold.

 

At December 31, 2010, the Company had $8.2 million in Junior Subordinated Deferrable Interest Debentures (the “debt securities”) issued and outstanding.  These securities were issued to Heritage Oaks Capital Trust II.  At December 31, 2010, the Company included $8.0 million of the net Junior Subordinated Debt in its Tier I Capital for regulatory reporting purposes.  For a more detailed discussion regarding these debt securities, see Note 9. Borrowings, of the consolidated financial statements, filed on this Form 10-K.

 

Summarized below are the Company’s and the Bank’s capital ratios at December 31, 2010 and 2009:

 

 

 

Regulatory Standard

 

December 31, 2010

 

December 31, 2009

 

 

 

Adequately

 

Well

 

Heritage Oaks

 

Heritage Oaks

 

Ratio

 

Capitalized

 

Capitalized

 

Bancorp

 

Bank

 

Bancorp

 

Bank

 

Leverage ratio

 

4.00%

 

5.00%

 

10.83%

 

10.52%

 

8.24%

 

7.74%

 

Tier I capital to risk weighted assets

 

4.00%

 

6.00%

 

13.94%

 

13.47%

 

9.59%

 

8.97%

 

Total risk based capital to risk weighted assets

 

8.00%

 

10.00%

 

15.21%

 

14.75%

 

10.85%

 

10.23%

 

 

The Leverage Ratio calculation simply divides common stockholders’ equity (reduced by goodwill and intangible assets) by the total assets.  In the Tier 1 Risk Based Capital Ratio, the numerator is the same as the leverage ratio, but the denominator is the total for “risk-weighted assets.”  Risk-weighted assets are determined by segregating all assets and off balance sheet exposures into different risk categories and weighting them by a percentage ranging from 0% (lowest risk) to 100% (highest risk).  The Total Risk Based Capital Ratio, again, uses “risk-weighted assets” in the denominator, but expands the numerator to include other capital items besides equity such as a limited amount of the loan loss reserve, long-term capital debt, certain types of preferred equity and other instruments.  The Bank’s capital ratios were also in compliance with capital requirements of a Leverage Ratio of 10.0% and a Total Risk Based Capital Ratio of 11.5% as stipulated by the Consent Order.

 

Liquidity

 

The objective of liquidity management is to ensure the continuous availability of funds to meet the demands of depositors, investors and borrowers.  Asset liquidity is primarily derived from loan payments and the maturity of other earning assets.  Liquidity from liabilities is obtained primarily from the receipt of new deposits.  The Bank’s Asset Liability Committee (“ALCO”) is responsible for managing the on and off-balance sheet commitments to meet the cash needs of customers while maintaining sufficient liquidity and diversity of funding sources to allow the Bank to meet expected and unexpected obligations in both stable and adverse conditions.  ALCO meets regularly to assess projected funding requirements by reviewing historical funding patterns, current and forecasted economic conditions and individual customer funding needs.  Deposits generated from the Bank’s customers serve as the primary source of liquidity.  The Bank has credit arrangements with correspondent banks that serve as a secondary liquidity source.  At December 31, 2010, these credit lines totaled $35.0 million.  While one of these two lines in the amount of $15.0 million is an unsecured line of credit, the Bank must provide collateral in order to borrow against the other line.  At December 31, 2010, the Bank had no borrowings against these lines.  As previously mentioned the Bank is a member of the FHLB and has collateralized borrowing capacities remaining of $96.7 million at December 31, 2010.  Additionally, the Bank also has a borrowing facility with the Federal Reserve.  The amount of available credit is determined by the collateral provided by the Bank.  As of December 31, 2010 the borrowing availability related to this facility was $12.1 million.

 

The Bank also manages liquidity by maintaining an investment portfolio of readily marketable and liquid securities. Most of these investments include mortgage backed securities and obligations of state and political subdivisions (municipal bonds) that provide a steady stream of cash flows.  As of December 31, 2010, the Company believes investments in the portfolio can be liquidated at their current fair values in the event they are needed to provide liquidity.  The ratio of liquid assets not pledged for collateral and other purposes to deposits and other liabilities was improved to 30.5% at December 31, 2010 compared to 20.5% at December 31, 2009.

 

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The ratio of gross loans to deposits (“LTD”), another key liquidity ratio, was improved to 84.9% at December 31, 2010 compared to 94.0% at December 31, 2009.

 

Critical Accounting Policies and Estimates

 

Our accounting policies are integral to understanding the Company’s financial condition and results of operations.  Accounting policies Management considers to be significant are disclosed in Note 1 of the consolidated financial statements filed on this Form 10-K, and should be read in conjunction with the Consolidated Financial Statements of the Company, including the notes thereto, appearing elsewhere in this report.  Our most complex accounting policies require Management’s judgment to ascertain the valuation of assets, liabilities, commitments and contingencies.  We have established detailed policies and control procedures that are intended to ensure valuation methods are well controlled and applied consistently from period to period. In addition, the policies and procedures are intended to ensure that the process for changing methodologies occurs in an appropriate manner.

 

The following is a brief listing of our current accounting policies involving significant Management valuation judgments:

 

·                  Investment Securities

·                  Loans and Interest on Loans

·                  Other Real Estate Owned

·                  Loans Held for Sale

·                  Allowance for Loan Losses

·                  Loan Charge-offs

·                  Appraisals for Collateral Dependent Loans

·                  Goodwill and Other Intangible Assets

·                  Income Taxes

·                  Supplemental Employee Compensation Benefits Agreements

 

Off-Balance Sheet Arrangements, Contractual Obligations and Contingent Liabilities

 

In the ordinary course of business, the Company may enter into off-balance sheet financial instruments consisting of commitments to extend credit, commercial letters of credit and standby letters of credit.  Such financial instruments are recorded in the financial statements when they are funded or related fees are incurred or received.

 

The following table provides a summary for the Company’s long-term debt and other obligations as of December 31, 2010 and 2009:

 

 

 

Less Than

 

One To Three

 

Three To Five

 

More Than

 

December 31,

 

December 31,

 

(dollar amounts in thousands)

 

One Year

 

Years

 

Years

 

Five Years

 

2010

 

2009

 

Long-term debt and other borrowings

 

$

38,500

 

$

6,500

 

$

-

 

$

8,248

 

$

53,248

 

$

78,403

 

Operating lease obligations

 

2,188

 

3,453

 

2,533

 

6,175

 

14,349

 

15,062

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total long-term debt and other obligations

 

$

40,688

 

$

9,953

 

$

2,533

 

$

14,423

 

$

67,597

 

$

93,465

 

 

 

As disclosed in Note 11 of the consolidated financial statements, the Company is contingently liable for letters of credit made to its customers in the ordinary course of business totaling $16.1 million at December 31, 2010 compared to the $17.7 million reported at the end of 2009.  Additionally, at December 31, 2010 and 2009 the Company had un-disbursed loan commitments, made in the ordinary course of business, totaling $114.2 million and $151.9 million, respectively.  At December 31, 2010 the balance of the Company’s allowance for losses on unfunded commitments was $0.3 million compared to $0.2 million reported at December 31, 2009.

 

There are no Special Purpose Entity (“SPE”) trusts, corporations, or other legal entities established by the Company which reside off-balance sheet.  There are no other off-balance sheet items other than the aforementioned items related to letter of credit accommodations and un-disbursed loan commitments.

 

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Item 7A.  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 impact both the level of interest income and interest expense recorded on a large portion of the Company’s assets and liabilities and the market value of all interest earning assets and interest bearing liabilities other than those which possess a short term to maturity.  Virtually all of the Company’s interest earning assets and interest bearing liabilities are located at the subsidiary Bank level.  Thus, virtually all of the Company’s interest rate risk exposure lies at the banking subsidiary level except for $8.2 million in subordinated debentures issued by the Company’s subsidiary grantor trusts.  As a result, all significant interest rate risk procedures are performed at the banking subsidiary level.  The subsidiary bank’s real estate loan portfolio which is concentrated primarily within Santa Barbara and San Luis Obispo Counties of California are subject to risks associated with the local economy.

 

The fundamental objective behind the management of the Company’s assets and liabilities is to maximize the Company’s economic value while maintaining adequate liquidity and an exposure to interest rate risk deemed by Management to be acceptable.  The Asset Liability Committee of the Board of Directors establishes the limits for interest rate risk the Bank’s Management must work within. The Company’s profitability is dependent to a large extent upon its net interest income, which is the difference between its interest income on interest-earning assets, such as loans and investments, and its interest expense on interest-bearing liabilities, such as deposits and borrowings.  The Company is subject to interest rate risk to the degree that its interest-earning assets re-price differently than its interest-bearing liabilities.  The Company manages its mix of assets and liabilities with the goals of limiting its exposure to interest rate risk, ensuring adequate liquidity and coordinating its sources and uses of funds.

 

The Company seeks to control interest rate risk exposure in a manner that will allow for adequate levels of earnings and capital over a range of possible interest rate environments.  The Company has adopted formal policies and practices to monitor and manage interest rate risk exposure.  Management believes historically it has effectively managed the effect of changes in interest rates on its operating results.  Management believes that it can continue to manage the effect of interest rate changes under various interest rate scenarios.

 

Management employs the use of an Asset and Liability Management software that is used to measure the Bank’s exposure to future changes in interest rates.  This model measures the expected cash flows and re-pricing of each financial asset and liability separately in measuring the Bank’s interest sensitivity.  Based on the results of this model, Management believes the Bank’s balance sheet is “liability sensitive.”  The Company generally expects contraction in its net interest income if rates rise and expects, conversely, increases in net interest income if rates fall.  The level of potential or expected contraction indicated by the tables below is considered acceptable by Management and is compliant with the Bank’s ALCO policies.  Management will continue to perform this analysis each quarter to further validate the expected results against actual data.

 

The hypothetical impacts of sudden interest rate movements applied to the Company’s asset and liability balances are modeled monthly.  The results of this movement indicate how much of the Company’s net interest income is “at risk” from various rate changes over a one year horizon.  This exercise is valuable in identifying risk exposures.  The results for the Company’s December 31, 2010 balances indicate that the net interest income at risk over a one year time horizon for a 1% and 2% parallel shift in interest rates are within the Company’s policy guidelines for such changes.

 

 

 

Rate Shock Scenarios

 

(dollar amounts in thousands)

 

-200bp

 

-100bp

 

Base

 

+100bp

 

+200bp

 

Net interest income (NII)

 

$

44,697

 

$

47,589 

 

$

47,026 

 

$

45,705

 

$

44,792

 

$ Change from base

 

$

(2,329

)

$

563 

 

$

 

$

(1,321

)

$

(2,234

)

% Change from base

 

-4.95%

 

1.20%

 

0.00%

 

-2.81%

 

-4.75%

 

 

It is important to note that the above table is a summary of several forecasts and actual results may vary.  The forecasts are based on estimates and assumptions of Management that may turn out to be different and may change over time.  Factors affecting these estimates and assumptions include, but are not limited to 1) competitor behavior, 2) economic conditions both locally and nationally, 3) actions taken by the Federal Reserve Board, 4) customer behavior and 5) Management’s responses.  Changes that vary significantly from the assumptions and estimates may have significant effects on the Company’s net interest income; therefore, the results of this analysis should not be relied upon as indicative of actual future results.

 

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Table of Contents

 

The following table provides a summary of the loans the Bank can expect to see come off their floors if the prime rate were to increase by the amounts presented as of December 31, 2010:

 

 

 

Move in Prime Rate (bps)

 

 

 

(dollar amounts in thousands)

 

+200

 

+250

 

+300

 

+350

 

 

 

Variable daily

 

$

3,721

 

$

17,017

 

$

65,027

 

$

121,861

 

 

 

Variable other than daily

 

-

 

10,592

 

62,160

 

180,238

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cumulative total variable at floor

 

$

3,721

 

$

27,609

 

$

127,187

 

$

302,099

 

 

 

 

The Company also attempts to quantify the impact of interest rate changes on borrowers’ ability to pay on loans and the impact of similar rate changes on the value of collateral held against loans.  To this end, the Company, from time to time, will sample loans and analyze them under a rate shock scenario to specifically assess the impact of the rate shock on financial ratios such as interest rate coverage and loan-to-value.  The results of the analysis have generally revealed that in the case of such a rate shock, a high percentage of loans tested would continue to express ratios within current underwriting guidelines. The results of these analyses are considered acceptable by Management.

 

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Table of Contents

 

Item 8.  Financial Statements and Supplementary Data

 

 

Heritage Oaks Bancorp and Subsidiaries

 

 

Management’s Assessment of Internal Control Over Financial Reporting

59

 

 

Report of Independent Registered Public Accounting Firm

60

 

 

Consolidated Financial Statements:

 

 

 

Consolidated Balance Sheets
As of December 31, 2010 and 2009

61

 

 

Consolidated Statements of Income
For the Years Ended December 31, 2010, 2009 and 2008

62

 

 

Consolidated Statements of Stockholders’ Equity
As of December 31, 2010, 2009 and 2008

63

 

 

Consolidated Statements of Cash Flows
For the Years Ended December 31, 2010, 2009 and 2008

64

 

 

Notes to Consolidated Financial Statements

66

 

 

The following un-audited supplementary financial data is included in this Annual Report on Form 10-K:

 

Quarterly Financial Information

107

 

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Table of Contents

 

Management’s Assessment of Internal Control over Financial Reporting

 

The management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting.  The Company’s internal control over financial reporting is a process designed under the supervision of the Company’s Chief Executive Officer and Chief Financial Officer to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the Company’s financial statements for external purposes in accordance with U.S. generally accepted accounting principles.

 

As of December 31, 2010, management assessed the effectiveness of the Company’s internal control over financial reporting based on the criteria for effective internal control over financial reporting established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and guidance issued by the Securities and Exchange Commission.  Based on the assessment, management determined that the Company maintained effective internal control over financial reporting as of December 31, 2010, based on those criteria.

 

The Company’s management, including its Chief Executive Officer and Chief Financial Officer, does not expect that its disclosure controls and procedures, or its internal controls will prevent all error and all fraud.  A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints and the benefit of controls must be considered relative to their costs.  Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected.

 

 

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Table of Contents

 

Report of Independent Registered Public Accounting Firm

 

Board of Directors

Heritage Oaks Bancorp

Paso Robles, California

 

We have audited the accompanying consolidated balance sheets of Heritage Oaks Bancorp and Subsidiaries (the “Company”) as of December 31, 2010 and 2009 and the related consolidated statements of income, changes in stockholders’ equity and cash flows for each of the years in the three year period ended December 31, 2010.  These consolidated financial statements are the responsibility of the Company’s management.  Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement.  An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements.  An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.  We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Heritage Oaks Bancorp and Subsidiaries as of December 31, 2010 and 2009, and the results of its operations, changes in its stockholders’ equity, and its cash flows for each of the years in the three year period ended December 31, 2010, in conformity with U.S. generally accepted accounting principles.

 

 

/s/Vavrinek, Trine, Day & Co., LLP

Rancho Cucamonga, California

March 10, 2011

 

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Heritage Oaks Bancorp and Subsidiaries

Consolidated Balance Sheets

 

 

 

December 31,

 

(dollar amounts in thousands)

 

2010

 

2009

 

Assets

 

 

 

 

 

Cash and due from banks

 

$

15,187

 

$

19,342

 

Interest bearing due from Federal Reserve Bank

 

4,264

 

17,046

 

Federal funds sold

 

3,500

 

4,350

 

Total cash and cash equivalents

 

22,951

 

40,738

 

 

 

 

 

 

 

Interest bearing deposits with other banks

 

119

 

119

 

Securities available for sale

 

224,966

 

121,180

 

Federal Home Loan Bank stock, at cost

 

5,180

 

5,828

 

Loans held for sale

 

11,008

 

9,487

 

Gross loans

 

677,303

 

728,679

 

Net deferred loan fees

 

(1,613

)

(1,825

)

Allowance for loan losses

 

(24,940

)

(14,372

)

Net loans

 

650,750

 

712,482

 

Property, premises and equipment, net

 

6,376

 

6,779

 

Deferred tax assets

 

21,163

 

10,553

 

Bank owned life insurance

 

13,843

 

12,549

 

Goodwill

 

11,049

 

11,049

 

Core deposit intangible

 

2,127

 

2,642

 

Other real estate owned

 

6,668

 

946

 

Other assets

 

6,412

 

10,825

 

 

 

 

 

 

 

Total assets

 

$

982,612

 

$

945,177

 

 

 

 

 

 

 

Liabilities

 

 

 

 

 

Deposits

 

 

 

 

 

Demand, non-interest bearing

 

$

182,658

 

$

174,635

 

Savings, NOW and money market deposits

 

384,202

 

365,602

 

Time deposits of $100 or more

 

117,842

 

117,420

 

Time deposits under $100

 

113,504

 

117,808

 

Total deposits

 

798,206

 

775,465

 

Short term FHLB borrowing

 

38,500

 

65,000

 

Long term FHLB borrowing

 

6,500

 

-    

 

Junior subordinated debentures

 

8,248

 

13,403

 

Other liabilities

 

9,902

 

7,558

 

 

 

 

 

 

 

Total liabilities

 

861,356

 

861,426

 

 

 

 

 

 

 

Commitments and contingencies (Notes 6 and 11)

 

-    

 

-    

 

 

 

 

 

 

 

Stockholders’ Equity

 

 

 

 

 

Preferred stock, 5,000,000 shares authorized:

 

 

 

 

 

Series A senior preferred stock; $1,000 per share stated value issued and outstanding: 21,000 shares as of December 31, 2010 and 2009

 

19,792

 

19,431

 

Series C preferred stock, $3.25 per share stated value; issued and outstanding: 1,189,538 shares and 0 as of December 31, 2010 and 2009, respectively

 

3,604

 

-    

 

Common stock, no par value; authorized: 100,000,000 shares; issued and outstanding:

 

 

 

 

 

25,082,344 shares and 7,771,952 shares as of December 31, 2010 and 2009 respectively

 

101,140

 

48,747

 

Additional paid in capital

 

7,002

 

3,242

 

Retained (deficit) / earnings

 

(9,161

)

13,407

 

Accumulated other comprehensive loss, net of tax benefit of $783 and $752 as of December 31, 2010 and 2009, respectively

 

(1,121

)

(1,076

)

 

 

 

 

 

 

Total stockholders’ equity

 

121,256

 

83,751

 

 

 

 

 

 

 

Total liabilities and stockholders’ equity

 

$

982,612

 

$

945,177

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

61



Table of Contents

 

Heritage Oaks Bancorp and Subsidiaries

Consolidated Statements of Income

 

 

 

For The Years Ended December 31,

 

(dollar amounts in thousands except per share data)

 

2010

 

2009

 

2008

 

Interest Income

 

 

 

 

 

 

 

Interest and fees on loans

 

$

44,129

 

$

45,530

 

$

47,038

 

Interest on investment securities

 

 

 

 

 

 

 

Mortgage backed securities

 

5,200

 

3,023

 

1,970

 

State and muncipal securities

 

1,308

 

896

 

741

 

Interest on time deposits with other banks

 

2

 

3

 

8

 

Interest on balances due from Federal Reserve Bank

 

90

 

49

 

-    

 

Interest on federal funds sold

 

5

 

21

 

140

 

Interest on other securities

 

60

 

37

 

253

 

Total interest income

 

50,794

 

49,559

 

50,150

 

Interest Expense

 

 

 

 

 

 

 

Interest on savings, NOW and money market deposits

 

3,238

 

3,815

 

4,375

 

Interest on time deposits in denominations of $100 or more

 

2,077

 

2,505

 

2,436

 

Interest on time deposits under $100

 

2,133

 

2,564

 

2,892

 

Other borrowings

 

599

 

1,165

 

2,861

 

Total interest expense

 

8,047

 

10,049

 

12,564

 

Net interest income before provision for loan losses

 

42,747

 

39,510

 

37,586

 

Provision for loan losses

 

31,531

 

24,066

 

12,215

 

Net interest income after provision for loan losses

 

11,216

 

15,444

 

25,371

 

Non Interest Income

 

 

 

 

 

 

 

Fees and service charges

 

2,428

 

2,965

 

3,284

 

Mortgage origination income

 

2,020

 

1,253

 

568

 

Debit/credit card transaction fee income

 

1,249

 

976

 

895

 

Earnings on bank owned life insurance

 

585

 

504

 

474

 

Bancard merchant fee income

 

198

 

180

 

231

 

Other than temporary impairment (OTTI) losses on investment securities:

 

 

 

 

 

 

 

Total impairment loss on investment securities

 

(1,214

)

(1,956

)

-    

 

Non credit related losses recognized in other comprehensive income

 

1,007

 

1,584

 

-    

 

Net impairment losses on investment securities

 

(207

)

(372

)

-    

 

Gain on sale of investment securities

 

783

 

333

 

37

 

Gain on sale of SBA loans

 

222

 

213

 

-    

 

Gain / (loss) on sale of OREO

 

24

 

(280

)

-    

 

Gain on sale of furniture fixtures and equipment

 

59

 

-    

 

-    

 

Gain on extinguishment of debt

 

1,700

 

-    

 

-    

 

Other

 

435

 

426

 

717

 

Total non interest income

 

9,496

 

6,198

 

6,206

 

Non Interest Expense

 

 

 

 

 

 

 

Salaries and employee benefits

 

18,042

 

15,502

 

15,561

 

Equipment

 

1,653

 

1,445

 

1,404

 

Occupancy

 

3,805

 

3,472

 

3,138

 

Promotional

 

690

 

644

 

823

 

Data processing

 

2,676

 

2,743

 

2,704

 

Loan department costs

 

1,251

 

1,289

 

258

 

Write-downs of foreclosed assets

 

3,686

 

1,514

 

-    

 

Regulatory assessment costs

 

2,657

 

1,984

 

475

 

Audit and tax advisory costs

 

571

 

625

 

464

 

Directors fees

 

551

 

355

 

318

 

Outside services

 

1,712

 

1,801

 

922

 

Telephone / communications costs

 

369

 

275

 

324

 

Amortization of intangible assets

 

514

 

1,049

 

861

 

Stationary and supplies

 

460

 

431

 

428

 

Provision for unfunded loan commitments

 

80

 

-    

 

-    

 

Other general operating costs

 

1,315

 

1,387

 

1,754

 

Total non interest expense

 

40,032

 

34,516

 

29,434

 

(Loss) / income before provision for income taxes

 

(19,320

)

(12,874

)

2,143

 

(Benefit) / provision for income taxes

 

(1,760

)

(5,825

)

497

 

Net (loss) / income

 

(17,560

)

(7,049

)

1,646

 

Dividends and accretion on preferred stock

 

5,008

 

964

 

-    

 

Net (loss) / income available to common shareholders

 

$

(22,568

)

$

(8,013

)

$

1,646

 

 

 

 

 

 

 

 

 

(Loss) / Earnings Per Common Share

 

 

 

 

 

 

 

Basic

 

$

(1.30

)

$

(1.04

)

$

0.22

 

Diluted

 

$

(1.30

)

$

(1.04

)

$

0.21

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

62



Table of Contents

 

Heritage Oaks Bancorp and Subsidiaries

Consolidated Statements of Stockholders' Equity

 

 

 

 

 

 

 

 

 

 

 

 

 

Accumulated

 

 

 

 

 

 

 

Common Stock

 

Additional

 

Retained

 

Other

 

Total

 

 

 

Preferred

 

Number of

 

 

 

Paid-In

 

Earnings/

 

Comprehensive

 

Stockholders’

 

(dollar amounts in thousands)

 

Stock

 

Shares

 

Amount

 

Capital

 

(Deficit)

 

Income/(loss)

 

Equity

 

Balance, December 31, 2007

 

$

-    

 

7,317,932

 

$

43,996

 

$

672

 

$

24,598

 

$

184

 

$

69,450

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Exercise of stock options

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(including $115 excess tax benefit from exercise of stock options)

 

 

 

74,706

 

420

 

 

 

 

 

 

 

420

 

5% stock dividend distributed May 16, 2008

 

 

 

366,294

 

4,233

 

 

 

(4,233

)

 

 

 

 

Cash paid in lieu of fractional shares

 

 

 

 

 

 

 

 

 

(5

)

 

 

(5

)

Cash dividends paid during 2008

 

 

 

 

 

 

 

 

 

(586

)

 

 

(586

)

Share-based compensation expense

 

 

 

 

 

 

 

383

 

 

 

 

 

383

 

Issuance of restricted share awards

 

 

 

1,050

 

 

 

 

 

 

 

 

 

 

 

Retirement of restricted share awards

 

 

 

(6,904

)

 

 

 

 

 

 

 

 

 

 

Comprehensive income:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

 

 

 

 

 

 

 

 

1,646

 

 

 

1,646

 

Unrealized security holding losses (net of $892 tax benefit)

 

 

 

 

 

 

 

 

 

 

 

(1,254

)

(1,254

)

Realized gains on sale of securities (net of $15 tax)

 

 

 

 

 

 

 

 

 

 

 

(22

)

(22

)

Total comprehensive income

 

 

 

 

 

 

 

 

 

 

 

 

 

370

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, December 31, 2008

 

$

-    

 

7,753,078

 

$

48,649

 

$

1,055

 

$

21,420

 

$

(1,092

)

$

70,032

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Issuance of 21,000 shares of Series A Senior preferred stock and common stock warrant

 

19,152

 

 

 

 

 

1,848

 

 

 

 

 

21,000

 

Accretion on Series A preferred

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

stock discount

 

279

 

 

 

 

 

 

 

(279

)

 

 

 

 

Dividends paid on preferred stock

 

 

 

 

 

 

 

 

 

(685

)

 

 

(685

)

Exercise of stock options

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(including $9 excess tax benefit from exercise of stock options)

 

 

 

24,121

 

98

 

 

 

 

 

 

 

98

 

Share-based compensation expense

 

 

 

 

 

 

 

339

 

 

 

 

 

339

 

Retirement of restricted share awards

 

 

 

(5,247

)

 

 

 

 

 

 

 

 

 

 

Comprehensive loss:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net loss

 

 

 

 

 

 

 

 

 

(7,049

)

 

 

(7,049

)

Unrealized security holding (losses) on securities (net of $5 tax benefit)

 

 

 

 

 

 

 

 

 

 

 

(7

)

(7

)

Reclassification (gains) on sale of securities (net of $137 tax)

 

 

 

 

 

 

 

 

 

 

 

(196

)

(196

)

Reclassification OTTI recognized in income (net of $153 tax benefit)

 

 

 

 

 

 

 

 

 

 

 

219

 

219

 

Total comprehensive loss

 

 

 

 

 

 

 

 

 

 

 

 

 

(7,033

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, December 31, 2009

 

$

19,431

 

7,771,952

 

$

48,747

 

$

3,242

 

$

13,407

 

$

(1,076

)

$

83,751

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Issuance of 56,160 shares of Series B preferred stock

 

52,351

 

 

 

 

 

 

 

 

 

 

 

52,351

 

Discount on Series B preferred stock

 

(3,456

)

 

 

 

 

3,456

 

 

 

 

 

-    

 

Conversion of Series B preferred stock to common stock

 

(52,351

)

17,279,995

 

52,351

 

 

 

 

 

 

 

-    

 

Issuance of 1,189,538 shares of Series C preferred stock

 

3,604

 

 

 

 

 

 

 

 

 

 

 

3,604

 

Accretion on Series A preferred stock discount

 

361

 

 

 

 

 

 

 

(361

)

 

 

-    

 

Accretion on Series B preferred stock discount

 

3,456

 

 

 

 

 

 

 

(3,456

)

 

 

-    

 

Dividends paid on preferred stock

 

 

 

 

 

 

 

 

 

(262

)

 

 

(262

)

Accrued dividends on preferred stock

 

 

 

 

 

 

 

 

 

(929

)

 

 

(929

)

Exercise of stock options

 

 

 

11,260

 

42

 

 

 

 

 

 

 

42

 

Share-based compensation expense

 

 

 

 

 

 

 

304

 

 

 

 

 

304

 

Issuance of restricted share awards

 

 

 

26,565

 

 

 

 

 

 

 

 

 

 

 

Retirement of restricted share awards

 

 

 

(7,428

)

 

 

 

 

 

 

 

 

 

 

Comprehensive loss:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net loss

 

 

 

 

 

 

 

 

 

(17,560

)

 

 

(17,560

)

Unrealized security holding gain (net of $206 tax)

 

 

 

 

 

 

 

 

 

 

 

294

 

294

 

Reclassification for net gains on investments included in earnings (net of $322 tax)

 

 

 

 

 

 

 

 

 

 

 

(461

)

(461

)

Reclassification of OTTI recognized in income (net of $85 tax benefit)

 

 

 

 

 

 

 

 

 

 

 

122

 

122

 

Total comprehensive loss

 

 

 

 

 

 

 

 

 

 

 

 

 

(17,605

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, December 31, 2010

 

$

23,396

 

25,082,344

 

$

101,140

 

$

7,002

 

$

(9,161

)

$

(1,121

)

$

121,256

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

63



Table of Contents

 

Heritage Oaks Bancorp and Subsidiaries

Consolidated Statements of Cash Flows

 

 

 

For The Years Ended December 31,

 

(dollar amounts in thousands)

 

2010

 

2009

 

2008

 

Cash flows from operating activities:

 

 

 

 

 

 

 

Net (loss) / income

 

$

(17,560

)

$

(7,049

)

$

1,646

 

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

 

 

 

 

 

 

 

Depreciation and amortization

 

1,288

 

1,165

 

1,092

 

Provision for loan losses

 

31,531

 

24,066

 

12,215

 

Amortization of premiums / discounts on investment securities, net

 

1,924

 

131

 

(148

)

Amortization of intangible assets

 

515

 

1,049

 

860

 

Share-based compensation expense

 

304

 

339

 

383

 

Federal Home Loan Bank dividends received

 

-    

 

-    

 

(209

)

Gain on sale of available for sale securities

 

(783

)

(333

)

(37

)

Other than temporary impairment

 

207

 

372

 

-    

 

Gain on extinguishment of debt

 

(1,700

)

-    

 

-    

 

Increase in loans held for sale

 

(1,521

)

(1,548

)

(7,037

)

Net increase in bank owned life insurance

 

(519

)

(435

)

(414

)

Increase in deferred tax asset

 

(17,684

)

(2,856

)

(1,526

)

Deferred tax assets valuation allowance adjustment

 

7,105

 

-    

 

-    

 

Loss on sale and write-downs on other real estate owned

 

3,650

 

1,794

 

-    

 

Increase in other assets

 

(9,301

)

(12,331

)

(4,221

)

Increase / (decrease) in other liabilities

 

1,415

 

731

 

(1,007

)

Excess tax benefit related to share-based compensation expense

 

-    

 

(9

)

(115

)

 

 

 

 

 

 

 

 

Net Cash (Used) / Provided In Operating Activities

 

(1,129

)

5,086

 

1,482

 

 

 

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

 

 

Purchase of securities, available for sale

 

(164,923

)

(99,400

)

(18,417

)

Sale of available for sale securities

 

33,389

 

16,040

 

1,537

 

Maturities and calls of available for sale securities

 

674

 

1,439

 

2,210

 

Proceeds from principal reductions and maturities

 

 

 

 

 

 

 

of available for sale securities

 

26,650

 

11,360

 

9,482

 

Maturities of time deposits with other banks

 

-    

 

-    

 

211

 

Purchase of Federal Home Loan Bank stock

 

-    

 

(705

)

(1,869

)

Redemption of Federal Home Loan Bank stock

 

648

 

-    

 

-    

 

Purchase of equity investments

 

(1,000

)

-    

 

-    

 

Sale of equity investments

 

155

 

-    

 

-    

 

Decrease / (increase) in loans, net

 

27,311

 

(68,612

)

(75,037

)

Allowance for loan and lease loss recoveries

 

2,890

 

98

 

130

 

Purchase of property, premises and equipment, net

 

(944

)

(1,129

)

(1,579

)

Proceeds from sale of property, premises and equipment

 

59

 

-    

 

-    

 

Purchase of bank owned life insurance

 

(775

)

(1,377

)

(400

)

Proceeds from sale of foreclosed collateral

 

4,187

 

7,806

 

-    

 

 

 

 

 

 

 

 

 

Net Cash Used In Investing Activities

 

(71,679

)

(134,480

)

(83,732

)

 

 

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

 

 

Increase / (decrease) in deposits, net

 

22,741

 

171,944

 

(41,287

)

Proceeds from Federal Home Loan Bank borrowing

 

45,000

 

75,000

 

380,000

 

Repayments of Federal Home Loan Bank borrowing

 

(65,000

)

(119,000

)

(279,000

)

(Decrease) / increase in repurchase agreements

 

-    

 

(2,796

)

860

 

Decrease in junior subordinated debentures

 

(3,455

)

-    

 

-    

 

Excess tax benefit related to share-based compensation expense

 

-    

 

9

 

115

 

Proceeds from exercise of stock options

 

42

 

89

 

305

 

Preferred stock dividends paid

 

(262

)

(685

)

(586

)

Cash paid in lieu of fractional shares

 

-    

 

-    

 

(5

)

Proceeds from issuance of preferred stock and common stock warrants, net

 

55,955

 

21,000

 

-    

 

 

 

 

 

 

 

 

 

Net Cash Provided By Financing Activities

 

55,021

 

145,561

 

60,402

 

 

 

 

 

 

 

 

 

Net increase / (decrease) in cash and cash equivalents

 

(17,787

)

16,167

 

(21,848

)

Cash and cash equivalents, beginning of year

 

40,738

 

24,571

 

46,419

 

 

 

 

 

 

 

 

 

Cash and cash equivalents, end of year

 

$

22,951

 

$

40,738

 

$

24,571

 

 

64



Table of Contents

 

Supplemental Cash Flow Disclosures

 

 

 

For The Years Ended December 31,

 

(dollar amounts in thousands)

 

2010

 

2009

 

2008

 

Cash Flow Information

 

 

 

 

 

 

 

Interest paid

 

$

8,214

 

$

10,147

 

$

12,630

 

Income taxes paid

 

$

7,825

 

$

460

 

$

3,915

 

 

 

 

 

 

 

 

 

Non-Cash Flow Information

 

 

 

 

 

 

 

Change in other valuation allowance for investment securities

 

$

(76

)

$

27

 

$

(2,167

)

Transfers to other real estate owned or foreclosed collateral

 

$

13,342

 

$

9,678

 

$

1,401

 

Conversion of preferred stock to common stock

 

$

52,351

 

$

-

 

$

-

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

65



Table of Contents

 

Note 1.  Summary of Significant Accounting Policies

 

The accounting and reporting policies of Heritage Oaks Bancorp (“the Company”) and subsidiaries conform to accounting principles generally accepted in the United States of America and to general practices within the banking industry.  A summary of the Company’s significant accounting and reporting policies consistently applied in the preparation of the accompanying financial statements follows:

 

Principles of Consolidation

 

The Consolidated Financial Statements include the Company and its wholly owned subsidiaries, Heritage Oaks Bank, (the “Bank”) and CCMS Systems, Inc.  Inter-company balances and transactions have been eliminated.

 

Nature of Operations

 

The Company has been organized as a single operating segment.  Its primary subsidiary, Heritage Oaks Bank (“the Bank”), operates fifteen branches within San Luis Obispo and Santa Barbara counties.  The Bank offers traditional banking products such as checking, savings, money market account and certificates of deposit, as well as mortgage loans and commercial and consumer loans to customers who are predominately small to medium-sized businesses and individuals.

 

Investment in Non-Consolidated Subsidiary

 

The Company accounts for its investment in its wholly owned special purpose entity, Heritage Oaks Capital Trust II (the “Trust II”), using the equity method under which the subsidiary’s net earnings are recognized in the Company’s statements of income.

 

Use of Estimates in the Preparation of Financial Statements

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”) requires Management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  Actual results could differ from those estimates.

 

Estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan losses, the valuation of real estate acquired in connection with foreclosures or in satisfaction of loans, the carrying value of the Company’s deferred tax assets and estimates used in the determination of the fair value of certain financial instruments.

 

In connection with the determination of the allowance for loan losses and foreclosed real estate, Management obtains independent appraisals for significant properties.  While Management uses available information to recognize losses on loans and foreclosed real estate and collateral, future additions to the allowance may be necessary based on changes in local economic conditions.  In addition, regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for loan losses and foreclosed real estate.  Such agencies may require the Company to recognize additions to the allowance based on their judgments about information available to them at the time of their examination.  Because of these factors, it is reasonably possible that the allowance for loan losses and foreclosed real estate may change in future periods.

 

The Company uses an estimate of its future earnings in determining if it is more likely than not that the carrying value of its deferred tax assets will be realized over the period they are expected to reverse.  If based on all available evidence, the Company believes that a portion or all of its deferred tax assets will not be realized; a valuation allowance may be established.  During 2010 the Company established a valuation allowance for a portion of its deferred tax assets.  See also Note 10. Income Taxes, of the consolidated financial statements, filed on this Form 10-K.

 

The degree of judgment utilized in measuring the fair value of financial instruments generally correlates to the level of pricing observability.  Financial instruments with readily available active quoted prices or for which fair value can be measured from actively quoted prices generally will have a higher degree of observable pricing and a lesser degree of judgment utilized in measuring fair value.

 

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Conversely, financial instruments rarely traded or not quoted will generally have little or no observable pricing and a higher degree of judgment is utilized in measuring the fair value of such instruments.  Observable pricing is impacted by a number of factors, including the type of financial instrument, whether the financial instrument is new to the market and not yet established and the characteristics specific to the transaction.

 

Cash and Cash Equivalents

 

Banking regulations require that all banks maintain a percentage of their deposits as reserves in cash or on deposit with the Federal Reserve Bank.  The Bank is in compliance with the reserve requirements as of December 31, 2010.  The Company maintains amounts due from banks that exceed federally insured limits.  Historically the Company has not experienced any losses in such accounts.  For purposes of reporting cash flows, cash and cash equivalents include cash, due from banks, Federal Funds sold, and interest bearing due from the Federal Reserve.  Generally, Federal Funds sold and interest bearing due from Federal Reserve balances represent excess liquidity that the Company and/or Bank sells to other institutions overnight.

 

Investment Securities

 

In accordance with U.S. GAAP,  investment securities are classified in three categories and accounted for as follows:  debt and mortgage-backed securities that the Company has the positive intent and ability to hold to maturity are classified as held to maturity and are measured at amortized cost; debt and equity securities bought and held principally for the purpose of selling in the near term are classified as trading securities and are measured at fair value, with unrealized gains and losses included in earnings; debt and equity securities not classified as either held to maturity or trading securities are deemed as available for sale and are measured at fair value, with unrealized gains and losses, net of applicable taxes, reported as a separate component of stockholders’ equity.  The fair values of most securities that are designated available for sale are based on quoted market prices.  If quoted market prices are not available, fair values are extrapolated from the quoted prices of similar instruments or through the use of other observable data supporting a valuation model.  Gains or losses on sales of investment securities are determined on the specific identification method.  Premiums and discounts are amortized or accreted using the interest method over the expected lives of the related securities and recognized in interest income.

 

Declines in the fair values of individual held to maturity and available for sale securities below their cost that are other than temporary result in write-downs of individual securities to their fair value.  The related write-downs are included in earnings as realized losses. In estimating other-than-temporary impairment losses, Management considers: (1) the length of time the security has been in an unrealized loss position, (2) the extent to which the security’s fair value is less than its cost, (3) the financial condition of the issuer, (4) any adverse changes in ratings issued by various rating agencies, (5) the intent and ability of the Bank to hold such securities for a period of time sufficient to allow for any anticipated recovery in fair value and (6) in the case of mortgage related securities, credit enhancements, loan-to-values, credit scores, delinquency and default rates, cash flows and the extent to which those cash flows are within Management’s initial expectations based on pre-purchase analyses.

 

Federal Home Loan Bank Stock

 

The Bank is a member of the Federal Home Loan Bank (“FHLB”) and as a condition of membership; the Bank is required to purchase stock in the FHLB. The required ownership of FHLB stock is based on the level of borrowing the Bank has obtained from the FHLB. The investment is considered equity securities with no actively traded market.  Such investments are carried at cost, which is equal to the value at which they may be redeemed.  Any dividend income received from the stock is reported as a component of interest income.

 

Loans and Interest on Loans

 

Loans are stated at the principal amount outstanding, net of unearned discount and unamortized deferred fees and costs. Interest is accrued daily on the outstanding principal balances.  Loans which are more than 90 days delinquent with respect to interest or principal, unless they are well secured and in the process of collection, and other loans on which full recovery of principal or interest is in doubt, are placed on non-accrual status.  When loans are placed on non-accrual status, all interest previously accrued but not collected is reversed against current period interest income.  Interest income generally is not recognized on specific non-accruing loans unless the likelihood of further loss is remote.  Interest payments received on such loans are applied as a reduction to the loan principal balance.

 

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Interest accruals are resumed on such loans only when they are brought current with respect to interest and principal and when, in the judgment of Management, all remaining principal and interest is fully collectible, there has been at least six months of sustained repayment performance since the loan was placed on non-accrual and/or Management believes based on current information that such loan is no longer impaired.  Certain consumer loans, such as smaller balance installment loans, may be directly charged to the allowance for loan losses when they become 120 days past due. The Company recognizes a loan as impaired when, based on current information and events, it is probable that it will be unable to collect both the contractual interest and principal payments as scheduled in the loan agreement. Income recognition on impaired loans conforms to that used on non-accrual loans.

 

Nonrefundable fees and certain costs associated with originating or acquiring loans are deferred and amortized as an adjustment to interest income over the contractual lives of the loan. Upon prepayment, unamortized loan fees, net of costs, are immediately recognized in interest income. Other fees, including those collected upon principal prepayments, are included in interest income when received.

 

Loans held for sale are carried at the lower of aggregate cost or fair value, which is determined by the specified value in the commitments.  Net unrealized losses, if any, are recognized through a valuation allowance by charges to expense.

 

Other Real Estate Owned

 

Real estate and other property acquired in full or partial settlement of loan obligations is referred to as other real estate owned (“OREO”).  OREO is originally recorded in the Company’s financial statements at fair value less any estimated costs to sell.  When property is acquired through foreclosure or surrendered in lieu of foreclosure, the Company measures the fair value of the property acquired against its recorded investment in the loan.  If the fair value of the property at the time of acquisition is less than the recorded investment in the loan, the difference is charged to the allowance for loan losses.  Any subsequent fluctuations in the fair value of OREO are recorded against a valuation allowance for foreclosed assets, established through a charge to non-interest expense.  All related operating or maintenance costs are charged to non-interest expense as incurred.  Any subsequent gains or losses on the sale of OREO are recorded in other income.

 

Allowance for Loan Losses

 

The allowance for loan losses is maintained at a level which, in Management’s judgment, is adequate to absorb credit losses inherent in the loan portfolio as of the date of the balance sheet.  The amount of the allowance is based on Management’s evaluation of the collectability of the loan portfolio, including the nature and volume of the portfolio, credit concentrations, trends in historical loss experience, the level of certain classified balances and specific impaired loans, and economic conditions and the related impact on specific borrowers and industry groups.  The allowance is increased by a provision for loan losses, which is charged to earnings and reduced by charge-offs, net of recoveries.  Changes in the allowance relating to impaired loans are charged or credited to the provision for loan losses.  Because of uncertainties inherent in the estimation process, Management’s estimate of credit losses inherent in the loan portfolio and the related allowance may change.

 

A portion of the allowance is specifically allocated to impaired loans whose full collectability is uncertain. Such allocations are determined on a loan-by-loan basis. A second allocation is based in part on quantitative analyses of historical credit loss experience.  The results of those analyses are used to determine standard loss factors which are then applied to all loan balances not specifically identified as impaired.  The third component of the allowance is considered the subjectively determined allocation. This portion of the allowance is established to address additional qualitative factors, consistent with Management’s analysis of the level of risks inherent in various segments of the loan portfolio, which are related to the risks of the Company’s general lending activity.  Included in the subjectively determined allocation of the allowance is the risk of losses that are attributable to national or local economic or industry trends, economic and business conditions, trends in the level of past due and non-performing loans and other factors. By nature, these risks are difficult to quantify with a specific number.

 

The measurement of impaired loans is generally based on the present value of expected future cash flows discounted at the historical effective interest rate stipulated in the loan agreement, except that all collateral-dependent loans are measured for impairment based on the fair value of the collateral.  In measuring the fair value of the collateral, Management uses assumptions and methodologies consistent with those that would be utilized by unrelated third parties.  Allowances for impaired loans are generally determined based on collateral values or the present value of estimated cash flows.  See also Note 3. Loans and Note 4. Allowance for Loan Losses, for additional discussion concerning credit quality and the allowance for loan losses.

 

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Loan Charge-offs

 

Loan balances are charged-off when the loan becomes 120 days past due, unless it is well secured and/or in the process of collection.  The Company may defer charge-off on a loan, due to certain factors the Company has identified that may work to its benefit in minimizing potential losses.  Those factors may include: working with the borrower to restructure their obligation to the Company in an effort to bring about a more favorable outcome, the identification of an additional source of repayment, sufficient collateral to cover the Company’s recorded investment in the loan, or any other identified factor that may work to strengthen the credit and reduce the potential for loss.

 

For most real estate and commercial loans, the Company generally recognizes a charge-off to bring the carrying balance of the loan down to the estimated fair value of the underlying collateral or some other determination of fair value when: (i) Management determines that the asset is no longer collectible, (ii) repayment prospects for the credit have become unclear and/or are likely to occur over a time-frame the Company deems to be no longer reasonable, (iii) the loan or portion of the loan has been deemed a loss by the Company’s internal review and/or independent review functions, or has been deemed a loss by regulatory examiners, (iv) the borrower has or is in the process of filing for bankruptcy.

 

Appraisals for Loans Secured by Collateral

 

For loan fundings greater than $500 thousand the Bank has a policy to perform an annual review of the borrower’s financial condition and of any real estate securing the loan.  This review includes, among other things, a physical inspection of the real estate securing the loan, an analysis of any related rent rolls, an analysis of all borrower and guarantor tax returns and financial statements.  This information is used internally by the Bank to validate all covenants and the risk grade assigned to the loan.  If during the review process the Bank learns of additional information that would suggest that the borrower’s ability to repay has deteriorated since the original underwriting of the loan, and repayment may now be dependent on liquidation of the collateral an additional independent appraisal of the collateral is requested.  If based on the updated appraisal information it is determined the value of the collateral is impaired and the Bank no longer expects to collect all previously determined amounts related to the loan as stipulated in the loan’s original agreement, the Bank typically moves to establish a valuation allowance for such loans or charge-off such differences.  Once a loan is deemed to be impaired and/or the loan was downgraded to substandard status, the loan becomes the responsibility of the Bank’s Special Assets department, which provides more diligent oversight of problem credits.  This oversight includes, among other things, a review of all previous appraisals of collateral securing such loans and determining in the Bank’s best judgment if those appraisals still represent the current fair value of the loan.  Additional appraisals may be ordered at this time if deemed necessary.

 

Property, Premises and Equipment

 

Land is carried at cost.  Premises and equipment are carried at cost less accumulated depreciation and amortization.  Depreciation is computed using the straight-line method over the estimated useful lives, which ranges from three to ten years for furniture and fixtures and forty years for buildings.  Leasehold improvements are amortized using the straight-line method over the estimated useful lives of the improvements or the remaining lease term, whichever is shorter.  Expenditures for improvements or major repairs are capitalized and those for ordinary repairs and maintenance are charged to expense as incurred.

 

Goodwill and Intangible Assets

 

Intangible assets are comprised of goodwill, core deposit intangibles and other identifiable intangibles acquired in business combinations. Intangible assets with definite useful lives are amortized over their respective estimated useful lives. If an event occurs that indicates the carrying amount of an intangible asset may not be recoverable, Management reviews the asset for impairment. Any goodwill and any intangible asset acquired in a purchase business combination determined to have an indefinite useful life is not amortized, but is at least annually evaluated for impairment.

 

The Company uses several valuation methodologies in evaluating goodwill for impairment including a discounted cash flow approach that includes assumptions made concerning the future earnings potential of the organization, and a market-based approach that looks at values for organizations of comparable size, structure and business model.  The Company’s assessment of goodwill at December 31, 2010, pursuant to its Goodwill Impairment Testing Policy, was performed with the assistance of an independent third party and resulted in no impairment.

 

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Income Taxes

 

The Company accounts for income taxes in accordance with FASB ASC 740, Income Taxes, resulting in two components of income tax expense: current and deferred. Current income tax expense approximates taxes to be paid or refunded for the current period. Interest expense and penalties associated with unrecognized tax benefits, if any, are classified as income tax expense in the Consolidated Statements of Income.  The Company does not have any uncertain income tax positions and has not accrued for any interest or penalties as of December 31, 2010 and 2009.

 

The Company determines deferred income taxes using the balance sheet method. Under this method, the net deferred tax asset or liability is based on the tax effects of the differences between the book and tax bases of assets and liabilities, and recognizes enacted changes in tax rates and laws in the period in which they occur. Deferred income tax expense results from changes in deferred tax assets and liabilities between periods. Deferred tax assets are recognized subject to Management’s judgment that realization is more likely than not. In making the determination whether a deferred tax asset is more likely than not to be realized, management seeks to evaluate all available positive and negative evidence including the possibility of future reversals of existing taxable temporary differences, projected future taxable income, tax planning strategies and recent financial results. A deferred tax asset valuation allowance is established to reduce the net carrying amount of deferred tax assets if it is determined to be more likely than not that all or some portion of the deferred tax asset will not be realized. Based on its evaluation of the Company’s deferred tax assets as of December 31, 2010, Management determined that it was appropriate to record a valuation allowance of $7.1 million for a portion of the Company’s deferred tax assets during 2010. Going forward, Management will review the deferred tax asset on a quarterly basis. In the event Management later determines that it is more likely than not the Company will be able to realize the tax benefits of its cumulative losses in future years, all or part of the deferred tax asset valuation allowance may be reversed.  See also Note 10. Income Taxes, of these consolidated financial statements for additional information related to deferred income taxes.

 

Bank Owned Life Insurance

 

The Company has purchased life insurance policies on certain employees.  These Bank Owned Life Insurance (“BOLI”) policies are recorded in the consolidated balance sheets at their cash surrender value.  Income and expense from these policies and changes in the cash surrender value are recorded in non-interest income and non-interest expense in the consolidated statements of income.

 

Supplemental Employee Compensation Benefits Agreements

 

The Company has entered into supplemental employee compensation benefits agreements with certain executive and senior officers.  The measurement of the liability under these agreements includes estimates involving life expectancy, length of time before retirement and expected benefit levels.  Should these estimates vary substantially from actual events, we could incur additional or reduced expense to provide these benefits.

 

Disclosure about Fair Value of Financial Instruments

 

The Company’s estimated fair value amounts have been determined by the Company using available market information and appropriate valuation methodologies.  However, considerable judgment is required to develop the estimates of fair value.  Accordingly, the estimates are not necessarily indicative of the amounts the Company could have realized in a current market exchange.  The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts.

 

Although Management is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued for purposes of these financial statements since the balance sheet date and, therefore, current estimates of fair value may differ significantly from the amounts presented in the accompanying notes.

 

Financial Instruments

 

In the ordinary course of business, the Company has entered into off-balance sheet financial instruments consisting of commitments to extend credit, commercial letters of credit, and standby letters of credit as more fully described in Note 11 of these consolidated financial statements.  Such financial instruments are recorded in the financial statements when they are funded or related fees are incurred or received.

 

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Comprehensive Income

 

In accordance with U.S. GAAP the Company classifies items of other comprehensive income by their nature in the financial statements and displays the accumulated other comprehensive income separately from retained earnings in the equity section of the Balance Sheet. Changes in the unrealized gain (loss) on available for sale securities net of income taxes was the only component of accumulated other comprehensive income for the Company for the years ended December 31, 2010, 2009 and 2008.

 

(Loss) / Earnings Per Share

 

Basic (loss) / earnings per share (“EPS”) excludes dilution and is computed by dividing income available to common stockholders by the weighted-average number of common shares outstanding for the period.  Diluted EPS is calculated using the “Treasury Stock Method” and reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity.  In accordance with U.S. GAAP, when the Company’s net income available to common stockholders is in a loss position, the diluted earnings per share calculation utilizes average shares outstanding.

 

Share-Based Compensation

 

U.S. GAAP requires companies to recognize in the income statement the grant-date fair value of stock options and other equity-based forms of compensation issued to employees over the employees’ requisite service period (generally the vesting period).  The Company uses a straight-line method for the recognition of all share-based compensation expense.  All share-based compensation awards are granted with an exercise price equal to the estimated fair value of the underlying common stock on the date of grant as required by the Company’s Equity Based Compensation Plan.  See also Note 15. Share-Based Compensation Plans, of these consolidated financial statements for additional information related to share-based compensation.

 

Reclassifications

 

Certain amounts in the 2008 and 2009 financial statements have been reclassified to conform to the 2010 presentation.

 

Recent Accounting Pronouncements

 

On July 21, 2010, the Financial Accounting Standards Board (“FASB) issued Accounting Standards Update (“ASU”) No. 2010-20, “Receivables (Topic 310): Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses.” The new disclosures will require significantly more information about credit quality in a financial institution’s loan portfolio. This statement addresses only disclosures and does not change recognition or measurement of the allowance for loan losses. The provisions under this statement are effective for interim and annual reporting periods beginning after December 15, 2010 and are reflected in these consolidated financial statements.  Portions of ASU No. 2010-20 were required for disclosure in the 2010 Form 10-K while the full disclosure requirements of the ASU are required to be disclosed with the Company’s first quarter 2011 Form 10-Q filing.  The adoption of this ASU did not have a material impact on the Company’s financial statements.

 

In April 2010, the FASB issued ASU No. 2010-18, “Effect of a Loan Modification When the Loan Is Part of a Pool That Is Accounted for as a Single Asset.”  ASU No. 2010-18 provides guidance on accounting for acquired loans that have evidence of credit deterioration upon acquisition, specifically those loans acquired and accounted for in the aggregate as a pool. As a result of the amendments in this Update, modifications of loans that are accounted for within a pool under Subtopic 310-30 do not result in the removal of those loans from the pool even if the modification of those loans would otherwise be considered a troubled debt restructuring. An entity will continue to be required to consider whether the pool of assets in which the loan is included is impaired if expected cash flows for the pool change.  The Company was required to adopt the provisions of this ASU in its first interim period beginning after July 15, 2010.  The adoption of this ASU did not have a material impact on its consolidated financial statements.

 

In February 2010, the Financial FASB issued ASU No. 2010-09, “Subsequent Events (Topic 855) Amendments to Certain Recognition and disclosure Requirements.”  The amendments remove the requirement for an SEC registrant to disclose the date through which subsequent events were evaluated.  Removal of the disclosure requirement did not have an effect on the nature or timing of subsequent events evaluations performed by the Company.  ASU 2010-09 became effective upon issuance.

 

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In January 2010, the FASB issued ASU No. 2010-06, “Fair Value Measurements and Disclosures (Topic 820):  Improving Disclosures about Fair Value Measurements.”  ASU 2010-06 revises two disclosure requirements concerning fair value measurements and clarifies two others.  It requires separate presentation of significant transfers into and out of Levels 1 and 2 of the fair value hierarchy and disclosure of the reasons for such transfers.  It will also require the presentation of purchases, sales, issuances, and settlements within Level 3 on a gross basis rather than a net basis.  The amendments also clarify that disclosures should be disaggregated by class of asset or liability and that disclosures about inputs and valuation techniques should be provided for both recurring and non-recurring fair value measurements.  These new disclosure requirements were effective for the period ended March 31, 2010, except for the requirement concerning gross presentation of Level 3 activity, which is effective for fiscal years beginning after December 15, 2010.  The adoption of this ASU did not have a material impact on the Company’s consolidated financial statements.

 

In December 2009, FASB issued an accounting standard incorporated into Accounting Standards Codification (“ASC”) 860.  This update codifies SFAS No. 166, “Accounting for Transfers of Financial Assets—an Amendment of FASB Statement No. 140,” which was previously issued by the FASB in June 2009 but was not included in the original codification.  This update to ASC 860 creates more stringent conditions for reporting a transfer of a portion of a financial asset as a sale, clarifies other sale-accounting criteria, and changes the initial measurement of a transferor’s interest in transferred financial assets. This statement is effective for all annual and interim reporting periods beginning after November 15, 2009.  Under this standard, in order to recognize the transfer of a portion of a financial asset as a sale, the transferred portion and any portion that continues to be held by the transferor must represent a participating interest, and the transfer of the participating interest must meet the conditions for surrender of control. To qualify as a participating interest: (i) the portions of a financial asset must represent a proportionate ownership interest in an entire financial asset, (ii) from the date of transfer, all cash flows received from the entire financial asset must be divided proportionately among the participating interest holders in an amount equal to their share of ownership, (iii) involve no recourse (other than standard representation and warranties) to, or subordination by, any participating interest holder, and (iv) no party has the right to pledge or exchange the entire financial asset. If the participating interest or surrender of control criteria are not met the transfer is not accounted for as a sale and de-recognition of the asset is not appropriate.  Rather the transaction is accounted for as a secured borrowing arrangement. The impact to certain transactions such as the sale of SBA loans or certain participations being reported as secured borrowings rather than derecognizing a portion of a financial asset would increase total assets (loans) and liabilities (other borrowings).  The terms contained in certain participation and loan sale agreements are outside the control of the Company and largely relate to Small Business Administration (“SBA”) loan sales.  These sales agreements contain recourse provisions (generally 90 days) that will initially preclude sale accounting.  However, once the recourse provision expires, transfers of portions of financial assets may be reevaluated to determine if they meet the participating interest definition and subsequently accounted for as a sale.  As a result, The Company will report SBA transfers as secured borrowings over the period for which recourse provisions exist, which will result in the deferral of any potential gain on sale from these transactions, assuming all other sales criteria for each transaction are met. The Company does not believe it has or will have a significant amount of participations subject to recourse provisions or other features that would preclude de-recognition of the assets transferred.  The Company adopted this accounting standard on January 1, 2010 and it has not had a material impact on the Company’s consolidated financial statements.

 

In June 2009, the FASB issued an accounting standard, incorporated into ASC topic 810 “Consolidation,” that seeks to improve financial reporting by companies involved with variable interest entities. Also addressed under this standard are concerns about the application of certain key provisions, including those in which the accounting and disclosures do not always provide timely and useful information about a company’s involvement in a variable interest entity.  The standard requires a company to perform analyses to determine if its variable interest(s) give it a controlling financial interest in a variable interest entity.  These analyses identify the primary beneficiary of the variable interest entity as the company that has both of the following characteristics: (a) the power to direct the activities of a variable interest entity that most significantly impact the company’s economic performance; and (b) the obligation to absorb losses of the entity that could potentially be significant to the variable interest entity or the right to receive benefits from the entity that could potentially be significant to the variable interest entity.  This standard is effective for all annual and interim reporting periods beginning after November 15, 2009 with earlier application prohibited.  The adoption of this standard did not have a material impact on the Company’s financial statements.

 

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Note 2.  Investment Securities

 

The investment securities portfolio was comprised solely of securities classified as available for sale. The tables below set forth the fair values of investment securities available for sale at December 31, 2010 and 2009:

 

(dollar amounts in thousands)

 

 

 

Gross

 

Gross

 

 

 

 

 

Amortized

 

Unrealized

 

Unrealized

 

 

 

As of December 31, 2010

 

Cost

 

Gains

 

Losses

 

Fair Value

 

Obligations of U.S. government agencies

 

$

6,684

 

$

-    

 

$

(248

)

$

6,436

 

Mortgage backed securities

 

 

 

 

 

 

 

 

 

Agency

 

159,448

 

1,653

 

(484

)

160,617

 

Non-agency

 

10,170

 

233

 

(1,344

)

9,059

 

State and municipal securities

 

49,459

 

242

 

(1,956

)

47,745

 

Other securities

 

1,109

 

-

 

-

 

1,109

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

226,870

 

$

2,128

 

$

(4,032

)

$

224,966

 

 

 

 

 

 

 

 

 

 

 

As of December 31, 2009

 

 

 

 

 

 

 

 

 

Obligations of U.S. government agencies

 

$

108

 

$

-

 

$

(4

)

$

104

 

Mortgage backed securities

 

 

 

 

 

 

 

 

 

Agency

 

78,203

 

619

 

(872

)

77,950

 

Non-agency

 

21,935

 

1,184

 

(2,966

)

20,153

 

State and municipal securities

 

22,653

 

421

 

(210

)

22,864

 

Other securities

 

109

 

-

 

-

 

109

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

123,008

 

$

2,224

 

$

(4,052

)

$

121,180

 

 

During the year ended December 31, 2010, the Company sold $33.4 million in available for sale investments and recognized aggregate gross gains of $0.8 million.  For the years ended December 31, 2009 and 2008, the Company recognized aggregate gross gains in the amounts of $0.3 million and $37 thousand, respectively.

 

Other than Temporary Impairment (“OTTI”)

 

The Company periodically evaluates investments in the portfolio for other than temporary impairment and more specifically when conditions warrant such an evaluation.  When evaluating whether impairment is other than temporary, the Company considers, among other things, the following: (1) the length of time the security has been in an unrealized loss position, (2) the extent to which the security’s fair value is less than its cost, (3) the financial condition of the issuer, (4) any adverse changes in ratings issued by various rating agencies, (5) the intent and ability of the Company to hold such securities for a period of time sufficient to allow for any anticipated recovery in fair value and (6) in the case of mortgage related securities, credit enhancements, loan-to-values, credit scores, delinquency and default rates, cash flows and the extent to which those cash flows are within Management’s initial expectations based on pre-purchase analyses.

 

When an investment is deemed to be other than temporarily impaired, an entity is required to assess whether it has the intent to sell the investment, or if it is more likely than not that it will be required to sell the investment before its anticipated recovery of its full basis in the security.  According to U.S. GAAP, if either of these conditions is met, the entity must recognize an OTTI loss on the investment in the current period through the income statement including amounts attributable to both credit and market conditions.  However, if an entity does not intend, nor anticipates it will be required to sell the investment, it must still perform an evaluation of future cash flows it expects to receive from the investment to determine if a credit loss has occurred.  In the event that a credit loss has been projected to have occurred, only the amount of impairment related to the credit loss is recognized through earnings.  OTTI amounts related to all other factors, such as market conditions, are recorded as a component of accumulated other comprehensive income.

 

The presentation of OTTI losses are made in the consolidated statements of income on a gross basis (the total amount by which the investment’s amortized cost basis exceeds its fair value at the time it was evaluated for OTTI) with an offset for the amount of OTTI recognized in other comprehensive income (OTTI related to all other factors such as market conditions).  The net charge to earnings, referred to as credit related losses, reflects the portion of the impaired investment the Company estimates it will no longer recover.

 

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The Company monitors investments in the portfolio on a regular basis.  When investments in an unrealized loss position exhibit certain characteristics that lead Management to believe those losses may be other than temporary, an evaluation of such investments is performed with the assistance of an independent third party to determine if and to what extent those investments are other than temporarily impaired.  The Company’s evaluation of impaired investments includes estimating future cash flows from the investment the Company expects to collect, based on an assessment of all available information about the applicable investment.  The Company considers such factors as: the structure of the security and the Company’s position within that structure, the remaining payment terms for the security, prepayment speeds, default rates, loss severity on the collateral supporting the security, expected changes in real estate prices, and assumptions regarding interest rates, to determine whether the Company will recover the remaining amortized cost basis of the security. If the Company’s evaluation results in a present value of expected cash flows that is less than the remaining amortized cost basis of the security, an OTTI credit loss is deemed to have occurred, and a charge to current earnings is recorded.  On a quarterly basis the Company, with the assistance of an independent third party, performs an updated evaluation on all securities for which OTTI was previously recognized.

 

During 2010 the Company updated its evaluation on several securities for which OTTI was previously recognized in the fourth quarter of 2009.  These updated evaluations were performed on several non-agency whole loan collateralized mortgage obligations (“CMOs”), and resulted in additional OTTI credit related losses substantially related to one security of $0.2 million.  Total OTTI credit related losses on this particular security as of December 31, 2010 were $0.4 million.  As of December 31, 2010 the Company did not have the intent nor did it anticipate it would be required to sell this particular security.

 

As of December 31, 2010, unrealized losses on other non-agency CMOs within the Company’s investment portfolio were primarily attributable to continued illiquidity in the market related to such investments, uncertainty regarding current and future economic conditions and declines in credit metrics related to the underlying collateral.  However, as of December 31, 2010, the Company does not believe these securities would be settled at a price less than the amortized cost of the Company’s investment. Because the Company does not have the intent to sell these investments and it is not more likely than not that the Company will be required to sell these investments before anticipated recovery of fair value, which may be at maturity, the Company did not consider these investments to be other than temporarily impaired as of December 31, 2010.  However, it is possible that the underlying loan collateral of these securities will perform worse than is currently expected, which could lead to adverse changes in cash flows on these securities and future OTTI losses.  Events that could trigger material unrecoverable declines in fair values, and therefore potential OTTI losses for these securities in the future, include, but are not limited to, further significantly weakened economic conditions, continued illiquidity in the market for such investments, and further deterioration of underlying credit metrics such as: significantly higher levels of default, loss in value on the underlying collateral, and deteriorating credit enhancement.

 

As of December 31, 2010 net unrealized losses on state and municipal securities totaled $1.7 million, compared to a net unrealized gain of $0.2 million as of December 31, 2009.  Management believes the decline in values of such investments is not credit related and can be attributed to the continued uncertainty surrounding economic conditions.  As of December 31, 2010 the Company did not believe the decline in the values in municipal investments was other than temporary.

 

The following table provides additional information related to the OTTI losses the Company has recognized as of December 31, 2010:

 

 

 

As of December 31, 2010

 

 

 

 

 

OTTI Related

 

 

 

 

 

OTTI Related

 

to All Other

 

Total

 

(dollar amounts in thousands)

 

to Credit Loss

 

Factors

 

OTTI

 

Balance, beginning of the period

 

$

372

 

$

1,584

 

$

1,956

 

Additional charges on securities for which OTTI was previously recognized

 

207

 

(571

)

(364

)

Less: losses related to OTTI securities sold

 

(45

)

(70

)

(115

)

 

 

 

 

 

 

 

 

Balance, end of the period

 

$

534

 

$

943

 

$

1,477

 

 

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Table of Contents

 

Those investment securities available for sale which have an unrealized loss position at December 31, 2010 and 2009 are detailed below:

 

 

 

Securities In A Loss Position For

 

 

 

 

 

(dollar amounts in thousands)

 

Less Than Twelve Months

 

Twelve Months or More

 

Total

 

 

 

Fair

 

Unrealized

 

Fair

 

Unrealized

 

Fair

 

Unrealized

 

As of December 31, 2010

 

Value

 

Loss

 

Value

 

Loss

 

Value

 

Loss

 

Obligations of U.S. government agencies

 

$

6,339

 

$

(245

)

$

96

 

$

(3

)

$

6,435

 

$

(248

)

Mortgage backed securities

 

 

 

 

 

 

 

 

 

 

 

 

 

Agency

 

56,164

 

(469

)

2,094

 

(15

)

58,258

 

(484

)

Non-agency

 

-    

 

-    

 

4,780

 

(1,344

)

4,780

 

(1,344

)

State and municipal securities

 

38,731

 

(1,936

)

136

 

(20

)

38,867

 

(1,956

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

101,234

 

$

(2,650

)

$

7,106

 

$

(1,382

)

$

108,340

 

$

(4,032

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

As of December 31, 2009

 

 

 

 

 

 

 

 

 

 

 

 

 

Obligations of U.S. government agencies

 

$

-    

 

$

-    

 

$

104

 

$

(4

)

$

104

 

$

(4

)

Mortgage backed securities

 

 

 

 

 

 

 

 

 

 

 

 

 

Agency

 

38,625

 

(870

)

357

 

(2

)

38,982

 

(872

)

Non-agency

 

-    

 

-    

 

11,618

 

(2,966

)

11,618

 

(2,966

)

State and municipal securities

 

6,012

 

(210

)

-    

 

-    

 

6,012

 

(210

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

44,637

 

$

(1,080

)

$

12,079

 

$

(2,972

)

$

56,716

 

$

(4,052

)

 

There were ten securities that have been in a loss position for twelve months or longer as of December 31, 2010, compared to twelve as of December 31, 2009.  These unrealized losses can be attributed in large part to continued market volatility as well as general concerns surrounding current and future economic conditions.  As the Company has the ability to hold these securities until maturity, or for the foreseeable future, no declines are deemed to be other than temporary at December 31, 2010 other than those previously disclosed.

 

The amortized cost and fair values of investment securities available for sale at December 31, 2010 and 2009, by contractual maturity are shown below.  Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

 

 

 

 

2010

 

2009

 

 

 

Amortized

 

 

 

Amortized

 

 

 

(dollar amounts in thousands)

 

Cost

 

Fair Value

 

Cost 

 

Fair Value

 

Due one year or less

 

$

39,815

 

$

40,483

 

$

2,727

 

$

2,752

 

Due after one year through five years

 

120,666

 

121,032

 

81,236

 

80,376

 

Due after five years through ten years

 

34,020

 

32,686

 

16,911

 

17,020

 

Due after ten years

 

32,369

 

30,765

 

22,134

 

21,032

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

226,870

 

$

224,966

 

$

123,008

 

$

121,180

 

 

Securities having a carrying value and a fair value of $9.9 million and $5.2 million at December 31, 2010 and 2009, respectively, were pledged to secure public deposits and for other purposes as required by law.

 

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Note 3.  Loans

 

The following table sets forth the balance for each major loan category as of December 31, 2010 and 2009:

 

 

 

December 31,

 

(dollar amounts in thousands)

 

2010

 

2009

 

Real Estate Secured

 

 

 

 

 

Multi-family residential

 

$

17,637

 

$

20,631

 

Residential 1 to 4 family

 

21,804

 

25,483

 

Home equity lines of credit

 

30,801

 

29,780

 

Commercial

 

348,583

 

337,940

 

Farmland

 

15,136

 

13,079

 

Commercial

 

 

 

 

 

Commercial and industrial

 

145,811

 

157,270

 

Agriculture

 

15,168

 

17,698

 

Other

 

153

 

238

 

Construction

 

 

 

 

 

Single family residential

 

11,525

 

15,538

 

Single family residential - Spec.

 

2,391

 

3,400

 

Tract

 

-    

 

2,215

 

Multi-family

 

2,218

 

2,300

 

Hospitality

 

-    

 

14,306

 

Commercial

 

27,785

 

27,128

 

Land

 

30,685

 

52,793

 

Installment loans to individuals

 

7,392

 

8,327

 

All other loans (including overdrafts)

 

214

 

553

 

 

 

 

 

 

 

Total loans, gross

 

677,303

 

728,679

 

 

 

 

 

 

 

Deferred loan fees

 

1,613

 

1,825

 

Reserve for possible loan losses

 

24,940

 

14,372

 

 

 

 

 

 

 

Total loans, net

 

$

650,750

 

$

712,482

 

 

 

 

 

 

 

Loans held for sale

 

$

11,008

 

$

9,487

 

 

Concentration of Credit Risk

 

At December 31, 2010 and 2009, $508.6 million and $544.6 million of the Company’s loan portfolio was collateralized by various forms of real estate.  Such loans are generally made to borrowers located in the counties of San Luis Obispo and Santa Barbara.  The Company attempts to reduce its concentration of credit risk by making loans which are diversified by project type.  While Management believes that the collateral presently securing this portfolio is adequate, there can be no assurances that further significant deterioration in the California real estate market would not expose the Company to significantly greater credit risk.

 

Loans serviced for others are not included in the accompanying balance sheets.  The unpaid principal balance of loans serviced for others, exclusive of Small Business Administration (“SBA”) loans was $13.4 million and $16.3 million at December 31, 2010 and 2009, respectively.

 

The Company also originates SBA loans for sale to governmental agencies and institutional investors.  At December 31, 2010 and 2009, the unpaid principal balance of SBA loans serviced for others totaled $6.4 million and $4.4 million, respectively.  The Company recognized gains from the sale of SBA loans was $0.2 million during 2010 and 2009, respectively.  The Company did not recognize gains from the sale of SBA loans in 2008.

 

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Table of Contents

 

Impaired Loans

 

The following table provides a summary of the Company’s investment in impaired loans as of and for the year ended December 31, 2010:

 

 

 

 

 

Unpaid

 

Impaired Loans

 

Specific

 

Average

 

Interest

 

 

 

Recorded

 

Principal

 

With Specific

 

Without Specific

 

Allowance for

 

Recorded

 

Income

 

(dollar amounts in thousands)

 

Investment

 

Balance

 

Allowance

 

Allowance

 

Impaired Loans

 

Investment

 

Recognized

 

Real Estate Secured

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Multi-family residential

 

$

-    

 

$

-    

 

$

-    

 

$

-    

 

$

-    

 

$

-    

 

$

-    

 

Residential 1 to 4 family

 

748

 

896

 

-    

 

748

 

-    

 

988

 

-    

 

Home equity lines of credit

 

1,019

 

1,019

 

-    

 

1,019

 

-    

 

508

 

-    

 

Commercial

 

18,322

 

20,539

 

4,706

 

13,616

 

1,085

 

18,890

 

67

 

Farmland

 

2,626

 

2,773

 

-    

 

2,626

 

-    

 

2,745

 

-    

 

Commercial

 

 

 

 

 

 

 

 

 

 

 

-    

 

 

 

Commercial and industrial

 

5,858

 

6,474

 

903

 

4,955

 

461

 

8,010

 

150

 

Agriculture

 

246

 

384

 

-    

 

246

 

-    

 

1,294

 

-    

 

Other

 

-    

 

-    

 

-    

 

-    

 

-    

 

-    

 

-    

 

Construction

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Single family residential

 

1,311

 

1,310

 

952

 

359

 

476

 

945

 

-    

 

Single family residential - Spec.

 

1,250

 

1,250

 

-    

 

1,250

 

-    

 

1,108

 

-    

 

Tract

 

-    

 

-    

 

-    

 

-    

 

-    

 

311

 

-    

 

Multi-family

 

479

 

896

 

-    

 

479

 

-    

 

481

 

-    

 

Hospitality

 

-    

 

-    

 

-    

 

-    

 

-    

 

-    

 

-    

 

Commercial

 

-    

 

100

 

-    

 

-    

 

-    

 

245

 

-    

 

Land

 

3,371

 

3,771

 

1,478

 

1,893

 

235

 

6,935

 

-    

 

Installment loans to individuals

 

370

 

502

 

-    

 

370

 

-    

 

396

 

17

 

All other loans (including overdrafts)

 

-    

 

-    

 

-    

 

-    

 

-    

 

-    

 

-    

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Totals

 

$

35,600

 

$

39,913

 

$

8,039

 

$

27,561

 

$

2,257

 

$

42,855

 

$

234

 

 

The Company considers a loan to be impaired when, based on current information and events, it is probable the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement.  The Company may also consider a loan impaired when based on certain information and events surrounding a borrower, it is determined that the likelihood of the Company receiving all scheduled payments, including interest, when due is remote.

 

The Company classifies non-accruing loans, loans 90 days or more past due and still accruing, and loans recently classified as troubled debt restructurings as impaired loans.  When loans are placed on non-accrual status, all accrued but uncollected interest is reversed from earnings.  Once on non-accrual status payments received on such loans are generally applied as a reduction of the loan principal balance.  Interest on such loans is only recognized on a cash basis and is generally not recognized on specific impaired loans unless the likelihood of further loss is remote.  Loans may be returned to accruing status if the Company believes that all remaining principal and interest is fully collectible and there has been at least six months of sustained repayment performance since the loan was placed on non-accrual.  If interest on non-accruing loans had been recognized at the original interest rates stipulated in the respective loan agreements, interest income would have increased $3.0 million, $1.3 million and $0.9 million in 2010, 2009, and 2008, respectively.  The Company did not record income from the receipt of cash payments related to non-accruing loans during the years ended December 31, 2010, 2009 and 2008.  Interest income recognized on impaired loans in the table above represents interest the Company recognized on performing troubled debt restructurings.

 

The provisions of U.S. GAAP permit the valuation allowances reported in the table above to be determined on a loan-by-loan basis or by aggregating loans with similar risk characteristics.  Because the loans currently identified as impaired have unique risk characteristics, valuation allowances the Company recorded were determined on a loan-by-loan basis.  It should be noted that a significant portion of the Company’s impaired loans were carried at fair value as of December 31, 2010 and 2009, resulting in large part from the charge-off of loan balances following the receipt of appraisal information on the underlying collateral.

 

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The following table summarizes impaired loan balances for prior periods as presented below:

 

 

 

December 31,

(dollar amounts in thousands)

 

2009

 

2008

 

Non-accruing loans

 

$

38,170

 

$

18,327

 

Loans 90 days or more past due

 

151

 

348

 

Troubled debt restructures (exclusive of loans on non accrual)

 

9,703

 

52

 

 

 

 

 

 

 

Total impaired loans

 

$

48,024

 

$

18,727

 

 

 

 

 

 

 

Imparied loans with a valuation allowance

 

$

6,155

 

$

1,091

 

Valuation allowance related to impaired loans

 

$

852

 

$

206

 

Impaired loans without a valuation allowance

 

$

41,869

 

$

17,636

 

 

 

 

 

 

 

Average recorded investment in impaired loans

 

$

32,781

 

$

14,114

 

Cash receipts applied to reduce principal balance

 

$

7,042

 

$

1,638

 

 

At December 31, 2010 and 2009, $10.4 million and $12.9 million in loans were classified as troubled debt restructurings (“TDRs”), respectively.  Of those balances $2.8 million and $9.7 million were accruing as of December 31, 2010 and 2009, respectively.  In a majority of cases, the Company has granted concessions regarding interest rates, payment structure and maturity.  Forgone interest related to TDRs totaled $0.2 million and $0.1 million for the years ended December 31, 2010 and 2009, respectively.  As of December 31, 2010, the Company was not committed to lend any additional funds to borrowers whose obligations to the Company were restructured.

 

Credit Quality and Credit Risk Management

 

The Company manages credit risk not only through extensive risk analyses performed prior to a loan’s funding, but through the ongoing monitoring of loans within the portfolio, and more specifically certain types of loans that generally involve a greater degree of risk, such as commercial real estate, commercial lines of credit, and construction/land loans.  The Company monitors loans in the portfolio with the assistance of a semi-annual independent loan review.  These reviews generally not only focus on problem loans, but also pass credits within certain pools of loans that may be expected to experience stress due to economic conditions.

 

This process allows the Company to validate credit ratings, underwriting structure, and the Company’s estimated exposure in the current economic environment as well as enhance communications with borrowers where necessary in an effort to mitigate potential future losses.

 

The Company has a credit committee, chaired by the Chief Credit Officer and is comprised of other senior level credit officers.  The credit committee establishes the Company’s desire for funding certain types of credit and regularly reviews the Company’s position with respect to credit quality pursuant to the Company’s lending policy.  The Company’s lending policy is established by the Chief Credit Officer and is reviewed annually by the Board of Directors for approval.  The lending policy establishes underwriting criteria, sets portfolio concentration limits, provides criteria for the proper risk grading of loans, requires internal reviews of all pass graded credits meeting certain criteria, and contains requirements concerning the identification of and regular monitoring of problem loans.

 

The policy also provides that analyses shall be conducted on all significant problem loans at least quarterly, in order for the Company to properly estimate its potential exposure to loss associated with such credits in a timely manner.  The policy also provides that a detailed listing of all problem loans be provided to the Company’s credit committee on a regular basis.  Additionally, the Company maintains a subset of pass list loans designated as “watch” loans, that for any of a variety of reasons, Management believes require additional regular review.  Pass graded loans which are designated as watch credits are more heavily scrutinized than other pass rated credits in the portfolio, so that any potential weaknesses that may develop in such credits are more quickly identified, thereby serving to mitigate potential losses.

 

Pursuant to the Company’s lending policy, all loans in the portfolio are assigned a risk rating, which allows Management, among other things, to identify the risk associated with each credit in the portfolio, and to provide a basis for estimating credit losses inherent in the portfolio.  Risk grades are generally assigned based on information concerning the borrower, and the strength of the collateral.  Risk grades are reviewed regularly by the Company’s credit committee, and are scrutinized by independent loan reviews performed semi-annually, as well as by regulatory agencies during scheduled examinations.  The Company grades all loans as either: (i) pass, (ii) special mention, (iii) substandard, and (iv) doubtful.

 

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Table of Contents

 

The following provides brief definitions for credit ratings assigned to loans in the portfolio:

 

·                  Pass – strong credit quality with adequate collateral or secondary source of repayment and little existing or known weaknesses, however may include credits with exposure to certain factors that may adversely impact the credit if they materialize.  Such factors may be credit / relationship specific or general to an entire industry.

 

·                  Special Mention – credits that have potential weaknesses that deserve Management’s close attention.  If not corrected, these potential weaknesses may result in deterioration of the repayment prospects for the credit at some future date.

 

·                  Substandard – credits that have a defined weakness or weaknesses which may jeopardize the orderly liquidation of the loan through cash flows, making it likely that repayment may have to come from some other source, such as the liquidation of collateral.  The Company is more likely to incur losses on substandard credits if the weakness or weaknesses identified in the credit are not corrected.

 

·     Doubtful – credits that possess the characteristics of a substandard credit, but because of certain existing deficiencies related to the credit, full collection is highly questionable.  The probability of incurring some loss on such credits is high, but because of certain important and reasonably specific pending factors which may work to the advantage of strengthening the credit, charge-off is deferred until such time the Company becomes reasonably certain that certain pending factors related to the credit will no longer provide some form of benefit.

 

The Company has a Special Assets department whose primary responsibility is to manage the workout and recovery operations with respect to problem assets.  When a loan is downgraded to substandard status or below, it becomes the responsibility of the Special Assets department.  The objective of the Special Assets department is to then work with the borrower to bring resolution to the weaknesses identified in the credit, or if necessary, provide the Company with a strategy for exiting the relationship, such as the repossession and subsequent liquidation of collateral.  All non-accruing loans are placed under the supervision of the Special Assets department.

 

Loans typically move to non-accruing status from the Company’s substandard risk grade.  When a loan is first classified as substandard, the Company obtains updated appraisal information on the underlying collateral. Once the updated appraisal is obtained and analyzed by Management, a valuation allowance, if necessary, is established against such loan or a loss is recognized by a charge to the allowance for loan losses if Management believes that the full amount of the Company’s recorded investment in the loan is no longer collectable.  Therefore, at the time a loan moves into non-accruing status, a valuation allowance typically has already been established or balances deemed uncollectable on such loan have been charged-off.  If upon a loan’s migration to non-accruing status appraisals obtained while the loan was classified as substandard are deemed to be out dated, the Company typically orders new appraisals on underlying collateral in order to have the most current indication of fair value.  If a complete appraisal is expected to take a significant amount of time to complete, while waiting for an appraisal, the Company may also rely on a broker’s price opinion or other meaningful market data, such as comparable sales, in order to derive its best estimate of a property’s fair value at the time of decision to classify the loan as substandard and/or non-accruing.  Once a loan is placed on non-accruing status an analysis of the underlying collateral is performed at least quarterly, and corresponding changes in any related valuation allowance are made or balances deemed to be fully uncollectable are charged-off.

 

The Company typically moves to charge-off loan balances when, based on various evidence, it believes those balances are no longer collectable.  Such evidence may include updated information related to a borrower’s financial condition or updated information related to collateral securing such loans.  Such loans are monitored internally on a regular basis by the Special Assets department, which is responsible for obtaining updated periodic appraisal information for collateral securing problem loans.  If a loan’s credit quality deteriorates to the point that collection of principal through traditional means is believed by Management to be doubtful, and the value of collateral securing the obligation is sufficient, the Company generally takes steps to protect and liquidate the collateral.  Any loss resulting from the difference between the Company’s recorded investment in the loan and the fair market value of the collateral obtained through repossession is recognized by a charge to the allowance for loan losses.

 

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Table of Contents

 

The following table stratifies the loan portfolio by the Company’s internal risk grading system as well as certain other information concerning the credit quality of the loan portfolio as of December 31, 2010:

 

 

 

 

 

Credit Risk Grades

 

Days Past Due

 

 

 

 

 

 

 

Total Gross

 

 

 

Special

 

 

 

 

 

 

 

 

 

90+ and Still

 

Non-

 

Accruing

 

(dollar amounts in thousands)

 

Loans

 

Pass

 

Mention

 

Substandard

 

Doubtful

 

30-59

 

60-89

 

Accruing

 

Accruing

 

TDR

 

Real Estate Secured

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Multi-family residential

 

$

17,637

 

$

17,637

 

$

-    

 

$

-    

 

$

-    

 

$

-    

 

$

-    

 

$

-    

 

$

-    

 

$

-    

 

Residential 1 to 4 family

 

21,804

 

20,054

 

282

 

1,468

 

-    

 

-    

 

-    

 

-    

 

748

 

-    

 

Home equity lines of credit

 

30,801

 

29,575

 

89

 

1,137

 

-    

 

40

 

24

 

-    

 

1,019

 

-    

 

Commercial

 

348,583

 

266,232

 

33,786

 

47,000

 

1,565

 

1,212

 

-    

 

-    

 

17,752

 

570

 

Farmland

 

15,136

 

8,980

 

2,693

 

3,463

 

-    

 

-    

 

-    

 

-    

 

2,626

 

-    

 

Commercial

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Commercial and industrial

 

145,811

 

131,594

 

2,166

 

10,835

 

1,216

 

284

 

26

 

-    

 

3,921

 

1,937

 

Agriculture

 

15,168

 

12,062

 

2,555

 

551

 

-    

 

-    

 

-    

 

-    

 

246

 

-    

 

Other

 

153

 

153

 

-    

 

-    

 

-    

 

-    

 

-    

 

-    

 

-    

 

-    

 

Construction

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Single family residential

 

11,525

 

9,399

 

816

 

1,310

 

-    

 

-    

 

-    

 

-    

 

1,311

 

-    

 

Single family residential - Spec.

2,391

 

-    

 

1,141

 

1,250

 

-    

 

-    

 

-    

 

-    

 

1,250

 

-    

 

Tract

 

-    

 

-    

 

-    

 

-    

 

-    

 

-    

 

-    

 

-    

 

-    

 

-    

 

Multi-family

 

2,218

 

-    

 

1,739

 

-    

 

479

 

-    

 

-    

 

-    

 

479

 

-    

 

Hospitality

 

-    

 

-    

 

-    

 

-    

 

-    

 

-    

 

-    

 

-    

 

-    

 

-    

 

Commercial

 

27,785

 

27,287

 

498

 

-    

 

-    

 

-    

 

-    

 

-    

 

-    

 

-    

 

Land

 

30,685

 

16,618

 

9,213

 

4,854

 

-    

 

-    

 

-    

 

-    

 

3,371

 

-    

 

Installment loans to individuals

 

7,392

 

7,009

 

8

 

375

 

-    

 

10

 

-    

 

-    

 

96

 

274

 

All other loans (including overdrafts)

 

214

 

214

 

-    

 

-    

 

-    

 

-    

 

-    

 

-    

 

-    

 

-    

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Totals

 

$

677,303

 

$

546,814

 

$

54,986

 

$

72,243

 

$

3,260

 

$

1,546

 

$

50

 

$

-    

 

$

32,819

 

$

2,781

 

 

Note 4.  Allowance for Loan Losses

 

The Company has established an allowance for loan losses to account for probable incurred losses inherent in the loan portfolio as of the date of the balance sheet.  The allowance is comprised of three components, specific credit allocation, general portfolio allocation, and a subjectively determined allocation.  The specific credit allocation is assigned to loans that have been individually evaluated for impairment, such as loans placed on non-accrual status and any other loan which Management has identified as impaired.  The general portfolio allocation is determined by collectively evaluating pools of loans for impairment.  The subjectively determined allocation is determined through judgments the Company makes regarding certain qualitative factors that may impact the credit quality of various segments of the loan portfolio.

 

Specific Credit Allocation

 

The specific credit allocation of the allowance is determined through the measurement of impairment on certain loans that have been identified during each reporting period as impaired.  A loan is considered impaired when based on certain information and events surrounding a borrower, it is determined that the likelihood of the Company receiving all scheduled payments, including interest, when due is remote.  Once a loan is classified as impaired, the Company places the loan under the supervision of its Special Assets department.  The Special Assets department is responsible for performing comprehensive analyses of impaired loans, including obtaining updated financial information regarding the borrower, obtaining updated appraisals on any collateral securing such loans and ultimately determining the extent to which such loans are impaired.  Once the amount of impairment on specific impaired loans has been determined, the Company establishes a corresponding valuation allowance which then becomes a component of the Company’s specific credit allocation in the allowance for loan losses.

 

General Portfolio Allocation

 

The general portfolio allocation of the allowance is determined by pooling performing loans by collateral type and purpose, such as the stratification presented in Note 3.  These loans are then further segmented by an internal loan grading system that classifies loans as: pass, special mention, substandard and doubtful.  Estimated loss rates are then applied to each segment according to loan grade to determine the amount of the general portfolio allocation.  Estimated loss rates are determined through an analysis of historical loss rates for each segment of the loan portfolio, based on the Company’s prior experience with such loans.

 

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Subjectively Determined Allocation

 

The subjectively determined allocation of the allowance is determined by estimates the Company makes in regard to certain internal and external factors that may have either a positive or negative impact on the overall credit quality of the loan portfolio.  Internal factors include trends in credit quality of the loan portfolio, the existence and the effects of concentrations, the composition and volume of the loan portfolio and the quality of loan review as well as any other factor determined by Management to have an impact on the credit quality of the loan portfolio.  External factors include local state and national economic and business conditions.  While Management regularly reviews the estimated impact these internal and external factors are expected to have on the loan portfolio, there can be no assurance that an adverse change in any one or combination of these factors will not be in excess of Management’s expectations.

 

The determination of the amount of the allowance and any corresponding increase or decrease in the level of provisions for loan losses is based on Management’s best estimate of the current credit quality of the loan portfolio and any probable inherent losses as of the balance sheet date.  The nature of the process in which Management determines the appropriate level of the allowance involves the exercise of considerable judgment.  While Management utilizes its best judgment and all available information in determining the adequacy of the allowance, the ultimate adequacy of the allowance is dependent upon a variety of factors beyond the Company’s control, including but not limited to, the performance of the loan portfolio, changes in current and future economic conditions and the view of regulatory agencies regarding the level of classified assets.  Continued weakness in economic conditions and any other factor that may adversely affect credit quality, result in higher levels of past due and non-accruing loans, defaults, and additional loan charge-offs, which may require additional provisions for loan losses in future periods and a higher balance in the Company’s allowance for loan losses.

 

The following table summarizes the allocation of the allowance as well as the activity in the allowance attributed to various segments in the loan portfolio as of and for the year ended December 31, 2010:

 

 

 

Real Estate

 

 

 

 

 

 

 

 

 

All Other

 

 

 

(dollar amounts in thousands)

 

Secured

 

Commercial

 

Construction

 

Land

 

Installment

 

Loans

 

Total

 

Balance, December 31, 2009

 

$

6,851

 

$

4,814

 

$

1,007

 

$

1,644

 

$

40

 

$

16

 

$

14,372

 

Charge-offs

 

(5,500)

 

(13,738)

 

(1,259)

 

(3,113)

 

(243)

 

-     

 

(23,853

)

Recoveries

 

120

 

1,436

 

10

 

1,311

 

13

 

    

 

2,890

 

Provisions for loan losses

 

10,414

 

16,995

 

1,595

 

2,158

 

356

 

13

 

31,531

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, December 31, 2010

 

$

11,885

 

$

9,507

 

$

1,353

 

$

2,000

 

$

166

 

$

29

 

$

24,940

 

Amount of allowance attributed to:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Specifically evaluated impaired loans

 

$

1,085

 

$

461

 

$

476

 

$

235

 

$

-     

 

$

-     

 

$

2,257

 

General portfolio allocation

 

$

10,800

 

$

9,046

 

$

877

 

$

1,765

 

$

166

 

$

29

 

$

22,683

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Loans individually evaluated for impairment

 

$

20,260

 

$

2,503

 

$

2,560

 

$

3,372

 

$

94

 

$

-     

 

$

28,789

 

Specific reserves to total loans individually evaluated for impairment

 

5.36%

 

18.42%

 

18.59%

 

6.97%

 

0.00%

 

0.00%

 

7.84%

Loans collectively evaluated for impairment

 

$

413,701

 

$

158,629

 

$

41,359

 

$

27,313

 

$

7,298

 

$

214

 

$

648,514

 

General reserves to total loans collectively evaluated for impairment

 

2.61%

 

5.70%

 

2.12%

 

6.46%

 

2.27%

 

13.55%

 

3.50%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total gross loans

 

$

433,961

 

$

161,132

 

$

43,919

 

$

30,685

 

$

7,392

 

$

214

 

$

677,303

 

Total allowance to gross loans

 

2.74%

 

5.90%

 

3.08%

 

6.52%

 

2.25%

 

13.55%

 

3.68%

 

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The following table summarizes activity in the allowance for loan losses for the prior periods presented:

 

 

 

For the years ended December 31,

(dollar amounts in thousands)

 

 

2009

 

2008

 

Balance at beginning of period

 

 

$

10,412

 

$

6,143

 

Provision for loan losses

 

 

24,066

 

12,215

 

Loans charged-off:

 

 

 

 

 

 

Commercial real estate

 

 

339

 

340

 

Residential 1-4 family

 

 

558

 

555

 

Commercial and industrial

 

 

5,816

 

3,854

 

Agriculture

 

 

2,224

 

-     

 

Construction

 

 

2,218

 

1,837

 

Land

 

 

8,886

 

1,434

 

Other

 

 

163

 

56

 

 

 

 

 

 

 

 

Total charge-offs

 

 

20,204

 

8,076

 

 

 

 

 

 

 

 

Recoveries

 

 

98

 

130

 

 

 

 

 

 

 

 

Balance at end of period

 

 

$

14,372

 

$

10,412

 

 

Each segment of loans in the portfolio possess varying degrees of risk, based on, among other things, the type of loan being made, the purpose of the loan, the type of collateral securing the loan, and the sensitivity the borrower has to changes in certain external factors such as economic conditions.  The following provides a summary of the risks associated with various segments of the Company’s loan portfolio, which are factors Management regularly considers when evaluating the adequacy of the allowance:

 

·  Real estate secured – consist primarily of loans secured by commercial real estate, multi-family, farmland, and 1-4 family residential properties.  Also included in this segment are equity lines of credit secured by real estate.  As the majority of this segment is comprised of commercial real estate loans, risks associated with this segment lie primarily within that loan type.  Adverse economic conditions may result in a decline in business activity and increased vacancy rates for commercial properties.  These factors in conjunction with a decline in real estate prices may expose the Company to the potential for losses if a borrower cannot continue to service the loan with operating revenues, and the value of the property has declined to a level such that it no longer fully covers the Company’s recorded investment in the loan.

 

·  Commercial and Industrial – consist primarily of commercial and industrial loans (business lines of credit), agriculture loans, and other commercial purpose loans.  Repayment of commercial and industrial loans is generally provided from the cash flows of the related business to which the loan was made.  Adverse changes in economic conditions may result in a decline in business activity, which can impact a borrower’s ability to continue to make scheduled payments.  The risk of repayment of agriculture loans arises largely from factors beyond the control of the Company or the related borrower, such as commodity prices and weather conditions.

 

·  Construction / Land segments – construction and land loans generally possess a higher inherent risk of loss than other portfolio segments.  Risk arises from the necessity to complete projects within specified cost and time limits.  Trends in the construction industry may also impact the credit quality of these loans, as demand drives construction activity.  In addition, trends in real estate values significantly impact the credit quality of these loans, as property values determine the economic viability of future construction projects.

 

·  Installment – the installment loan portfolio is comprised primarily of a large number of small loans with scheduled amortization over a specific period. The majority of installment loans are made for consumer and business purchases.  Weakened economic conditions may result in an increased level of delinquencies within this segment, as economic pressures may impact the capacity of such borrowers to repay their obligations.

 

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Note 5.  Other Real Estate Owned (“OREO”)

 

The following table summarizes the change in the balance of other real estate owned for the years ended December 31, 2010 and 2009:

 

 

 

 

For the years ended

 

 

 

 

December 31,

 

(dollar amounts in thousands)

 

 

2010

 

2009

 

Beginning balance

 

 

$

946

 

$

1,337

 

Additions

 

 

13,280

 

9,595

 

Dispositions

 

 

(3,906

)

(8,521

)

Write-downs

 

 

(3,652

)

(1,465

)

 

 

 

 

 

 

 

Ending balance

 

 

$

6,668

 

$

946

 

 

 

Note 6.  Property, Premises and Equipment

 

At December 31, 2010 and 2009, property, premises and equipment consisted of the following:

 

 

 

 

December 31,

 

(dollar amounts in thousands)

 

 

2010

 

2009

 

Land

 

 

$

1,240

 

$

1,240

 

Furniture and equipment

 

 

9,194

 

8,574

 

Building and improvements

 

 

6,871

 

6,789

 

Construction in progress

 

 

122

 

4

 

 

 

 

 

 

 

 

Total cost

 

 

17,427

 

16,607

 

 

 

 

 

 

 

 

Less: accumulated depreciation and amortization

 

 

11,051

 

9,828

 

 

 

 

 

 

 

 

Total property, premises and equipment

 

 

$

6,376

 

$

6,779

 

 

Depreciation expense totaled $1.3 million, $1.2 million and $1.1 million for the years ended 2010, 2009 and 2008, respectively. The Company leases land, buildings, and equipment under non-cancelable operating leases expiring at various dates through 2022.  See Note 11. Commitments and Contingencies, of these consolidated financial statements for a more detailed discussion regarding the Company’s operating lease obligations.

 

 

Note 7.  Intangible Assets

 

Intangible assets consist of goodwill and core deposit intangible assets.  The balance of goodwill at December 31, 2010 was $11.0 million, unchanged from that reported at December 31, 2009.  As discussed in Note 1. Summary of Significant Accounting Policies, of these consolidated financial statements, the Company’s annual test for impairment of goodwill was performed with the assistance of an independent third party and indicated the value of goodwill was not impaired as of December 31, 2010.

 

Core deposit intangible (“CDI”) assets are subject to amortization.  Amortizations for 2010, 2009 and 2008 were $0.5 million, $1.0 million and $0.9 million, respectively.

 

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Table of Contents

 

The following table summarizes the gross carrying amount, accumulated amortization and net carrying amount of core deposit intangibles and provides an estimate for future amortization as of December 31, 2010:

 

 

 

Gross Carrying

 

Accumulated

 

Net Carrying

 

(dollar amounts in thousands)

 

Amount

 

Amortization

 

Amount

 

Core deposit intangible

 

$

6,320

 

$

(4,193

)

$

2,127

 

 

 

 

Beginning

 

Estimated

 

Ending

 

Period

 

Balance

 

Amortization

 

Balance

 

Year 2011

 

$

2,127

 

$

(653

)

$

1,474

 

Year 2012

 

$

1,474

 

$

(757

)

$

717

 

Year 2013

 

$

717

 

$

(717

)

$

-    

 

 

 

Note 8.  Time Deposit Liabilities

 

The following table provides a summary for the maturity of the Bank’s time certificates of deposit as of December 31, 2010:

 

 

 

Amount Due

 

 

 

(dollar amounts in thousands)

 

 

2011

 

2012

 

2013

 

2014

 

2015

 

 

Total

 

Time certificates of deposit

 

 

$

152,557

 

$

59,889

 

$

15,215

 

$

981

 

$

2,704

 

 

$

231,346

 

 

 

Note 9.  Borrowings

 

The Bank has several sources from which it may obtain borrowed funds, including two sources that it considers primary in obtaining secondary funding, Federal Funds purchased through arrangements it has established with correspondent banks and advances from the Federal Home Loan Bank.  Borrowing may be obtained for a variety of reasons including daily liquidity needs and balance sheet growth.  Additionally, the Bank had a collateralized borrowing line with the Federal Reserve Bank in the amount of $12.1 million as of December 31, 2010.   The following provides a summary of the borrowing available to the Bank and Company as well borrowings that were outstanding as of December 31, 2010:

 

Federal Funds Purchased - The Bank has borrowing lines with correspondent banks totaling $15.0 million as of December 31, 2010 and 2009.  As of December 31, 2010, there were no balances outstanding on these borrowing lines.

 

Federal Home Loan Bank Advances - At December 31, 2010, the Bank had the following borrowings with the FHLB, the majority of which are collateralized by loans:

 

Amount

 

Interest

 

Maturity

 

Borrowed

 

 

Rate

 

Variable/Fixed

 

 

Date

 

$

35,000

 

 

0.17%

 

Variable

 

 

1/31/2011

 

3,500

 

 

0.46%

 

Fixed

 

 

12/12/2011

 

3,500

 

 

0.85%

 

Fixed

 

 

12/10/2012

 

3,000

 

 

1.28%

 

Fixed

 

 

12/10/2013

 

 

 

 

 

 

 

 

 

 

 

$

45,000

 

 

0.32%

 

 

 

 

 

 

 

At December 31, 2010, $366.5 million in loans were pledged as collateral to the FHLB for the borrowings presented in the table above.  Additionally, the Bank has an $11.7 million letter of credit with the FHLB secured by loans.  At December 31, 2010, the Bank had a remaining borrowing capacity with existing collateral of $96.7 million secured by loans and securities.

 

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Table of Contents

 

Other Secured Borrowings The Bank currently originates and sells Small Business Administration (“SBA”) loans which have an initial 90 day guarantee period after the sale date during which non-performance by the borrower may require the repurchase of the note by the Bank from the investor.  GAAP requires the Bank to leave the principal balance of the note on its balance sheet and record a corresponding secured borrowing for the sold portion of the note until the guarantee period has ended, at which time the Bank may record the sale of the loan.  As of December 31, 2010, the Bank had no such secured borrowings on its balance sheet.  During 2011 the SBA plans to remove the 90 day guarantee period from its purchase contracts thereby eliminating the need for the Bank to record secured borrowings on these particular loan sales going forward.

 

Junior Subordinated Debentures

 

On October 27, 2006, the Company issued $8.2 million of Floating Rate Junior Subordinated Debt Securities to Heritage Oaks Capital Trust II, a statutory trust created under the laws of the State of Delaware.  These debentures are subordinated to effectively all borrowings of the Company.  The Company used the proceeds from the issuance of these securities for general corporate purposes, which include among other things, capital contributions to the Bank, investments, payment of dividends, and repurchases of our common stock.

 

On September 20, 2007, the Company issued $5.2 million of Junior Subordinated Deferrable Interest Debentures to Heritage Oaks Capital Trust III (“Trust III”), a statutory trust created under the laws of the State of Delaware.  These debentures issued to Trust III were subordinated to effectively all borrowings of the Company.  The Company used the proceeds from the sale of the securities to assist in the acquisition of Business First National Bank, for general corporate purposes, and for capital contributions to the Bank.  In June 2010, the Company repurchased $5.0 million in face amount trust preferred securities issued by Trust III, and the related $5.2 million junior subordinated debentures issued by the Company.  The repurchase resulted in a pre-tax gain of approximately $1.7 million.  Trust III was dissolved in December 2010.

 

At December 31, 2010, the Company had a total of $8.2 million in Junior Subordinated Deferrable Interest Debentures issued and outstanding, issued to Heritage Oaks Capital Trust II.  The debt securities can be redeemed at par if certain events occur that impact the tax treatment, regulatory treatment or the capital treatment of the issuance.  Upon the issuance of the debt securities, the Company purchased a 3.1% minority interest in Heritage Oaks Capital Trust II, totaling $248 thousand.  The balance of the equity of Heritage Oaks Capital Trust II is comprised of mandatory redeemable preferred securities and is included in other assets.  Interest associated with the securities issued to Heritage Oaks Capital Trust II is payable quarterly at a variable rate of 3-month LIBOR plus 1.72%.

 

The following table provides a summary of the securities the Company has issued to Heritage Oaks Capital Trust II as of December 31, 2010:

 

 

 

Amount

 

Current

 

Issue

 

Scheduled

 

Call

 

 

 

(dollar amounts in thousands)

 

Borrowed

 

Rate

 

Date

 

Maturity

 

Date

 

Rate Type

 

Heritage Oaks Capital Trust II

 

$

8,248

 

2.01

%

27-Oct-06

 

Aug-37

 

Nov-11

 

Variable 3-month LIBOR + 1.72%

 

 

The Company has the right under the indenture to defer interest payments for a period not to exceed twenty consecutive quarterly periods (each an “Extension Period”) provided that no extension period may extend beyond the maturity of the debt securities.  If the Company elects to defer interest payments pursuant to terms of the agreements, then the Company may not (i) declare or pay any dividends or distributions on, or redeem, purchase, acquire or make a liquidation payment with respect to any of the Company’s capital stock, or (ii) make any payment of principal or premium, if any, or interest on or repay, repurchase or redeem any debt securities of the Company that rank pari passu with or junior in interest to the Debt Securities, other than, among other items, a dividend in the form of stock, warrants, options or other rights in the same stock as that on which the dividend is being paid or ranks pari passu with or junior to such stock.  The prohibition on payment of dividends and payments on pari passu or junior debt also applies in the case of an event of default under the agreements.

 

During the second quarter of 2010, the Company elected to defer interest payments on its outstanding junior subordinated debentures in order to comply with the terms of the Written Agreement entered into between the Company and the Federal Reserve Bank of San Francisco.  As a result during 2010 the Company accrued but has not paid approximately $132 thousand in interest on $8.2 million in borrowing associated with Heritage Oaks Capital Trust II.  For more information concerning the Written Agreement, please see Note 22. Regulatory Order and Written Agreement, of these consolidated financial statements.

 

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Table of Contents

 

Pursuant to U.S. GAAP, the Company is not allowed to consolidate Trust II into the Company’s financial statements.  On February 28, 2005, the Federal Reserve Board issued a rule which provides that, notwithstanding the deconsolidation of such trusts, junior subordinated debentures, such as those issued by the Company, may continue to constitute up to 25% of a bank holding company’s Tier I capital, subject to certain limitations which were to become effective on March 31, 2009.  However, on March 17, 2009, the Federal Reserve Board issued a ruling to delay the effective date of limitations on trust preferred securities until March 31, 2011.  At December 31, 2010, the Company included $8.0 million of the net junior subordinated debt in its Tier I Capital for regulatory capital purposes.

 

 

Note 10.  Income Taxes

 

The Company is subject to income taxation by both federal and state taxing authorities.  Income tax returns for the years ended December 31, 2009, 2008, and 2007 are open to audit by federal authorities and our California returns are open to audit for the years ended December 31, 2009, 2008, 2007, and 2006.  The following table provides a summary for the current and deferred amounts of the Company’s income tax provision (benefit) for the years ended December 31, 2010, 2009, and 2008:

 

 

 

 

For The Years Ended December 31,

 

(dollar amounts in thousands)

 

 

2010

 

2009

 

2008

 

Current:

 

 

 

 

 

 

 

 

Federal

 

 

$

6,553

 

$

(2,951

)

$

1,192

 

State

 

 

2,253

 

(18

)

831

 

 

 

 

 

 

 

 

 

 

Total current provision / (benefit)

 

 

8,806

 

(2,969

)

2,023

 

 

 

 

 

 

 

 

 

 

Deferred:

 

 

 

 

 

 

 

 

Federal

 

 

(8,535

)

(1,446

)

(898

)

State

 

 

(2,031

)

(1,410

)

(628

)

 

 

 

 

 

 

 

 

 

Total deferred (benefit) / provision

 

 

(10,566

)

(2,856

)

(1,526

)

 

 

 

 

 

 

 

 

 

Total income tax (benefit) / provision

 

 

$

(1,760

)

$

(5,825

)

$

497

 

 

The table below summarizes the Company’s net deferred tax asset as of December 31, 2010 and 2009:

 

 

 

 

December 31,

 

(dollar amounts in thousands)

 

 

2010

 

2009

 

Deferred tax assets

 

 

 

 

 

 

Reserves for loan losses

 

 

$

18,161

 

$

6,444

 

Forgone interest on non-accrual loans

 

 

853

 

599

 

Fixed assets

 

 

227

 

102

 

Accruals

 

 

472

 

140

 

Alternative minimum tax credit

 

 

18

 

18

 

Deferred income

 

 

2,191

 

2,440

 

Deferred compensation

 

 

1,971

 

1,718

 

Net operating loss carryforward

 

 

958

 

949

 

Investment securities valuation

 

 

864

 

820

 

Other than temporary impairment

 

 

225

 

167

 

Other real estate owned

 

 

1,582

 

78

 

Realized built-in loss subject to § 382

 

 

4,293

 

-    

 

Charitable contribution

 

 

28

 

28

 

 

 

 

31,843

 

13,503

 

Valuation allowance

 

 

(7,105

)

-    

 

 

 

 

 

 

 

 

Total deferred tax assets

 

 

24,738

 

13,503

 

 

 

 

 

 

 

 

Deferred tax liabilities

 

 

 

 

 

 

Fair value adjustment for purchased assets

 

 

781

 

864

 

Deferred costs, prepaids and FHLB advances

 

 

857

 

908

 

State deferred tax

 

 

1,937

 

1,178

 

 

 

 

 

 

 

 

Total deferred tax liabilities

 

 

3,575

 

2,950

 

 

 

 

 

 

 

 

Net deferred tax assets

 

 

$

21,163

 

$

10,553

 

 

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Table of Contents

 

Deferred Tax Assets Valuation Allowance

 

U.S. GAAP requires that companies assess whether a valuation allowance should be established against deferred tax assets based on the consideration of all available evidence using a “more likely than not” standard.  In making such judgments, significant weight is given to evidence, both positive and negative, that can be objectively verified.  U.S. GAAP provides that a cumulative loss in recent years is significant negative evidence in considering whether deferred tax assets are realizable, and also limits projections of future taxable income to that which can be estimated over a reasonable amount of time.  The pre-tax losses the Company reported in 2010 and 2009 provided significant negative evidence to support the Company’s position that a portion of its deferred tax assets would not be realized as of December 31, 2010.  As a result, the Company recorded a partial valuation allowance of approximately $7.1 million for its deferred tax assets in 2010 through a charge to income tax expense.

 

The Company’s determination of the valuation allowance for a portion of its deferred tax assets was based on an analysis of cumulative pre-tax losses over a three year horizon, including those reported in 2010, a projection of future taxable income over a period of time the Company believed to be reasonably estimable (“the projection period”), and a detailed analysis to determine the amount of the deferred tax asset expected to be realized over the projection period.  The ultimate realization of the Company’s deferred tax assets is dependent on the generation of future taxable income during the periods in which those temporary differences reverse.  Given the Company was in a three year cumulative pre-tax loss position as of December 31, 2010, it became less likely the Company would generate enough future taxable income over the projection period in order for all of its deferred tax assets to be realized.

 

Companies are subject to a change in control test under Section 382 of the Internal Revenue Code, that if met, would limit the annual utilization of pre-change in control net operating loss (“NOL”) carry-forwards as well as the ability to use certain unrealized built-in losses as tax deductions (as determined by Section 382 testing).  As a result of the Company’s March 2010 private placement, a change in control was deemed to have occurred under Section 382.  Under Section 382, the annual limitation on the Company’s ability to utilize such NOL carry forwards and built in losses will be equal to the product of the applicable long-term tax exempt rate and the sum of the values of the Company’s common stock and TARP preferred stock immediately before the change in control.  The Company’s ability to utilize deductions related to credit losses during the twelve month period following the change in control is also limited under Section 382, in conjunction with net operating loss carry-forwards, to the extent that such deductions reflect a net loss that was “built-in” to the Company’s assets immediately prior to the ownership change.  Furthermore, the Company is also limited on utilization of deductions other than credit losses (e.g. loss on sale of securities) to the extent those losses were determined to be “built in” at the Section 382 change in control date for the five-year period following such date.  Limitations placed on the Company’s ability to deduct certain significant items for tax purposes further supported the Company’s position that a portion of its deferred tax assets would not be realized as of December 31, 2010.

 

The deferred tax assets for which there is no valuation allowance relate to amounts that are expected to be realized through subsequent reversals of existing taxable temporary differences over the projection period.  The accounting for deferred taxes is based on an estimate of future results.  Differences between anticipated and actual outcomes of these future tax consequences could have an impact on the Company’s consolidated results of operations or financial position.  The Company’s deferred tax assets will be analyzed quarterly for changes affecting realizability and the valuation allowance may be adjusted in future periods accordingly.  The Company will analyze changes in near-term market conditions and consider both positive and negative evidence as well as other factors which may impact future operating results in making any decision to adjust the valuation allowance in future periods.

 

The following table reconciles the statutory federal income tax (benefit)/expense and rate to Company’s effective income tax (benefit)/expense and rate for the years ended December 31, 2010, 2009, and 2008:

 

 

 

2010

 

2009

 

2008

 

(dollar amounts in thousands)

 

Amount

 

Percent

 

Amount

 

Percent

 

Amount

 

Percent

 

(Benefit) / tax provision at federal statutory tax rate

 

$

(6,762

)

(35.0

)

$

(4,377

)

(34.0

)

$

728

 

34.0

 

State income taxes, net of federal income tax benefit

 

(1,372

)

(7.1

)

(942

)

(7.3

)

134

 

6.3

 

Deferred tax asset valuation allowance

 

7,105

 

36.8

 

-

 

-    

 

-    

 

-    

 

Bank owned life insurance

 

(182

)

(0.9

)

(148

)

(1.1

)

(139

)

(6.5

)

Tax exempt income, net of interest expense

 

(492

)

(2.6

)

(383

)

(3.0

)

(282

)

(13.2

)

Other, net

 

(57

)

(0.3

)

25

 

0.2

 

56

 

2.6

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total income tax (benefit) / provision

 

$

(1,760

)

(9.1

)

$

(5,825

)

(45.2

)

$

497

 

23.2

 

 

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Table of Contents

 

As part of the bank acquisitions in 2003 and 2007, the Company has approximately $0.5 million and $1.1 million of net operating losses (“NOL”) available for carry-forward for federal and state tax purposes, respectively, at December 31, 2010.  Additionally, the Company has approximately $6.2 million in NOL available for carry-forward for state tax purposes related to operating losses the Company incurred during 2009.  The realization of the NOL is limited for federal tax purposes and for state tax purposes under current tax law.  Any amount not utilized for federal tax purposes and state tax purposes will expire in various years through 2020 and 2013, respectively.  The Company also has $18 thousand in alternative minimum tax credit that has no expiration date and a charitable contribution NOL set to expire in 2014.

 

 

Note 11.  Commitments and Contingencies

 

The Company, from time to time is involved in various litigation.  In the opinion of Management and the Company’s legal counsel, the disposition of all such litigation pending will not have a material effect on the Company’s financial statements.

 

Commitments to Extend Credit

 

In the normal course of business, the Bank enters into financial commitments to meet the financing needs of its customers.  These financial commitments include commitments to extend credit and standby letters of credit.  Those instruments involve, to varying degrees, elements of credit and interest rate risk not recognized in the statement of financial position.

 

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract.  Standby letters of credit are conditional commitments to guarantee the performance of a Bank customer to a third party.  Since many of the commitments and standby letters of credit are expected to expire without being drawn upon, the total amounts do not necessarily represent future cash requirements.  The Bank evaluates each customer’s credit worthiness on a case-by-case basis and the amount of collateral obtained, if deemed necessary by the Bank, is based on Management’s credit evaluation of the customer.  The Bank’s exposure to loan loss in the event of nonperformance on commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments.  The Bank uses the same credit policies in making commitments as is done for loans reflected in the consolidated financial statements.

 

As of December 31, 2010 and 2009, the Bank had the following outstanding financial commitments whose contractual amount represents credit risk:

 

 

December 31,

(dollar amounts in thousands)

 

2010

 

2009

 

Commitments to extend credit

 

$

141,331

 

$

151,900

 

Standby letters of credit

 

16,080

 

17,678

 

 

 

 

 

 

 

Total commitments and standby letters of credit

 

$

157,411

 

$

169,578

 

 

Commitments to extend credit and standby letters of credit are made at both fixed and variable rates of interest.  At December 31, 2010, the Company had $25.1 million in fixed rate commitments and $132.3 million in variable rate commitment and standby letters of commitment.

 

Other Commitments

 

The following table provides a summary of the future minimum lease payments the Bank is expected to make based upon obligations at December 31, 2010:

 

 

 

Due

 

Due

 

Due

 

Due

 

Due

 

Due More

 

 

 

(dollar amounts in thousands)

 

2011

 

2012

 

2013

 

2014

 

2015

 

Than 5 Years

 

Total

 

Non-cancelable operating leases

 

$

2,188

 

$

1,871

 

$

1,582

 

$

1,345

 

$

1,188

 

$

6,175  

 

$

14,349

 

 

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Table of Contents

 

The Company has leases that contain options to extend for periods from five to twenty years.  Options to extend which have been exercised and the related lease commitments are included in the table above.  Total rent expense charged for leases during the reporting periods ended December 31, 2010, 2009, and 2008, were approximately $2.4 million, $2.4 million and $2.3 million, respectively.

 

At December 31, 2010, the Company had two subleases in place.  These subleases are for various terms and accounted for an approximate $70 thousand credit to rental expense during 2010.  The Company currently expects to receive sublease revenue for 2011 and 2012 of $44 thousand and $25 thousand, respectively.

 

 

Note 12.  Regulatory Matters

 

The Company (on a consolidated basis) and the Bank are subject to various regulatory capital requirements administered by federal banking agencies.  Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Company’s and the Bank’s financial statements.  Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of the Company’s and the Bank’s assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices.  The Company’s and the Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.  Prompt corrective action provisions are not applicable to bank holding companies.

 

Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined) and of Tier I capital (as defined) to average assets (as defined).  Management believes, as of December 31, 2010, the Company and the Bank meet all capital adequacy requirements to which it is subject.

 

To be categorized as well-capitalized, the Bank must maintain minimum capital ratios as set forth in the table below. However, on March 4, 2010, the Bank entered into a Consent Order with the FDIC that requires higher levels of Tier I Leverage and Total Risk Based ratios. See also Note 22.  Regulatory Order and Written Agreement, of these consolidated financial statements, for additional information related to the Consent Order.

 

As of the most recent regulatory examination the Company and the Bank were designated as well capitalized by its regulators.

 

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The following table also sets forth the Company’s and the Bank’s actual regulatory capital amounts and ratios as of December 31, 2010 and 2009:

 

 

 

Actual

 

Capital Needed For
Adequacy Purposes

 

Capital Needed
To Be Well Capitalized
Under Prompt Corrective
Action Provisions

 

(dollar amounts in thousands)

 

Capital
Amount

 

Ratio

 

Capital
Amount

 

Ratio

 

Capital
Amount

 

Ratio

 

As of December 31, 2010

 

 

 

 

 

 

 

 

 

 

 

 

 

Total capital to risk-weighted assets:

 

 

 

 

 

 

 

 

 

 

 

 

 

Company

 

$

114,892

 

15.21%

 

$

60,411

 

8.0%

 

N/A

 

N/A

 

Heritage Oaks Bank

 

$

111,235

 

14.75%

 

$

60,332

 

8.0%

 

$

75,415

 

10.0%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Tier I capital to risk-weighted assets:

 

 

 

 

 

 

 

 

 

 

 

 

 

Company

 

$

105,258

 

13.94%

 

$

30,205

 

4.0%

 

N/A

 

N/A

 

Heritage Oaks Bank

 

$

101,613

 

13.47%

 

$

30,166

 

4.0%

 

$

45,249

 

6.0%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Tier I capital to average assets:

 

 

 

 

 

 

 

 

 

 

 

 

 

Company

 

$

105,258

 

10.83%

 

$

38,870

 

4.0%

 

N/A

 

N/A

 

Heritage Oaks Bank

 

$

101,613

 

10.52%

 

$

38,622

 

4.0%

 

$

48,278

 

5.0%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

As of December 31, 2009

 

 

 

 

 

 

 

 

 

 

 

 

 

Total capital to risk-weighted assets:

 

 

 

 

 

 

 

 

 

 

 

 

 

Company

 

$

86,522

 

10.85%

 

$

63,796

 

8.0%

 

N/A

 

N/A

 

Heritage Oaks Bank

 

$

81,450

 

10.23%

 

$

63,690

 

8.0%

 

$

79,612

 

10.0%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Tier I capital to risk-weighted assets:

 

 

 

 

 

 

 

 

 

 

 

 

 

Company

 

$

76,497

 

9.59%

 

$

31,898

 

4.0%

 

N/A

 

N/A

 

Heritage Oaks Bank

 

$

71,441

 

8.97%

 

$

31,845

 

4.0%

 

$

47,767

 

6.0%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Tier I capital to average assets:

 

 

 

 

 

 

 

 

 

 

 

 

 

Company

 

$

76,497

 

8.24%

 

$

37,141

 

4.0%

 

N/A

 

N/A

 

Heritage Oaks Bank

 

$

71,441

 

7.74%

 

$

36,940

 

4.0%

 

$

46,176

 

5.0%

 

 

As disclosed in Note 9. Borrowings, of these consolidated financial statements, the proceeds from the issuance of Junior Subordinated Debentures, subject to percentage limitations, are considered Tier I capital by the Company for regulatory reporting purposes.  At December 31, 2010 and 2009, the Company included $8.0 million of proceeds from the issuance of the debt securities in its Tier I capital.

 

Additionally, it should be noted that based on the regulatory definition of Tier I and Total Risk Based capital, the Company and Bank are subject to certain limitations with regard to the amount of the allowance for loan losses that may be included in the calculation of Total Risk Based capital as well as the level of deferred tax assets that may be considered in the calculation of Tier I and Total Risk Based capital calculations.  At December 31, 2010, the amount of the Bank’s allowance for loan losses not qualified for inclusion totaled approximately $15.6 million for the Bank and the Company.  The amount of the Company’s deferred tax assets not qualified for inclusion totaled approximately $12.2 million for the Bank and $11.9 million for the Company as of December 31, 2010.

 

Note 13.  Salary Continuation Plan

 

The Company established salary continuation agreements with certain senior and executive officers, as authorized by the Board of Directors.  These agreements provide for annual cash payments for a period not to exceed 15 years, payable at age 60-65, depending on the agreement.  In the event of death prior to retirement age, annual cash payments would be made to the beneficiaries for a determined number of years.  At December 31, 2010 and 2009, the present value of the Company’s liability under these Agreements was $3.0 million and $2.7 million, respectively, and is included in other liabilities in the Company’s consolidated financial statements.  For the years ended December 31, 2010, 2009 and 2008, expenses associated with the Company’s salary continuation plans were $383 thousand, $327 thousand and $425 thousand, respectively.  The Company maintains life insurance policies, which are intended to fund all costs associated with the agreements.  The cash surrender values of these life insurance policies totaled $13.8 million and $12.5 million, at December 31, 2010 and 2009, respectively.

 

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Table of Contents

 

Note 14.  Employee Benefit Plans

 

During 1994, the Company established a savings plan for employees that allow participants to make contributions by salary deduction equal to 15 percent or less of their salary pursuant to section 401(k) of the Internal Revenue Code.  Employee contributions are matched up to 25 percent of the employee’s contribution.  Employees vest immediately in their own contributions and they vest in the Company’s contribution based on years of service.  Expenses the Company incurred associated with the plan were $164 thousand, $154 thousand and $209 thousand, for the years ended December 31, 2010, 2009, and 2008, respectively.

 

The Company sponsors an employee stock ownership plan (“ESOP”) that covers all employees who have completed 12 consecutive months of service, are over 21 years of age and work a minimum of 1,000 hours per year.  The amount of the Company’s annual contribution to the ESOP is at the discretion of the Board of Directors.  The Company made no contributions to the plan during 2010, 2009 and 2008.

 

 

Note 15.  Share-Based Compensation Plans

 

At December 31, 2010, the Company had share-based compensation awards outstanding under two share-based compensation plans, which are described below:

 

The “2005 Equity Based Compensation Plan”

 

The 2005 Equity Based Compensation Plan (the “2005 Plan”) authorizes the granting of Incentive Stock Options, Non-Qualified Stock Options, Stock Appreciation Rights, Restricted Stock Awards, Restricted Stock Units and Performance Share Cash Only Awards.  The 2005 Plan provides for a maximum of ten percent (10%) of the Company’s issued and outstanding shares of common stock as of March 25, 2005 and adjusted on each anniversary thereafter to be ten percent (10%) of the then issued and outstanding number of shares.  As of December 31, 2010, the maximum number of shares that were available for issuance from the 2005 Plan was 110,742.

 

In the event of a change in control in which the Company is not the surviving entity, all awards granted under the 2005 Plan shall immediately vest and or become immediately exercisable, except as otherwise determined at the time of grant of the award and specified in the award agreement or unless the survivor corporation, or the purchaser of assets of the Company agrees to assume the obligations of the Company with respect to all outstanding awards or to substitute such awards with equivalent awards with respect to the common stock of the successor.

 

The “1997 Stock Option Plan”

 

The 1997 Stock Option Plan is a tandem stock option plan permitting options to be granted either as “Incentive Stock Options” or as “Non-Qualified Stock Options” under the Internal Revenue Code.  All outstanding options were granted at prices equal to the fair market value of the Company’s stock on the day of the grant.  Options granted vest at a rate of 20% per year for five years, and expire no later than ten years from the grant date.  However, on May 26, 2005, the stockholders of the Company approved the 2005 Plan, discussed in the preceding paragraph, which stipulates no further grants will be made from the 1997 Stock Option Plan.

 

Restricted Stock Awards

 

The Company grants restricted stock periodically as a part of the 2005 Plan for the benefit of employees.  Restricted shares issued typically “cliff” vest in a period of three to five years.

 

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Table of Contents

 

The following table summarizes activity with respect to restricted share-based compensation for the years ended December 31, 2010, 2009 and 2008:

 

 

 

 

 

Average Grant

 

 

 

Shares

 

Date Fair Value

 

Balance December 31, 2007

 

69,615

 

$

18.05

 

Granted

 

1,050

 

12.14

 

Vested

 

-    

 

-     

 

Forfeited/expired

 

(6,904

)

18.24

 

 

 

 

 

 

 

Balance December 31, 2008

 

63,761

 

$

17.93

 

Granted

 

-    

 

-     

 

Vested

 

-    

 

-     

 

Forfeited/expired

 

(5,247

)

17.69

 

 

 

 

 

 

 

Balance December 31, 2009

 

58,514

 

$

17.96

 

Granted

 

26,565

 

3.10

 

Vested

 

-    

 

-     

 

Forfeited/expired

 

(7,428

)

18.24

 

 

 

 

 

 

 

Balance December 31, 2010

 

77,651

 

$

12.85

 

 

Compensation costs related to restricted stock awards are charged to earnings (included in salaries and employee benefits) over the vesting period of those awards.  The total income tax benefit recognized related to restricted stock compensation was $35 thousand, $67 thousand and $74 thousand for the years ended December 31, 2010, 2009 and 2008.  No restricted shares vested during 2010, 2009 and 2008.  At December 31, 2010, there was a total of $100 thousand of unrecognized compensation expense related to non-vested restricted stock which is expected to be recognized over a weighted average period of 2.1 years.

 

Stock Options

 

The following table provides a summary of information related to the Company’s stock option awards for the years ended December 31, 2010, 2009 and 2008:

 

 

 

 

 

Average

 

 

 

Options

 

Average

 

 

 

 

 

Exercise

 

Options

 

Available for

 

Fair Value

 

 

 

Shares

 

Price

 

Exercisable

 

Grant

 

Options Granted

 

 Balance at December 31, 2007

 

463,160

 

$

8.36

 

379,848

 

454,472

 

$

4.19

 

Granted

 

29,150

 

10.97

 

 

 

 

 

 

 

Forfeited

 

(7,910

)

8.20

 

 

 

 

 

 

 

Expired

 

(2

)

4.42

 

 

 

 

 

 

 

Exercised

 

(75,568

)

4.05

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 Balance at December 31, 2008

 

408,830

 

$

9.34

 

331,742

 

516,294

 

$

4.64

 

Granted

 

58,590

 

5.31

 

 

 

 

 

 

 

Forfeited

 

(2,561

)

3.73

 

 

 

 

 

 

 

Exercised

 

(24,121

)

3.73

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 Balance at December 31, 2009

 

440,738

 

$

9.15

 

346,333

 

462,584

 

$

4.57

 

Granted

 

328,423

 

3.11

 

 

 

 

 

 

 

Forfeited

 

(17,364

)

10.28

 

 

 

 

 

 

 

Exercised

 

(11,260

)

3.73

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 Balance at December 31, 2010

 

740,537

 

$

6.53

 

360,671

 

110,742

 

$

3.24

 

 

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Table of Contents

 

The total intrinsic value (the amount by which the stock price exceeded the exercise price on the date of exercise) of options exercised in all plans during the three years ended 2010, 2009 and 2008 was $0, $39 thousand and $0.3 million, respectively.  The intrinsic value of options outstanding in all plans at December 31, 2010 was approximately $60 thousand.  There was no intrinsic value for options outstanding as of December 31, 2009 and 2008.  Given the weighted average exercise price of exercisable options was higher than the Company’s stock price at December 31, 2010, 2009 and 2008, there was substantially no intrinsic value for options exercisable as of those dates.

 

The Company received income tax benefits of $9 thousand and $115 thousand for the years ended December 31, 2009 and 2008, respectively, related to the exercise of non-qualified employee stock options, and disqualifying dispositions in the exercise of incentive stock options.  The Company did not record tax benefits related to the exercise of options in 2010.

 

Share-Based Compensation Expense

 

The following table provides a summary of the expense the Company recognized related to share-based compensation awards.  The table below also shows the remaining expense associated with those awards as of and for the years ended December 31, 2010, 2009 and 2008:

 

 

 

For The Years Ended December 31,

 

 (dollar amounts in thousands)

 

2010

 

2009

 

2008

 

 Share-based compensation expense:

 

 

 

 

 

 

 

Stock option expense

 

$

218

 

$

177

 

$

202

 

Restricted stock expense

 

86

 

162

 

181

 

 

 

 

 

 

 

 

 

 Total expense

 

$

304

 

$

339

 

$

383

 

 Unrecognized compensation expense:

 

 

 

 

 

 

 

Stock option expense

 

$

519

 

$

247

 

$

277

 

Restricted stock expense

 

100

 

239

 

493

 

 

 

 

 

 

 

 

 

 Total unrecognized expense

 

$

619

 

$

486

 

$

770

 

 

As of December 31, 2010, there was a total of $0.5 million of unrecognized compensation cost related to non-vested stock options which is expected to be recognized over a weighted average period of 2.5 years.

 

The following table presents the assumptions used in the calculation of the weighted average fair value of options granted at various dates during 2010, 2009 and 2008 using the Black-Scholes option pricing model:

 

 

 

2010

 

2009

 

2008

 

 Expected volatility

 

43.75%

 

36.57%

 

35.50%

 

 Expected term (years)

 

7

 

10

 

10

 

 Dividend yield

 

0.00%

 

0.00%

 

2.40%

 

 Risk free rate

 

2.04%

 

3.18%

 

3.53%

 

 

 

 

 

 

 

 

 

 Weighted-average grant date fair value

 

$

1.48

 

$

2.78

 

$

3.88

 

 

The table above presents the assumptions used to estimate the fair value of stock options granted on the date of grant using the Black-Scholes pricing model.  The Black-Scholes model incorporates a range of assumptions for inputs that are disclosed in the table above.  Expected volatilities are based on the daily historical stock price over the expected life of the option.  The expected term of options granted is derived from the output of the model and represents the period of time that options granted are expected to be outstanding.  Dividend yields are estimated based on the dividend yield on the Company’s common stock at the time of grant.  The risk-free rate for periods within the contractual life of the stock option is based on the U.S. Treasury yield curve in effect at the time of grant.  The Company recognizes share-based compensation costs on a straight line basis over the vesting period of the award, which is typically a period of 3-5 years.  The Company estimates forfeiture rates based on historical employee option exercise and termination experience.

 

Estimates of fair value derived from the Company’s use of the Black-Scholes pricing model are theoretical values for stock options and changes in the assumptions used in the models could result in different fair value estimates.  The actual value of the stock options granted will depend on the market value of the Company’s common stock when the options are exercised.

 

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Note 16.  Related Party Transactions

 

The Bank has entered into loan and deposit transactions with certain directors and executive officers of the Bank and the Company.  These loans were made and deposits were taken in the ordinary course of business and, in Management’s opinion, were made at prevailing rates and terms.

 

The following table sets forth loans made to directors and executive officers of the Company as of December 31, 2010 and 2009:

 

 

 

For The Years Ended December 31,

 

 (dollar amounts in thousands)

 

2010

 

2009

 

 Outstanding balance, beginning of year

 

$

24,317

 

$

28,460

 

 Additional loans made

 

17,335

 

8,624

 

 Repayments

 

(16,726

)

(12,767

)

 

 

 

 

 

 

 Outstanding balance, end of year

 

$

24,926

 

$

24,317

 

 

Deposits from related parties held by the Bank at December 31, 2010 and 2009 amounted to $6.9 million and $5.8 million, respectively.

 

 

Note 17.  Restriction on Transfers of Funds to Parent

 

There are legal limitations on the ability of the Bank to provide funds to the Company.  Dividends declared by the Bank may not exceed, in any calendar year, without approval of the California Department of Financial Institutions (“DFI”), its respective net income for the year and the retained net income for the preceding two years.  Section 23A of the Federal Reserve Act restricts the Bank from extending credit to the Company and other affiliates amounting to more than 20 percent of its contributed capital and retained earnings.

 

Additionally, as disclosed in Note 22. Regulatory Order and Written Agreement, of these consolidated financial statements, the Bank and Company are currently operating under a Consent Order by the FDIC and DFI as well as a Written Agreement with the Federal Reserve Bank of San Francisco.  The Consent Order and Written Agreement contain provisions that prohibit the Bank from paying any dividends or other forms of payment that may represent a reduction in the Bank’s equity to the Holding Company.

 

 

Note 18.  Fair Value of Assets and Liabilities

 

Fair Value Measurements

 

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between willing market participants at the measurement date. In determining fair value, the Company maximizes the use of observable market inputs and minimizes the use of unobservable inputs.  Observable inputs generally reflect readily available market-derived or market-based information obtained from independent sources, while unobservable inputs reflect the Company’s estimate about market data.  Based on the observability of the significant inputs used, the Company classifies its fair value measurements in accordance with the three-level hierarchy. This hierarchy is based on the quality and reliability of the information used to determine fair value.  Financial assets and liabilities carried at fair value are classified and disclosed in one of the following three categories:

 

Level 1 - Quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date. Level 1 assets and liabilities may include debt and equity securities that are traded in an active exchange market and that are highly liquid and are actively traded in over-the-counter markets.

 

Level 2 - Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations whose inputs are observable and can be corroborated by market data. Level 2 financial instruments typically include U.S. Government debt and agency mortgage-backed securities, municipal securities, residential mortgage loans held for sale, OREO, and impaired loans whose fair value was derived from obtaining observable market data for underlying collateral.

 

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Level 3 - Valuations are based on at least one significant unobservable input that is supported by little or no market activity and is significant to the fair value measurement of the asset or liability.  Level 3 assets and liabilities may include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation. This category typically includes mortgage servicing assets, and certain impaired loans whose fair values may not be readily extrapolated from observable market data for underlying collateral.

 

The Company used the following methods and significant assumptions to estimate fair value:

 

Securities - The fair value of securities available for sale are determined by obtaining quoted prices on nationally recognized exchanges or matrix pricing which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather relying on the security’s relationship to other benchmark quoted securities.

 

Loans Held For Sale - The fair value of loans held for sale is determined, when possible, using quoted secondary market prices. If no such quoted price exists, the fair value of the loan is determined using quoted prices for a similar asset or assets, adjusted for the specific attributes of that loan.

 

Impaired Loans - The Company determines the fair value of impaired loans using an updated appraisal of the underlying collateral securing such loans, or in some cases an observable market price for similar collateral if an appraisal is expected to an extended period of time to complete.  As such, the Company records impaired loans as non-recurring Level 2 when the fair value of the underlying collateral is based on an observable market price or current appraised value.  When current market prices are not available or the Company determines that the fair value of the underlying collateral is further impaired below appraised values, the Company records impaired loans as non-recurring Level 3.  At December 31, 2010, the Company’s impaired loans were evaluated based on the fair value of their underlying collateral based upon the most recent appraisal available to the Company less costs to sell.

 

Other Real Estate Owned and Foreclosed Collateral - Other real estate owned and foreclosed collateral are adjusted to fair value, less any estimated costs to sell, at the time the loans are transferred into this category.  The fair value of these assets is based on independent appraisals, observable market prices for similar assets, or Management’s estimation of value.  When the fair value is based on independent appraisals or observable market prices for similar assets, the Company records other real estate owned or foreclosed collateral as non-recurring Level 2.  When appraised values are not available, there is no observable market price for similar assets, or Management determines the fair value of the asset is further impaired below appraised values or observable market prices, the Company records other real estate owned or foreclosed collateral as non-recurring Level 3.

 

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The following table provides a summary of the financial instruments the Company measures at fair value on a recurring basis as of December 31, 2010 and 2009:

 

 

 

Fair Value Measurements Using

 

 

 

 (dollar amounts in thousands)
 
As of December 31, 2010

 

Quoted Prices in
Active Markets for
Identical Assets
(Level 1)

 

Significant Other
Observable
Inputs
(Level 2)

 

Significant
Unobservable
Inputs
(Level 3)

 

Assets At
Fair Value

 

 Assets

 

 

 

 

 

 

 

 

 

Obligations of U.S. government agencies

 

$

-      

 

$

6,436

 

$

-     

 

$

6,436

 

Mortgage backed securities:

 

 

 

 

 

 

 

 

 

Agency

 

-      

 

160,617

 

-     

 

160,617

 

Non-agency

 

-      

 

9,059

 

-     

 

9,059

 

Obligations of state and muncipal securities

 

-      

 

47,462

 

283

 

47,745

 

Other securities

 

-      

 

1,109

 

-     

 

1,109

 

 

 

 

 

 

 

 

 

 

 

Total assets measured on a recurring basis

 

$

-      

 

$

224,683

 

$

283

 

$

224,966

 

 

 

 

 

 

 

 

 

 

 

 As of December 31, 2009

 

 

 

 

 

 

 

 

 

 Assets

 

 

 

 

 

 

 

 

 

Obligations of U.S. government agencies

 

$

-      

 

$

104

 

$

-     

 

$

104

 

Mortgage backed securities:

 

 

 

 

 

 

 

 

 

Agency

 

-      

 

77,950

 

-     

 

77,950

 

Non-agency

 

-      

 

20,153

 

-     

 

20,153

 

Obligations of state and muncipal securities

 

-      

 

22,127

 

737

 

22,864

 

Other securities

 

-      

 

109

 

-     

 

109

 

 

 

 

 

 

 

 

 

 

 

Total assets measured on a recurring basis

 

$

-      

 

$

120,443

 

$

737

 

$

121,180

 

 

The following table provides a summary of the changes in balance sheet carrying values associated with Level 3 financial instruments during the twelve months ended December 31, 2010:

 

 (dollars in thousands)

 

Beginning
Balance

 

Gains
Included in OCI (1)

 

Purchases,
Issuances, and
Settlements

 

Sales and
Maturities

 

Ending
Balance

 

 December 31, 2010

 

 

 

 

 

 

 

 

 

 

 

Obligations of state and muncipal securities

 

$

737

 

$

(10)

 

$

-     

 

$

(444

)

$

283

 

 December 31, 2009

 

 

 

 

 

 

 

 

 

 

 

Obligations of state and muncipal securities

 

$

774

 

$

(37)

 

$

-     

 

$

-     

 

$

737

 

 

The assets presented under level 3 of the fair value hierarchy represent available for sale investment securities in the form of certificates of participation where an active market for such securities is not currently available.

 

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The following table provides a summary of the financial instruments the Company measures at fair value on a non-recurring basis as of December 31, 2010 and 2009:

 

 

 

Fair Value Measurements Using

 

 

 

 

 

 (dollar amounts in thousands)
 
As of December 31, 2010

 

Quoted Prices in
Active Markets for
Identical Assets
(Level 1)

 

Significant Other
Observable
Inputs
(Level 2)

 

Significant
Unobservable
Inputs
(Level 3)

 

Assets At
Fair Value

 

Total
Gains/(Losses)

 

 Assets

 

 

 

 

 

 

 

 

 

 

 

Impaired loans

 

$

-    

 

$

33,343

 

$

-     

 

$

33,343

 

$

(2,691)

 

Loans held for sale

 

-    

 

11,008

 

-     

 

11,008

 

-      

 

Other real estate owned

 

-    

 

6,668

 

-     

 

6,668

 

(3,447)

 

Goodwill

 

-    

 

-     

 

11,049

 

11,049

 

-      

 

 

 

 

 

 

 

 

 

 

 

 

 

Total assets measured on a non-recurring basis

 

$

-    

 

$

51,019

 

$

11,049

 

$

62,068

 

$

(6,138)

 

 

 

 

 

 

 

 

 

 

 

 

 

 As of December 31, 2009

 

 

 

 

 

 

 

 

 

 

 

 Assets

 

 

 

 

 

 

 

 

 

 

 

Impaired loans

 

$

-    

 

$

47,172

 

$

-     

 

$

47,172

 

$

(20,204)

 

Loans held for sale

 

-    

 

9,487

 

-     

 

9,487

 

-      

 

Other real estate owned

 

-    

 

946

 

-     

 

946

 

-      

 

Goodwill

 

-    

 

-     

 

11,049

 

11,049

 

-      

 

 

 

 

 

 

 

 

 

 

 

 

 

Total assets measured on a non-recurring basis

 

$

-    

 

$

57,605

 

$

11,049

 

$

68,654

 

$

(20,204)

 

 

During the fiscal year ended December 31, 2010, the carrying amount of goodwill assets were compared to the fair value of such assets.  The Company determined that goodwill assets were not impaired and that carrying amount of those assets as of December 31, 2010 approximates their fair value.

 

Fair Value of Financial Instruments

 

The fair values presented represent the Company’s best estimate of fair value using the methodologies discussed below. The fair values of financial instruments which have a relatively short period of time between their origination and their expected realization were valued using historical cost. The values assigned do not necessarily represent amounts which ultimately may be realized. In addition, these values do not give effect to discounts to fair value which may occur when financial instruments are sold in larger quantities. The estimated fair value of financial instruments at December 31, 2010 and 2009 is summarized in the table below:

 

 

 

2010

 

2009

 

 

 

Carrying

 

 

 

Carrying

 

 

 

 (dollar amounts in thousands)

 

Amount

 

Fair Value

 

Amount

 

Fair Value

 

 Assets

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

22,951

 

$

22,951

 

$

40,738

 

$

40,738

 

Interest-bearing deposits

 

119

 

119

 

119

 

119

 

Investments and mortgage-backed securities

 

224,966

 

224,966

 

121,180

 

121,180

 

Federal Home Loan Bank stock

 

5,180

 

5,180

 

5,828

 

5,828

 

Loans receivable, net of deferred fees and costs

 

675,690

 

678,916

 

726,854

 

731,045

 

Loans held for sale

 

11,008

 

11,008

 

9,487

 

9,487

 

Bank owned life insurance

 

13,843

 

13,843

 

12,549

 

12,549

 

Accrued interest receivable

 

3,986

 

3,986

 

3,639

 

3,639

 

 Liabilities

 

 

 

 

 

 

 

 

 

Non interest-bearing deposits

 

182,658

 

182,658

 

174,635

 

174,635

 

Interest-bearing deposits

 

615,548

 

617,296

 

600,830

 

596,782

 

Federal Home Loan Bank advances

 

45,000

 

45,025

 

65,000

 

65,180

 

Junior subordinated debentures

 

8,248

 

7,713

 

13,403

 

12,390

 

Accrued interest payable

 

423

 

423

 

590

 

590

 

 

The Company has financial instruments with off balance sheet risk in the normal course of business to meet the financing needs of its customers.  These financial instruments include commitments to extend credit and standby letters of credit.

 

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The estimated fair value of these financial instruments at December 31, 2010 and 2009 is summarized in the table below:

 

 

 

Notional

 

Cost to Cede

 

Notional

 

Cost to Cede

 

 

 

Amount

 

or Assume

 

Amount

 

or Assume

 

Off-balance sheet instruments, commitments to extend credit and standby letters of credit

 

$

157,411

 

$

1,574

 

$

169,578

 

$

1,696

 

 

The following methods and assumptions were used by the Company in estimating fair values of financial instruments:

 

Cash and Cash Equivalents - The carrying amounts reported in the balance sheet for cash and cash equivalents approximate the fair values of those assets due to the short-term nature of the assets.

 

Interest Bearing Deposits at Other Financial Institutions - The carrying amounts reported in the balance sheet for interest bearing deposits at other financial institutions approximates the fair value of these assets due to the short-term nature of the assets.

 

Investments Including Federal Home Loan Bank Stock and Mortgage-Backed Securities - Fair values are based upon quoted market prices, where available. If quoted market prices are not available, fair values are extrapolated from the quoted prices of similar instruments or through the use of other observable data supporting a valuation model.  Fair values for holdings of Federal Home Loan Bank stock is based on carrying amounts due to the redemption provisions.

 

Loans, Loans Held for Sale, and Accrued Interest Receivable - For variable-rate loans that re-price frequently and with no significant change in credit risk, fair values are based on carrying amounts.  The fair values for other loans (for example, fixed rate loans and loans that possess a rate variable other than daily) are estimated using discounted cash flow analysis, based on interest rates currently being offered for loans with similar terms to borrowers of similar credit quality.  Loan fair value estimates include judgments regarding future expected loss experience and risk characteristics.

 

The fair value of loans held for sale is determined, when possible, using quoted secondary market prices.  If no such quoted price exists, the fair value of the loan is determined using quoted prices for a similar asset or assets, adjusted for the specific attributes of that loan.  The carrying amount of accrued interest receivable approximates its fair value.

 

Bank Owned Life Insurance - Fair values are based on current cash surrender values at each reporting date provided by the underlying insurers.

 

Federal Home Loan Bank Advances - The fair value disclosed for FHLB advances is determined by discounting contractual cash flows at current market interest rates for similar instruments.

 

Interest Bearing Deposits and Accrued Interest Payable - The fair values disclosed for interest bearing deposits (for example, interest-bearing checking accounts and passbook accounts) are, by definition, equal to the amount payable on demand at the reporting date (that is, the carrying amounts).  The fair values for certificates of deposit are estimated using a discounted cash flow analysis that applies interest rates currently being offered on certificates to a schedule of aggregated contractual maturities on such time deposits.  The carrying amount of accrued interest payable approximates its fair value.

 

Junior Subordinated Debentures - The fair value disclosed for junior subordinated debentures is based on contractual cash flows at current market interest rates for similar instruments.

 

Off-Balance Sheet Instruments - Fair values of commitments to extend credit and standby letters of credit are based upon fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreement and the counterparties’ credit standing.

 

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Note 19.  Earnings / (Loss) Per Share

 

The following is a reconciliation of net income and shares outstanding to the income and number of shares used to compute earnings per share.  Share information has been retroactively adjusted for stock dividends as discussed in Note 20 of these Consolidated Financial Statements:

 

 

 

For The Years Ended December 31,

 

 

 

2010

 

 

 

2009

 

 

 

2008

 

(dollar amounts in thousands except per share data)

 

Net
Loss

 

 

Shares

 

 

 

Net
Loss

 

 

 

Shares

 

 

 

Net
Income

 

 

 

Shares

 

Net (loss) / income

 $

(17,560)

 

 

 

 

 

 

$

(7,049)

 

 

 

 

 

 

 

$

1,646

 

 

 

 

 

Dividends and accretion on preferred stock

 

(5,008)

 

 

 

 

 

 

(964)

 

 

 

 

 

 

 

-     

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net (loss) / income available to common shareholders

 $

(22,568)

 

 

 

 

 

 

$

(8,013)

 

 

 

 

 

 

 

$

1,646

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted average shares outstanding

 

 

 

 

17,312,306

 

 

 

 

 

 

 

7,697,234

 

 

 

 

 

 

 

7,641,726

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic (loss) / earnings per common share

$

(1.30)

 

 

 

 

 

 

$

(1.04)

 

 

 

 

 

 

 

$

0.22

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Dilutive effect of share-based compensation awards, common stock warrant, and convertible perpetual preferred stock

 

 

 

 

-

 

 

 

 

 

 

 

-

 

 

 

 

 

 

 

111,287

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted average diluted shares outstanding

 

 

 

 

17,312,306

 

 

 

 

 

 

 

7,697,234

 

 

 

 

 

 

 

7,753,013

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Diluted (loss) / earnings per common share

$

(1.30)

 

 

 

 

 

 

$

(1.04)

 

 

 

 

 

 

 

$

0.21

 

 

 

 

 

 

Basic earnings / (loss) per common share are computed by dividing net income / (loss) applicable to common shareholders by the weighted-average number of common shares outstanding for the reporting period.  Diluted earnings / (loss) per common share are computed by dividing net income available to common shareholders by the weighted-average number of common shares outstanding over the reporting period, adjusted to include the effect of potentially dilutive common shares.  Potentially dilutive common shares are calculated using the Treasury Stock Method and include incremental shares issuable upon exercise of outstanding stock options, other share-based compensation awards and any other security in which its conversion / exercise may result in the issuance of common stock, such as the warrant the Company issued to the U.S. Treasury during 2009 or the Series C Perpetual Preferred Stock the Company issued during 2010.  U.S. GAAP prohibits the computation of diluted loss per common share from assuming exercise or issuance of securities that would have an anti-dilutive effect, which can occur when the Company reports a net loss.  As a result, any potential dilution associated with share-based compensation awards, the warrant issued to the U.S. Treasury, and the Series C Perpetual Preferred Stock were not included in the calculation of diluted loss per common share for the periods presented in which the Company reported a net loss.

 

 

Note 20.  Cash Dividends, Stock Dividends and Stock Splits

 

On April 24, 2008, the Board of Directors declared a five percent stock dividend payable on May 16, 2008 to stockholders of record on May 2, 2008.  All references in financial statements and notes to financial statements to number of shares, per share amounts, and market prices of the Company’s common stock have been restated to reflect the increased number of shares outstanding.  The Company paid no cash dividends on its common stock during the years ended December 31, 2010 and 2009.  Dividends declared and paid to holders of common stock during 2008 totaled $0.08 per share.

 

 

Note 21.  Preferred Stock

 

Under its Amended Articles of Incorporation, the Company is authorized to issue up to 5,000,000 shares of preferred stock, in one or more series, having such voting powers, designations, preferences, rights, qualifications, limitations and restrictions as determined by the Board of Directors.

 

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U.S Treasury’s Capital Purchase Program (“CPP”)

 

On March 20, 2009, the Company issued 21,000 shares of Series A Senior Preferred Stock to the U.S. Treasury under the terms of the CPP for $21.0 million with a liquidation preference of $1,000 per share.  The preferred stock carries a coupon of 5% for five years and 9% thereafter.  Senior preferred stock issued to the U.S. Treasury is non-voting, cumulative, and perpetual and may be redeemed at 100% of their liquidation preference plus accrued and unpaid dividends following three years from the date of issue.  In addition, the Company issued a warrant to the U.S. Treasury to purchase shares of the Company’s common stock in an amount equal to 15% of the preferred equity issuance or approximately $3.2 million (611,650 shares).  The warrant is exercisable immediately at a price of $5.15 per share, will expire after a period of 10 years from issuance and is transferable by the U.S. Treasury.  The warrant may be dilutive to earnings per common share during reporting periods in which the warrant is not anti-dilutive.

 

The U.S. Treasury may transfer a portion or portions of the warrant, and/or exercise the warrant at any time.  The U.S. Treasury has agreed not to exercise voting power with respect to any common shares issued to it upon exercise of the warrant.  At December 31, 2010, there had been no changes to the number of common shares covered by the warrant nor had the U.S. Treasury exercised any portion of the warrant.

 

The proceeds received from the U.S. Treasury were allocated to the Series A Senior Preferred Stock and the warrant based on their relative fair values.  The fair value of the Series A Senior Preferred Stock was determined through a discounted future cash flow model at a discount rate of 10%.  The fair value of the warrant was calculated using the Black-Scholes option pricing model, which includes assumptions regarding the Company’s dividend yield, stock price volatility, and the risk-free interest rate.  As a result the Company recorded the Series A Senior Preferred Stock and the warrant at $19.2 million and $1.8 million, respectively.  The Company is accreting the discount on the Series A Senior Preferred Stock over a period of five years with corresponding charges to retained earnings.

 

For the years ended December 31, 2010 and 2009 accrued and paid dividends and accretion on the Series A Senior Preferred Stock totaled $1.6 million and $1.0 million, respectively.  Additionally, the Company is subject to certain limitations during its participation in the CPP including:

 

·                  The requirement to obtain consent from the U.S. Treasury for any proposed increases in common stock dividends prior to the third anniversary date of the preferred equity issuance.

 

·                  The Series A Senior Preferred Stock cannot be redeemed for three years unless the Company obtains proceeds to replace the Series A Senior Preferred Stock through a qualified equity offering.

 

·                  The U.S. Treasury must consent to any buy back of our common stock.

 

The Company must adhere to restrictions placed on the amount of and type of compensation paid to its executives while participating in the CPP, pursuant to section 111 of the Emergency Economic Stabilization Act of 2008, as amended (“EESA”).

 

In the second quarter of 2010 the Company was required to defer dividend payments on its Series A Senior Preferred Stock to comply with the terms of the Written Agreement entered into between the Company and the Federal Reserve Bank of San Francisco.  If the Company fails to pay dividends on Series A Senior Preferred Stock for a total of six quarters, whether or not consecutive, the U.S. Treasury will have the right to elect two members of the Company’s Board of Directors, voting together with any other holders of preferred shares ranking pari passu with the Series A Senior Preferred Stock.  These directors would serve on the Company’s Board of Directors until such time as the Company has paid in full all dividends not previously paid, at which time these directors’ terms of office would immediately terminate.  As of December 31, 2010, the Company had not paid dividends on Series A Preferred Stock for three consecutive quarters.

 

For more information concerning the Written Agreement, please refer to Note 22. Regulatory Order and Written Agreement, of these consolidated financial statements.

 

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Private Placement and Preferred Stock Conversion

 

On March 12, 2010 the Company announced that it completed a private placement of 52,088 shares of its Series B Mandatorily Convertible Adjustable Cumulative Perpetual Preferred Stock (“Series B Preferred Stock”) and 1,189,538 shares of its Series C Convertible Perpetual Preferred Stock (“Series C Preferred Stock”), raising gross proceeds of $56.0 million. In addition, $4.0 million was placed in escrow for a second closing of 4,072 shares of Series B Preferred Stock, which then closed during the second quarter of 2010.  Total gross proceeds raised in the private placement were $60.0 million and total costs associated with the capital raising efforts were $4.0 million, which represent a reduction of the addition to equity from the private placement.

 

In June 2010, the Company received shareholder approval to convert all outstanding shares of Series B Preferred Stock to common stock and as a result the Company issued 17,279,995 shares of common stock in June 2010.

 

The Series B Preferred Stock was mandatorily convertible into common stock, upon the approval by shareholders of the Company’s common stock at a conversion price of $3.25 per common share.  As indicated above, shareholder approval occurred during the second quarter of 2010.  The conversion price of $3.25 per common share was less than the fair market value of the Company’s common stock on March 10, 2010, (the “commitment date”) the date the Company made a firm commitment to issue the Series B Preferred Stock.  The fair market value of the Company’s common stock on the commitment date was $3.45 per share.  Therefore, the Series B Preferred Stock was issued with a contingent beneficial conversion feature that had an intrinsic value equal to the $0.20 per share difference between the share price on the commitment date and the conversion price of the Series B Preferred Stock.  The intrinsic value of the beneficial conversion feature related to the entire Series B Preferred Stock issuance was $3.5 million.  The recognition of the beneficial conversion feature was contingent upon the approval of the Company’s shareholders of the conversion of the Series B Preferred Stock to common stock and thus was recognized in June 2010 when such approval was received at the Company’s annual meeting of shareholders.

 

Upon conversion of the Series B Preferred Stock the related beneficial conversion feature was recorded in conjunction with the establishment of a discount on the Series B Preferred Stock and a corresponding increase in additional paid in capital.  The immediate accretion of the entire Series B Preferred Stock discount occurred through a charge to retained earnings in June 2010, when the Company converted the outstanding Series B Preferred Stock to common stock.

 

Series C Preferred Stock is a non-voting class of stock substantially similar in priority to the common stock of the Company, except for a liquidation preference over the Company’s common stock.  The Series C Preferred Stock will convert to shares of common stock on a one share for one share basis if the original holder of such shares transfers them to an unaffiliated third party. The Series C Preferred Stock will not be redeemable by either the Company or by the holders.  Holders of the Series C Preferred Stock do not have any voting rights, including the right to elect any directors, other than the customary limited voting rights with respect to matters significantly and adversely affecting the rights and privileges of the Series C Preferred Stock.

 

As is the case with the Series B Preferred Stock, the fair market value of the Company’s common stock was higher than the conversion price of $3.25 per share of the Series C Preferred Stock on the date the Company made a firm commitment to issue the Series C Preferred Stock.  Therefore, the Series C Preferred Stock also has a contingent beneficial conversion feature associated with it.  However, since the conversion of the Series C Preferred Stock remains contingent upon the holder’s transfer of the securities to an unaffiliated third party with no specified date for its conversion to common stock, the Company will record the contingent beneficial conversion feature as an initial discount on Series C Preferred Stock and additional paid in capital, with a concurrent immediate accretion of the established discount and corresponding charge to retained earnings on the date the Series C Preferred Stock converts to common stock.  The amount of the contingent beneficial conversion feature is approximately $0.2 million and will be recorded as described upon the original holder’s transfer of Series C Preferred Stock to an unaffiliated third party.  Such transfer has not occurred as of December 31, 2010.

 

It should be noted that two investors in the Company’s March 2010 private placement have Board observation rights, while one of the two investors also has Board nomination rights.

 

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Note 22.  Regulatory Order and Written Agreement

 

On March 4, 2010, the FDIC and the DFI issued a Consent Order (the “Order”) to the Bank that requires, among other things, the Bank to increase its capital ratios, reduce its classified assets and increase Board oversight of Management. The Board and Management responded aggressively to the Order to ensure full compliance within all of the stipulated time frames. Management will continue to take all actions necessary to maintain compliance with all provisions within the Order. Such actions included the completion of the capital raise previously discussed, which brought the Bank into compliance with the capital requirements of the Order.  Additionally and as previously discussed, a Written Agreement was entered into between the Company and the Federal Reserve Bank of San Francisco on March 4, 2010. The Company and Bank believe it has successfully addressed the requirements of both the Order and the Written Agreement.

 

The following provides a summary of certain provisions in the Consent Order as well as the Written Agreement.  Please also refer to the Company’s current reports filed on Form 8-K with the SEC on March 10, 2010 and March 8, 2010, respectively for a more complete description of the provisions of the Consent Order and Written Agreement.

 

Consent Order

 

The Bank’s stipulation to the issuance by the joint FDIC and DFI Order resulted from certain findings in a report of examination resulting from an examination of the Bank conducted in September 2009.  In entering into the stipulation to entry of the Order, the Bank did not concede the findings or admit to any of the assertions in the report of examination (“ROE”).

 

Under the Order, the Bank is required to take certain measures as more fully discussed below.  The Bank has taken several steps to comply with the Order, most importantly completing a capital raise as previously discussed.  As mentioned, Management and the Board aggressively responded to the Order and achieved full compliance within the time frames set forth in the Order, and will continue to take all steps necessary to maintain such compliance.

 

·                  Among the corrective actions required are for the Bank to develop and adopt a plan to maintain the minimum capital requirements for a “well-capitalized” bank, and to reach and maintain a Tier 1 leverage ratio of at least 10% and a total risked based capital ratio of 11.5% at the Bank level beginning 90 days from the issuance of the Order.

 

·                  Pursuant to the Order, the Bank must retain qualified management, must notify the FDIC and the DFI in writing when it proposes to add any individual to its Board of Directors or to employ any new senior executive officer, and must conduct an independent study of management and personnel structure of the Bank. A consultant was retained to complete the required management study, and the Bank believes it complied with the Order’s timelines for completion of such study and implementation by the Board of a plan to address the findings of such study.  As part of the capital raise, the Company and the Bank obtained regulatory approval to add as a director of both the Bank and Company, one of the principals of the investor in the transaction that acquired approximately 14.4% of the outstanding voting shares of the Company.  The addition of a director to the Company’s Board of Directors required an amendment to the Company’s bylaws to increase the range of the size of the board.  Such an amendment was approved by the shareholders at the Company’s 2010 annual meeting of shareholders.

 

·                  Under the Order the Bank’s Board of Directors must also increase its participation in the affairs of the Bank, assuming full responsibility for the approval of sound policies and objectives and for the supervision of all the Bank’s activities. The Board of Directors believes it has always provided appropriate oversight of the Bank, but took immediate steps to reevaluate such oversight and enhance where appropriate, the frequency and duration and the scope and depth of matters covered at its Board meetings in response to the current economic environment and concerns raised in the ROE.

 

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·                  In direct response to the ROE, a new joint regulatory compliance committee was formed at both the Bank and Company levels to oversee the Bank’s and Company’s response to all regulatory matters, including the Order and the Written Agreement, discussed below.  Detailed tracking of the Order’s requirements, and the Bank’s progress in responding thereto, is reviewed and reported at all such committee meetings, with regular reports then being provided by the committee to the full Board.  Further, and prior to the issuance of the Order, the Board directed its Chairman, Michael Morris, to significantly increase his direct oversight of Management and involvement in Bank and Company affairs to ensure an appropriate response at both the Bank and Company to the concerns raised in the recent examination of the Bank.

 

·                  The Order further requires the Bank to increase its Allowance for Loan Losses (“ALLL”), as of the date of the ROE, by $3.5 million and to review and revise its ALLL methodology.  The Bank subsequently made provisions of $19.3 million in the third and fourth quarters of 2009.  The Bank also revised its policy for determining the adequacy of the ALLL to include an assessment of market conditions and other qualitative factors. The Bank’s policy otherwise continues to provide for a comprehensive determination of the adequacy of its ALLL which is to be reviewed promptly and regularly at least once each calendar quarter and be properly reported, and any deficiency in the allowance must be remedied in the calendar quarter it is discovered, by a charge to current operating earnings.

 

·                  With respect to classified assets as of the date of the ROE, the Order also requires the Bank to charge-off or collect all assets classified as “Loss” and one-half of the assets classified as “Doubtful” and within 180 days of the Order to reduce its level of assets classified as “Substandard” to no more than the greater of $50.0 million or 50% of Tier 1 capital plus the ALLL.  The Bank complied with the requirement of the 2009 ROE in this regard and reduced the level of classified assets identified during the 2009 ROE to less than $50 million or 50% of Tier 1 capital plus ALLL well before the 180 day deadline.  However, due to the continued migration of loans to classified status during 2010; as of December 31, 2010, the Bank had classified assets over $50 million and over 50% of Tier 1 capital plus ALLL.  The Bank has also developed and implemented a process for the review and approval of all applicable asset disposition plans.

 

·                  The Order requires that the Bank develop or revise, adopt and implement a plan, which must be approved by the FDIC and DFI, to reduce the amount of Commercial Real Estate loans extended, particularly focusing on reducing loans for construction and land development.  In addition, the Bank was required to develop a plan for reducing the number of pass graded loans designated as “watch list” credits to an acceptable level, and develop or revise its written lending and collection policies to provide more effective guidance and control over the Bank’s lending function.  The Bank has accomplished all of these requirements.

 

·                  The Order restricts the Bank from taking certain actions without the prior written consent of the FDIC and the DFI, including paying cash dividends, and from extending additional credit to certain types of borrowers. The Bank has not paid cash dividends since the first quarter of 2008. In addition, the Bank has put processes and controls in place to ensure extensions of credit, directly or indirectly, are not granted to those who are related to borrowers of loans charged-off or classified as “Loss”, “Substandard” or “Doubtful” in the ROE. The Bank has also acknowledged that neither the loan committee nor the Board of Directors will approve any extension to a borrower classified “Substandard” or “Doubtful” in the ROE without first collecting all past due interest in cash.

 

·                  The Order further requires the Bank to develop or revise, adopt and implement a revised liquidity policy, and to adopt a contingency funding plan to adequately address contingency funding sources and appropriately reduce contingency funding reliance on off-balance sheet sources.  The Bank has since revised its current liquidity policy and has developed a contingency funding plan.

 

·                  The Order also requires that the Bank prepare and submit a revised business plan, that is to include a comprehensive budget, and a 3 year strategic plan, and to further revise its investment policy.  The Bank has since prepared a comprehensive budget and revised the investment policy and developed a revised business plan and 3 year strategic plan.

 

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Written Agreement

 

On March 4, 2010, the Company entered into a written agreement with the FRB (the “Written Agreement”), which requires the Company to take certain measures to improve its safety and soundness. Under the Written Agreement, the Company is required to develop and submit for approval, a plan to maintain sufficient capital at the Company and the Bank within 60 days of the date of the Written Agreement. The Written Agreement further provides, among other things, that the Company shall not: declare or pay dividends without prior approval of the FRB, take dividends from the Bank, make any distribution of interest, principal or other sums on subordinated debt or trust preferred securities, incur, increase, or guarantee any debt.

 

The forgoing discussion of the Order and Written Agreement are qualified in their entirety by reference to the complete text of the Order and Written Agreement, which can be found on the Current Reports on Form 8-K filed March 10, 2010, and March 8, 2010, respectively.

 

Note 23.  Subsequent Events

 

Events or transactions that provided evidence about conditions that did not exist at December 31, 2010, but arose before the financial statements were available to be issued have not been recognized in the financial statements.  Based on all currently available information, the Company is not aware of any such events.  Events or transactions that were deemed to be of a material nature and provide evidence about conditions that did exist at December 31, 2010 have been recognized in these consolidated financial statements.

 

Note 24.  Parent Company Financial Information

 

Heritage Oaks Bancorp

Condensed Balance Sheets

 

 

 

December 31,

 

(dollar amounts in thousands)

 

2010

 

2009

 

Assets

 

 

 

 

 

Cash

 

$

683

 

$

382

 

Federal funds sold

 

3,500

 

4,350

 

Total cash and cash equivalents

 

4,183

 

4,732

 

Prepaid and other assets

 

266

 

428

 

Investment in subsidiaries

 

126,116

 

92,085

 

 

 

 

 

 

 

Total assets

 

$

130,565

 

$

97,245

 

 

 

 

 

 

 

Liabilities

 

 

 

 

 

Junior subordinated debentures

 

$

8,248

 

$

13,403

 

Other liabilities

 

1,061

 

91

 

 

 

 

 

 

 

Total liabilities

 

9,309

 

13,494

 

 

 

 

 

 

 

Stockholders’ Equity

 

 

 

 

 

Preferred stock

 

23,396

 

19,431

 

Common stock

 

101,140

 

48,747

 

Additional paid in capital

 

7,002

 

3,242

 

Retained (deficit) / earnings

 

(9,161

)

13,407

 

Accumulated other comprehensive loss

 

(1,121

)

(1,076

)

 

 

 

 

 

 

Total stockholders’ equity

 

121,256

 

83,751

 

 

 

 

 

 

 

Total liabilities and stockholders’ equity

 

$

130,565

 

$

97,245

 

 

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Heritage Oaks Bancorp

Condensed Statements of Income

 

 

 

For The Years Ended

 

 

 

December 31,

 

(dollar amounts in thousands)

 

2010

 

2009

 

2008

 

 

 

 

 

 

 

 

 

Income

 

 

 

 

 

 

 

Equity in undisbursed (loss) / income of subsidiaries

 

$

(18,432

)

$

(6,532

)

$

2,230

 

Interest

 

14

 

29

 

72

 

Gain on sale of investment securities

 

474

 

-

 

-

 

Gain on extinguishment of debt

 

1,700

 

-

 

-

 

Total (loss) / income

 

(16,244

)

(6,503

)

2,302

 

 

 

 

 

 

 

 

 

Expense

 

 

 

 

 

 

 

Salary

 

142

 

150

 

127

 

Equipment

 

(33

)

(57

)

(57

)

Other professional fees and outside services

 

345

 

239

 

236

 

Interest

 

245

 

574

 

755

 

 

 

 

 

 

 

 

 

Total expense

 

699

 

906

 

1,061

 

 

 

 

 

 

 

 

 

Total operating (loss) / income

 

(16,943

)

(7,409

)

1,241

 

Income tax expense / (benefit)

 

617

 

(360

)

(405

)

 

 

 

 

 

 

 

 

Net (loss) / income

 

$

(17,560

)

$

(7,049

)

$

1,646

 

 

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Heritage Oaks Bancorp

Condensed Statements of Cash Flows

 

 

 

For The Years Ended

 

 

 

December 31,

 

(dollar amounts in thousands)

 

2010

 

2009

 

2008

 

 

 

 

 

 

 

 

 

Cash flows from operating activities:

 

 

 

 

 

 

 

Net (loss) / income

 

$

(17,560

)

$

(7,049

)

$

1,646

 

Adjustments to reconcile net income to net cash provided by/(used in) operating activities:

 

 

 

 

 

 

 

Decrease in other assets

 

162

 

29

 

36

 

Increase / (decrease) in other liabilities

 

40

 

(131

)

(86

)

Share-based compensation expense

 

142

 

150

 

127

 

Gain on extinguishment of debt

 

(1,700

)

-    

 

-     

 

Undistributed loss / (income) of subsidiaries

 

18,432

 

6,532

 

(2,230

)

 

 

 

 

 

 

 

 

Net cash provided / (used) in operating activities

 

(484

)

(469

)

(507

)

 

 

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

 

 

Sale of equity investments

 

155

 

-    

 

-    

 

Contribution to subsidiary

 

(52,500

)

(17,000

)

(1,750

)

 

 

 

 

 

 

 

 

Net cash used in investing activities

 

(52,345

)

(17,000

)

(1,750

)

 

 

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

 

 

Cash paid in lieu of fractional shares

 

-    

 

-    

 

(5

)

Cash dividends paid

 

(262

)

(685

)

(586

)

Decrease in junior subordinated debentures

 

(3,455

)

-    

 

-    

 

Proceeds from issuance of preferred stock

 

55,955

 

19,151

 

-    

 

Proceeds from issuance of common stock warrants

 

-    

 

1,849

 

-    

 

Proceeds from the exercise of options

 

42

 

98

 

421

 

 

 

 

 

 

 

 

 

Net cash provided / (used) by financing activities

 

52,280

 

20,413

 

(170

)

 

 

 

 

 

 

 

 

Net increase / (decrease) in cash and cash equivalents

 

(549

)

2,944

 

(2,427

)

 

 

 

 

 

 

 

 

Cash and cash equivalents, beginning of year

 

4,732

 

1,788

 

4,215

 

 

 

 

 

 

 

 

 

Cash and cash equivalents, end of year

 

$

4,183

 

$

4,732

 

$

1,788

 

 

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Quarterly Financial Information (un-audited)

 

The following table provides a summary of results for the periods indicated:

 

 

 

For The Quarters Ended,

 

 

Q4

 

Q3

 

Q2

 

Q1

 

Q4

 

Q3

 

Q2

 

Q1

 

(dollar amounts in thousands, except per share data)

 

2010

 

2010

 

2010

 

2010

 

2009

 

2009

 

2009

 

2009

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest income

 

$

12,462

 

$

12,706

 

$

13,176

 

$

12,450

 

$

13,534

 

$

11,860

 

$

12,269

 

$

11,896

 

Net interest income

 

10,817

 

10,842

 

11,140

 

9,947

 

10,836

 

9,265

 

9,842

 

9,567

 

Provision for credit losses

 

5,831

 

4,400

 

16,100

 

5,200

 

9,500

 

9,756

 

2,700

 

2,110

 

Non interest income

 

1,788

 

2,507

 

3,613

 

1,586

 

1,445

 

1,593

 

1,500

 

1,660

 

Non interest expense

 

12,462

 

9,874

 

8,828

 

8,866

 

8,826

 

10,251

 

8,014

 

7,425

 

(Loss) / income before provision for income taxes

 

(5,688

)

(925

)

(10,175

)

(2,533

)

(6,045

)

(9,149

)

628

 

1,692

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net (loss) / income

 

517

 

(10,903

)

(5,835

)

(1,339

)

(3,416

)

(5,242

)

507

 

1,102

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Dividends and accretion on preferred stock

 

491

 

357

 

3,809

 

351

 

351

 

352

 

250

 

11

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net (loss) / income available to common shareholders

 

$

26

 

$

(11,260

)

$

(9,644

)

$

(1,690

)

$

(3,767

)

$

(5,594

)

$

257

 

$

1,091

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(Loss) / earnings per common share

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic

 

$

0.00

 

$

(0.45

)

$

(0.86

)

$

(0.22

)

$

(0.48

)

$

(0.73

)

$

0.03

 

$

0.14

 

Diluted

 

$

0.00

 

$

(0.45

)

$

(0.86

)

$

(0.22

)

$

(0.48

)

$

(0.73

)

$

0.03

 

$

0.14

 

 

Item 9.  Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

 

None.

 

 

Item 9A.  Controls and Procedures

 

As required by SEC Rule 13a-15(b), the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer along with the Company’s Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of the end of the period covered by this report. The evaluation of disclosure controls and procedures includes an evaluation of some components of the Company’s internal control over financial reporting, and internal control over financial reporting is also separately evaluated on an annual basis for purposes of providing the management report which can be found under Item 8. Financial Statements and Supplementary Data, beginning on page 58 of this report. Based upon that evaluation, the Company’s Chief Executive Officer along with the Company’s Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective in timely alerting them to material information relating to the Company (including its consolidated subsidiary) required to be included in the Company’s periodic SEC filings.  During the third quarter of 2010 management identified a material weakness with regard to its financial reporting process as described Item 4. Controls and Procedures of the Form 10-Q filed for the quarter ended September 30, 2010.  Management has created a new internal control designed to mitigate the material weakness reported in the September 30, 2010 Form 10-Q which it believes will be effective in remediating the internal control deficiency that resulted in the reporting of the material weakness.  Other than remediation of this material weakness, there have been no significant changes in the Company’s internal control over financial reporting during the Company’s most recent fiscal quarter that have materially affected, or are likely to materially affect, the Company’s internal control over financial reporting.

 

Disclosure controls and procedures are the Company’s controls and other procedures that are designed to ensure that information required to be disclosed by the Company in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. These controls and subsequent results are communicated to executive management providing the ability to make timely decisions regarding required disclosure.

 

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Item 9B.  Other Information

 

None.

 

 

Part III

 

Item 10.  Directors, Executive Officers and Corporate Governance

 

Code of Ethics

 

We have adopted a Code of Conduct, which applies to all employees, officers and directors of the Company and Bank.  Our Code of Conduct meets the requirements of a “code of ethics” as defined by Item 406 of Regulation S-K and applies to our Chief Executive Officer, Chief Financial Officer and Principal Accounting Officer, as well as all other employees, as indicated above.  Our Code of Conduct is posted on our website at www.heritageoaksbancorp.com under the heading “Investor Relations – Governance Documents.”  Any change to or waiver of the code of conduct (other than technical, administrative and other non-substantive changes) will be posted on the Company’s website or reported on a Form 8-K filed with the Securities and Exchange Commission.  While the Board may consider a waiver for an executive officer or director, the Board does not expect to grant such waivers.

 

There have been no material changes to the procedures by which security holders may recommend nominees to the Company’s Board during 2010.

 

The balance of the information required by Item 10 of Form 10-K is incorporated by reference from the information contained in the Company’s Proxy Statement for the 2011 Annual Meeting of Shareholders which will be filed pursuant to Regulation 14-A.

 

Item 11.  Executive Compensation

 

The information required by Item 11 of Form 10-K is incorporated by reference from the information contained in the Company’s Proxy Statement for the 2011 Annual Meeting of Shareholders which will be filed pursuant to Regulation 14-A.

 

Item 12.  Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

 

The information required by Item 12 of Form 10-K is incorporated by reference from the information contained in the Company’s Proxy Statement for the 2011 Annual Meeting of Shareholders which will be filed pursuant to Regulation 14-A. See Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

 

Item 13.  Certain Relationships and Related Transactions, and Director Independence

 

The information required by Item 13 of Form 10-K is incorporated by reference from the information contained in the Company’s Proxy Statement for the 2011 Annual Meeting of Shareholders which will be filed pursuant to Regulation 14-A.

 

Item 14.  Principal Accounting Fees and Services

 

The information required by Item 14 of Form 10-K is incorporated by reference from the information contained in the Company’s Proxy Statement for the 2011 Annual Meeting of Shareholders which will be filed pursuant to Regulation 14-A.

 

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Part IV

 

Item 15.  Exhibits, Financial Statement Schedules

 

(a) 1. Financial Statements

 

The Company’s Consolidated Financial Statements, include the notes thereto, and the report of the independent registered public accounting firm thereon, are set forth in the index for Item 8 of this form.

 

(a) 2. Financial Statement Schedules

 

All financial statement schedules for the Company have been included in the Consolidated Financial Statements or the related footnotes.  Additionally, a listing of the supplementary financial information required by this item is set forth in the index for Item 8 of this Form 10-K.

 

(a) 3. Exhibits

 

A list of exhibits to this Form 10-K is set forth in the “Exhibit Index” immediately preceding such exhibits and is incorporated herein by reference.

 

(b) Exhibits Required By Item 601 of Regulation S-K

 

Reference is made to the Exhibit Index on page 111 for exhibits filed as part of this report.

 

(c) Additional Financial Statements

 

Not Applicable.

 

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Signatures

 

Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

The Company

 

/s/ Lawrence P. Ward

 

/s/ Thomas J. Tolda

Lawrence P. Ward

 

Thomas J. Tolda

Chief Executive Officer

 

Executive Vice President, Chief Financial Officer

Dated:   March 10, 2011

 

and Principal Accounting Officer

 

 

Dated:   March 10, 2011

 

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.

 

/s/ Michael Morris

Chairman of the Board of Directors

March 10, 2011

Michael Morris

 

 

 

 

 

/s/ Donald H. Campbell

Vice Chairman of the Board of Directors

March 10, 2011

Donald H. Campbell

 

 

 

 

 

/s/ Michael Behrman

Director

March 10, 2011

Michael Behrman

 

 

 

 

 

/s/ Kenneth Dewar

Director

March 10, 2011

Kenneth Dewar

 

 

 

 

 

/s/ Mark C. Fugate

Director

March 10, 2011

Mark C. Fugate

 

 

 

 

 

/s/ Dolores T. Lacey

Director

March 10, 2011

Dolores T. Lacey

 

 

 

 

 

/s/ James J. Lynch

Director

March 10, 2011

James J. Lynch

 

 

 

 

 

/s/ Merle F. Miller

Director

March 10, 2011

Merle F. Miller

 

 

 

 

 

/s/ Daniel J. O’Hare

Director

March 10, 2011

Daniel J. O’Hare

 

 

 

 

 

/s/ Michael E. Pfau

Director

March 10, 2011

Michael E. Pfau

 

 

 

 

 

/s/ Alex Simas

Director

March 10, 2011

Alex Simas

 

 

 

 

 

/s/ Lawrence P. Ward

Director

March 10, 2011

Lawrence P. Ward

 

 

 

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Table of Contents

 

Exhibit Index

 

(3.1a)

 

Articles of Incorporation incorporated by reference from Exhibit 3.1a to Registration Statement on Form S-4 No. 33-77504 filed with the SEC on April, 1994.

 

 

 

(3.1b)

 

Amendment to the Articles of Incorporation filed with the Secretary of State on October 16, 1997 filed with the SEC in the Company’s 10-KSB for the year ending December 31, 1997.

 

 

 

(3.1c)

 

Certificate of Amendment of Articles of Incorporation of Heritage Oaks Bancorp, filed with the SEC on Form 8-K on March 5, 2009.

 

 

 

(3.1d)

 

Certificate of Amendment of Bylaws of Heritage Oaks Bancorp, filed with the SEC on Form 8-K on April 23, 2009.

 

 

 

(3.2)

 

The Company Bylaws as amended November 16, 2000 filed with the SEC in the Company’s 10-KSB for the year ended December 31, 2000.

 

 

 

(4.1)

 

Specimen form of The Company stock certificate incorporated by reference from Exhibit 4.1 to Registration Statement on Form S-4 No. 33-77504 filed with the SEC on April 8, 1994.

 

 

 

(4.2)

 

Certificate of Determination of Series B Mandatorily Convertible Adjustable Rate Cumulative Perpetual Preferred Stock, filed with the SEC on Form 8-K on March 15, 2010.

 

 

 

(4.3)

 

Certificate of Determination of Series C Convertible Perpetual Preferred Stock, filed with the SEC on Form 8-K on March 15, 2010.

 

 

 

(4.4)

 

Certificate of Determination of Fixed Rate Cumulative Perpetual Preferred Stock, Series A of Heritage Oaks Bancorp, filed with the SEC on Form 8-K on March 23, 2009.

 

 

 

(4.5)

 

Specimen form of certificate of Fixed Rate Cumulative Perpetual Preferred Stock, Series A of Heritage Oaks Bancorp, filed with the SEC on Form 8-K on March 23, 2009.

 

 

 

(4.6)

 

Form of Warrant to Purchase Common Stock of Heritage Oaks Bancorp, filed with the SEC on Form 8-K on March 23, 2009.

 

 

 

(10.1)

 

1990 Stock Option Plan incorporated by reference from Exhibit 10.2 to Registration Statement on Form S-4 No. 33-77504, filed with the SEC on April 8, 1994.

 

 

 

(10.2)

 

Form of Stock Option Agreement incorporated by reference from Exhibit 4.2 to Registration Statement on Form S-4 No. 33-77504, filed with the SEC on April 8, 1994.

 

 

 

(10.5)

 

The Company 1995 Bonus Plan, filed with the SEC in the Company’s 10K Report for the year ended December 31, 1994.

 

 

 

(10.6)

 

Salary Continuation Agreement with Lawrence P. Ward, filed with the SEC in the Company’s 10-QSB Report for the quarter ended March 31, 2001.

 

 

 

(10.7)

 

Salary Continuation Agreement with Gwen R. Pelfrey, filed with the SEC in the Company’s 10K Report for the year ended December 31, 1994.

 

 

 

(10.11)

 

1997 Stock Option Plan incorporated by reference from Exhibit 4a to Registration Statement on Form S-8 No.333-31105 filed with the SEC on July 11, 1997 as amended, incorporated by reference, from Registration Statement on Form S-8, File No. 333-83235 filed with the SEC on July 20, 1999.

 

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Table of Contents

 

(10.12)

 

Form of Stock Option Agreement incorporated by reference from Exhibit 4b to Registration Statement on Form S-8 No. 333-31105 filed with the SEC on July 11, 1997.

 

 

 

(10.15)

 

Master data processing agreement with Mid West Payment Systems, Inc. commencing October 1, 1998 filed with the SEC in the Company’s 10-KSB for the year ended December 31, 1998.

 

 

 

(10.16)

 

Salary Continuation Agreement with Margaret A. Torres, filed with the SEC in the Company’s 10KSB Report for the year ended December 31, 1999.

 

 

 

(10.17)

 

Salary Continuation Agreement with Paul Tognazzini, filed with the SEC in the Company’s 10-KSB Report for the year ended December 31, 2001.

 

 

 

(10.19)

 

Service Bureau Processing Agreement entered into between Alltel Information Services, Inc. and Heritage Oaks Bank, dated August 1, 1999. Filed with the SEC in the Company’s 10-KSB reported for the year ended December 31, 1999.

 

 

 

(10.22)

 

Executive Salary Continuation Agreement dated February 1, 2002 between Heritage Oaks Bank and Margaret A. Torres, filed with the SEC in the Company’s 10-QSB reported for March 31, 2002.

 

 

 

(10.23)

 

Executive Salary Continuation Agreement dated February  1, 2002 between Heritage Oaks Bank and Paul Tognazzini, filed with the SEC in the Company’s 10-QSB reported for March 31, 2002.

 

 

 

(10.24)

 

Executive Salary Continuation Agreement dated February 1, 2002 between Heritage Oaks Bank and Gwen R. Pelfrey, filed with the SEC in the Company’s 10-QSB reported for March 31, 2002.

 

 

 

(10.25)

 

Executive Salary Continuation Agreement dated February 1, 2002 between Heritage Oaks Bank and Gloria Brady, filed with the SEC in the Company’s 10-QSB reported for March 31, 2002.

 

 

 

(10.26)

 

Executive Salary Continuation Agreement dated February 1, 2002 between Heritage Oaks Bank and Joe Carnevali, filed with the SEC in the Company’s 10-QSB reported for March 31, 2002.

 

 

 

(10.27)

 

Executive Salary Continuation Agreement dated February 1, 2002 between Heritage Oaks Bank and Donna Breuer, filed with the SEC in the Company’s 10-QSB reported for March 31, 2002.

 

 

 

(10.28)

 

Executive Salary Continuation Agreement dated February 1, 2002 between Heritage Oaks Bank and Chris Sands, filed with the SEC in the Company’s 10-QSB reported for March 31, 2002.

 

 

 

(10.29)

 

Money Access Services Processing Agreement for ATM processing, signed on October 3, 2002, filed with the SEC in the Company’s 10-QSB reported for September 30, 2002.

 

 

 

(10.30)

 

The Company Employee Stock Ownership Plan, Summary Plan Description, filed with the SEC in the Company’s 10-KSB reported for December 31, 2002.

 

 

 

(10.31)

 

The Company Employee Stock Ownership Plan, Summary of Material Modifications to the Summary Plan Description dated July 2002, filed with the SEC in the Company’s 10-KSB reported for December 31, 2002.

 

 

 

(10.32)

 

A Construction Agreement dated February 12, 2003 between Heritage Oaks Bank and HBE Financial Facilities, a Division of HBE Corporation, filed with the SEC in the Company’s 10-QSB for March 31, 2003.

 

 

 

(10.33)

 

Executive Salary Continuation Agreement dated July 1, 2003 between Heritage Oaks Bank and Mark Stasinis, filed with the SEC in the Company’s 10-QSB reported for June 30, 2003.

 

 

 

(10.34)

 

Executive Salary Continuation Agreement dated July 1, 2003 between Heritage Oaks Bank and Kelley Stolz, filed with the SEC in the Company’s 10-QSB reported for June 30, 2003.

 

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Table of Contents

 

(10.35)

 

Executive Salary Continuation Agreement dated July 1, 2003 between Heritage Oaks Bank and Paul Deline, filed with the SEC in the Company’s 10-QSB reported for June 30, 2003.

 

 

 

(10.36)

 

Executive Salary Continuation Agreement dated July 1, 2003 between Heritage Oaks Bank and Mitch Massey, filed with the SEC in the Company’s 10-QSB reported for June 30, 2003.

 

 

 

(10.38)

 

Promissory Note executed on October 3, 2003 for $3.5 million with Pacific Coast Bankers Bank, filed with the SEC in the Company’s 10-QSB reported for September 30, 2003.

 

 

 

(10.39)

 

Employment Agreement with Lawrence P. Ward, President and Chief Executive Officer of Heritage Oaks Bank, dated February 1, 2004 and filed with the SEC in the Company’s 10-KSB reported for December 31, 2003.

 

 

 

(10.41)

 

Fifth Amendment to Service Bureau Processing Agreement dated June 19, 2004 between Fidelity Information Services, Inc. and Heritage Oaks Bank, filed with the SEC in the Company’s 10QSB for June 30, 2004.

 

 

 

(10.43)

 

Form of Change in Control Agreements.

 

 

 

(10.44)

 

Consent Order between Heritage Oaks Bank and the Federal Deposit Insurance Corporation, filed with the SEC on Form 8-K on March 10, 2010.

 

 

 

(10.45)

 

Consent Order between Heritage Oaks Bank and the California Department of Financial Institutions, filed with the SEC on Form 8-K on March 10, 2010.

 

 

 

(10.46)

 

Securities Purchase Agreement, filed with the SEC on Form 8-K on March 10, 2010.

 

 

 

(10.47)

 

Registration Rights Agreement, filed with the SEC on Form 8-K on March 10, 2010.

 

 

 

(10.48)

 

Written Agreement by and between Heritage Oaks Bancorp and Federal Reserve Bank of San Francisco, filed with the SEC on Form 8-K on March 8, 2010.

 

 

 

(10.49)

 

Securities Purchase Agreement, filed with the SEC on Form 8-K on March 23, 2009.

 

 

 

(14)

 

Code of Ethics, filed with the SEC in the Company’s 10-KSB for the year ended December 31, 2003.

 

 

 

(21)

 

Subsidiaries of the Company. Heritage Oaks Bank is the only financial subsidiaries of the Company.

 

 

 

(23)

 

Consent of Independent Registered Accounting Firm**

 

 

 

(31.1)

 

Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002**

 

 

 

(31.2)

 

Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002**

 

 

 

(32.1)

 

Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002**

 

 

 

(32.2)

 

Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002**

 

 

 

(99.1)

 

Certification of Principal Executive Officer pursuant to 31 CFR § 30.15**

 

 

 

(99.2)

 

Certification of Principal Financial Officer pursuant to 31 CFR § 30.15**

 

 

 

 

 

 

**Filed herewith.

 

113